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Earnings, Revenue And Income Add To Tax Exemption And Fed Rate Hike Recessionary Perfect Storm

by: Alan Longbon

A recession is pre-programmed into the U.S. economy.

Government fiscal flows are set to decrease at the end of the year from tax exemption expiry.

S&P 500 earnings, revenue and income forward earnings are set to drop at the same time and is no coincidence.

On April 20, 2018, I wrote this article about how the Congressional Budgetary Office had unwittingly shown when the next two likely recessions are coming. A relatively light one in 2019 and then a much stronger one after 2025, if the economy and government policy continue on their present track.

Since that time some further articles have appeared on SA to confirm this picture. The purpose of this article is to put all the collaborating information together in one place.

The key findings from my earlier article were:

To carry out the assessment, a balance of sectoral flows model was used after the work of British economist Professor Wynne Godley.

In 1970, Professor Wynne Godley moved to Cambridge, where, with Francis Cripps, he founded the Cambridge Economic Policy Group [CEPG]. In early 1974 (after playing around with concepts devised in conversation with Nicky Kaldor and Robert Neild), Wynne Godley first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government's budget balance, less the current account balance, is equal, by definition, to the private sector balance.

Government spending [G] + Private sector spending [P] + Current Account Balance [X] = 0 = GDP = GDI

Firstly, the key CBO charts.

CBO charts

This is one of the best charts for predicting the recession that starts after late 2018. Here, one can see that the CBO expects real GDP to lift into late-2018 and then fall into 2019 and bottom in 2021. That is the first and next recession. The reason for the recession is that, at the end of 2018, private tax relief clauses expire. All of a sudden, tax rates rise and extract billions of dollars out of the economy where they will appear on no measure of the money stock, not M1, M2, M3, I challenge anyone to show me where these tax dollars are stored for later usage. When one extracts dollars from an economy, it has to shrink by that amount, and that is shown in the CBO chart.

The chart and the CBO note below it show that, in 2025, another set of income tax exemptions expire and result in a big jump in tax extraction and that this accelerates into 2028. There are the reason and magnitude of the second recession predicted by the CBO.

Refining the Information

The findings of my article were picked up and refined by my friend and fellow SA author Robert P. Ballan in this excellent article. Robert and his PAM team used their in-house proprietary charting and analysis tools to refine the CBO charts and also add a lot of other financial flow streams to the picture. The charts are shown below.

CBO Forecast of Government Outlays, Potential, Actual GDP (Real), GDP

Here is a zoomed view:

CBO Forecast of Government Outlays, Potential, Actual GDP (Real), GDP

The key aspects are:

  1. The flows show a peak in 2018 and then a drop.
  2. Looking back, a slowdown and decrease in flows are associated with a recession (gray bars).
  3. An acceleration and increase in flows end the recession.

Mr. Market Adds His View

Since Robert and I wrote our complementary articles, I came across some interesting data from SA earnings expert Brian Gilmartin in this article recently.

The chart that caught my eye and I found very interesting is shown below.

Brian's forte is all things earnings, and especially forward earnings. Brian had the chart above especially prepared to show his point.

The point is that earnings, revenue and net income growth rates of the S&P are peaking now, (shown highlighted yellow 2018 Q1) will be strong but flat over the next few quarters and then fall off a cliff in 2019 Q1.

What this means is that the market also recognizes the impact of the decline in fiscal flows from the federal government and what this means for the private sector financial balance. The flows are dropping as the tax exemptions expire, and the federal government withdraws billions of dollars out of the economy in taxes that would otherwise have been recycled as company earnings, revenue, and income.

This is an assessment quite apart from a federal government department and is a market assessment of the near future that concurs with that of the CBO, Robert and myself. This is the private sector talking.

The Federal Reserve Bank Accelerating the Decline

Adding to the "perfect mini storm" scenario is the Federal Reserve Bank [Fed].

The Fed is intent on raising interest rates to "normalize" them at a 2% to 3% range. The rate of change in the interest raising regime is shown in the chart below.

I follow the Fed and its flawed logic in this article.

The Fed's logic is that it can cool an overheating economy and therefore "tame" inflation if it raises the price of money offered as credit via commercial banks.

This is despite the fact that bank credit creation has never been weaker as the chart below shows.

There is no credit boom to bring back under control. If anything, credit creation needs a shot in the arm rather than a kick in the head.

What the Fed will achieve with its monetary tightening regime is a worsening of the crash that is coming in 2019. Tighter monetary conditions will add amplitude to the GDP drop and stock market crash that the expiration of the tax exemptions is going to cause.

A higher cost of loan funds will not assist either households or businesses to save, spend or profit more. Higher rates only add to bank profits in the form of higher debt service.

The Likely Outcome

Come late 2018 there will be:

1. A marked slowdown in business as the tax exemptions expire and taxes increase.

2. GDP will fall.

3. Inflation will fall, or deflation will occur. The Fed will congratulate itself.

4. The stock market will fall with income, earnings, and revenue. This could well be exacerbated by a panic as there are many investors alive now that have already suffered the dot-com crash of 2000 and the GFC of 2007-09. These investors are "gunshy." I know I am, I have done them both.

5. Unemployment will rise as inventories build, the product is not sold, and production is throttled back.

Free coffee and doughnuts anyone?

6. The federal government deficit will involuntarily increase as it pays unemployment benefits to the newly unemployed, this is known as an automatic stabilizer. People made unemployed by the tax exemption expiry. There is a direct connection between the money supply, income, and employment. The tax exemption expiry will in effect "undo" themselves and put income back into the economy by way of welfare benefits.

7. The Fed will again lower interest rates. This will lower the cost of business and living. Because the level of private debt is so high, 150% of GDP, this will not lead to an explosion in lending as the old logic no longer applies because the economy is "all loaned" up and not many creditworthy borrowers want a loan.

8. The combination of a larger federal deficit (increased money supply) and less expensive credit (Fed rate drop) will restart the economy again for its rise into 2025 when the next set of tax exemptions expire, much larger this time, and a much larger recession waits. There is a chance that the federal government and politicians learn the link between the money supply, income, and employment and the recession averted; however, this is very remote and so far over 200 years of monetary and fiscal policy have shown no evidence of learning ability.

In the meantime, the rest of 2018 will be okay going into the peak. At the end of this month, the Fed tax refunds come out and a large part will be most likely invested in the stock market as well as cause a lift in GDP. This is discussed in this article in more detail.

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.