Forget Tax Cuts: Liquidity Remains The True Market Elixir

Nov. 27, 2017 3:44 PM ETEWBC, GLD, GSG, KBWR, PKW, RINF, VYM, XLF2 Comments
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Douglas Adams


  • While US markets continue to price in the possibility of tax cuts, the possibility pales against the role of high levels of liquidity in the financial system.
  • A consequence of central bank activity throughout the developed world, the disparity of interest rates across the developed world distorts traditional market signals.
  • Financial conditions are as loose today as they were prior to the 1994 Fed move that bludgeoned bond markets and shocked investors worldwide.
  • A more transparent Fed will remove excess liquidity in a more predictable and protracted fashion over a period that will stretch into the next decade.
  • Tax cuts then come as an ill-timed and ill-advised distraction given prevailing economic conditions.

Markets continue to doubt the feasibility of the Republican tax program passing the Senate, which pretty much defines market insouciance to date. The dollar (green line in Figure 1, below) remains well below its peak in early December of last year when expectations of economic reflation were at their height. Similarly, the yield on the 10-year Treasury note (back line in Figure 1, below) reached a yield of 2.60% in the first week of December from a post-WWII trough of 1.36% in the first week of July 2016. In March, the yield on the 10-year note reached a 3-year high of 2.62% when the fires of economic reflation burned hot only to pull back in the wake of the Senate's vivid display of incompetence in failing to pass a repeal of the Affordable Care Act. Inflation expectations (red line in Figure 1, below) dished up a similar plate, peaking in December 2016 only to fall back as price inflation continued to hover about historic lows.

Figure 1: The US Dollar Index ($USD), 10-year Treasury ($TNK), Inflation Expectations (RINF)

This market indifference appears to be recalibrating since September, as US assets appear to be reversing a steady downward slide since spring. Market expectations appear on the rise as the tax cut debate has taken on the hue of a make-or-break exercise for congressional Republicans as mid-term elections loom large on the political horizon less than a year hence. Similarly, the yield on the 10-year Treasury note has been on the rise since hitting a year-to-date (YTD) low of 2.03% in early September, closing at 2.34% through Friday's market close (24 Nov). Market measures of inflation are also increasing with the break-even spread on inflation protected 10-year Treasury notes up to 186 basis points at Friday's market close (24 Nov), but still well below the 208 b/p posted in early January when the fervor around economic reflation was at its height.

Figure 2: I-Shares S&P GSCI Commodity Index (GSG) and SPDR Gold Shares (GLD)

Commodities have also been blazing an upward path since sketching out its lowest post of the past twenty years in the latter weeks of June. The S&P GSCI Commodity Index GSG is up just over 14% since September and just under 22% since June. GSG is heavily weighted toward energy with correlations just shy of 1:1. That said, a ratio that divides out the presence of Western Texas Intermediate crude indicates the overall commodity picture as being more nuanced to the downside. Current trends in global energy have more to do with OPEC's upcoming semi-annual meeting at the end of the month in Vienna, political turmoil between Sunni and Shia in the Gulf region and some equivocation by Russia to a full year extension of crude production cuts for 2018. A similar factoring with copper shows modest gains through much of September and profit-taking through the closing weeks of September and into much of October (see Figure 2, above). Copper has long been a proxy for global economic growth due to the red metal's presence in so many infrastructural and construction applications. While global growth estimates continue to climb across the world stage, copper supplies remain buoyant while infrastructural spending remains muted. Still, GSG is trading well above its 50-day trading average since the latter part of July. Meanwhile, gold continues to carve out a more traditional path in the opposite direction to the dollar, peaking in September well above its 50-day trading average only to fall well below that average by month's end where the metal has largely traded sideways for much of October and into November. Gold will continue along such a path until such time when the Republican tax program gets closer to a vote in the Senate in the first weeks of December (see Figure 2, above).

