The United States, world’s largest economy, adds to global market worries with tax cuts, treasury yields, trade wars and talk of treason.
By David Dapice*
The dramatic single day fall in the US stock market has raised a red flag, but reactions fall along predictable lines: Bears see dark clouds while the bulls dismiss the correction as a mere bump on the road to higher stock prices. For the road ahead, analysis must include a non-market factor – a constitutional crisis that could overwhelm policymaking.
A correction was overdue, given the relentless rise of the market with low volatility and high valuations. Add the consequences of major tax-cut legislation, pressing need to lift the debt ceiling and an incipient trade war promoted by the Trump administration, and economic prospects look less balmy. The markets are also digesting consequences of the investigation on Russian meddling into the US presidential campaign and links with the Trump election campaign.
Stock markets at one point declined about 10 percent from recent all-time highs, but are still up about 20 percent from late 2016 and several times higher than during the worst of the global financial crisis in 2009. Many commentators have correctly pointed out that most major economies are likely to grow this year, corporate profits are strong, and good news of job and wage gains probably played a role in stoking fears of inflation and interest rates rising faster than expected. Investors ponder if the slump is a long-overdue pause in a surprisingly relentless upward trend, or if “the market” is signaling something more troubling.
Start with the major US legislative action that took effect with the New Year – the tax cut. Cutting taxes during a time of near full employment and rising interest rates, as well as growing federal deficits, is not a usual step for rational economic managers. Some groups estimate that next year’s deficits will top $1 trillion during a period of full employment, or 5 percent of GDP. While large deficits may help during periods of high unemployment, balanced or surplus budgets are typical when tax revenues are high because the economy is strong. If a recession did hit, the Federal Reserve would try to stabilize the economy with limited firepower from low interest rates and no help from fiscal policy.
Treasury yields on 10-year debt jumped from 1.5 percent in 2016 to 2.8 percent recently – a huge move in a normally sedate market. Yields on 10-year bonds are usually close to the rate of nominal GDP growth. For example, they were 4 to 6 percent in the decade before the 2007-2009 financial crisis led to huge purchases of debt by the Federal Reserve and plunging interest rates. If real GDP growth and inflation are both about 2 percent, then normal bond yields would approach 4 percent – substantially higher than today’s levels. This would provide competition with stocks and put downward pressure on stock prices. Note too that the Federal Reserve is slowly allowing its trillions of dollars of bonds purchased during its quantitative easing to expire without rolling the money into the bond market. There is a chance that China, a major buyer of Treasury debt, will tire of financing a nation threatening a trade war.
Stock bulls argue that corporate profits are high and growing, boosted by the recent tax cut. But adding demand at full employment shows some signs of driving up wages, which would put pressure on profits. Baby boomers, nearly 30 percent of the labor force, are retiring. Immigration, a major source of labor supply, is diminishing in response to aggressive enforcement measures. These imply labor scarcity going forward. Corporate profits averaged 6 to 10 percent of GDP from 1980 to 2005. Profits, at a record 14 percent share of GDP, may struggle for the projected growth of 11.6 percent a year as GDP grows at 5 percent.
Another argument from optimists: The tax cuts are also tax reform, expected to create higher growth and more tax revenues. Proponents argue that the Congressional Budget Office does not take sufficient account of such growth in its assessment. Yet when the Atlanta Federal Reserve surveyed businesses, only 11 percent said they would increase capacity due to the tax cut. Most cited a shortage of skilled workers as a major constraint. In 2004, the last time there was a tax amnesty allowing overseas profits of multinationals to be brought back to the United States without paying the full corporate tax rate, the main impact was to boost stock buybacks and mergers, not new investment. Most mainstream models do not anticipate a major boost beyond a few tenths of a percent to GDP growth over the next five years. Labor force growth is low; educational levels that boost productivity are not growing much, and productivity growth is sluggish.
Another source of policy uncertainty is President Donald Trump’s stance on trade. Literally trillions of dollars have been invested on the assumption that world trading patterns, or at least rules, would remain relatively stable. If tariffs and quotas are imposed on many products, that leads to higher prices or shortages in importing countries as well as unemployment in exporting countries. Disruptions to the North American Free Trade Agreement or trade with China could test the patience of trading partners. The last time the United States tried a tit-for-tat response was in the 1930s when trade, output and employment collapsed. Most do not want to repeat this experience, but the Trump administration’s brinkmanship seems to accept that some retaliation is likely. No one knows how far the administration may go, but the risks surely give trade partners and corporate investors pause.
Tax cuts during full employment, trade wars and rising interest rates with rich equity valuations are normally bad for stock prices, at least after the exuberance of extra demand wears off and society must confront the policy results. This is fairly standard economics. But another challenge looms – the possibility of a full-blown constitutional crisis. The president used the word “treason” to describe Democrats reticence toward applause during his first State of the Union address. Trump has also encouraged Republicans in Congress to discredit the Federal Bureau of Investigation and the Justice Department as they pursue questions about Russian influence and collusion by his campaign. Reports suggest that Trump considered and still wants to fire anyone aggressively investigating these issues or balking at equating loyalty to the constitution with loyalty to him. Republicans control majorities in Congress and while some push back, no legislation protects the special prosecutor and many indications suggest that findings on Trump could become a partisan issue. The resulting constitutional crisis would reach far beyond tax policy.
Volatility in stock prices may simply signal a return to normal risks, signifying little in terms of the prospects for the real economy. Or, the market could be recognizing global risks as a once stable country transforms into a more dangerous and complicated place. Risks do not imply inevitable crises, but do raise red flags about problems that must be handled. A skilled group of leaders and policymakers who understood the risks could reduce the probability of crisis while a partisan group of loyalists living for the news cycle and the president’s approval rating heightens chances. The market may be re-evaluating US leadership and finding the odds are not as good as they had once assumed.
*David Dapice is the economist of the Vietnam and Myanmar Program at Harvard University’s Kennedy School of Government.