Enough Hot Air to Fill A Hot Air Balloon!
The equity markets have become rather too complacent and are rallying on the back of a promise that won’t and cannot be fulfilled by Trump. That promise is to lower the tax rate from 39% to 15% and the delay of the Wall Construction Bill until September to avoid shutting the Government down Friday. For so much potential disruption markets are very complacent.
So why the skepticism. The Trump Tax cuts look to add about $2 trillion to the deficit over a ten year period. For Ryan and company the Republicans want a neutral budget. So Ryan and a number of Republicans need to be convinced that such a large tax cut won’t add significantly to the budget. Besides to get the Bill through a simple House majority won’t work because this means that the Bill unravels in ten years’ time. Trump will announce the Policy tomorrow however he will need to garner a lot of support to have any chance of the Bill being passed. To get to revenue neutral Trump will require an offset tax imposed on goods crossing the Mexican and Canadian border, a plan that is very unpopular with many U.S. Corporates and also Republicans.
The basis of Trump’s Tax Bill is that such a tax cut will stimulate growth and allow the US Economy to grow at a growth rate in excess of 3% pa over the ten year period. This is a massive call for an already very mature economy which has seen steady growth of around 1.8% for the last 7 years. The latest read on the economy is due Friday and the expected GDP for the first quarter is about 1% annualised the weakest pace of growth for over a year. Given Trump was quick to jump on earlier numbers I ponder whether he will take the accolades for such a poor number.
A tax cut won’t lead to growth. What it will stimulate and my belief is this is the driver for the equity markets is that corporates will use the extra cash to pay dividends and announce share buybacks. Increased productivity won’t occur because businesses are unlikely to commit long term money to projects where the tax situation could easily be reversed in ten years’ time. Equity markets can continue to rally and frankly they probably don’t require much growth if taxes are cut to 15%.
Long term growth will be the victim and so too the deficit. This is not so good for fixed rate bonds and the U.S. as a triple AAA rated country could be in jeopardy. Trump has already signaled some intentions through taxing Canadian lumber and looking to tax Canadian dairy products. The protectionist barriers are already rising.
For Trump to get to 3% he needs an increase in productivity and wages. With the U.S. falling behind in manufacturing this requires retooling, a risky affair if your competitor is passing the tax cut onto investors by way of share buybacks or increasing dividends neither of which increase growth rates. New technology is a disruption event and this places many people out of work. Unfortunately most new U.S. technology is either in armaments or social media. Social media does not lead to significant productivity gains.
For Trump to achieve his 3% goal companies will need to invest in capex and actually start to do things, given the earlier experiences such as when Bush lowered taxes to allow funds to be repatriated under the proviso of being productively used those funds went to share buybacks.
The current situation can prevail for some time. Equities will remain buoyant until it becomes apparent the tax cuts won’t be as large as announced. Bonds will be weak and given the chance of significant tax cuts for corporates, the Fed could become quite aggressive in raising rates. If the U.S. dollar weakens then much of the plan unravels as costs and inflation balloon. For exporters they will struggle with a strong dollar so much of the growth has to be internally generated.
The outlook to expect may well be strong equities weaker and confused bonds but not too weak, perhaps topping out around 2.6%. Geopolitical risks are looming large. The euphoria in Europe over the likelihood of Macron becoming the French President could unravel if Le Pen continues to receive the strong support of Russian hackers, the same group that helped sway the U.S. election.
On the day bonds retreated marginally and are now back at 2.33%. the U.S. curve steepened marginally out a point. The spreads are 2/10 at 05.70, 10/30 at 65.40 and the 2/30 at 171.30 (out 2 pts). The German 10 year bund moved back to 0.37 that’s out about 20 from a week ago. The French 10 year closed at 0.85%.
The Dollar Index is unchanged, the Canadian Dollar slipped 0.5%and the yen fell 0.6%.
Commodities were mixed. Copper staged a recovery on diminishing inventory and it was also less inventory that allowed oil to rebound to close at $49.40. The weak trend for iron ore continues.
Aussie Market Today.
I expect today to be a topsy turvey day. Bonds will be weaker and this trend could continue through until Friday when the U.S. GDP for the 1st quarter is released. Equities should remain strong bolstered by short covering and the euphoria of a massive tax cut in the USA. I expect bonds to widen by about 5 bp on the day.