Figure 3: Powershares Regional Banking (KBWR), SPDR Financial Sector (XLF), Powershares Buyback Achievers (PKW), Vanguard High Dividend Yield (VYM) and the KBW Nasdaq Bank Index ($BKX)

In the broader market, large financial stocks captured by SPDR Financial Sector (XLF) have followed the September rebound paradigm with sharp gains through the beginning week of November, up just under 13% (see Figure 3, above). Small and regional bank shares, almost exclusively domestic and much more positioned to benefit from any decline in their overall federal tax liabilities, soared in anticipation as investors priced in the possibility of the bill's final passage. KBWR was up just under 15% for the two months-its highest post since March. East-West Bancorp (EWBC), the ETF's largest holding, was up just under 16% for the two-month period.

Share buyback programs loom large in the banking sector, despite the year's 5-year downturn in buyback spending by S&P 500 listed companies YTD. Banks fall in a rather different category on this score. In the wake of the financial crisis, Fed approval for bank capital spending plans cut back both on dividend and buyback programs in most banks under its regulatory supervision. With economic improvement, the Fed grip on bank shareholder spending has loosened, clearing the way for more robust programs to return retained earnings to shareholders, reflected by the surge in Powershares Buyback Achievers ETF PKW through its 50-day trading average in early September. Similarly, Vanguard High Dividend Yield (VYM) broke through its 50-day trading average in early September as enhanced shareholder payout programs are being priced into the current market mix

Of course, the big concern here to banks most certainly, and to the greater economy in particular-is the endgame surrounding the flattening of the yield curve. Further evidence is readily visible in the sharp, simultaneous 2%+ drop in the KBW Nasdaq Bank Stock Index, XLF and KBWR in the opening days of November (see Figure 3, above). The spread between the 2-year and 10-year Treasury notes is now at 0.60 basis points through Friday's market close (24 Nov), the narrowest spread since September 2007.

The flattening of the yield curve that separates the yield of a surging 2-year from that of a sagging 10-year Treasury note, continues to heighten uncertainty in all quarters of the investing world. The last time the yield curve was similarly compressed was just prior to the official beginning of the Great Recession of 2007 in December of that year. Then, housing prices had already peaked in the spring of 2006 with the downside impact affecting prices at the national level by April of 2007. They would not return to a sustainable upside trend until March 2012. The structured products derived from failing US mortgages spread financial contagion throughout the world. By way of contrast, economic conditions today are, for all practical purposes, a world apart. US economic growth is on fairly solid footings. Global growth is on the uptick. US unemployment is at a 17-year low. Markets continue to put up record closes. Oil prices are going up. Still, inflation remains at historic lows and wage growth remains locked at 2.40% YOY. Yet a weak dollar and depressed long-term yields historically have signaled anemic growth prospects for the foreseeable future. Most other economic data signals more growth.

The Fed's control of short-term interest rates is not what it once was in years past. Just under 17% of its $2.46 trillion Treasury holdings have durations of less than a year, a function of Operation Twist that switched out short- for long-term Treasuries from September 2011 to June 2012. Now, roughly 83.4% of the Fed's balance sheet mature in a year or more with 38% maturing in five years or more. As for mortgage backed securities (MBS), 98% of the Fed's $1.78 trillion of holdings mature in 10 years or more. With an estimated $12 trillion of assets on the collective balance sheets of central banks of the developed world, currency values are now much more sensitive to the upper reaches of the yield curve-a significant change in the traditional paradigm. Central bank rates in Europe and Japan are below zero. Higher interest rates attract short-term speculative flows in pursuit of carry interest, or the difference in yield between US debt on the one hand and that of Japan, German and British debt at all levels of denomination on the other. Higher rates are traditionally associated with better growth prospects or inflation is on the uptick-both conditions usually adding nominal strength to the respective national currency. That paradigm has broken down for much of the year given the relative weakness of the dollar against persistent capital flows into the US Treasury market from Japan, Europe and the UK seeking higher rates of return on fixed income investments.

Figure 4: National Financial Conditions Index (NFCI)

Liquidity continues to slosh about the US financial system. In addition to four upticks in the federal funds rate since December 2015 and the fifth hike projected for next month, the Fed has embarked on the long and winding road of balance sheet reduction this past October. The program extracts $10 billion a month from the US financial system which ratchets up $10 billion per quarter to $50 billion/month by the 4th quarter 2018 which projects out a balance sheet total of roughly $3 trillion by the end of 2020. Markets remain astonishingly quiescent to the Fed's tightening.

