I (re)heard a good trading quote the other day… “Ever wonder why fund managers can’t beat the S&P 500? ‘Cause they’re sheep — and the sheep get slaughtered.” The line is by Gordon Gekko, from the movie Wall Street. I didn’t realize when I first saw the movie decades ago that sheep are followers. I just thought Gekko was saying other fund managers were meek. And now you know why I was not a literature major (or a farmer). In any event, it’s perfectly fine to be a sheep – you just need to know when to get out. It feels like the herd consensus positioning is to be short the reds and long the golds. This makes some sense in a “stronger economy, with foreign QE” environment.
The number one determinant of growth next year will be the reaction of the economy to tax reform. It is widely expected that we will get net positive effects from the following fiscal stimulus next year:
- Corporate Tax Rate decline. This should be a net positive to corporate cash flow. This could improve investment, productivity, wages, etc. We have had companies like AT&T announce $1,000 bonuses to its employees, so an increase in wage pressures is possible. Sure AT&T needs to get on the administration’s good side to get their Time Warner merger approved. But a bonus is a bonus. It now makes more sense for firms on the margin to stay in the US (fewer inversions, etc). Global companies may also find US more attractive. We should get a surge in new passthrough businesses from the new tax deduction, so more money could find its way into individuals’ hands.
- Corporate Repatriation. What will companies do with the cash (also from tax savings)? Even if you think most of the money goes back to shareholders (buybacks/dividends), some of the money could leak to employees or investment.
- Tax uncertainty removed. We could get a surge in investments just from the uncertainty of the tax plan being removed.
- Instant expensing of investments. Any time you get an immediate deduction, it makes investment that much more attractive. We could have a short term investment boom, although I suppose you could argue that part of earlier investment could be pulling forward future investment.
- Individual Tax Rate decline. Most of the tax breaks go to the wealthy, but in the short term, many middle class families will get a noticeable reduction in taxes. This could boost spending.
- Infrastructure Plan. Trump did mention an infrastructure plan for January. This could lead to a surge in new projects.
That’s a lot of stimulus. So a monkey (or sheep) could look at the above and say the above will be on net good for the economy – at least in the short term. Most of the benefits are going to businesses, which can have wider benefits. The key question is, to what extent are the stimulative benefits of the above already priced into the current markets?
Considering how positive most economists seem and how short the market sentiment seems to be with fixed income, the baseline view seems to be for solid “above average” growth. That’s reasonable. But I always want to do a “sheep-check.” My limited sample of economists seems to indicate between 3-4 hikes next year. The Fed thinks about 3 hikes next year. It seems like the markets want to be bearish rates. So why are the markets only pricing in 2 hikes next year? When something does not compute, we either: (1) have insane value on the curve, or (2) we may be missing something when everyone has on the same trade (sheep alert). Captain Obvious will be looking for signs next week to see which of the two scenarios we may be looking at. In particular, I want to see whether the curve flattening the past two weeks was window dressing for year-end balance sheets, or a real move. Stay tuned.
Another one of my favorite movies from the last millennium was My Cousin Vinny. I like looking at the evidence and poking some holes. Sometimes, nothing comes out of it. But it can’t hurt to go over some tail scenarios.
- Health care mandate fines eliminated. The CBO estimates that 13million more would be uninsured after 10 years. I would think this could mean fewer jobs somewhere down the line. Do you need as many people in billing, pharmaceutical, or most other medical fields? It seems to me hiring in healthcare increased after Obamacare. If a part of Obamacare is taken back, do we still need all those people on the payroll? Combined with all the healthcare mergers, it’s possible we could get mass layoffs in an area of the economy that has had strong hiring during the recovery.
- International repercussions. There were some global ramifications to the tax changes. How are other countries, and entities like the WTO going to react? Countries usually don’t sit idly by when offshore tax policies negatively affect their competitive position.
- Hit to high tax states. We are probably 5-10 years away from some states starting to turn into Puerto Rico. For example, the SALT deduction and real estate tax caps are probably going to speed Illinois into some kind of default/bankruptcy. Having many of your major cities (New York, LA, Chicago, etc) and states in fiscal distress can’t be good. We may also get some large government layoffs to make ends meet.
- Could cause major hit to real estate markets – especially in high tax states. It was one thing paying $2 million for a 1200 sq ft apartment in NYC, when you could deduct your SALT, mortgage interest and property taxes from your Federal taxes. With significantly reduced deductions, that’s makes the calculation even worse. If you do a discounted cash flow analysis using theoretical cash flow (rent), and subtract the costs, the real estate value is severely negative. The only reason to take out large loans to buy overpriced housing in these markets was if you thought real estate prices would keep going higher. Why does this sound familiar?
- We may have had a pull-forward of housing sales, to get grandfathered into higher deductions. Housing sales were strong at the end of the year. Anyone thinking about a larger mortgage had an incentive to buy quickly to get grandfathered into higher deductions. We’ll get an idea of the true path of housing sales next month. Any noticeable housing slowdown could affect construction jobs.
- Limited interested deductibility. This could result in reduced bond issuance. Along with possibly lower mortgage activity (and volumes from deductibility caps), we could see fewer spread products (corporates and mortgages) on the margin. This may be partially responsible for flattening the ED curve last month.
- Investment boom could be temporary. Immediate depreciation may just be a pulling-forward of activity.
- What kind of loopholes will people find? An obvious example would be an increase in the number of passthrough entities (subcontracting), because of the new deduction. Why be salaried and pay more individual tax? There may be ways to deduct SALT and mortgage interest, if you are some kind of business, rather than an individual. There could also be unforeseen negative impacts. I’m not sure the exact details have been written for most of the tax reform. And even if they were, I am no tax attorney. But I do know there will be unanticipated consequences from this hasty piece of legislation.
What will the net effect of the fiscal stimulus be from all of the above factors? This is the big question in my mind for Q1. I’m guessing the equity markets have been forward-looking and are positioned optimistically. The surge in equities the past year may be just be all of the positives above. What happens after the expected “windfall” earnings reports and investment headlines next quarter? We are at a major crossroad in the direction of the economy in the first half of next year. We need to keep an open mind and not be sheep to existing narratives.