Season’s Greetings to Global Bankers from Rosy Scenario

By Roy C. Smith

It's a happy time of year, made more so by a Goldman Sachs global economic forecast (entitled “As Good as It Gets”) that predicts 4% growth in 2018, up from 3.6%. It was 5.4% in 2010. Still, all around the world economies are growing again, inflation is lagging so rates are still low, and market analysts all want us to stay fully invested in equities despite the roaring global bull market and all-time highs of the last year.

Indeed, many investors are happy to explain away the rallies (S&P 500, MSCI and FTSE 100, et.al.) as just catching up to where we ought to be after finally escaping the low-growth grip of the Great Recession. “Total real return” from the S&P 500 index (i.e., including dividends, and adjusted for inflation) from 2000 until now was 3.1%, up from 2.3% through November 2016, so Mr. Trump did make a difference. Even so, the total real return trend line from 1980 until now was 7.9%, so we still have more catching up to do, don’t we?

Overall, the rallies in the US, Europe and Japan have ignored politics and their many antics and implications, despite their being constantly in the news. Mr. Trump is now treated by investors as we treat teen agers – ignore what they say, but watch what they do. As Rosy often points out, Mr. Trump has never been nearly as bad for the world economy as he declared he would be (China, North Korea, NAFTA), and his aggressive domestic agenda has lagged far behind his promises. Investors in Europe also seem to have retained their sangfroid, despite the excitement of Brexit, Catalonia, the amorphous German coalition, uncertain Italian elections, and some backsliding in Austria, Poland and Hungary. Investors are showing confidence in their private sectors, not their governments.

Mr. Trump’s tax bill is a needed political victory with some modest economic benefit. Gary Cohn, Mt. Trump’s chief economic advisor, says growth next year will be 4.0%, but Cohn’s old firm, Goldman Sachs, forecasts tax cuts will increase GDP growth by only 0.2% for only two years, leading to an annual US growth rate of about 2.5% in 2018. But Goldman also says growth will slow again in 2019 (to 1.9%) due to labor and other constraints. Rosy and some other economists believe the momentum from the 3.1% average growth in the second and third quarters of 2017 will carry over into 2018. This must justify the 20% S&P 500 return for this year, doesn’t it?

Brexit remains a mess, but with the $50 billion “divorce settlement” behind it, the rest should fall into line.  Negotiations don’t really have to fall off the cliff, do they? Rosy thinks Mrs. May’s weak coalition will collapse, Labour will get in, and the Brits will have another referendum, only this time explaining the pros and cons more effectively.  Surely, if they understood it better, with the Tory ideologues pushed to the sidelines, the great British people would vote to remain. Recent polls show the opposite result, however.

Rosy says we should relax about Russia and China. Putin is troublesome but unimportant economically. China is important, but its slowing growth rate has stabilized around 6.5%, which is still very strong, and the much-feared credit collapse hasn’t happened. Xi Jinping has established himself as supreme leader and is using his vast centralized power to promote large showcase projects and to manage the economy smoothly, despite increased interference and bullying of the private sector, sheltering of inefficient state-owned enterprises, suppression of migrant workers, and being under huge pressure to improve health care and pension services. China’s stock market was up only 6% in 2017; Rosy thinks it may be a buying opportunity.

Bank regulators are easing up a bit. The terms of Basel IV are now set, though they won’t come into effect until 2027. It has a new capital requirement for “operational risk,” to include large settlements from prosecutions. Banks now seem well enough capitalized and controlled by stress tests, so some of the rest of the pressure applied after the crisis can be relaxed. But, there is nothing going on to repeal or reform Dodd-Frank - the effort to reform it passed by the House of Representatives has gone nowhere in the Senate. Nevertheless, the stock market rally has lifted the prices of US banks, but only JP Morgan (+130%) and Wells Fargo (+70%) are significantly ahead of where they were a decade ago. Citigroup (-85%) and Bank of America (-45%) are both still significantly behind.

However, the stock prices of the top four European capital market banks (Barclays, Credit Suisse, Deutsche Bank and UBS) are all still about 75% below their prices of a decade ago, with most trading well below book value. They are lagging way behind their US competitors and are a long way from returns on equity greater than their cost of equity capital.  Even Rosy acknowledges that their long term economic viability is doubtful.

Rosy has believed for years that each new year will be the one in which a lagging US or European bank will split itself up into more manageable segments, and each year she has been wrong. Maybe 2018 will be different; the new CEOs of Barclays, Credit Suisse and Deutsche Bank have learned how hard it is to be a competitively-significant, globally-integrated investment bank. With stock prices trading well below book value, spin offs still make sense for them.

All in all, Rosy says things will be great in 2-0-1-8. Drink up. It’s as good as it gets.

  

Will the Tax Cut Make a Difference?

By Roy C. Smith

Leaving aside how the sausage got made, the Trump administration got its tax cut and all the bragging rights related to it. But will it boost growth?

Here are some things we know already. The US economy has recovered momentum in the last two quarters, perhaps inspired by Mr. Trump but it is hard to tell. Goldman Sachs is now optimistically forecasting a 2.5% growth rate in 2018, a big improvement from the average of 2% for the last decade. Goldman Sachs includes in its forecast a growth pickup of 0.3% from the tax cuts. This is nice, but seems rather small for a tax cut that, even with dynamic scoring (that takes the new growth into account), still has a price tag of about $1 trillion to be added to the national debt.

There is, however, a lot of uncertainty with this tax bill which favors the corporate sector over consumers. Most of the tax revenues from corporations come from the 3,600 publicly traded corporations and large privately-owned companies that don’t actually pay the 35% maximum rate, but a lower rate that averages around 24%. Cutting the maximum rate to 20% won’t make much difference. The rest of corporate taxes are collected from the 5 million or so small businesses that generally don’t make enough profit, especially after expensing family payrolls and other things, to pay the full rate, so there shouldn’t be that much revenue lost from their cuts. In any event, not all the tax savings will be reinvested in new plant and equipment – some will be used for dividends, stock buybacks or debt reduction that contributes much less to GDP growth. Estimating such things and future corporate tax revenues to the government is done more by modeling than by knowing a lot about how corporations will act. This suggests that both the net benefit and the revenue loss from the corporate tax cuts may be much less than expected.

Further, the “middle-class” taxpayers (those who rank in the upper 50% to 90% of income earned) will receive a mixed bag of benefits and added costs from the tax bill. The wealthier end of this group is likely to lose more in deductions than they gain in cuts. And, 47% of all citizens don’t pay federal income tax at all, so won’t benefit from cuts. How much of a net increase in consumption will result from what Mr. Trump calls the “biggest tax cut is history” is hard to know, but it could be quite modest.

In any case, the tax bill occurs when the economy is experiencing a growth spurt following a decade of slow-growth recovery from the financial crisis. Annualized growth for the last two quarters has averaged 3.2% with unemployment expected to drop below 4%. Adding a stimulus now may boost inflation more than real growth.

More worrisome, however, is the longer-term growth outlook. Even with the tax cuts, several growth forecasts, including Goldman Sachs’, fall off again to the 1.9% area after 2018 due to labor shortages, impeded by tougher immigration policies, and rising inflation and interest rates.

Meanwhile, the federal deficit is increasing because Social Security and Medicare costs are expanding to accommodate the retiring baby-boomers. According to a June 2017 report by the Congressional Budget Office, the fiscal deficit reached 3.7% of GDP (up from 3.0) and is estimated to be 5.2% by 2027. With the tax cuts added, the deficit will reach 5.1% in 2021, according to Goldman Sachs, and total debt will be nearly as high a percentage of GDP (110%) as it was at its peak year in 1945. This would represent a serious increase in the deficit burden that traditionally has been a concern to Republicans, but is not now (except for one Senator, Bob Corker, who is retiring). Of course, if the tax cuts, on balance, don’t reduce revenues as much as expected, the deficit will increase less than otherwise.

The tax cut is mainly a political event. Their economic impact is likely to be less than advertised.