This sloshing liquidity provides ample fuel for surging equities while at the same time cushioning market shocks-thus keeping volatility largely locked at historic lows. Companies up and down the credit ratings ladder are still able to borrow at close to record low rates, placing demand--rather than supply--of funding at the fore of the investment debate. Meanwhile, the dollar has fallen off sharply from highs earlier in the year when market expectations around economic reflation were at their peak. There is little doubt that Fed's forward guidance skills have become much more transparent and predictable in recent years. Yet it is by far this outsized level of liquidity in the financial system that has allowed markets to take monetary tightening to date largely in stride. The current National Financial Conditions Index (NFCI) measure is at -0.93 for the week ending 17 November. This means financial conditions in the greater economy are almost a full standard deviation looser than long-term averages. The last time financial conditions were this loose was in August 1993 (see Figure 4, above). Then, the conditions were overcome by a determined and opaque Greenspan Fed which launched a "shock and awe" broadside with a punishing series of six hikes in the federal funds rate throughout the following year that shocked investors and literally bludgeoned the bond markets-but nonetheless returned the economy to rough equilibrium by the end of the decade.

Fast-forward to the closing weeks of 2017. While loose financial conditions are of equal size and dimension as they were in 1994 according to the Federal Reserve Bank of Chicago data, the probability of the Fed launching a 1994-type barrage on investors and markets alike is all but unconscionable. Unlike in 1994, a more transparent Yellen and soon-to-be Powell Fed is now demonstrably willing to accept inflation below its 2% target. Accordingly, loose financial conditions will be with us for the foreseeable future, providing the same fecund equity environment-well into the next decade. Core PCE inflation is not projected to breach the 2% threshold before 2019-if then-according to the Fed's September Summary of Economic Projections (SEP). Another SEP projection and Janet Yellen's last press conference as Fed chair comes at the conclusion of the December FOMC meeting in several weeks' time. Through September, the Fed has penciled in two upticks in the federal funds rate for 2018. The probability of more rate upticks for 2018 and beyond coming out of the December FOMC meeting is likely a good deal higher than zero. By this time next year, the Fed's unwind of its balance sheet will cap out at $50 billion a month through the end of 2020.

Talk of tax cuts in the US only serves to complicate current economic conditions. While in years past such a reordering of the US tax structure, merits aside, would be expected at the very least to steepen the yield curve, such expectations based on yesterday's models could very well come up far short of the mark. With little in the Republican tax cut program to promote greater savings or incent Americans to consume less, short of deficit spending or the Fed abruptly reversing its balance sheet rewind and actively borrowing again from future growth, the funding of the $1.5 trillion tax cut would come substantially from abroad through the sale of stocks, bonds and other US assets. Augmenting an already active international carry trade flow, the added funds would likely further pressure US assets to the upside which could see the yield curve flattening even more as a result. A recent study by the University of Pennsylvania's Wharton School estimates the increase to the US trade deficit in the neighborhood of $800 billion over the 10-year period, or about 16% higher than current levels. The Wharton study estimates government debt issues will approach $2 trillion over the period with foreigners buying about $800 billion. This adds about $80 billion to the annual trade deficit for the period. By way of comparison, the US-Mexico trade deficit through the end of 2016 was $56 billion.

Historically, savings rates are little affected by tax cuts. The top tax rate in 1980 was 70%. By 1988 the top rate had dropped to 28% as the Reagan years came to an end. From there, the top rate noodled around to 39.6% under Clinton only to fall again to 35% under GW Bush and came to rest at 39.6% during the Obama tenure. American savings rates have continued to fall steadily since the Reagan years, showing little correlation with the ebb and flow of tax rates over the period. While Reagan enacted the largest tax cut in history as a proportion of GDP in 1981, he also signed tax increases in 1982, 1983 and again in 1984 as tax cuts failed to either meet revenue projections or keep up with increased military spending during the period. In Reagan's time, foreigners owned about 10% of US assets, about a third of the total currently owned, or about 35% according to according estimates by the Tax Policy Institute. That proportion will increase dramatically under the Republican tax program-a rather curious example of "America First." Capital coming from abroad, will more likely come in dribs and drabs as the lag time from initial investment to full production is measured in multiple years that could extend well beyond the effective life of the Republican tax program.

