Thursday, December 1, 2016

Tax Cuts Have a Price

Bonds are the main show.  Despite what you hear about all the Trump theme plays, like financials and industrials, the big move is happening in bonds.  The carnage is extreme and will have lasting implications for the sustainability of this bull market.  The stock market is not strong enough or cheap enough to sustain an uptrend with this kind of relentless rise in yields.  At a certain point, the high dividend plays become roach motels and bonds become more attractive on a relative value basis.

The Trump experiment of having big tax cuts and big deficits is taking from one hand and giving it to another.  They are taking money away from bond holders and giving them to the high income earners, corporations, and to equity holders.  Lighting a flaming torch to all those bonds outstanding is a bold experiment in testing how deeply dependent financial markets are on low interest rates.  The global economy will collapse under a huge weight of debt if Trump gets 100% of what he wants.

QE is free money.  Tax cuts are not free money.  There is no price to pay in the financial markets with QE.  But there is one to pay with tax cuts.  When there is no QE, the price to be paid for running up huge budget deficits is higher interest rates.  An economy growing like it did in the 1980s and 1990s can handle a 10 yr yield above 5%.  An economy this weak would go into a deep recession if the yields got even a sniff of that level.

I am not saying we will keep selling off in bonds and enter a bond bear market.  But too many equity investors are sanguine about rising interest rates.  They are what cash flows are discounted off of.  I have serious doubts that these tax cuts will boost growth as many think.  The Bush tax cuts did very little for the economy from 2001 to 2012.  Most tax cuts are saved, not spent as many people think.  And since most of the Trump tax cuts will go to the rich, most of the extra money will be saved.  You are mostly shifting savings from the bond market to a mix of stocks, bonds, real estate, and cash.

While Trump has succeeded in killing the bond market, I don't think he will succeed in keeping the equity bull market going.  The best way to support the financial markets as we have seen over the past 7 years is through monetary policy, not fiscal policy.  As I figured, the end game for this bull market would come on hopes for a stronger economy, which would take away the monetary policy stimulus this bull market has thrived off of.  If I am long stocks, a Fed feeling confident about the economy and higher inflation is the last thing I would want to see.

No comments: