Kass: The Death Of Supply-Side Economics

by Doug Kass, Seabreeze Partners Management

• It now Appears the Trump Tax Cut is having little impact on business fixed investment and on domestic GDP
• The tax cut has had a negative impact on the U.S. deficit and on our National Debt
• The likely failure of Supply-Side Economics will likely weigh on 2019-20 economic and profit growth and on the 2020 elections

“The Trump administration’s $1.5 trillion cut tax package appeared to have no major impact on businesses’ capital investment or hiring plans, according to a survey released a year after the biggest overhaul of the U.S. tax code in more than 30 years.

The National Association of Business Economics’ (NABE) quarterly business conditions poll published on Monday found that while some companies reported accelerating investments because of lower corporate taxes, 84 percent of respondents said they had not changed plans. That compares to 81 percent in the previous survey published in October.

The White House had predicted that the massive fiscal stimulus package, marked by the reduction in the corporate tax rate to 21 percent from 35 percent, would boost business spending and job growth. The tax cuts came into effect in January 2018. “—Reuters, “$1.5 Trillion U.S. Tax Cut Has No Major Impact on Business Capex Plans: Survey” 

Despite a massive $1.5 trillion tax cut for corporations implemented at the beginning of 2018, Monday’s release of the latest NABE survey in which 84% of the participants said they have made no changes to their capital spending intentions or hiring plans, when combined with the recent evidence of slowing domestic economic growth, should question the belief and highlight the shortcomings of supply-side economics.

1. After robust growth in business fixed investment in the first half of 2018, capital spending turned flat in the third quarter of 2018, and it appears to have continued to weaken.
   
2. Following the January 2018 tax cut, real U.S. GDP surged in the second quarter of 2018 but moderated in the following quarter; the rate of change continues to decelerate

Here are some of the investment, economic and political ramifications of the possible death and growing ineptness of supply-side economics.

* Slowing domestic economic and corporate profit growth. The deceleration in the rate of Real GDP growth in 2018-2019 appears to be eerily reminiscent of 2007-2008. As noted in my 15 Surprises for 2019:

“We learn, in 2019, the extent to which economic activity was pulled forward by the protracted period of historically low interest rates, as capital spending, retail sales, housing and autos founder further.

With U.S. Real GDP growth falling to 1% to 2% in the first half of 2019, inflation remaining stubbornly high (especially of a wage-kind as the labor market remains tight) and with cost pressures unable to be passed on, the threat of recession intensifies.

By the third quarter of 2019 U.S. Real GDP turns negative. Tax collections collapse as government spending continues to rise. The budget deficit forecasts are lifted to over $2 trillion.

The U.S. falls into a recession in the last half of 2019, followed by a lengthy period of stagnating economic growth and higher inflation (stagflation).
A dysfunctional, non-unified and discombobulated Europe also falls into a recession in 2019, with significant ramifications for U.S. multinationals that populate the S&P Index.

U.S./Chinese trade tensions push the global economy down the hill as the year progresses and GDP growth in China comes in below 5.0%. The IMF reduces its global economic growth forecast three times next year. S&P per share earnings fall by over 10% in 2019.”

* Larger deficits and a higher level of national debt. From Monday’s “Political Turmoil, Huge Debt and Slowing Global Growth Underlie the Bear Case” (hat tip to John Mauldin):

“For a long time, politics have had a short-term significance to the market, but the long-term driving factor was a growing semi-free, semi-capitalistic economy. Further, for almost 40 years the Federal Reserve, beginning with Volcker, provided an era of extraordinarily low rates and easy money. It let governments and businesses worldwide grow their debts alarmingly fast. As I’ve demonstrated in other letters, global debt could easily reach $500 trillion in a few years. Investors and businesses act like that is normal and can continue.

At some point, we will have a recession exacerbated by extraordinarily high corporate debt. Just like subprime mortgage debt triggered the last recession, corporate debt will trigger the next one. (I am sure there will be congressional hearings and global angst, and new rules will be instituted to limit future corporate debt, at the same time ignoring and indeed increasing government debt. Sigh.)

