We’re About To Go Off The Central Bank Cliff

Tax Bill Debate Is Heated

Like it or not, the tax plan is still dominating the headlines. It’s arguably more important to figure out what will be in the bill than determining whether it will pass. There is heated rhetoric coming from the House. For example, conservative Representative Kevin Brady said, “I think that both the individual and the corporate AMT — it's costly, it's complex — really on the business side, undermines many of the pro-growth and pro-American provisions in the tax code." As you can tell, he’s angry with the Senate’s plan because it includes an alternative minimum tax. The AMT is important because the provision raises over $300 billion which means the GOP will need to take the Senate bill to conference instead of just having the House pass it. The over $300 billion comes from repealing the R&D credit which is $113 billion and the participation exemption which is $216 billion. The participation exemption is an exemption from taxation for a shareholder in a company on dividends received and potential capital gains from sold shares.

It makes sense that the House would be angry because they are going to need to give in to the Senate’s demands. The Senate bill is close to what we have now, so it’s not surprising to see them unhappy. As you can see from the table below, the Senate bill starts cutting corporate tax rates in 2019 which is one year after the House bill. Moving it back makes sense to because the economy is doing well now. It might start to falter in 2019, meaning the tax cut could act as a stimulus. That’s not the reason the Senate has that in the plan; it’s more about managing the deficit increase. One bright side of the Senate plan is the individual tax cuts expire after 2025. The key credit expires in 2022 for the House bill. It would be great if all the benefits from each plan were combined, but that wouldn’t be fiscally responsible. I think the market has a good understanding of what the final plan will be. That might not be so great because the market sold off throughout yesterday and had a poor performance on Tuesday. The S&P 500 was down 0.37%. It was down for the 3rd straight day which is the longest losing streak since August.

Jeffrey Gundlach Talks QE Unwind

In a presentation for DoubleLine, Jeffrey Gundlach claimed the slide below was the most important of the deck. As you can see, it shows the central bank balance sheet cliff that we are about to go over. I’ve been discussing this topic for some time now as it has been clear for a while that the ECB would be ending its bond buying program in 2018. Part of the reason why the BOJ can’t keep going with its bond and stock buying is because it is running out of securities to buy. I’ve seen projections with it increasing and ones like the one below which shows it decreasing.

As you can see, the central bank expansions have been correlated with investment grade bonds and the MSCI World market. I wouldn’t be surprised to see the correlation end because the emerging markets are looking strong and America will possibly be getting a tax cut which will boost the economy. I’m not saying there will be no effect; I’m just not expecting a crash like the slide below indicates. I don’t even think it’s the most important aspect driving the market. I think inflation is the most important factor. I’ve moderately changed my tune on the effect of balance sheet expansions after the Fed’s announcement on its unwind didn’t cause stocks to fall.

Economic Growth To Turn On The Jets In Q4

Most of the economic forecasts show GDP growth in Q4 will be the best of the year. The chart below shows the quarter over quarter annualized GDP growth adjusted for inventory changes and trade along with the manufacturing and services ISM which are weighted 1/3rd and 2/3rds respectively to account for their weight in the economy. As you can see, qualitative data points imply GDP growth will be 3.5% in Q4. This means we are in the strongest part of the year which is the strongest year of this expansion. It’s important to recognize how quickly things can change because last year was the weakest year of the expansion.

Global Growth Expectations The Best Since 2011

As I mentioned, the economy can change quickly. That doesn’t stop economists from taking the current trends and extrapolating them into the future. It’s tough to make predictions; don’t give in to recency bias. Next year might not continue this momentum. It’s amazing to see how close Goldman, Barclay’s, UBS, JP Morgan, Morgan Stanley, and SocGen are with their global GDP predictions. I’m not saying 2018 won’t be a good year. I’m just saying that you shouldn’t be fooled into thinking it’s a lock because of how closely clustered the estimates are. A lot of the GDP growth will depend on India which was in the doghouse this year. It’s ironic that the economists are putting growth on the path it has been on while relying on one of the countries which didn’t have a great year. India was hurt by the demonetization efforts. Hopefully it can use its favorable demographics to get GDP growth above 7% again.

Conclusion

The tax bill will continue to affect the stock market in the next 2 weeks as the path of the bill is uncertain; its contents are still up for grabs. Even though the S&P 500 is on a 3 day losing streak, it is still within 1% of its all-time high. I will be very surprised if there is a 3% correction by the end of the year. The last few trading days have had a lot of volume, but that will quickly dry up as holiday trading usually is sparse.

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