Written by: Benjamin Bimson CIMA® / CIO, BCJ Financial Group
Markets have continued their relentless rise. In fact, the Dow passed 23,000 for the first-time last week and held up, closing off the week at 23,328. Think about where we were at on Jan 1, 2017, when the Dow opened at 19,872.
It certainly seems that the bets have all been on multiple Republican initiatives to overhaul the healthcare and tax systems. However, healthcare aside, would tax cuts really help?
Ned Davis research wrote a brief about what they see as bullish implications. These include1:
- Raising incentives for work and increasing income will likely produce more of it.
- Simplifying the tax code could free up a lot of time for other more productive pursuits and improve consumer confidence.
- Further expensing of investments could help stimulate investment.
Points that cause some concern include1:
- Kennedy and Reagan years were much larger drops [in effective tax rates].
- The cut from 35% to 20% for corporate taxes sound huge, but the effective tax rate on nonfinancial corporations is already quite low at 21.8%.
- Tax cuts can stimulate the economy short-term, but since they increase budget deficits, it leads to lower economic growth longer-term.
- Prior Fed tightening cycles have historically led to a bear market or recession, or both.
Of course, these points are hypothetical, but there are some interesting things that need to be watched.
First thing to consider is the economic cycles. The financial markets (think investments) tend to lead the economy by about 6-9 months on average. For this reason, leading economic indicators matter most for determining directions for investments. Here is a list of many of the components in the leading, coincidental and lagging indexes. The list is not all inclusive but gives a good indication of what is considered.
These indicators are put into an index by the Economic Cycle Research Institute, and we like to keep track of their trends to help us in our determination of some elements in our tactical models.
To see this visually, here is how things have looked over the past year or so with a highlighted portion around 2017 Hurricane season due the huge impacts in Texas and Florida affecting unemployment.
There were some concerning trends developing in early 2017 that seem to have picked up in recent months despite the horrible hurricane season. The coincidental index ticked down largely due to payrolls suffering post hurricanes, but this is expected to pick up in the coming months. If the upward breakout continues, spurred by tax cuts, we could hang onto this economic front.
However, as deficits grow and interest rates rise, the concern is whether that would be enough to goose the economy into further sustained growth which inspires a much longer expansion and a prolonged bull market.
So far interest rates have behaved and not dramatically changed course to the point we would be concerned about the short term in trend. Rates are still under the moving average and this is bullish for stocks.
This all is good news for markets probably through the end of 2018, especially if tax reform does happen. Stock sentiment is still high and advancing, the economy is not showing signs that we are imminently at the top of the bull market and interest rates are not squeezing us out just yet. The Trump administration is working hard to give the economy every chance it can get to keep chugging along.
The big questions will be if we can sustain the initial grown and if we will be able to effectively keep a lid on budget deficits. It is good to be realistic and understand the bottom line, that tax cuts are likely to help some, in the short term. Depending on how it gets done, the deficit will become a focal point, but the Fed will also continue to be a key player.
So far things look good, but we are constantly monitoring for any signs that it is beginning to crack.
1- US Markets. Ned Davis Research. October 18, 2017 [10/20/17]
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