This corporate debt will precipitate a liquidity crisis and create havoc in all sorts of “unrelated” markets. Investors will learn, once again, that all asset classes are globally correlated in a crisis. There will be few places to hide.
But then the recession will end, as all recessions do, and recovery begin, because that is what happens after recessions. Except it will be different this time.

Recovery from the Great Recession was the slowest on record. The next recovery will be even slower. I have written about that, citing Lacy Hunt and others.

Debt that is not self-funding is future consumption brought forward. We are currently enjoying consumption and growth that cannot happen in the future. Debt, then, is a drag on future growth, and the amount of debt the world now has will be a monster drag on future growth. (Note the distinction between debt for current consumption and debt for future production. There is an enormous difference.) “

* The tax cut did not trickle down, it trickled up; it produced a further widening in the gap between the haves and have nots. As Seth Klarman recently warned, the “Screwflation of the Middle Class” will likely have adverse economic, social and investment ramifications:

“Social frictions remain a challenge for democracies around the world, and we wonder when investors might take more notice of this. The recent “yellow vest” marches in France, which subsequently spread to Belgium, Holland, and Canada, began as a petition against fuel tax hikes, and grew through social media into a mass protest movement led by suburban commuters, small business owners, and truck drivers. The demonstrations, which appear to have broken out spontaneously throughout the country, became widespread and even violent. While the French government is clearly concerned – in December, it reversed the planned tax increases while announcing a higher minimum wage – the financial markets have taken the unrest largely in stride, as the French 10-year note at year-end yielded a meager 70 basis points…

Social and economic advancement in America today seems increasingly dependent on demography and geography. The economic advantages enjoyed by college graduates continue to grow. Unsurprisingly, income growth in most major metropolitan areas surpasses gains in rural areas of the country. Economic inequality continued to worsen in 2018, and for many, real wages have not increased in decades. It seems clear that economic anxiety contributed to the election of Donald Trump in 2016.The divide between Americans has been exacerbated by the echo chambers of modern- day media and the internet. Many have written of how, in only about four decades, an America of three broadcast networks has become an America of hundreds of cable channels. A few decades ago, we had less connectivity but more connection. David Brooks and others write regularly about the challenges of increased loneliness and isolation. A person today can have a thousand Facebook friends, and few, if any, actual friends.”

* Lower price/earnings ratios. The failure of the largest tax cut in three decades to catalyze economic activity is not market- or valuation-friendly.

* An opportunity for Democrats and a likely Trump defeat in 2020. As I wrote recently:

“With real GDP turning negative in 2019’s second half, Democrats attempt to replace Republicans’ supply-side economics with a smarter theory of growth. Recognizing just as inflation and other ills opened the door for criticism of Keynesian economics in the 1970s, so have inequality and disinvestment done the same for critiques of supply side today. In 2019, the Democrats turn the table on the supply-siders and give a voice through thoughtful proposed legislation, making the affirmative case for the Democratic theory of growth geared to raising wages and putting more money in the hands in working- and middle-class people’s pocket and investing in their needs. Americans enthusiastically embrace this alternative of how the economy works and grows and spreads prosperity and reject and defeat the longstanding Republican economic narrative, seeing it as a better way to spur on the economy than giving rich people more tax cuts.

Asking the question “Has it worked for you?” and given the fairy tale of added revenue from growth and the widening hole in the deficit, rampant inequality, the fear of being bankrupted by medical catastrophe and massive student debt obligations, Democrats provide a practical alternative to cutting taxes for the rich and decreasing regulation, which has failed to unleash as much innovation and economic activity as was promised by the Trump administration. The legislation, which puts more money in middle-class pockets, defends and supports the notion that the public sector can make better decisions than the private sector. Referred to as the “middle- income economic bill,” it is co-sponsored by a leading, conservative and respected Republican member of Congress and begins to gain bipartisan support in Congress, driving a stake through the supply side’s heart.”

Bottom Line

The largest tax cut in more than three decades has failed to catalyze business fixed investment and aggregate domestic economic growth, once again calling into question the virtue of supply-side economics.

This policy failure will have economic, political and market ramifications,- most of which are not market-friendly.

Copyright © Seabreeze Partners Management