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.
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