CIO Insights

With Rich Weiss

General Investing | April 2021

Higher Taxes, Market Impact? What to Know

By Rich Weiss | 5 minutes

To fund their multi-trillion-dollar infrastructure spending plans, the Biden administration is proposing raising taxes on corporations and wealthy individuals. Investors are wondering what effect such a tax increase may have on the markets.

Impact on Stocks

Corporate taxes translate directly to corporate profits, and a change in corporate tax rates would likely show up very quickly in stock prices. Of course, no one knows the magnitude or timeline of any potential tax increase.

The market reaction would likely anticipate actual changes in the level of corporate taxes. During the last round of corporate tax cuts that took effect in early 2018 (the Tax Cut and Jobs Act of 2017), the effect on profits and stock returns was swift.

Individual Taxes and Consumer Spending

Personal income taxes, on the other hand, have a less direct relationship with financial markets. Higher taxes could be expected to limit consumer spending and, therefore, economic growth over time. The effect on growth depends greatly on how any potential tax changes are structured and implemented.

For example, the current proposal would increase taxes on only the highest earners, preserving the after-tax income and purchasing power of the vast majority of Americans.

The Debt Factor

Presumably, though, personal and corporate tax increases will eventually be necessary to pay back the growing federal deficit.

We are looking ahead to a careful balancing act between growth, rates and taxes, all of which will be necessary to pay down that debt over time. 

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New Administration, New Policy Impacts?

We’ve written extensively about the folly of betting on political outcomes, so let’s put that right up front. But people do continue to ask us questions about how we factor in policy implications for various segments of the economy and markets.

With that said, I can relay some of the major issues before us, and what the conventional wisdom may tell us. Remember, it’s not what you think is likely to happen that matters most. It’s the likelihood of that actually happening measured against what the market has already priced in (whether market prices appear to reflect these policies).


What's Ahead?

The conventional wisdom holds that a unified Democratic government could lead to the following:

More stimulus—including the potential for a $1.9 trillion stimulus package.

That may be good news for the economy, equities, the consumer and municipalities in the near term. However, this may already be priced into the markets to some extent.

Modest tax hikes on corporations and high-income individuals.

We don’t believe this is fully priced in, as the probability and details are still uncertain.

More regulation in some sectors, plus a boost for clean energy and infrastructure spending. 

The Biden administration’s block of the Keystone XL pipeline is the first major example of regulatory changes. The fracking industry and Big Tech may also see some obstacles placed in their way in terms of tighter regulations and/or higher minimum taxes. 

Potential Roadblocks for Policy Initiatives

We think it's important to remember that unified control does not always mean unlimited control. Individual members of Congress have competing interests and agendas that can limit policy options. In 2017, for example, Republicans controlled the White House, Senate and House of Representatives but were unable to pass a repeal of the Affordable Care Act. 

Democrats currently hold the slimmest possible majority. This means that the more extreme or hotly debated measures, such as a Green New Deal, still have a difficult pathway to becoming law given the party’s heavy reliance on moderates who may be up for re-election in 2022.

It’s also important to distinguish between those policy initiatives that require a simple majority vote in Congress versus those that mandate a “supermajority” of 60% or even a two-thirds vote.


Updates to Legislative Approval

Last week, Congress passed a budget resolution bill which makes it easier to pass certain legislation. “Budget reconciliation” is the term used to describe the process through which major budget policy objectives can be approved with only a simple majority vote—now much more likely with a 50/50 Senate split and VP Harris as the tie-breaker. These bills can focus on one of three facets of the budget process:

  • Spending
  • Revenues
  • Debt limit

Next, consider that to end a filibuster and bring any new legislation to a vote requires a three-fifths (60 out of 100) majority vote. Changing Senate rules, for example, face an even higher hurdle, requiring two-thirds of the Senate to approve. So, except for certain items which can be handled under the “budget reconciliation” process, many issues before the Senate would require at least 60 votes to pass, lest they be filibustered.


Final Word

Even with the White House, House and Senate under Democrat control, the slim margin of power in both Houses puts a lower probability on major, lightening-rod political and economic issues being approved.

Reflation Is Not Inflation

We’ve been getting a lot of questions about the economic recovery, fiscal stimulus and the likelihood of inflation. What are the odds we get past the worst of COVID and its economic repercussions by the end of this summer? Will inflation re-ignite this year as the markets seem to be implying right now?

Thanks to the vaccine rollout, an economic recovery and even more government stimulus on the way, it seems we are finally transitioning to a post-pandemic “normal.” Counterintuitively, though, the stock and bond markets have seen recent selloffs, perhaps because of worries that the economy could overheat and lead to inflation.

The first point we’d make is that “reflation”—rehabbing a damaged economy—is not the same thing as an inflation shock. In our view, reflation refers to the process of stimulating the economy by increasing the money supply and/or using fiscal stimulus to boost activity following a downturn in the business cycle.

Think of it like reinflating your bike tire when it’s flat—adding some air is necessary to get back on the road. That’s a far cry from the inflation that many seem to be fearing.

