4 Dec 2017
Writing legislation is hard. It’s not enough to just sum up the spirit of what you’re trying to achieve, you have to ensure that it covers all eventualities, is fair and works the way you intend. And drafting tax law is the hardest of all.
So when you rush through the details in a bid to be home in time for Christmas, you’re likely to make a few mistakes. One of these clangers has already been spotted by businesses, just hours after the Senate voted in favour of a tax plan that will now be reconciled with the House of Representatives version over the next few days. During the last-minute wrangling, the alternative minimum tax – a tax regime that strips out deductions and must be paid if it results in a higher bill than the main tax code – was put back into the tax reform bill. This clause, which affects both people and companies, had been cut very early on as part of the simplification of the tax rules. Unfortunately, because it’s set at the same rate as the new 20% corporate rate, it effectively means all research and development credits would be worthless. That has led to uproar from technology, manufacturing and pharmaceutical companies, which predominantly benefit from these tax subsidies.
Whoops. The alternative minimum was put back in to win over hold-out Republican senators worried about the budget deficit, which will balloon under the plan. It could be reversed, but the money would still have to be found elsewhere – upsetting someone else in the process. There will be plenty more stories like this seeping out of Washington over the next few days as the tax reform package races toward becoming law. But the most insidious mistakes won’t be known for years to come. Tax policies create a mind-boggling web of incentives that can distort commerce and society for generations. That’s why you usually take your time and tread carefully.
As it is, we believe the tax cuts will have a minimal economic effect. Most of the personal tax benefits are going to people that are less likely to spend the windfall. Most businesses – by their own admission – are not likely to invest more or raise wages with the extra profits. What it could do is boost people’s mood though. Sometimes, reality matters less than perception. With a tax-cut in the pipe – modest though it may be – middle-income Americans may become more hopeful, more confident and more industrious. That by itself could give the US economy a lift.
Still, one development that would not lead to a triumphant America is the impeachment of President Donald Trump. Last week, his former national security adviser, Michael Flynn, admitted lying to the FBI about his contact with Russian officials. His confession dragged Mr Trump’s son-in-law Jared Kushner closer to the scandal as well. US markets didn’t take the news too well: the S&P 500 dipped and US treasuries rallied. We expect this case to remain in the background for some time; a stack of political dynamite waiting to go off.
The year winds down
US technology companies and those that have benefited from strong upward momentum over the year took a bit of a step down last week.
Some of this may have been due to the tax deal struck in the Senate, but it seems mostly a continuation of early profit-taking after a solid year. There have been some extremely good returns posted by the darlings of the S&P 500 and it is understandable that some investors are looking to bank their winnings. Cash has been flowing into areas that have had a rough time of late, including retailers and value stocks. Department stores bucked a long-term trend by posting surprisingly strong sales over the Thanksgiving weekend, both in-store and online.
It’s been a strong year for the US share market, with overseas money pouring back in after fo
ur consecutive years of outflows. According to Deutsche Bank, $66.4bn of foreign cash was added to US stocks during the nine months to 30 September. This may have been a response to the 9% fall in the dollar over 2017, which makes US assets cheaper to foreign investors. The US economy has also been posting strong data, from labour markets to consumer and business confidence through to GDP growth. Our research suggests that American economic heft may have peaked, however, and will start to trend slightly downward from here.
Europe has also been riding high lately. Economic news has been broadly positive, while company earnings have been punchy indeed this year. Again, we believe this has likely hit its top and numbers will begin to recede from here. Consumer confidence struck a 15-year high recently, but households have taken on a significant amount of extra debt over the past few quarters. The GDP growth provided by households and businesses peaked in 2016 and European banks, in the main, are still burdened with enormous amounts of non-performing loans. We don’t expect the bloc to come crashing down into recession, but we think its growth will settle somewhat below where it is now.
As for the UK … well. We think there won’t be a recession in the UK, but growth will probably be lacklustre. Consumer confidence recently fell to its joint-lowest point since the referendum as real wage growth remains deeply negative. The real yield of the 10-year gilt is deeply negative, at -1.67%, which implies poor future economic growth. In contrast, the US treasury real 10-year yield is 0.34%. In fact, real yields in countries with negative interest rates – Japan and Europe – are higher than in the UK.
That doesn’t mean FTSE companies will perform badly necessarily. Those that do a lot of business overseas would benefit from accelerating global growth and weakness in sterling. The FTSE 100 in particular would see most of such gains. Still, the UK economy is groaning. The government’s Brexit deal could have large repercussions for both foreign investment – both direct and in the stock market – as well as the growth rate for Britain. This week will see the discussions of political and sovereignty issues come to a head: an agreement in principle is needed about the European Court of Justice and the Irish border before the parties can move on to trade negotiations next year. A delay here could be damaging.