The biggest threat to the improving US economy?

James Juliano Insights

The largest threat to an improving US economic recovery and rising US equity prices is a monetary or fiscal/tax policy error.

For now, monetary policy remains well behaved. The US$ is strong in gold terms and has been strengthening since the first quarter of 2013. This may not be by design. The “Fed talk” is all about a monetary policy we believe operates within a flawed model. The Federal Reserve board is watching market based signals to help guide them, but they may interpret those signals incorrectly. For example, they claim to be closely monitoring declining inflation expectations embedded in market pricing of TIPS, Treasury Inflation Protected Securities.

These markets suggest that inflation expectations over the next five years are 1.6% and falling. Forward TIPS markets measure what the five year inflation rate will be five years from now, and they signal inflation to be 1.7% and falling. This is excellent news, but the Fed still speaks about having a 2% inflation target rate. With market measured inflation falling and future inflation expectations low the Fed may be tempted to enact incorrect monetary policy in an attempt to spark the unwise inflation they claim to want.

That’s the bad news.

The good news is that the Federal Reserve is conducting monetary policy in a very different way from what they say they want. While the Fed’s monetary policy model may be broken, their actions have been consistent with matching the supply and demand for US dollars with a preference for a stronger US$. This is a key ingredient for what we call an “economic green zone” of prosperity, innovation, jobs and real wealth building. So far, a Fed monetary policy error is not happening and gold prices do not signal one is coming. A more serious current threat is a fiscal/tax policy error. Obama’s recently released budget says it all. Having learned nothing from an electorate that a few short months ago rejected his tax/spend agenda by overwhelmingly electing GOP candidates in the House and Senate, Obama is doubling down on his bad
policies. Tax increases dominate his egregious 300-page budget proposal that includes things like:

  • New 14% tax on foreign profits on which companies have already paid foreign taxes but under current law would have to pay another 35% if they repatriate them
  • Tax increase on capital gains to 28% from 23.8%
  • Elimination of the “step-up basis” for calculating capital gains at death. Under current law heirs pay a
    40% tax on estates above $5.3 million, but their tax basis on, say, inherited stocks is the value at the time of death. Obama wants to eliminate that provision, which in essence means socking heirs with a double death tax of another 28% on the gains earned by the deceased over a lifetime
  • Another bid for the Buffett Rule, or an individual minimum tax of about 30%
  • Limits on retirement accounts

Obama either doesn’t understand or doesn’t care that voters resoundingly chose to move away from policies like these during the midterm elections, and we do not think Obama is stupid. A big threat now is how Republicans position themselves and policy in contrast to Obama’s anti growth agenda.

There are two choices:

  1. GOP can soften the pro growth ideas that got them elected and move towards tax increase compromises with the White House, or
  2. GOP can double down on their pro growth, lower taxes, lower spending agenda to drive a nail in the
    coffin of the White House’s failing economic agenda.

The Presidential election in 2016 rests upon this decision. Remember, Mitt Romney failed to follow through on a real pro growth agenda to combat Obama’s tax and spend ideas. With no clear plan for growth, voters decided his “slippery, rich guy” appeal wasn’t worth their vote versus maintaining the government subsidy status quo under Obama.

Republicans now hold the Congressional power with a Senate/House majority to pave a new fiscal/tax policy path. No more compromising on failed ideas of the last decade. No more last minute “cliff” deals made in fear of voter backlash. Instead, Republicans can and should offer new and powerful pro growth spending and tax ideas that pave the way for a real pro growth candidate in 2016.

However, politicians in power often do what is safe instead of what got them elected. Republicans risk making a tax/spend compromise with Obama in an effort to not upset any voters who may take away their newly found power. A fiscal/tax policy error is the biggest risk to the current US equity bull market.

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