Continuing with our bicycle analogy, inflation would be akin to continuing to pump up a tire that’s already under pressure. But as we’ve been saying for some time now, we just don’t see evidence that the economic tire is already fully inflated and under significant inflationary pressure.

Could Inflation Reignite in 2021?

Despite what markets are currently pricing in (whether market prices appear to reflect the possibility of inflation), my own belief is that it’s unlikely we see inflation overheating in the near future. A COVID “tail” and aftereffects could well extend into 2022, resulting in a more modest rebound than everyone appears to be envisioning.

To be clear, we’re not donning our doctor’s smock to make this call. We simply think it’s hard to argue that the pandemic will be done and dusted by the summer, and that economic activity will resume exactly as before even once herd immunity is reached.

It seems more reasonable to us to assume a longer, gradual workout and recovery. Just consider the long-term “scarring” effects of the pandemic on the labor market, or the “K-shaped” recovery that is leaving many consumers and parts of the economy behind.

A K-Shaped, Diverging Economic Recovery

Source: Investopedia, November 2020.

Wage Inflation Isn’t on the Horizon

Also consider that the labor market is in no shape to drive wage inflation. It’s really difficult to envision rising inflation with the labor output gap still so large and unemployment so high. Even the recent rebound in industrial commodity prices, we would argue, is recovering lost ground from last year and unlikely to drive meaningful, enduring inflation going forward.

Main Inflation Drivers Just Aren’t Here Yet

Having said that, we recognize that this is a contrarian position. Interest rates are rising and the yield curve is steepening. This is an indication that the bond market is actively concerned about inflation.

And we do not dispute that we will have to deal with the consequences of all the government monetary and fiscal stimulus poured into the economy at some point. The real question is, when?

Without the kick to inflation that comes from rapid economic growth and rising employment, we just don’t think it’s likely inflation will reignite anytime soon. 

Will Current Policies Jumpstart Inflation?

Many factors can drive inflation. But current policies—huge fiscal stimulus and government debt, and even a nudge from “green” energy plans—seem to be creating an environment that’s ripe for price increases. Are these pressures enough to reignite inflation down the road?

“Green” Inflation? Maybe, Maybe Not

It’s possible that “green” policies designed to promote alternative energy may promote inflation. To the extent policies are implemented solely for environmental, social, or governance reasons, they could be detrimental to near-term investment returns, economic growth and/or inflation.

But there’s also an argument that green policies could be beneficial to the economy, especially over longer time periods, and might actually work to tame inflation. More abundant and diverse sources of energy could encourage lower prices by increasing energy supply and market stability. A more robust energy network or diverse energy sources may also help eliminate or reduce the utility network shutdowns seen in California and Texas, for example.

Similarly, rising adoption of alternative energy sources could hasten peak oil demand, when new technology makes alternatives more cost effective than oil. This would suggest a potential transition from oil scarcity to abundance—and likely falling oil prices.

More Immediate Inflation Concerns

My sense is that most investors are concerned with more immediate threats on the inflation front, rather than the impact of green policies.

Some of the biggest near-term inflation risks would come from increasing manufacturing and consumer demand amid a presumed rapid recovery, as well as from a weak dollar (importing inflation).

Labor costs are another major potential driver of inflation, but these haven’t risen significantly given the slack in the labor markets. It’s hard to see inflation being led by labor markets while the participation rate (those employed or looking for work) is so low. Of course, we have to put a big asterisk here because of the potential for an increase in the federal minimum wage over time.

Finally, the threat of a cost-push type of inflation from higher oil and commodity prices is real, though this is chiefly due to increased demand and not the rise of alternative energy sources. (Cost-push inflation is when increased wage and production costs drive increases in overall prices.)

The Economic Inflation Equation

With respect to government spending and increased money supply (from Federal Reserve policies) driving inflation, the basic equation/recipe for monetary inflation is “M * V.” That is, Money Supply times the Velocity of money. 

Money Supply  x  Velocity of Money  =  Monetary Inflation

In other words, without significant economic growth spurring more financial transactions (i.e., more “velocity” or turnover of money in the economy), there isn’t a high likelihood of inflation. Increasing the money supply is a necessary, but not sufficient, condition for inflation.

Is Inflation Coming? Don’t Pencil It in Yet

When will we see inflation? The timing depends on the real economy growing and eventually overheating, which may not occur for some time. For context, consider that many people expected price increases in the 10+ years of economic growth after the global financial crisis. But because the economy never overheated, we never saw much (or any) inflation.

Having said that, we recognize that rates are rising and the yield curve is steepening, suggesting  the bond market is concerned about inflation.

We don’t ignore that or disregard what the market is telling us. We are simply saying that while we can see the argument for higher prices ahead, we can also see all the obstacles on the road to meaningfully and sustainably higher inflation.

Ultimately, we believe investors do well to incorporate a diversified inflation hedge as part of their portfolio allocation. This way, you can add the potential of some inflation protection in the context of your overall portfolio. You also won’t be faced with choices about making wholesale changes into or out of certain asset classes while you try to guess or anticipate changes in inflation expectations.

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