Will tax cuts release a flood of new capital investment? Here again, the answer is at best nuanced. According to the Republican tax plan, the US government will share the cost of new investments by allowing companies to fully expense investments in the year it was made until the provision sunsets in 2023. This pushes any resulting economic growth dividend for the greater economy from domestic capital into the outer years of the program-if then. In the immediate years, revenue losses will more than likely exacerbate short-term budgetary deficits and accentuate government borrowing to make up the difference. Under the 1981 Reagan tax cut, GDP rose from $46.022 billion to $61.38 billion through the end of 1989, just under 34% for the period. Fixed investment rose from $45.82 billion to $61.8 billion, or just under 35%. More recently, the GW Bush tax cuts of 2001 saw US GDP grow from $10.508 billion to $15.785 billion or just under 51% through the end of the 4th quarter 2011. Fixed investment for the same period went from $1.978 billion to $2.302 billion, or just under 17% for the period.

On the deficit side, the effects are clearly delineated. The US deficit went from $78.97 billion in 1981 to $152.64 billion by the end of 1989, up just over 93%. The Bush tax cuts blazed a similar path. The US deficit went from a surplus of $128 billion in 2001 to a deficit of $1.30 trillion by the end of 2011. Even through the end of 2007 and the beginning of the Great Recession of 2007 in December of that year, the deficit had reached $160.7 billion.

The pressure to reduce government outlays will be intense. Under congressional pay-as-you-go rules, the Office of Management & Budget (OMB) will be forced to offset increases in the deficit due to the tax cut package by a reduction in spending of an estimated $136 billion in 2018, according to CBO estimates released last week. The offsets will include an automatic cut of some $25 billion from Medicare. Chained CPI, the inflation measure of the Republican tax cut program, will likely migrate quickly to the spending side of the federal budget. The main difference between chained and headline CPI measures of inflation stems from the frequency of calibration of the respective indices. Chained CPI is calibrated monthly and, accordingly, more sensitive to changing prices in the greater economy. Headline CPI is calibrated once every two years which artificially overstates inflation in declining inflation environments and understates inflation in rising inflation environments. While the weightings of the two measures are the same, chained CPI will push households into higher tax brackets more quickly in a rising inflation environment. Similarly, cost-of-living increases will be lower on the spending side, reducing government outlays to safety-net benefits such as Social Security, Medicare and Medicaid. These spending cuts will be the source of heated legislative fights between Democrats and Republicans over spending priorities moving forward. The potential savings on the spending side would be in the billions-targeting those households most vulnerable to cuts in benefit checks at the lower rungs of the national income scale. The political debate over such cuts will frame the coming mid-term elections in 2018 if the tax measure does indeed clear the Senate. Meanwhile, the Congressional Budget Office (CBO) already projects a deteriorating path with spending set to rise from 21% GDP in 2017 to 25% in 2028-37.

None of the foregoing points will likely change the historic pattern of corporate decision-makers seeing such a tax windfall as a temporary event which could be easily reversed with a change in the political composition in Washington over the next or several electoral cycles. Accordingly, booked tax savings are even more likely to augment shareholder enhancement programs, like special distributions, increased dividends and share buybacks rather than forming the basis of future investment decisions. Recent market gains in banking stocks with augmented dividend and buyback programs stand witness (see Figure 3, above). Historically, worker pay packages fall low on the list of corporate priorities when the latter confronts unforeseen windfalls of new-found money.

