Friday, April 28, 2017
The Economy: "Markets Are Priced for Perfection"
"Markets Are Priced for Perfection"
By Jim Rickards
"Yesterday was a turning point in the "Trump Trade" euphoria. We saw the eagerly awaited unveiling of the actual Trump tax plan, the one markets have been rallying on since November. I’ll get to the details in a moment. But let’s first look at how the euphoria started...
Immediately after the election on Nov. 8, the market took a look at Trump's policies and liked what they saw. Trump promised lower taxes, less regulation and fiscal stimulus. Companies with domestic earnings rallied because lower taxes meant higher after-tax earnings and more stock buybacks. Equipment companies rallied on expected infrastructure spending. Banks rallied on the prospect of repealing Dodd-Frank and higher net interest margins. Pharmaceutical stocks rallied on Obamacare repeal. Defense stocks rallied on more defense spending. Everything rallied! There was nothing not to like.
The problem is that none of the numbers added up and the market rally ignored congressional realities. The U.S. is $20 trillion in debt with the highest debt-to-GDP ratio since World War II. Another $1 trillion of infrastructure spending was never in the cards. Any tax cuts have to be "revenue neutral," which means cuts have to be "paid for" with tax increases or lost deductions somewhere else. That's just moving the tax burden around, not really cutting it overall - so there is no net stimulus.
Obamacare repeal was one of Trump's first big failures. It may happen yet, since the hawkish House Freedom Caucus and the moderate House “Tuesday Group” of Republicans may have now reached a compromise bill each can support. But the path forward is uncertain, and it’s not clear there’s yet enough support for House approval, let alone the Senate. But health care reform’s initial failure taught the market that there's a huge gap between what the president says and what actually happens in Congress.
Now back to yesterday’s tax plan... It was a big nothingburger, almost embarrassing. The market promptly traded down. The Trump tax plan does not have nearly enough in the way of revenue raisers to pay for rate cuts from 39% to 33% on individuals or the more extreme cut from 35% to 15% on corporations.
Elimination of deductions for state taxes is certain to generate opposition from governors and legislators from high-tax states like California and New York. I don’t want to wade too deeply into the weeds, but expensing of equipment purchases was left out of the package entirely. There was an absence of detail and no clear path to congressional approval. It was not even a well-thought-out bargaining position. The "plan" looked more like a press release designed to dress up the "first 100 days" website than anything of substance.
It gets worse. Independent of the pros and cons of specific policies, the Trump proposal has created a huge amount of uncertainty about when and how rates will be cut. Humans respond predictably to such uncertainty. Again, I don’t want to get into too much detail here, but if rates will be lower next year, why not push your income back to 2018 if you can? If rates are higher this year, why not pull your expenses forward if you can? If capital expenditures can be expensed next year but not this year, why not wait until next year to make a capital expenditure? And so on.
You may or may not think too much about these things, depending on your circumstances, but these are the questions that businesses have to deal with. In short, the tax uncertainty could kill the economy this year. Add to that the prospect of a Fed rate hike in June and existing signs of weakness and we may be in a recession by this summer. The stock market has not priced in any of these eventualities. Now reality is beginning to sink in for stocks.
Below, I show you why the markets are “priced for perfection” and why they’re going to be sorely disappointed by what’s coming next. Read on.
Trump unveiled his tax plan Wednesday. Part of his agenda calls for a reduction of the corporate tax rate from 35% to 15%. It’s unclear at this moment what the final result will be after all the negotiations and political horse trading that will inevitably take place. It’s very likely Trump planned to enter negotiations at 15%, fully expecting a compromise bill resulting in a demonstrably higher rate. It’s the art of the deal. But it doesn’t seem particularly well thought out.
It’s difficult to project the impact the tax cuts will have on the economy, of course. But without offsetting spending reductions or making up the revenue somewhere else, a tax cut could balloon the deficit. Estimates vary, but a 15% tax rate without offsets could cost the government trillions of dollars in lost tax revenues over the next decade. But Trump advisors believe they can avoid a debt crisis through higher than average growth. This is mathematically possible but extremely unlikely.
The Trump team hopes for nominal deficits of about 3% of gross domestic product (GDP) and nominal GDP growth of about 6%, consisting of 4% real growth and 2% inflation. If that happens, the debt-to-GDP ratio will decline and a crisis might be averted.
