What Happened After the 1986 Tax Reform?

One way to get a handle on the likely course of the markets next year is to see what happened after the 1986 tax reform legislation, the previous effort to reform the tax code before this year's.  This past episode suggests stocks have more room to climb over the next few months while Treasury yields risk jumping above 3% this Spring.   Such a scenario would fit with the one I outlined in my October 29 blog.  But, the 1986-87 market behavior suggests there could be abrupt shifts in the market, which will probably be difficult to predict.

The earlier tax reform legislation passed in October 1986.  It may have helped to boost economic growth from an already strong pace.  Real GDP Growth sped up to 4.5% in 1987 from 3.0% in 1986.  Inflation also sped up, with the Core CPI rising to 4.2% in 1987 from 3.8% in 1986.

In 1986-87, the S&P 500 Index rallied by 14.2% over the 4 months following the tax reform law (see table below).  However, the rally had followed a wobbly market over the prior 4 months, in which there was a 2.8% pt cumulative decline.  Some of the post-law rally may have been catch-up.
The current situation has a different start.  Stocks rallied a cumulative 5.5% over the 4 months prior to the 2017 legislation.  So, there should be less of a catch-up now than in 1986-87.  Nevertheless, net of the market behavior prior to the tax law, stocks still have room to climb another 10% through April if they are to be consistent with the post-1986 experience.  To be sure, such a gain is unlikely now, given the very high price-earnings ratio for the S&P 500.  The P/E Ratio was high relative to the prior few years in 1986-87, as well, but not as high as now.

In the earlier episode, the 10-year Treasury yield fell 37 BPs after the legislation was signed, having backed up 28 BPs in anticipation of the bill.  The decline in yield proved temporary, however, with a massive sell-off in the 4th month after the legislation went into effect.

Currently, Treasuries sold off only at the end of the month when it was certain that the legislation would pass.  This sell-off also could unwind before resuming, as in 1986-87.  But, the unwinding would likely be smaller than in 1986-87, inasmuch as the prior backup in yield was smaller to begin with.

The run-up in yields, along with a market focus on the Trade Deficit and weaker dollar, eventually resulted in the stock market crash of October 1987.  This history suggests that significant downside risk to the stock market could develop in the second half of 2018.  Moreover, rather than a wider Federal Deficit being the big problem facing the markets, a wider Trade Deficit (and consequently  a weaker dollar) could be the main perceived problem as the tax-related boost to spending results in a surge in imports.
 
      Month                      S&P 500                     10-Year Treasury Yield
                                  (m/m % change)          (level, percent, monthly avg) 
                                  1986-87       2017                   1986-87       2017
       t-3                       -2.1             -0.1                     7.30              2.35
       t-2                        2.0              1.9                      7.17              2.36
       t-1                       -2.7              2.3                     7.45               2.20
       t                           0.0              1.4                      7.43               2.39
       t+1                       3.2                                        7.25
       t+2                       1.4                                        7.11
       t+3                       6.4                                        7.08
       t+4                       6.2                                        8.02
       t+5                      -0.8                                        8.61
       t+6                       0.7                                        8.40    
     
t = month tax legislation was passed

Macro Background Positive for Stocks: Q417 Corporate Profits Next

The macroeconomic and policy backgrounds are now very positive for the stock market.  As a result, stocks should continue to rally into February.  Even if there is some profit taking after the tax cut is passed and signed into law, the pullback should be short-lived thanks to the other positive fundamentals.  Treasuries are likely to remain range bound, as yields are held down by low inflation.

The economy is strong.  The Atlanta and NY Fed models now project 3.3-4.0% for Q417 Real GDP Growth, and the NY Fed model's early call is 3.2% for Q118 GDP.  The weather is a big unknown for Q118.  But, if GDP is held down by bad winter weather, it should rebound in the Spring.

Fiscal and monetary policy are pro-growth.  On the fiscal side, the tax cut should boost the bottom line of corporations, if not the economy, next year.  On the monetary side, the Fed is sticking to a gradual pace of rate hikes for 2018, despite having lifted its economic growth forecast for 2018.  The next potential Fed rate hike is not until the March FOMC meeting.

The next round of corporate earnings reports, for Q417 and mostly due in January-February, is expected to be strong.  Consensus looks for a +10.6% y/y increase in Q417 S&P 500 earnings, up from 8.6% in Q317.  Indeed, the macro evidence points to good corporate profits.   The weaker dollar and solid foreign economic growth should help the bottom line of corporations with earnings abroad.  The oil sector should continue to be boosted by higher oil prices.  Overall price and wage inflation do not suggest any significant reduction in profit margins.   The only apparent drawback is a difficult comparison with profits in Q416, as the latter were strong according to the GDP measure of corporate profits.  That is, the y/y comparison should be more difficult for Q417 than it was for Q317.   

