More Tax Cuts, Midterms And The History Of ‘Exogenous Macro Shocks’

Do you want to see something funny? Of course you do, and I’m happy to oblige.

Let’s go to Donald Trump who, speaking to reporters after an event in Nevada, suggested he’s going to push through a “major tax cut for middle income people” before November:

Ok, so a couple of things there. First of all, November is  – checks notes – eleven days from now. So when he says “a little before then”, that would suggest Trump thinks he’s going to roll out major tax legislation next week. You can draw your own conclusions about the relative feasibility of that “plan”.

Second, note that the President accidentally admitted the first tax cuts weren’t actually for middle income people, but rather for corporations. Everybody of course knows that, but his half-hearted effort to talk around it after realizing what he said is amusing nonetheless.

Why bring this up? For one thing, because it’s hilarious, but that’s not the only reason. With the midterms just weeks away, Wall Street is starting to focus intently on what the various possible outcomes might mean for equities into year end. One key debate is what the read-through will be for further tax cuts and for the fiscal impulse more generally.

I’ll save you a little bit of suspense: The fiscal impulse is going to wane irrespective of the outcome. That’s important, because without the boost to corporate bottom lines from the tax cuts and the concurrent buyback bonanza, U.S. stocks likely wouldn’t have held up as well as they have in 2018.

Have a look at this chart from BofAML, which shows actual and forecasted EPS growth (yellow dots) versus EPS growth ex-the impact of the tax cuts (orange bars):

(BofAML) 

That’s quite the boost/sugar high. You can see the effect on sentiment in another visual from BofAML which depicts the ratio of “better”/”stronger” to “worse”/”weaker” mentions on corporate earnings calls:

(BofAML) 

The risk, clearly, is a Democratic sweep. Although it’s not entirely clear to me there’s much more the GOP can do in terms of boosting the economy with tax cuts (i.e., I think they’re going to reach the point of diminishing returns on this all the while ballooning the deficit), it’s unquestionably true that a Democratic sweep would impair sentiment.

“Management teams have been upbeat about the economic environment and about spending on capex, whether driven by better tax treatment of capex or windfall earnings driven by tax reform and a threat of a reversal or uncertainty might slow down or halt spending”, BofAML writes, in a note dated Thursday, adding that “corporates most prevalent use of windfall earnings is capex and hiring, and the risk of a reversal to parts of the Tax Reform and Jobs Act could adversely impact corporate spending, corporate and consumer confidence and thus the US economy.”

Let’s just go ahead and ignore the rather contentious debate about whether corporations are in fact predisposed to favoring capex and hiring over buybacks. The point, for our purposes here, is that a Democratic sweep (however desirable from a social perspective) does have the potential to be highly destabilizing for markets – and not just because it would dent corporate sentiment.

“A democratic sweep could increase the risk of congressional investigations and while this scenario is currently not on the table, in the event of impeachment proceedings, it could be classified as an exogenous macro ‘shock’,” BofAML goes on to write, in the same note cited above. Here’s a bit more from the bank on the history of such shocks and a brief summary of the risks around a Democratic sweep:

Historically, shocks have driven a 6% peak to trough decline, but the market has generally recovered much of the initial selloff (Table 2), in our view. A longer term risk is that of reversing tax reform, which has contributed double-digit earnings growth to S&P 500 companies. Another risk under a Democratic sweep (or gridlock) is failure to enact pro-growth measures over the next two years that might create economic momentum for the incumbent.

How likely is this to play out? Not likely.

As Goldman reminds you, “prediction markets show a 65% likelihood that Democrats capture the House and 85% probability that Republicans maintain control of the Senate.”

(Goldman)

One final note: Right-wing outlets are quite fond of reminding folks about just how unreliable prediction markets turned out to be in the lead up to populist coups like Brexit and Trump’s election win.

There would be more than a little poetic justice if that same unreliability ended up manifesting itself in a surprise Democratic sweep next month.