The stimulative federal policy regime that has been so supportive of the current bull market is evolving. The Federal Reserve is edging closer to beginning the process of removing monetary stimulus, while fiscal policy is edging closer to retargeting its focus. Taken together, these emerging developments are creating a degree of uncertainty, to the point where some market observers are warning of a period of higher volatility, and possibly an equity market correction. That such uncertainty is coinciding with a period of seasonal weakness historically makes such warnings all the more unsettling. Of course, whether markets respond unfavorably to these developments remains to be seen.
The Federal Reserve has been preparing the ground for the start of tapering its bond purchase program for some time. It is not a question of if, but when that process will begin. The Fed meets next week and could outline its plan then. The weaker than expected August jobs report may push that decision out to November, although the hawks on the Federal Open Markets Committee (FOMC) would prefer not to wait. But how much of a difference a few weeks makes is debatable. Either way, tapering is coming. The larger question for investors is how quickly tapering concludes, further preparing the ground for the first rate hike of the next tightening cycle. Chairman Powell has taken pains to point out that tapering and rate hikes should be viewed independently. And although that distinction may be important, it is also likely true that any rate hikes are not likely to commence until tapering is complete. If the Fed moves more quickly than expected to end its bond purchases, that would bring forward the market's estimate of how soon rates might rise, and how quickly the Fed takes the punch bowl away.
Rising Inflation Gives the Fed Reason to Move Quickly; But the Employment Situation Provides Rationale for Caution
The argument for moving along this path more quickly is the rise in inflation. The Fed has stayed with its judgement that much of the rise is due to supply side constraints that will dissipate over time, and therefore of only modest concern. But not all FOMC members agree. On Tuesday of this week, the August Consumer Price Index (CPI) report will be released and is expected to show some welcome moderation from the prior month. The headline rate is expected to show a year-over-year increase of 5.3 percent, down slightly from 5.4 percent in July, which was its highest reading since 2008. The core rate is expected to increase by 4.2 percent, down from 4.3 in July and 4.5 percent in June.
An uneven recovery in the labor market has been the counter argument for moving more slowly toward tapering. The Delta variant is responsible for some of that, as is a mismatch between job openings and skill sets. But there is no denying that jobs are plentiful, and labor conditions are improving, the August disappointment notwithstanding. Initial jobless claims last week fell to a new recovery low, and the July Job Opening and Labor Turnover (JOLTS) report showed a record 10.9 million job openings.
Fiscal Policy is Changing and Investors Are on Alert for Any Surprises
Fiscal policy is also evolving. Emergency spending designed to get the economy moving quickly in the wake of the pandemic has been financed primarily with debt. The federal budget deficit in fiscal 2020 was 14.9 percent of GDP. The fiscal 2021 deficit, which ends in three weeks, is forecast to total 13.4 percent of GDP. (For those with a nostalgic bent, the budget was last in balance twenty years ago).
In contrast, the current push to ramp-up spending on both physical and social infrastructure, is intended to be financed, at least in part, through higher taxes. Both corporations and high-income individuals are in the crosshairs. Developments are moving quickly, although Democratic Senator Manchin said yesterday, he is doubtful that a September 27 vote deadline can be achieved. But an outline of proposed tax increases is beginning to emerge. A working document being circulated in Congress reportedly calls for an increase in the statutory corporate tax to 26.5 percent, up from the current 21 percent rate. That is lower than the 28 percent preferred by the White House, but higher than the 25 percent rate preferred by moderate Senate Democrats. The top individual bracket would rise to 39.6 percent and include a surcharge on income above $5 million. Capital gains would rise from 20 to 25 percent, exclusive of the current surcharge on investment income. The proposal also contains some changes to the estate tax regime, although an effort to eliminate the current stepped-up basis provision has met with strong opposition, even among Democrats.
Unquestionably, policy is evolving and investors are on alert for any surprises. But it is also important to remember that the economy remains healthy and balance sheets, both corporate and personal, are strong. And although some changes to the tax code will be forthcoming, they will occur in the context of another massive round of federal spending, even if that spending turns out to be less than the White House would prefer.
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