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For every action, there is an equal and opposite reaction

January 31, 2018

US Tax Cuts – a global consequence...

 

A year on and the ‘Reality TV’ resident of the White House will be pleased with the exuberance his short term tax incentive is receiving from the Financial Markets. It’s stimulatory and it likely gives more room for the Federal Reserve to raise interest rates, as businesses keep more of the gross profit and hopefully some of that “extra” begins to trickle down to workers’ wages.

 

Global money seeks the best interest rate for the least risk. So, when we see higher interest rates in the USA, it’s inevitable that more capital will be pushed to that market. I believe that will accelerate the value of the USD, thus making money more expensive here (NZ & Australia). We’re not yet seeing that though, as strangely the USD has recently weakened. Picking currency in the short term is a tough job, with lots of variable components pushing perceived values in directions no one can easily predict.

 

Rising interest rates in the USA is surely easier for the American’s to bear, as they’ve already had a major residential property crash (GFC), during which time huge debts were written off or repaid. Consequently, the personal debt of Americans is substantially less than what we see “down under”, where we have some of the largest mortgage debt to income ratios in the World and the highest relative value Real Estate prices. Any large push on interest rates from here could spark accelerating mortgage defaults. So locally (Aust & NZ), I’m not sure we will see interest rates pushing higher any time soon.

 

We’re told the US tax cuts (already priced in the share market to an extent), will be a further boost to the US economy and may deliver an increase to business earnings (in the order of 20 to 25%)! Given share markets are forward pricing mechanisms, we imagine much of that hype from “lower tax” is already factored into the current share price of companies. As those benefits are actually yet to flow into the real economy, we’d say be cautious when buying shares at these levels. Prices look peaky.

 

The other thing with tax cuts is they’re not an entirely reliable long term source of permanent margin gain. This new upside can quickly evaporate, if new Government regulation or alternative taxes are pushed higher. Even so, they do offer an immediate boost to consumption, which will add to the party-like atmosphere we’re seeing. And just like any great party, the morning after may reveal a bigger mess than was anticipated. Let’s face it, especially if someone else is paying, a great party is fun and no one wants to miss out, but we may want a plan for how we deal with the consequence of “too much” fun.

 

The tax rate reduction for small to medium sized companies in the USA (aka “big” companies by NZ standards), is in the order of the difference between 36% & 21% - it’s significant for “middle” America. If we do see continued interest rate hikes, then it’s likely that pressure comes to bear on those who are most in debt, as higher rates force price rises, and that my friends is the beginning of reflation.

 

I don’t see a 1970’s style ‘stagflation’ (not with so much ‘technological disruption’, so many workers and global capacity), but inflation will be something more than we’ve seen for the last decade. What I do think will be similar to what we saw in the 70’s, is that house prices (in this country and I imagine Australia as well), won’t keep up with broader market inflation, and prices will adjust to a more realistic relative number. Indeed, if you think about it, the media and politicians all tell us that inflation has been muted for many years but, that is also untrue. Asset price inflation has been a very real force (housing and share markets), it’s only consumer/wage price inflation that has been extremely low (blame China).

 

Wage and productivity growth is what our nation needs; not rampant house price growth. Maybe the next round of inflation is precisely what the doctor ordered, to push wages higher. We then need productivity growth, not ever increasing immigration (indeed a mix of both being ideal). Unfortunately, immigration tends to pull wage growth down, as workers from countries less fortunate than our own will accept lower wages and in unskilled positions, the income gap widens.  

 

In summary. Lots is happening out there. Markets are not cheap. So, pay down debt. Invest strategically. Do not worry if we see pull backs, they’re just a dip. Governments are committed to keeping a good party going and they’ll take a much longer view around who ultimately pays for it.

 

Tony Munro CFPCM AFA

 

The views and opinions expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client.

A disclosure statement is available on request and free of charge.

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