If a tax package eventually clears the Senate-a big if indeed-the broad view would likely see little benefit accruing to technology and other companies with international scope from a 20% tax regime in the US. Most of these companies' effective tax liabilities are well below the 20% threshold through the routine use of routing large portions of international earnings through low-tax jurisdictions worldwide. That said, multinational companies in general and technology stocks in particular will likely continue to be the driving force of market gains given current liquidity conditions for the immediate and medium term moving forward.

Using the same broad brush, domestic companies should be beneficiaries of lower tax liabilities since many of these companies lack the international exposure that so effectively lowers the tax rates of companies with business in multiple-read lower-tax jurisdictions abroad. Small- and mid-sized banks should derive some benefit from the lower tax rate but will likely face negative offsets from a flatter yield curve which reduces earnings from loan portfolios. Larger banks generally have more international exposure and access to lower tax rates abroad so will benefit less from the proposed 20% US corporate tax rate. Shareholders of bank stocks and domestic utility companies should benefit from enhanced buyback, dividend and special distribution programs that would likely result from any windfall tax savings that materializes from congressional legislative initiatives.

Ancillary gains could come from companies expensing capital investments in the year it was made which could enhance earnings earlier in the investment cycle rather than over time under current law. The provision sunsets in 2023.

The 30% cap on interest to income deduction could limit the issuance amount of future debt which could be a severe blow to the breadth and volume of US debt markets. Highly leveraged companies such as equity buyout and hedge funds and some real estate investment trusts that take advantage of the deductibility of debt under current tax law would likely be negatively impacted by a 30% cap on interest to income deduction if the provision is included in any final tax cut package.

Bond markets will likely rally in the face of increased demand from foreign investors both to fund a possible tax hike in the US as well as to satisfy the arbitrage thirst for carry interest from Japan, Europe and the UK. This means the yield on the benchmark 10-year Treasury will trade in a narrow range at best or drift to the downside at worst. Such an outcome makes for a difficult situation in government debt markets where the interest rate sensitive 2-year note will continue to rally against continued yield lethargy at the 10-year level-further flattening the yield curve. Through Friday's market close (24 Nov) the 10-year Treasury note is down 4.3% on the year while the 2-year note is up just under 45% over the same period. The resulting spread of 0.60 basis points-and trending to the downside-offers up a good deal of investor uncertainty moving forward.

The dollar, whose value is now tied not to the short- but to the long-side of the yield curve, will stumble for the foreseeable future as the Fed tightens monetary policy through 2018 and beyond. The yield curve will continue to flatten with the interest rate sensitive 2-year note increasing with each expected uptick in the federal funds rate while the 10-year Treasury note will likely fail to gain traction due to continued carry trade from Japan and Europe where prime interest rates will remain below zero for the foreseeable future. Adding to this heavy lift is the additional government borrowing to finance an ill-timed and ill-advised tax cut. The dollar will likely have a difficult time in world currency markets-at least until such time when liquidity in the greater economy dissipates rather substantially from current levels and when interest rates in Japan and Europe rise from their current negative depths. It took the better part of six years after the 1994 experience for overall financial conditions in the US to return to relative balance (see Figure 4, above). The more measured and predictable approach already outlined by the Yellen Fed, which will likely be continued by the Powell Fed, will take a good deal longer to reach the same critical mass. If this scenario pans out, current levels of liquidity in the financial system will rule the day and the same click of multinational companies will continue to drive market results. The expected benefit from tax cuts to US-based companies with little or no foreign exposure could become pressured as a result. That said, the battle lines over any pending recession in the near-term, the historical signal of a flattening yield curve, have already been drawn.

There is little question that liquidity remains key to continued market buoyancy. That buoyancy will at some juncture begin to wear thin as the Fed's balance sheet unwind and rate upticks catch up and begin to gain traction. It is a bespoke program, designed to lower liquidity levels as transparently and as predictably as possible through the program's end date in 2020. So far, so good. Once this systematic tightening of monetary policy does gain traction in the greater economy, market players will fall back on more traditional behavioral patterns than clearly is evident today. If the Republican tax program does indeed clear its Senate hurdles, the impact of these diverging trends could be singular for all concerned. For now, the market prediction is for relatively smooth sailing and continued low volatility-until such time when it's not.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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