March may prove to be a pivotal month for the trajectory of both fiscal and monetary policy. In the immediate aftermath of the November 2016 elections, investors responded favorably to the prospects of more business- and market-friendly reforms from Washington, with the S&P 500 surging 12.4% from 11/9/2016 to 2/28/2017 (45% annualized). Most of this optimism was centered on the expectation for tax reform, deregulation, and infrastructure spending (in that order of importance), but the White House and Congressional Republicans chose to tackle healthcare reform first. Throughout March, a contentious intraparty debate in the House related to healthcare reforms exposed the difficulty of pushing the Trump Administration’s ambitious legislative agenda through both houses of Congress, and on March 24, Republican leadership in the House of Representatives canceled the vote. Consequently, enthusiasm in risk markets has dampened, particularly as it relates to expectations for tax reform and deregulation. In the end, markets were never that focused on healthcare reform, except as a proxy for future legislative battles. Getting these bills through the Senate would have been challenging enough, even with Republicans on the same page, but intraparty conflict makes it that much more difficult.
House Republicans say they will now move forward with tax reform legislation, likely using House Speaker Paul Ryan’s “Better Way” plan as the starting point. We provided an overview of this plan in the March commentary, and the biggest item of contention will likely be the inclusion of a border adjustment tax (BAT). Some Republicans support the BAT as a revenue offset to tax cuts, but others have expressed opposition, including President Trump. In a March 28 article, The Wall Street Journal (WSJ) suggested three primary options for tax reform from the Republican perspective: “A fast-track plan that would yield more quick action this year but limit how aggressively they can cut corporate and individual rates; a slower and more ambitious rewrite of the tax system that risks another nasty intraparty fight; and working with Democrats.”
The first two options would use “budget reconciliation” tactics, which would allow for a simple majority vote in the Senate to pass tax and spending bills without the threat of filibuster. The third option would be ideal, but it’s difficult to imagine Republicans and Democrats getting on the same page (it’s hard enough just getting Republicans on the same page). The WSJ article implied that option one (fast-track) was the most likely, given the results of the healthcare reform legislation; but it’s too early to tell at this point. In the end, a lack of meaningful reforms to corporate tax policies would almost certainly spark a negative reaction in equity and corporate credit markets. Of the three major policy issues that the markets have focused on post-election, corporate tax reform has been the biggest and most influential from a valuation perspective.
Stepping back, perhaps a bigger question for tax reform and infrastructure spending (as proposed by President Trump) is whether fiscal conservatives will support legislation that pushes the current budget deficit even further. The national debt is approximately $20 trillion (total debt outstanding), relative to nominal GDP of nearly $19 trillion. As Exhibit 1 illustrates, spending on defense, entitlements (makes up most of mandatory), and net interest on debt is projected to consume all revenues by 2019, which doesn’t account for tax reform. The United States has no trouble at this point in refinancing its debt, but that’s not to say deficit hawks in Congress won’t have major issues with reforms that create a deeper deficit without some offsetting cuts in entitlement spending. This increases the odds that actual tax reforms (assuming we see any) may be a mere shell of the initial Better Way plan.
The Fed Plows Along
As almost everyone expected, the FOMC announced a 25 basis point (bps) increase in the fed funds rate target range on March 15. Given the hawkish (and impromptu) comments from Fed Vice Chair Bill Dudley on February 28, market pricing shifted from a 25-35% probability of a March hike to 100% in the days that followed. Further, investors became concerned that the Fed might also convey other hawkish messages, such as an increase in the number of projected rate hikes in 2017 from three to four, as well as a change in the official statement guidance for balance-sheet reduction. In anticipation of both, Treasury yields rose 10-25 bps across the curve in the first two weeks of March; but when the official FOMC announcement came, the results were much more dovish than expected. The projections for GDP, unemployment, inflation and the fed funds rate were left essentially unchanged, and there were no changes whatsoever to the official statement with regard to guidance on eventual balance-sheet reduction.
In the press conference that followed the official releases, Fed Chair Janet Yellen was predictably pressed for more details on reinvestment tapering, and her tone did not suggest any urgency. She said that any discussion of balance-sheet reduction would be “a matter of prudent planning,” and she was dismissive of any particular level of the fed funds rate that might trigger this process. More specifically, Yellen said “the right way to look at it is in qualitative and not quantitative terms.” The idea of quantitative guidance for reinvestment tapering goes back to the minutes of the September 2015 FOMC meeting, which included staff simulations that suggested a 1-2% target fed funds rate before beginning the process. Many investors used that guidance as a tool for guessing the timing of any official announcement; but not surprisingly, Yellen was non-committal on any such guidelines. As she noted in the December 2016 press conference, the FOMC is more focused on normalizing the fed funds rate so they may “have some scope through traditional means of interest rate cuts” to respond to “an adverse shock” (i.e., recession). Most everyone is confident the Fed will begin to reduce the size of its balance sheet from the current $4.5 trillion level, but no one really knows how much or at what pace. A “normalized” Fed balance sheet in the current environment is closer to $2.5 trillion, according to some analysts, but the Fed may prefer something in the middle, given the perceived benefits of more reserves in the banking system.
Going forward, some are wondering whether the Fed will become even more aggressive with its normalization process as the year progresses. On March 31, February headline PCE rose to 2.1% on a year-over-year basis, the first time above 2% since April 2012, and PCE core held at 1.8% (January figure revised higher), just below the Fed’s year-end forecast of 1.9%. The overall economic data trend remains solid, but a major question now is whether or not a lack of progress on the fiscal front will negatively impact both sentiment and hard data, which could clearly affect the Fed’s thought process.
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