WHY THE ELEPHANT IN THE ROOM IS THE FED’S MONETARY POLICY
No proof of fiscal changes’ big influence on economy,
One would think, based on market reaction and media hype, that the version of U.S. tax reform just passed into law is a major gamebreaker for the cycle.
There certainly are fiscal stimuli that are somewhat effective when undertaken early in the cycle — where there is pent-up demand ready to be unleashed, but facing blockades for whatever reason. But the key to success is for fiscal and monetary policies to work in tandem, not at odds with each other. Only when fiscal stimulus is being accommodated by U.S. Federal Reserve policy is it truly effective in bolstering aggregate demand.
There are aspects of the tax bill that are appealing, but the areas of it that attempt to bolster demand — via incrementally higher fiscal deficits — are damaging insofar as they elicit a more aggressive tightening in Fed policy.
As an aside, we also have the most inexperienced Fed in three decades and a rotation among Federal Open Market Committee voters, which ensures a more hawkish bias in 2018.
There is also absolutely no historical evidence of fiscal policy changes triggering economic recoveries or recessions on their own.
Monetary policy has a far more powerful influence on the business and market cycle because the Fed, through its control over the monetary base, has the power to determine liquidity growth. And it is shifts in liquidity, not taxation or public spending, that exert the greatest effects on bull and bear markets, as well as on economic expansions and contractions.
This isn’t just a case of the yield curve now being only two more rate hikes shy of being inverted, with the usual legions of economists typically explaining this away as they did in 2000 and again in 2007. Go back and count the number of economists who helped keep you out of danger near the peak of the last cycle — you won’t need many fingers.
No, this is a case of dollars of monetary restraint against dollars of fiscal stimulus. Rates aside, the Fed is poised to unwind its bloated balance sheet by US$420 billion in 2018 (and a further US$600 billion in 2019). Most expect the tax cuts to add US$140 billion to economywide earnings in 2018, and just US$80 billion in extra nominal GDP gains. The expiry date and regressivity of the personal cuts will render them ineffective, all the more so with a depleted subthree-per-cent savings rate that is in need of a rebuild.
Corporate America is sitting on an epic US$2.4 trillion of liquid assets on their balance sheets, even before the passage of the tax bill, so it is an open question as to what marginal impact the business tax cuts will have. But with that liquidity level, how could it ever be claimed that the business sector needs any extra incentive to open the spending taps?
The expected incremental gains to nominal GDP and economywide profits have to be weighed against a US$420-billion withdrawal of monetary support due to the Fed’s quantitative tightening next year. If the Fed only raises rates twice, that’s an additional US$100-billion drag on nominal GDP next year.
At the margin, the Fed tightening in 2018 will have more than six times the impact on the economy than the fiscal loosening, and three times the impact on corporate profits.
The impact of this liquidity withdrawal on equity markets will be most evident in a shrinking P/E multiple, which will offset whatever earnings growth we see, leaving the S&P 500 flat on the year, though peppered with a lot more volatility (and more attractive reentry points) along the way.
Don’t be knocked around next year by focusing on the wrong thing. The elephant in the room in 2018 is Fed policy, not fiscal policy.