                                                                                                                                          Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q316            1.5                 -3.4                    2.2                              2.6          2.2
Q416            1.8               +16.4                   3.9                              2.7          2.2
Q117            2.0                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.2                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.6-2.9           +5.0                 -4.1                              2.4           1.6               57.2

December FOMC Meeting: A Negative for Treasuries and Stocks?

Wednesday's FOMC Meeting risks being a negative for Treasuries and, to a lesser extent, stocks.  Although a 25 BP rate hike is fully expected, the risk is that the Fed will shift up its expectations for the funds rate in 2018 -- the "dots."  The median expectation for the funds rate could shift up to 4-5 hikes from 3. 

A shifting up of the dots would be in response to a higher central tendency for Real GDP Growth in 2018. The latter conceivably could move up to 2.5-2.8% from 2.0-2.3%, as these forecasts build in the boost from a tax cut and take account of better-than-expected underlying momentum in the economy.  The Central Tendency for the Unemployment Rate will likely be lowered, as well.  The inflation outlook should be unchanged, but if anything could be raised in response to the higher growth forecasts.  The stronger growth expectations should mitigate the impact of higher rate expectations on the stock market.  Stocks also could be helped by movements in the Congressional conference committee to eliminate some of the anti-growth elements of the Senate bill, such as the AMT.

                                        Fed's Central Tendencies From September FOMC Meeting
                                                        2017                2018
Real GDP                                       2.2-2.5             2.0-2.3                               
Unemployment Rate                      4.2-4.3             4.0-4.2
PCE Deflator                                 1.5-1.6              1.8-2.0
Core PCE Deflator                        1.5-1.6              1.8-2.0

The economy's strong momentum is showing up in several indicators.  Both Initial and Continuing Claims fell below the November average in the latest week (table below).  The ECRI Leading Index has moved up to new highs in the past 3 weeks (chart below).   And, the NY Fed model's very early projection for Q118 Real GDP Growth is 3.1% after a projection of 3.9% in Q417.   

                                       Unemployment Claims (level)
                                  Initial                             Continuing
Oct Avg                      232k                                1.893 Mn
Nov Avg                     242                                  1.913
Latest Week                236                                  1.908


ECRI Leading Index (level)

November Employment Report Shows Strong Labor Market But Little Inflationary Pressures

The November Employment Report is a positive for stocks and a modest negative for Treasuries, as it  showed widespread strength in job creation but little inflationary signs.  The report should keep the Fed on course for a 25 BP rate hike next Wednesday and further gradual tightening in 2018.

The +228k m/m increase in November Payrolls was well above the +169k m/m average over the first 10 months of 2017.  Some of the strength could be a further rebound from the hurricanes in September.  But, some was also reflective of the underlying strength of the economy.   In particular, manufacturing jobs in the capital goods industries rose smartly.  Even retailers added jobs, despite the shift to shopping on the internet.  Besides the job gains, the Average Workweek rose, also signaling strength.

The labor market strength at this point takes some of the wind out of the strong productivity story.   Total Hours Worked are up about 2.5% (q/q, saar) so far in Q417.  Combined with the q/q surge in self-employed, it points to about 3.5% (q/q, saar) in the aggregate hours figure used to calculate productivity growth.   Unless forecasts of Q417 Real GDP Growth move higher than the  3.5-3.9% current range, Productivity Growth should be a modest 0.5% this quarter -- a slowdown from the pace of the prior two quarters.  It is too soon to say that Q417 GDP estimates will not climb higher, however.

There is little evidence of inflationary pressures in the November Employment Report.  Wage inflation is benign.  Average Hourly Earnings rose only 0.2% m/m, with the y/y edging up to 2.5% from 2.4% and staying below the 2.7% Q317 average.  The Unemployment Rate edged up to 4.11% from 4.07% in October.  (Both rounded to 4.1% in the headlines.)  The broadest measure of unemployment, U-6, rose to 8.0% from 7.9% in October, but remained below the 8.5% Q317 average. 

