the business cycle, interest rates and the tax cut

past cycles

The garden-variety business cycle since WWII has played out over about four years.   Stock market rises and falls have typically led this cycle by about six months.  Movement breaks out into around 2 1/2 years of up followed by 1 – 1 1/2 years of down.

The driving factor in the cycle has been government policy, in the form of Federal Reserve’s control of short-term interest rates.  Half a century ago, conventional wisdom held that fiscal policy took effect with such long lags that extra government spending or tax changes might end up addressing a problem that was no longer there.  So, the argument went, Congressional action would do more harm than good.  More recent Congresses have been dysfunctionally unable to pass potentially helpful bills.

a typical pattern

Let’s look at the beginning of an up cycle.  The economy has been sputtering–perhaps even declining–so the Fed lowers short-term interest rates.  In the world outside the US, lower borrowing costs make economically viable industrial projects that were previously on the shelf.  So companies build new plants and then hire new workers.  This leads to a pickup in consumer spending, which leads to more investment, which leads to more hiring…

At some point, the economy runs out of workers.  Companies still want to expand, so they begin to poach staff from rivals by offering (a lot) more money.  In advanced economies, inflation is always wage inflation, so price increases start to accelerate at unhealthy speed.

The Fed reacts by raising interest rates to cool the economy down.  Typically, the central bank goes too far.  Monetary policy doesn’t simply return to neutral.  It becomes restrictive, meaning the economy begins to sputter again.  Realizing its mistake, the central bank reverses course  …and an upcycle begins once more.

The US is different.  For whatever reason, consumer spending here doesn’t wait for new jobs to materialize.  Unlike the rest of the world, consumer doesn’t lag investment; it leads.

stocks and bonds

As the upcycle matures, bonds start to weaken because interest rates are beginning to rise.  Stocks, on the other hand, have an initial hiccup but then tend to go sideways to up.  That’s because earnings growth continues to be strong, offsetting the negative impact of rising rates.  Eventually, if/as the central bank become restrictive, stocks begin to decline as well–both because rates are continuing to rise and because investors begin to anticipate future profit declines.

this time is different

Normally, those words send chills up and down the spines of investors.  This time, however, the business cycle really is way different than the garden variety, in three ways:

–interest rate policy has been extremely stimulative for most of the past decade, as a necessary aid to rebuilding the economy after the (Washington-induced) financial crisis,  and because Congress has failed to help through fiscal policy.   Because short rates have been starting from essentially zero, they can rise a long way before beginning to damage the economy

–a little more than a year ago, as the Fed was continuing to withdraw stimulus to counter overheating (evidenced by crazy financial speculation), Congress passed tax cuts that, ten years too late, added over $100 billion annually to net stimulus

–the administration has implemented a hodge-podge of restrictions on trade, which appear, to me at least, to be much more damaging to the domestic economy than the consensus believes

the upshot

–if the trend of annual nominal GDP growth in the US is 4% – 5%, the tariffs may depress the figure for 2019 below that level

–it’s also up in the air as to how much the tariffs will take the edge off the earnings energy stocks need to fend off the negative effect of higher rates

–tax cuts boosted corporate eps in the US by about 20 percentage points.  The overall earnings gain will likely be about +25%.  Because both 2019 and 2018 figures contain the tax benefit (but 2017 numbers didn’t), the yoy eps gain for 2019 will likely drop to be on the order of +5% – +10%.  On the surface, then, earnings growth in 2019 will fall off a cliff.

Decelerating earnings growth like this is normally a sell signal.  On the other hand, the market traditionally doesn’t pay attention to one-off items, however large.  If this holds true again, the market should go sideways from here.

What are the algorithms thinking?  Better said, how are the algorithms programmed?


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  1. Pingback: What stocks to invest in = the business cycle, interest rates and the tax cut « PRACTICAL STOCK INVESTING | Stock Investing

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