All aboard the Tax Reform express! We are hearing quite a bit concerning tax reform, tax cuts, tax brackets and SALT (we explain this later). This appears to be the last big push for the Trump administration to get a victory in 2017. Some folks believe that there is a chance this reform could get done before the year end. Hey, Reagan did it, right? Oh, by the way, Reagan’s reform was accomplished with the help of a key Democratic senator, Ted Kennedy, and let’s not forget the small, often overlooked fact that Reagan won 49 states in his re-election campaign (come on, Minnesota!) While we are not political analysts, we are pretty sure that the current political environment is not as favorable for President Trump. If you need some evidence, just look at the recent war of words between our own Republican Senator from Tennessee, Bob Corker, and President Trump.
One of the key sticking points of the tax-reform debate—highlighted by Senator Corker—is whether the proposal increases the budget deficit (which would be labelled a “tax cut”) or is deficit neutral, meaning every dollar of tax cut is offset with a dollar of spending cut, so the budget deficit stays the same (which would earn the more acceptable label of “tax reform”). Moving from tax cut to tax reform is where SALT comes in. Currently, tax payers can reduce their federal taxes by the amount of state and local taxes (or SALT) they owe. Eliminating this deduction is one way to maintain a deficit neutral approach. In the Southeastern portion of Tennessee alone, roughly 20% of all tax filers claim the SALT deduction. 90% of those filers are households making less than $200,000 per year. Eliminating the SALT deduction, as proposed in one version of the White House’s tax reform, may very-well increase taxes on the middle class. Ouch, “tax reform” doesn’t sound so pleasant anymore, and as you can see, this can be as “politically” complicated as health care reform.
Then what is going on with stocks? Isn’t all the recent positive activity in the market based on expectations for tax reform? Maybe not. We believe that current market conditions have discounted much if not all policy reforms for the remainder of 2017. If it’s not tax reform driving the market, then what is? The continuing story of global growth is the dominant market driver (see our August “Notes”). The recent catastrophic weather has depressed the most recent jobs data, but it is not missed on economists that new manufacturing and housing developments are needed to replace / rebuild the estimated 100,000 homes and 500,000 autos damaged by Harvey alone. The US economy appears to be strong enough to handle the political discourse and economic data so much so that Janet Yellen and the Federal Reserve are widely expected to increase short term rates another 0.25% during their upcoming December meeting. It is this vote of confidence from the Fed, not the idea of lower taxes, that continues to push stock markets to new highs.
When will the good times end? What could derail the global stock market rally? We believe that the primary culprit would be a large and unexpected uptick in inflation. With unemployment in the low 4% range, history tells us that wages should be experiencing pressure to rise, giving us inflation. While such pressures are not yet visible, we should note that this is what the Fed wants to happen, only they want it to occur gradually and not be a surprise to anyone. We believe that the current mix of employment, sentiment, and growth favors the equity market. While market corrections are possible, we do not anticipate a recession anytime soon. It is common to measure bull markets by their length, but they do not end because they’ve reached a certain age. Another popular recession indicator is when short-term interest rates are higher than comparable long-term rates, ie. when the yield curve is inverted. Looking at the current yield curve, it seems the Fed can raise rates several more times before the curve inverts (and that’s assuming that long-term rates don’t move up as well, which they often do).
If any tax reform is passed, we will be paying attention to its potential impact on inflation and interest rates. In the meantime, we continue to stay the course with our portfolios. So, sit back and enjoy the slow, steady train ride that we believe should carry us through the final quarter of 2017.