US Tax Reform - An experiment in late cycle fiscal policyMar 5, 2018


Expansive fiscal policy normally makes headlines during recessions when classic Keynesian stimulus is used to jump-start the economy. The timing of recent US tax reform is therefore fairly unique because it is occurring as the US economy is in good health. Additionally, these reforms represent one of the largest fiscal stimulus measures in history, so their unique timing and scale call for some attention and analysis. In particular, the implications of US tax reform should be viewed against the potential for higher interest rates.

A brief history of rates

The future path of interest rates will have implications for valuations of many different asset classes, most notably stocks and bonds. Given that valuations are already quite stretched, there is some concern among investors that asset market volatility could spike if rates rise too far and too fast.

Historically, markets have not been as quick to price in interest rate increases as compared to the Federal Open Market Committee (FOMC) and its famous dot plots. For many years, the market has generally been right, while the FOMC has been consistently overestimating how fast interest rates would rise. However, this time the market was caught by surprise. Market expectations for 2018 and 2019 now appear to be tracking the path the FOMC has set out. The result has been a large repricing of risk in bonds, stocks, currencies and volatility.

The package

The recent US tax reform measures provide tax relief to both individuals and corporations, which could stimulate the demand side and, potentially, the supply side of the economy. More take-home pay for workers should support consumption, which makes up a substantial part of the US economy (an estimated 70% or more). This impact on its own should strengthen GDP growth and raise inflation across the economy.

On the supply side, companies could use the added cash for plant and equipment investments to increase productivity, particularly as pressures on wages continue to build. Theoretically, such a capital expenditure cycle could raise the productivity potential of the US economy allowing the US economy to grow faster without as much pressure on inflation. In our view, however, this will probably take longer to play out. We think the demand impact is more immediate and will outweigh the potential supply-side impact in the short term. This can lead to unwanted inflationary pressures.

Most economists believe the fiscal package will add about 0.5% to real GDP at a time when the US is already growing near 3% and above trend (assuming trend growth is 2% based on labour force growth and productivity, which is a generous assumption). In this case, we could see even faster growth and higher inflation putting the Fed (and the market) behind the yield curve. The jump in interest rates over the past few months has led the market to recalibrate its outlook for rate hikes. As a result, we have already seen higher volatility and a nearly 10% correction in stock markets.

Managing the portfolio

After 30 years of rising bond prices, investors may need to be reminded that bonds can experience capital loss as well as gains. As we have highlighted in previous articles, volatility could move back towards the long-term normal, rather than the extremely low levels experienced in the past few years. All else being equal, higher volatility should result in higher risk premiums in all asset classes, lowering returns across the board. As far as portfolio strategy is concerned, the aforementioned risks give us comfort in remaining underweight duration and the interest rate-sensitive equity sectors despite the selloff in rates we’ve experienced in the past few quarters.

Stephen Lingard’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.