TBT Financial Services

Weekly Commentary by Dr. Scott Brown

Thrill or chill on Capitol Hill?

January 16 – 20, 2017

Since the November election, the financial markets have priced in a more friendly business environment, with growth boosted by expansionary fiscal policy. However, the White House does not have absolute power. Congress writes the laws. While the outcome is uncertain, the legislative mechanics suggest that may see little, if any, tax cuts in calendar 2017.

With Republicans controlling the White House and both chambers of Congress, many see this as their best chance for tax reform. The House Speaker Ryan’s "Better Way" plan is expected to be the general blueprint for tax reform, but there will surely be many modifications along the way.

How will tax cuts be achieved, legislatively? The House of Representatives requires a simple majority vote. The journey through the Senate is more complicated.

The first possible path is through a tax reform bill, which would require 60 votes in the Senate. While that seems unlikely, given that the Republicans have only a 52-48 majority, it is not impossible. Republicans would have to get eight or more Democratic senators on board. A compromise plan would likely have smaller tax cuts than is currently anticipated, weighted toward large corporations, not small businesses and individuals. We would expect to see some change in tax rates for overseas earnings as part of the package.

The other Senate path is through budget reconciliation, which would require a simple majority (51 votes). The Senate would pass a budget resolution with reconciliation instructions, then develop legislation that comports to those instructions. However, the Senate can do only one set of reconciliation instructions per calendar year, and this year that set of instructions will be on repealing and replacing the Affordable Care Act. The Senate could add tax reform instructions in the budget resolution this year for calendar 2018, which means that tax cuts would occur next year. Note that the Affordable Care Act was paid for partly by higher taxes, and those increases may be jettisoned in healthcare reform (although it’s unclear what sort of replacement we may see in the months ahead).

The Senate is also subject to the Byrd rule. During the reconciliation process, a piece of legislation may be blocked if it increases the federal deficit beyond a ten-year window. This explains why the Bush tax cuts were not made permanent at their inception (changes would have to sunset to make the long-term numbers work out). This led to a series of extensions, until a compromise solution was reached.

Tax simplification should be a part of tax reform, and the elimination of many deductions would be expected to offset some of the cost of reducing tax rates. Steve Mnuchin, the Treasury Secretary nominee has said that tax reform will be revenue neutral, but that seems doubtful based on the numbers proposed during the campaign.

There are a large amount of tax deductions in the current law. Also called “tax expenditures,” these deductions totaled about $1.5 trillion in 2016 (vs. total tax receipts of $3.3 trillion) or about 8% of Gross Domestic Product. Early drafts of the tax reform plan would likely call for the elimination of many deductions, with the exception of (for individuals) the mortgage deduction and charitable contributions, and (for businesses) research and development. In the past, scaling back tax breaks has been extremely difficult, so we’re unlikely to see much change as tax legislation nears its final form.

Still, even if we don’t get the amount of tax cuts that the financial markets are hoping for, reduced regulation ought to create a more business-friendly environment. The first principle of regulation and enforcement is that principals matter. That is, priorities, effort, and direction flow from those in charge. For the financial sector, we are going to see a complete change in regulatory leadership in the next year and a half.

At the Fed, Janet Yellen’s terms as chair runs to February 3, 2018. At this point, it appears unlikely that President Trump will re-nominate her. She could stay on as a Fed governor (which runs to early 2024), but that is unlikely. Stanley Fischer’s term as vice-chair runs to June 12, 2018, and he would likely leave when Yellen does (his term as governor runs to early 2022). For the last year and a half, there have been two vacancies on the Fed’s Board of Governors. The Fed has taken on a greater supervisory role since the financial crisis, but the vice-chair for regulation has remained vacant. Governor Tarullo has served in that capacity, but is expected to leave if that slot is filled. Hence, the incoming president will be able to shape the Fed’s Board of Governors to his choosing.

Following the election, market participants have been enthusiastic about the possibility of a large infrastructure spending program. The view that this will be funded mostly through the private sector (as per Trump’s proposal) gained further credence following Elaine Chao’s hearing for Transportation Secretary. However, we still don’t have any details regarding how that is supposed to work, especially for rural areas needing transportation projects.

In short, post-election optimism is likely to turn to considerable second-guessing about priorities in Washington. Trump-transition people have suggested that there are no priorities. They will try to do everything at once. However, that’s not how Congress works. A new president normally enjoys a honeymoon period with Congress, but the Washington sausage factory is going to be interesting to watch.

December jobs report: Where to now?

January 9 – 13, 2017

The December Employment Report showed the job market to be in good shape. The pace of job growth slowed in 2016, partly reflecting tighter labor market conditions. The unemployment rate edged up, following an unusually large drop in November. It’s unclear how much slack remains in the job market, but tight conditions should lead to faster wage growth. Average hourly earnings rose 0.4% (+2.9% y/y) in December. These figures tend to be choppy (the three-month average was up 2.7% y/y). While the job market news has remained good, there is more uncertainty as investors try to gauge the size and timing of fiscal policy changes and how the Federal Reserve will respond.

Annual benchmark revisions to the establishment survey data are due in February, but early indications are that the story is unlikely to change much. Private-sector job growth slowed in 2016, while government payroll growth has picked up somewhat. Hiring at small firms was strong in 2014 and 2015, a healthy sign for the economy. However, the ADP Employment Report suggests that hiring at small firms has slowed in recent months, offset partly by a pickup in hiring at larger firms.