Washington Developments, the Tax Bills and the November Employment Report

Developments in Washington are likely to keep markets on edge this week, but stock-market positive outcomes are likely.   Besides potential for headline shock from the Russian inquiry and presumably the start of a House/Senate conference committee to reconcile the two versions of the tax bill, Congress must pass a Continuing Resolution to keep the government running past December 8.   The uncertainty of a Resolution could run to the deadline, which coincides with release of the November Employment Report.  The latter should not detract from the strong-growth story, but risks having Payrolls and Unemployment Rate come in softer than consensus.  Average Hourly Earnings risks being high.

The November Employment Report could be positive for both stocks and Treasuries, as it should attest to the economy's strength but risks a smaller-than-consensus Payroll print and higher-than-consensus Unemployment Rate.  Consensus is +198k m/m Payrolls (well above the +169k average so far this year) and a steady 4.1% Unemployment Rate.  Downside risk to Payrolls stems from the possibility of fewer-than-normal holiday workers having been hired by retailers this year as a result of the shift to on-line shopping.  The Unemployment Rate risks edging up, after an unusual drop in the Participation Rate (possibly hurricane related) pushed it down in October.  The consensus estimate of a high 0.3% m/m Average Hourly Earnings cannot be ruled out, however.   While calendar considerations are agnostic between 0.1% and 0.2% m/m, a drop  in low-paid holiday workers would add to AHE for composition reasons.   The y/y would climb to 2.7% -- near its recent high -- from 2.4% in October, if the m/m turns out to be 0.3%.

The markets' main focus on a reconciled tax bill probably will be whether the corporate tax cut is delayed to 2019 or not.   A delay would be viewed as mitigating the economic boost in 2018.  While this view would be a negative for stocks and a positive for Treasuries, the reality may be that a delay does not matter in terms of the economic impact.  Since business investment decisions are longer-term, a one-year delay may not significantly impact them.   Moreover, a delay would lower the odds of an aggressive Fed next year.

Even if the corporate tax cut is not delayed, critics of the bill argue that it will have little impact on the economy.   Model simulations show only a small lift to GDP growth.  Critics, such as Larry Summers, go further and say that a lower corporate tax rate would raise the "user cost of capital" for investments financed with debt -- making it costlier for businesses to invest. 

These complaints, however, may not be the full story.  The standard model of business equipment spending is based on expectations of demand for output pitted against the cost of capital.   The cost of capital is well specified.  But, econometric models, such as those used at the Fed and CBO, do not represent expectations well.  In particular, they do not incorporate shifts in "animal spirits," an imprecise term that essentially means the degree of aggressiveness in business decision making.  Conceivably, the current tax bills have boosted animal spirits.   Evidence for the latter is that equipment spending has been rising this year, perhaps in anticipation of lower tax rates, after falling in 2016.   Also, measures of business confidence have shot up since last year's presidential election.

The tax bills' critics would likely say that relying on a boost in animal spirits is "voodoo" economics.  And, since these spirits are not measurable,  they have a point.  But, Keynes thought they were important when he wrote his General Theory in the 1930s.   Moreover, the standard models likely did not predict the economy's strength so far this year -- missing out on some factor (animal spirits?) that was at work. 

The Atlanta Fed and NY Fed models say that the strong 3+% growth is continuing in Q417 -- they are currently estimating 3.5-3.9%, versus 3.3% in Q317.   (These models predict the current quarter based on known data and are not the same kind of model used to predict the future impact of a tax cut.)  A 3+% GDP for Q417 would almost certainly show strong productivity growth, the 3rd consecutive quarter to do so.  It is far from certain that trend productivity growth has ratcheted up, and the standard models used to predict the impact of a tax cut assume it has not.  But, a ratcheting up of trend productivity growth would mitigate the longer-run problems of the Federal deficit, Social Security, Medicare, etc.

It is too soon to say whether the proponents of the bills or their critics are right with regard to the economic impact.  It is fair to say, however, that the proponents may be ignoring the cost of capital, while the critics are ignoring the bills' potential impact on demand expectations or animal spirits.  Both sides' arguments should be viewed cautiously.

Nonetheless, with a tax cut bill passed by both Houses, the stock market impact of headlines from the Russian inquiry may be much more modest than what happened on Friday.  Besides Friday's plunge having been precipitated by "fake news" on ABC (subsequently retracted), other information coming out with regard to the Russian connection so far does not seem incriminating.  Even if the Administration is "handcuffed" by further revelations, Trump's wish list of additional government projects, such as the Mexican Wall, contains few, if any, with broad economic implications.  So, there would be little loss from a market perspective if they were stymied by the Russian inquiry.