David Rosenberg, the chief economist and strategist at Gluskin Sheff, said the Republican plan to stimulate the economy with tax cuts likely will push the Federal Reserve to raise interest rates faster than normal. That may mean bad news for stocks, which already are trading at higher-than-average valuations.
“Why would you stimulate fiscal policy heading into the ninth year of a late-cycle expansion?” he said in an interview on the Financial Sense Newshour podcast. “Why wouldn't you save your policy bullets from a fiscal perspective to also fight the next recession?”
While wage growth has been sluggish during the recovery since 2009, the unemployment rate is at a 17-year low of 4.1 percent, the Labor Department said last week. Average hourly earnings rose 2.5 percent from a year earlier. Faster gains in paychecks would help consumer spending, which accounts for about 70 percent of the economy.
“This is going to put the Fed in a bit of a box because… this is (economic) stimulus with a 4% unemployment rate heading into the ninth year of an expansion, which is going to cause the Fed to raise rates more than they otherwise would have,” he said. “The timing is really bad.”
The Republican-controlled Congress is in the final stages of approving a sweeping reform plan that will cut corporate and personal income taxes. President Donald Trump, who was elected last year on a pro-business platform of tax cuts, jobs growth and infrastructure spending, is expected to sign the bill into law as early as this month.
Rosenberg said U.S. government debt levels are too high to make fiscal stimulus as effective as it was in the past.
“There's no doubt that the corporate tax structure has to be changed, but not at the expense of raising the deficit at a time when the deficit is already 3.5 percent of GDP and a time when the gross public debt is more than 100% of GDP," he said. “If we had a balanced budget and we had a national debt to GDP ratio that was closer to 60% than 100%, you get a much bigger bang for the buck.”
The Fed cut rates to record lows in 2008 as the collapsing U.S. property bubble led to a major financial crisis and the worst economic slowdown since the Great Depression. The central bank began to raise rates two years ago as the U.S. economy continued to expand, even if it was the slowest recovery in the post-war period.
Monetary policy set by the Fed has a greater effect on the economy and asset valuations, Rosenberg said.
“I hearken back to the first tax cut engineered by Ronald Reagan in 1981 when he took the top marginal personal rate from 70% down to 50%,” Rosenberg said. “[Fed Chairman] Paul Volcker responded to that by raising rates and, quite unexpectedly and as a surprise to most economists at the time, we had a six quarter recession on our hands despite the fact that we had fiscal stimulus."
Stocks are expensive compared with historical trends for price-to-earnings ratios, he said. Publicly traded companies will need to post blowout earnings for the market to deliver gains as rates increase.
"The market is very expensive. Even with the tax stimulus, if you want to add on the $10 earnings per share with a lot of the goodies you'll get with the Senate and House version, you're still left with a 17.5 forward multiple for 2018,” he said. “Historically, the forward multiple is 15 and 17.5 is really what the peak was back in 2007. The multiples tell you that those expected returns are seriously constrained at this moment.”
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