Inflation, Taxes and the Need for Mindful Investing
On Friday, I had the privilege of speaking at the annual strategic investment symposium run by the College of Charleston in South Carolina. Sadly, like everything else over the past year, the conference was virtual and so I couldn’t revisit Charleston itself. Just to rub it in, the host let me know that it was sunny day in Charleston, with a high expected in the mid-to-upper 70s.
I can imagine an attendee, after earnestly absorbing the morning’s proceedings, taking advantage of the fine weather and settling into a comfortable chair on his veranda with a cool drink and some easy reading near at hand. But as the afternoon drew to a close, he would have packed up with care, as rain was expected that evening.
Small preparations for a small weather event.
However, the people of Charleston are well aware of nature’s fuller fury and families that have survived the many hurricanes that have battered the city over the generations take more serious long-term precautions. Storm shutters, reinforced roofs and steel doors are standard equipment. Extra care is taken to trim trees and clear gutters. And, as hurricane season approaches, careful attention is paid to the tropical forecast.
For investors, markets last week seemed like a spring day in Charleston, with the stock market drifting up to a new record high and long-term interest rates settling down after a steady rise from August of last year to early March. However, in the short run, investors need to recognize the potential for some headwinds from higher inflation and higher taxes. In addition, while no greater crisis appears imminent today, investors need to be prepared for the risk of a more significant surge in inflation and taxes in the years to come.
Inflation in the short run.
The week ahead should provide further evidence of a strengthening in near-term inflation pressures. We expect Tuesday’s CPI release for March to show a 0.6% gain overall and 0.2% excluding food and energy. This should boost year-over-year inflation by these measures to 2.6% and 1.5% respectively.
These year-over-year numbers are set to rise further in April, since prices fell sharply in April 2020 as the pandemic took hold. Because of this, inflation, even using the Fed’s preferred consumption deflator measures, is likely to exceed 2% on a year-over-year basis for the rest of 2021.
However, quite apart from base effects, there are some building areas of inflation pressure. Purchasing manager surveys, in both manufacturing and services, show very strong increases in the cost of inputs as bottlenecks restrict supplies. Oil prices have climbed in recent months reflecting both a pickup in global demand and some production discipline on the part of OPEC and Russia. Wage growth could remain relatively healthy in the months ahead as employers, staffing up for improved demand, will have to at least match the income provided to unemployed workers by enhanced unemployment benefits through September. Perhaps most importantly, almost $1.2 trillion in federal spending under the recently passed American Rescue Plan Act should make it easier for companies of all kinds to raise their prices.
Our base case assumption is that widespread vaccinations, along with the immunity acquired by many from contracting Covid-19, allows the pandemic to wind down over the summer, with most normal economic and social activity resuming by the fall. If this occurs, the economy should see a very strong surge in economic growth throughout this year, with unemployment falling to 4% in early 2022. However, beyond that point, barring further fiscal stimulus, growth should slow down and this could allow inflation to settle at the “a little above 2%” level that the Federal Reserve is targeting. Even this, however, should be consistent with long-term interest rates rising further, as the Fed begins to tapper bond purchases early next year. In addition, there is a distinct possibility that inflation could burn a little hotter if further fiscal measures pass Congress aimed at providing additional support to low and middle income families.
While much of this scenario would be very welcome, these somewhat higher rates would, of course, inflict losses on fixed income investors and could motivate a further rotation from growth to value within the equity market.
Taxes in the short run.
There is also a rising risk of higher taxes in the year ahead. President Biden has already outlined a proposal for higher corporate taxes to finance his infrastructure plan. This proposal includes an increase in the corporate tax rate from 21% to 28% and the adoption of a global minimum corporate tax of 21%. In addition, he is widely expected to propose increases in income and capital gains taxes on upper income individuals to finance an extension of recently passed enhancements to the child, dependent care and earned income tax credits.
Some of these proposed tax increases are likely to get watered down. In particular, one key Democratic senator appears opposed to pushing the corporate income tax above 25% while other countries with whom the U.S. would have to negotiate an global minimum corporate tax, would likely balk at a rate as high as 21%.
That being said, there is a good chance that legislation increasing both the corporate income tax rate and capital gains taxes for upper income households will pass before the end of the year. As in the case of inflation, it is hard to argue that markets have already “priced this in” and the passage of tax increases could represent a challenge to capital markets over the next year.
As in the case of inflation, however, there should be a short-term limit to the trend towards higher taxes. If Democrats lose five or more seats in the House of Representatives in the November 2022 mid-term elections, they will lose control of the House. History suggests that the odds are stacked heavily against them, as the President’s party has lost 5 or more seats in 18 of the last 21 mid-term elections going all the way back to the 1930s. If this transpires, further tax increases would likely be off the table. In addition, a Republican-controlled House would like block any further significant fiscal stimulus, cooling down both economic growth and the threat of inflation.
Inflation and taxes in the long run.
The prospects for higher inflation and taxes in the short run is real and should have real consequences in raising long-term interest rates and curtailing equity market returns, particularly on stocks with high valuations today.
However, investors should also recognize that there are longer term threats.
On the inflation front, decades of rising inequality have simultaneously contributed to rising asset prices while reducing the demand for goods and services. As we show on page 25 of The Guide to the Markets, the value of all U.S. financial assets, has now climbed to over six times GDP compared to between two and three times from the 1950s to the early 1990s. At some stage, either because of deliberate efforts to redistribute wealth or because holders of assets become nervous about their value, we could see substantial pressure to sell assets and buy goods and services, resulting in substantially higher inflation and falling real asset prices such as occurred in the 1970s.
On taxes, it is worth noting that the national debt has now more than tripled as a share of GDP since the start of the century with little evidence that either major political party in Washington sees this as a problem. Nor is it a problem, so long as interest rates remain close to zero. However, interest rates could rise substantially if inflation begins to accelerate and the Federal Reserve feels forced to adopt a hawkish stance for the first time in decades. Very high interest rates, which are suddenly sensitive to the level of the deficit, could force a future administration to raise revenues much more aggressively. Given political realities, such tax increases would very likely include higher taxes on corporations and capital gains, posing a significant challenge to investors.
These are scary and certainly premature thoughts for an economy just recovering from disaster. Still, investors would be well advised to check their exposure to higher inflation by limiting the duration of the fixed income assets and making sure they can participate in any further rotation from growth to value. In addition, it is important to keep an eye on Washington and the world. If the U.S. continues to push the envelope more than other nations in fiscal stimulus and deficit financing, investors may want to increase their exposure to overseas equities where valuations are cheaper and a less exuberant boom today could provide the comfort of a less painful bust in the years to come.