Once upon a time Washington was simple: on one hand you had Republican interests, on the other: Democrats, and inbetween them perhaps, the occasional independent or “green.” Now… it’s less simple. At last check, DC currently boasts at least nine different parties, groups, factions or ideologies. Which is why keeping track of who wants what, and how the various groups allign, in US politics has become quite complicated.
So, for all those confused, here is a table from Deutsche Bank which summarizes how the different groups within the White House, House and Senate align on key issues.
In the table above, Y=Yes, N= No, ? = Don’t know; ?N = bias is No.
Some notes: as DB’s Alan Ruskin writes, the table above is a very rough schematic, on how various groups are perceived to lean on key issues. Political positions are obviously fluid. Some observations include:
i) Perhaps reflective of past political positions, the perceived approach of Cohn and Treasury Secretary Mnuchin are in some respects better aligned with the Democrats than the GOP on individual taxes, although more in favor of supply side, corporate tax reform than the Democrat establishment.
ii) There may be serious ambivalences about specific tax cuts among some parties, but middle class tax cuts have cross party support, and would be harder to reject than anything on the expenditure side, like infrastructure spending. Middle class tax cuts is a better starting point than infrastructure spending for encouraging GOP support, before the President goes down the risky route of courting Democrats. As Table 2 indicates, the range of estimates on multipliers slightly favors infrastructure spending, but only modestly over tax cuts for the poor and middle class.
iii) Similarly, there is limited material opposition to a net fiscal stimulus in principle, if Meadows latest comments are an accurate reflection of the Freedom caucus; although the likely process of reconciliation will constrain ‘the permanence’ of any net stimulus.
And now that the main actors’ desires have been identified, how does the Trump reform path look like from here? Some additional observations on the “conventional long haul”, and the “alternative” route facing Trump, and everyone else in Washington, and how these would impact the US economy, market, the Fed’s “reaction function”, and last but not least, global risk appetite.
Gary Cohn met with President Trump on Thursday to give the President an outline of Tax Reform possibilities. The options vary widely, but from a market perspective are best thought of as a choice of two very different tracks: A long, ambitious and conventional path of comprehensive tax reform; or, a populist, possibly bi-partisan quick fiscal stimulus, with very limited “reform”. Both paths are fraught with political risks, but have their own allure, and each approach could have profoundly different market implications over the coming year.
i) There’s the conventional long haul, with tax bill developed in the House, enabled and support with direction from the White House. In this approach some past reform initiatives could be resuscitated. One example is meshing the 2014 Camp plan with many of the Brady-Ryan tax simplification tenets. This could allow for more focus on individual tax reform and exclude the controversial border adjusted tax. After all, BAT has many of the characteristics that sank the ACA repeal and replace, including extreme complexity, big winners and losers resulting in aggressive push back from entrenched interests, and, House leadership backing with questionable Senate support. It would be surprising, if BAT was high on Trump’s agenda, even if its exclusion means dramatically scaling back corporate tax reform ambitions.
ii) One alternative, is a much less ambitious route for a President to notch up a quick ‘legislative win’, by looking for measures that secure the greatest chance of fast passage, if necessary by reaching across the aisle. This approach would be driven by the White House in keeping with the latest administration comments that it ‘is driving the train’ and fits with a direct, unconventional, non-ideological approach. Of the measures that have most cross party appeal ‘middle class tax cuts’ best fit the description, even if both parties will find plenty to argue over what constitutes ‘middle-class’. Actions to encourage corporate foreign earnings repatriation and possibly some infrastructure spend would also be on the list of asks. ‘Reform’ and in particular the broadening of the tax base, by removing deductions would be kept to an absolute minimum to facilitate easy passage. The measures could be advertised as a tasty hors d’oeuvre before a main course, that may never arrive!
Neither the conventional path, nor the alternative route would have any material impact on the long-term natural rate of growth of near 2%. Small changes to the corporate tax would not fundamentally change the US status as a relatively high corporate tax country. Other possible changes like the full expensing of Capex is expensive, and would likely fall by the way side in a very limited corporate tax reform bill. For tax cuts, the growth impact will be dependent on the PCE channel; here the short-term cyclical boost to demand could still be substantial. As per Table 2, the estimates of multipliers on middle income tax cuts vary enormously, but the high estimate multipliers (1.5) are on the higher side of tax and spend multipliers. Infrastructure spending is also widely seen as having one of the higher multipliers.
There is nothing simple in the simplification of taxes. Simplification is deeply complicated and the removal of deductions has many of the characteristics of entitlements, with entrenched interests fighting hard for the status quo. Given the political uncertainties, the time value of money is enormous. Extending the time before any enactment, adds to the risks that nothing gets done; likely dilutes the stimulus; and, time adds to the uncertainty about the economic circumstances when the measures hit! In that light it appears as if the market is currently pricing in very little in the way of a fiscal stimulus, which helps explain the markets tepid reaction to the ACA repeal and replace failings.
Without a significant reduction in the corporate tax rate it is difficult to make strong arguments that Tax reform will impact trend growth, Corporate bond and equity inflows, and net FDI into the US. Instead, all the FX market’s emphasis will be on any cyclical growth stimulus, resultant monetary policy, and the portfolio flow channel.
Because of the way the market values time, the prevailing view for 2017 runs something like this:
If President Trump goes down the conventional, long and winding road toward tax reform, the Fed may tighten twice more this year, but the risks are if anything tilted to less, rather than more hikes. This is what is currently priced in.
If the President goes for a quick ‘legislative win’, the market will have to think in terms of the risks tilting quickly toward three more rate hikes this year.
Arguably 2018 Fed expectations should be even more profoundly impacted. Dec 2018 is also pricing in very little material fiscal stimulus given that only 44bps of funds tightening is priced in for 2018. If the market can see a 1% of GDP fiscal stimulus for each of 2018 and 2019, a minimum of an additional 25bps should be priced in for next year.
Most other asset classes will take their short-term directives from this broad outline on the impact of fiscal alternatives, although the FX market seems less sensitive to short-term Fed expectations, and more inclined to take its cue from Fed expectations beyond 2017; and, longer-term rates, like 10yr yield spreads.
Global Risk Appetite
Global Risk appetite was very resilient in the face of recent Washington events. The reasons include: i) The US economy is not in need of a stimulus, and may even do better in the long-term, if there is Washington gridlock. ii) less US growth means less Fed tightening, especially in 2018/19; and, iii) Outside the US, global growth is much more than a Trump reflation story. Global risk resilience in the face of US political uncertainties can continue, at least while political turmoil discourages US overheating, even if the US equity market will be less ebullient in the shorter-term.
In contrast,, if the President pursues the alternative ‘quick win’ approach and there is signs of House and Senate support, the market will go back to a view that meaningful stimulus will show up directly in the economy come Q1 2018 at the latest, and indirectly via financial conditions well before then. It is that kind of scenario that is needed to reinvigorate the bullish USD view. For dollar bulls there should be no equivocation – the fiscal hors d’oeuvres, are much preferred to risking starvation on the long & winding road.