Hamish McRae: Trump cuts may add to boom, but at what cost?

Changes: President Trump has clinched a big tax overhaul in the US

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4 December 2017

This week, all eyes will focus on America — and not just on the shenanigans concerning the President, his family, the Russians and lieutenant-general Michael Flynn.

The reason is the tax cut, or more precisely the interaction between the tax cuts passed by the Senate in the early hours of Saturday morning, and what was happening on the markets anyway. (The House version of the tax bill was passed last month.)

The problem with the markets is that there are too many moving parts, too many different forces at work.

That makes it hard to set the new information — the most important changes to the US tax code for more than 30 years — into the framework of what is there.

At a macroeconomic level, it isn’t usually a great idea to give a fiscal stimulus to an economy that is already close to full capacity.

You may extend the boom a bit longer but at the cost of a more serious reversal when it runs out of steam. But it is really hard to know what is full capacity in a predominantly service economy with a lot of part-time workers.

Take something as basic as the labour market.

Unemployment is 4.1%, the lowest, except for a brief period on 2000, since the Sixties. But is that really full employment when you have a lot of discouraged workers who may be enticed back into jobs, and a wodge of retirees who would quite like to supplement their pensions?

At a microeconomic level it is an important tax change because it will establish the 20% corporate tax rate as the global standard. Ireland has been the tail that wagged that particular dog, with its 12.5% rate pioneering the notion that a low rate would be a magnet for investment.

Now everyone — including the UK and most recently the Netherlands — has followed it down, though whether we gain much more by dipping below 20%, I’m not sure.

There is another side to the tax changes. We don’t know the detail, because Congress’s two versions of the tax Bill — those of the House and the Senate — will have to be reconciled in conference committee.

But there will be a one-off tax levied on the overseas balances of foreign subsidiaries, which hitherto were tax-free if left offshore.

Since it is primarily the high-tech giants who have most benefited from this provision, and as a result don’t pay a lot of tax anyway, it is those who have least to gain from the reforms.

This may exacerbate a movement that was already in train. There had already been a sharp reassessment of the valuation put on tech stocks. Last week the shares of Facebook and Netflix fell by more than 4%, Google’s parent Alphabet by 3% and Apple by more than 2%.

Instead, funds have been “rotating” into financial shares which seem to be emerging from their collective dog-house. Banks and other financial firms are potential winners from the new tax provisions.

It is hard to know how much to make of this. The run-up in the value of tech stocks has been so extreme that some sort of reversal has long been on the cards. But they so dominate the corporate league table that a serious reversal would have a huge knock-on impact.

The top names in the S&P500 run: Apple, Alphabet, Microsoft, Facebook, Amazon in that order. Quite a small percentage fall in the value of this handful of companies has a disproportionate impact on the value of the total pot of US Inc.

This rotation out of tech stocks is one of the moving parts. There are others. There is the general upward profile of US short-term interest rates. The Federal Reserve has indicated that it will increase rates at its meeting next week, but although the path beyond that is wide open, at the margin the tax cut is likely to steepen it.

If the cuts boost the economy as intended the US will not only be able to sustain, but actually require, higher short-term rates.

Then there is the bond market. So much has been said and written about the end of the 30-year bull market in bonds, and the beginning perhaps of a 30-year bear market, that I’m not sure there is much to be added here — except to note that as a general rule, big economic and financial trends take longer to get going than you would expect but happen more violently when they do.

As for the nine-year bull market in equities, Goldman Sachs has gone bearish. In a recent note it pointed out that for anyone with a 60/40 portfolio — 60% in equities, 40% in bonds — this has now become the longest bull market since the Twenties.

It believes the “bull market in everything” will soon come to an end. The result will be either “slow pain” or “fast pain”, as values adjust to historic norms.

Strong stuff. But there are always people who don’t want to miss that last bit of the boom, as what happened to bitcoin last week demonstrates. It may be that the tax cuts prolong the boom just that little bit longer.

Rationally what happens to the price of bitcoin should have zero impact on the price of mainstream assets. But a canary in the mine?

Hamish McRae: Trump cuts may add to boom, but at what cost?

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