Again, this outcome is extremely unlikely. Deficits are already over 3% of GDP and are projected by the Congressional Budget Office (CBO) to go higher. CBO estimates that both inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year, not the 6% the Trump team envisions.
The debt-to-GDP ratio is projected to soar even under the Trump team’s rosy scenarios. CBO projections show that deficits will increase to 5% of GDP in the years ahead, substantially higher than the hoped for 3% in the Trump team formula. Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.
Why is that important? Because retiring Baby Boomers will soon be making large demands on social security, Medicare, Medicaid, Disability payments, Veterans benefits and other programs that will drive deficits higher.
But there are numerous problems even with the CBO projections. They make no allowance for a recession in the next ten years. That is highly unrealistic considering that the current expansion is already one of the longest in history. A recession will demolish the growth projections and blow-up the deficits at the same time.
CBO also makes no allowance for substantially higher interest rates. With $20 trillion in debt, most of it short-term, a 2% increase in interest rates would quickly add $400 billion per year to the deficit in the form of increased interest expense in addition to any currently project spending.
Finally, CBO fails to consider the ground-breaking research of Kenneth Rogoff and Carmen Reinhart on the impact of debt on growth. I have discussed the 60% debt ratio danger threshold before. But there is an even more dangerous threshold of 90% debt-to-GDP revealed in the Rogoff-Reinhart research. At that 90% level, debt itself causes reduced confidence in growth prospects - partly due to fear of higher taxes or inflation - which results in a material decline in growth relative to long-term trends. Meanwhile, the U.S. debt-to-GDP ratio is currently at 105%, and heading higher. Under any standard, the U.S. is at the point where more debt produces less growth rather than more.
There’s almost no way Trump’s tax cutting or infrastructure policies can supply the stimulus the market is pricing in. As for growth, we are now in the eighth year of an expansion - quite long by historical standards. This does not mean a recession occurs tomorrow, but no one should be surprised if it does.
Productivity has stalled out in recent months. Economists are not sure why. It could be due to lack of investment by business, or that workers are not being trained in useful skills, or that everyone is spending too much time on social media. Whatever the cause, productivity is flat.
Fourth-quarter 2016 GDP came in at 1.9%, below expectations - the final chapter on the worst year of U.S. growth since 2011 when the economy was still healing from the global financial crisis. First-quarter 2017 growth is even slower. The Atlanta Fed estimates today that the economy grew at just 0.2% (seasonally adjusted), down from its April 18 projection of 0.5%. That’s stall speed essentially.
The strong dollar has a major headwind to growth, along with flat labor force participation and weak productivity growth. Growth in a major economy is simply the sum of increases in the labor force plus increases in productivity. Think about it. How many people are working and what is the output per worker? That’s it; that’s all there is. The reality is that the workforce is not growing.
These headwinds practically insure that the Trump growth projections are wholly unrealistic. With higher than expected deficits, and lower than projected real growth, there is one and only one way for the Trump administration to reduce the debt ratio - inflation. If inflation is allowed to rip to 4% and Fed financial repression can keep a lid on interest rates at around 2.5%, then it is possible to achieve 6% nominal growth with 5% deficits, which would be just enough to keep the debt ratio under control and even reduce it slightly.
Can Trump pull-off this finesse? Are his advisors even analyzing the problem along these lines? I have my doubts. But today’s stock market is priced for perfection. The Dow’s once again up around 21,000 - a good 12% higher than election night. Either growth will rebound based on “animal spirits” and the Trump stimulus working better than expected or markets will collapse once they realize the growth is not coming. By “collapse,” I mean a violent stock market correction, a falling dollar and major rallies in bonds and gold. I expect the latter.
Financial crises are not mainly about the business cycle. They’re about investor psychology, sudden shocks and the instability of the financial system. Right now investors have been lulled into complacency. But numerous shocks are waiting to happen and the system is highly unstable due to overleverage and nontransparency.
Despite Trump’s best efforts and positive policies, a collapse could happen any day unless radical steps are taken to prevent it - such as breaking up big banks and banning derivatives. I’ve been warning about this for a while, but now mainstream economists see the danger too. Nobel Prize winner Robert Shiller, for example, sees a stock market crash coming that could be worse than 1929 or 2000. I hope he’s wrong."