While job growth has slowed, it’s still beyond a sustainable pace (that is, stronger than would be consistent with the growth in the working-age population). As a consequence, the unemployment rate has declined. However, there are potential workers on the sideline – not officially counted as “unemployed,” but willing to take a good job if available. At this point in the cycle, the unemployment rate ought to level out as these workers return to the labor force. Labor force participation and the employment/population ratio have been little changed over the last year, but improvement is clearer for the key age cohort (those aged 25-54). As members of this key age cohort move into better jobs, opportunities should open up for younger workers. We still have some way to go before we are at full employment, but we are on our way.

As the job market tightens, wages will be bid up. Average hourly earnings rose at about a 2.0% annual rate in 2013 and 2014, picking up to 2.5% in 2015. While the monthly wage figures are uneven, the trend in wage inflation appears to be gradually higher. Note that while nominal (current dollar) wage growth has picked up, real (inflation-adjusted) wage growth has slowed relative to a year ago. But while real wage growth, the key driver of consumer spending, has slowed, it remains moderately strong by historical standards.

The labor market is the widest channel for inflation pressure. The Fed’s inflation hawks (mostly district bank presidents, not all of whom vote on monetary policy) worry that firms will pass higher costs along, and are more inclined to raise short-term interest rates sooner. The moderates (including Chair Yellen) seem willing to err on the side of waiting a little too long.

The Fed policy outlook is clouded by the uncertain outlook for fiscal policy (timing, magnitude), but the Fed will respond to the economic implication of policy changes in Washington once they occur. Uncertainty should be a major factor for the markets.

An uncertain outlook, but for whom?

December 19, 2016 – January 6, 2017

The outlook for 2017 is now shaping up as a battle of ideas, though few seem to be realizing it yet. The stock market has risen since the election. Consumers, small businesses owners, homebuilders, and manufacturers are all more optimistic. Many expect that a rollback in regulation, increased infrastructure spending, and lower taxes will spur growth. Yet, most economists, including those at the Fed, have raised their GDP forecasts for 2017 and 2018 only slightly at best. At the center of the discussion are differing views of how much stimulus we may get, how much slack remains in the labor market, and whether increased optimism can be self-fulfilling.

In the Fed’s revised Summary of Economic Projections, the median forecast for 2017 edged slightly higher, to 2.1% (from 2.0%), while the median forecast for 2018 GDP growth remained at 2.0%. In her post-FOMC press conference, Fed Chair Janet Yellen emphasized that the economic outlook is “highly uncertain.” Some, but not all, of the Fed governors and district bank presidents adjusted their forecasts for possible changes in fiscal policy (government spending and taxation) and other policies (deregulation) that might affect growth. Surveys of private-sector economists also showed only a mild increase in GDP growth expectations since the election.

Changes to the regulatory outlook are often difficult to gauge as a new administration takes charge. Laws may remain on the books, but they may be ignored. Just about everybody agrees that the country needs infrastructure investment, but it will likely be difficult to achieve through deficit spending. The House of Representatives no longer has earmarks (specific allocations in spending bills). Without the ability to do any “horse trading” for votes, it will be hard to reach a broad spending agreement. Funding infrastructure through the private sector would mean privatization. That may make some sense for airports, ports, or major bridges, but most Americans would bristle at the thought of having to pay simply to drive down the road. Privatization would also be unlikely to funnel infrastructure investment to where it is most needed.

Tax cuts should be easily achievable. It’s what Republicans do. However, it’s unclear how much of a reduction we’ll see. Reducing deductions could offset the impact of lower rates, but nobody is going to want to give up their current tax breaks.

The bigger question for economists is what happens when fiscal stimulus faces constraints in the job market. As the job market tightens, wages ought to rise more rapidly. Can firms pass the added labor costs along? If not, they will eat into corporate profits. Higher wages could lead to increased labor force participation and to reallocations of labor, putting workers into positions where they are more productive, and creating more room for more inexperienced workers to move up. This could certainly be accomplished through increased (labor-saving) capital investment. However, none of that is quick and easy. In her press conference, Chair Yellen said that fiscal policy could be effective if concentrated on efforts to boost productivity, but this takes time. Over the next year or two, GDP growth is likely to be constrained by a tight job market.

The effectiveness of fiscal stimulus may also be constrained by market reactions to it. That is, higher long-term interest rates would likely restrain the improvement in the housing market and limit business borrowing. A strong dollar would make U.S. exports more expense for the rest of the world (and also make foreign goods and services cheaper here). Indeed, we ought to see somewhat better growth in underlying domestic demand next year, but a wider trade deficit will likely keep GDP growth from picking up significantly. In an open economy, some fiscal stimulus leaks away to other countries (which is why it important to have coordinated fiscal stimulus in a global recession). One might expect restrictions on global trade to reduce that leakage, but trade disruptions could destabilize supply chains in a number of industries.

Might the increased optimism about growth be self-fulfilling? In the short term, perhaps. Firms have faced low borrowing costs and are generally flush with cash, but are unlikely to expand unless they expect increased demand for the goods and services that they produce. This has been the “chicken or egg” question for much of the recovery. However, if demand fails to materialize, there would be a clear downside to follow.

To be sure, the stock market’s recent rise is consistent with the renewed sense of optimism we’re seeing in many areas of the economy. However, there ought to be more uncertainty in the outlook for the next few years. There are many moving parts here, including Fed policy, long-term interest rates, and exchange rates, and they may not mesh all that well in 2017.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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