The key market risk right now

Updated: Mar 20, 2018

Let's first consider the broader global economic environment, in particular, the macro drivers of a “globally co-ordinated” gradual improvement in economies which are continuing to evolve. The primary driver of markets, at this point in time, is globally accommodative monetary policy, which underpins economic expansion and the rise in financial and real asset prices.

Coupled with the lack of any sustained response in markets to the negative surprises of Brexit, the Trump presidency, the subsequent disappointment in the lack of US government policy implementation and broadly benign global data, places us in the ‘Goldilocks’ zone of accommodative monetary policy, improving earnings and low volatility.

In this environment an absence of US government policy change might not be at all a bad thing. While at first glance, it doesn’t appear to be something that will pass through the house, let’s consider the proposed tax cuts in the US for a moment.

With US unemployment at 4.3%, US government debt at its ceiling at a time of large scale central bank bond purchases and the Federal Reserve Bank intending to further reduce its balance sheet and increase rates it is likely that “The biggest individual and business tax cut in American History” would have a low multiplier effect.

It would however add trillions in debt with a modest positive offset from the corporate repatriation tax. The amnesty on offshore held earnings in 2004 was at a 5.25 percent tax rate and two thirds of offshore held US earnings were repatriated at that time (which today would be $1.7 trillion of repatriation or a $70 billion tax collection).

It is worth noting that the cash repatriated in 2004 flowed predominantly to financing activities (mainly share buybacks) and not building more US manufacturing capacity or more jobs. Were the 2004 behaviour repeated this implies a very hefty 5 percent of US market capitalization. Naturally offshore earnings are much more concentrated in certain stocks which would be the likely candidates for large share buybacks. Thus, on the current tax outline we would see an increase in the share prices of the US multi-nationals who hold significant offshore US earnings (Apple et al).

Specifically, on the intended tax cut to corporates from 35% to 15% it is difficult to avoid the obvious conclusion that the sector in which earnings are very positive and debt levels low are getting the largest allocation of tax payers moneys. Alongside the repeal of inheritance tax and with high goverment debt levels this will be unpopular.

The current argument from republicans is that US companies have the highest tax rate of any of their major trading partners. Which is important, except almost no US corporate pays an effective tax rate of 35% (effective corporate tax rate in the US is circa 19%). Most would not have even benefitted by the originally mooted reduction to 25%, hence we are now discussing 15%. Which for many will represent an important but not significant change from current effective tax rates paid.

The additional government debt and the additional increase in the federal funds rate would however lead to higher public and private financing rates and potentially disrupt the ‘Goldilocks’ environment.

The further stated aim of the tax outline is to “Grow the economy and create millions of jobs”. At close to full employment, job creation pushes up wages and creates inflation by generating higher spending and investment which increases the price for goods, services and money. That doesn’t sound like something that would benefit markets longer term.

In all, the lack of execution on US government policy (despite the Trump media show) isn’t such a bad thing.

Author: Etienne Alexiou, CIO

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