With the promise of tax reform coming in the U.S., how should investors position their portfolios? Kim Parlee and Marko Papic, Chief Geopolitical Strategist, BCA Research, discuss the U.S. tax reform plan and how it could impact markets.
Marko Papic is the chief geopolitical strategist for BCA Research. He joins us from Montreal, where he's going to tell us what political and geopolitical events he's watching from an investment point of view. Marko, great to have you with us for two segments. I'm excited to have the conversation.
I want to start things off-- we're going to get into Europe and China, and I think I'll talk about things that are driving the global economy, but let's first start south of the border. Last time, I think, when you were on, we talked about a new tax bill that could be coming into the States. And we talked about the fact, or you talked about the fact, that the probability of it happening was high. And I think you went as far as to say is it going to happen this year. How are you still feeling about that?
I think the timing is a little bit pushed off. So instead of seeing the bill pass this year, I think we're going to see it pass by the end of first quarter of next year. But the probability, or rather, what the market is pricing in as a probability, has now caught up with our estimates. So in other words, the market is now realizing that, in fact, there is a much higher probability of a pretty stimulative tax reform bill passing than it was reading it in summer.
And how important is that as it pertains to the markets? I mean, you're talking about the fact that we're seeing the markets rally partly in that, but what impact do you think it's going to have?
Well, I think that this is the most important political, geopolitical issue going on right now, more important than Korea, Europe, and China. And that's because the United States is already pretty far advanced in its economic recovery, and we're going to have mild but still stimulus.
So it's pro-cyclical stimulus at the end of the economic cycle, which should be positive for inflation, which should therefore encourage the Fed to tighten more than the market currently expects. Right now it's about 40 basis points over the next two years, which is way too low. And it also means that the dollar will probably rally and that we're going to have a pretty positive outlook for the S&P 500 over the next 12 months.
And we did some research here at BCA Research. We looked at all the periods in US history after the Second World War when you had tightening monetary policy, which we have, and loosening fiscal policy. And there's been nine periods in time when this has happened. And universally they have been very, very bullish for stocks.
Let me ask you, when you layer on top of that mid-term elections-- and I think that's one of the key things, is that you've got, as you mentioned, pro-cyclical stimulus, fiscal stimulus, coming in. What is this going to mean, do you think, politically in terms of the midterms, Republicans, and President Trump?
Well, I think that the correlation is kind of reversed. In other words, what does the midterm election mean for tax reform? And the reason I say that is because President Trump is pretty unpopular right now generally, broadly speaking. And if you were to do a line of best fit between presidential approvals and the returns in the midterms for the ruling party, you would find that there is some correlation between the two, which would mean that right now, Republicans are looking at a potential loss of the House.
And so that is motivating them to accelerate the process of getting the tax reform or tax cuts or tax legislation, however you want to call this tax policy, I think that will motivate them. It will really focus them to get it done by November, and really by the summer, because in the summer, you're going to have primary elections, where Republicans are going to face primary challenges against anti-establishment candidates.
Let me ask you, how does this play, then, to the markets? I mean, when you take a look at-- yeah, just in terms of what's attractive given this unfolding of tightening monetary, loosening fiscal, and of course, midterms and everything else, what do you think is going to happen here from equities? Because I would say a lot of people find this still a very uncomfortable bull market.
Well, you know, it's been an uncomfortable bull market for eight years.
And yet we have climbed the wall of worry across different segments of the market, whether it was the Euro crisis, whether it was the problems with Chinese policymakers misreading the market with equities, and also just the currency, we've had a number of events that have caused this. And I just don't see that extra economic stimulus in the US is going to be received negatively.
In fact, lowering the corporate rate will be very beneficial for small caps. That's why they have been rallying, you know, wild over the last week, two weeks, because of this expectation of tax reform or in tax cuts. And so I think the party will go on.
Now the problem, of course, is that if you do have pro-cyclical stimulus, and if you do have the Fed emboldened to hike rates further, and if you have the 10-year rise over the next 12 months as this rally in stocks and risk assets goes on, then presumably the next recession should also be closer at hand because of the pro-cyclical stimulus. But that's really a story for 2019, not for 2018.
Can you explain that a little bit? Just take us through, because I don't think, maybe, everyone probably understands where you're going with that.
Right. So basically, if you have stimulus at the end of the economic cycle, which is pro-cyclical stimulus, that's going to add output, economic output, and the Fed is going to respond to that by being a lot more aggressive in terms of tightening. And it could lead to the 10-year rising to a point where it reaches, let's say, 3% or around there, and we reach full potential of the economy a lot faster. And then the Fed tightening actually becomes constrictive of growth.
And also lending costs rise, borrowing costs rise, and that hurts corporates and they start cutting back on some of their expenditure, they start laying off people, and you get a recession. So we could get that recession, which is a run of the mill, just a normal recession induced by tightening monetary policy, a little bit faster than normal. And that could happen in 2019 because of this stimulus that we have. We have a sugar high in 2018. The Fed moves to restrict it, and then in 2019 we get a recession.
Now I'm not talking about the end of the world kind of recession. I'm talking more the run of the mill recessions that really were the norm before 2000, before 1990s.
And is that, do you think, agnostic to who the Fed chair is? This is not a question of who's in there, but more just, this is what's going to happen. This is the cycle.
Well, I think that would obviously-- I mean, it's a great question. So it is an agnostic view. It is sort of a ceteris paribus, you know, all other things being equal. Now who's the next Fed chair is obviously not equal. And in that case, if you have a super dove, if you have somebody who is willing to be behind a curve, so to speak, and not raise interest rates as fast as one would do just through normal monetary policy, then perhaps the party could be delayed even further.
What would be the consequence of that? Sure, risk assets would outperform well into 2019. We wouldn't see this recession. But we would also see inflation surprise on the upside. We would see bonds get killed. And also the dollar would weaken considerably, because if the US economy is doing well, but the Fed is behind the curve and inflation starts overshooting, then the dollar is definitely going to be a loser.
And that's not a base case view. Our base case is that whoever it is that gets into the Fed chair position would ultimately follow Yellen's path, and she is the one that started tightening in a dovish way. Nonetheless, she has been tightening. And if we have this little bit more of economic stimulus, then what that really means is that over the next 12 months, aside from the continued outperformance of the S&P 500, I think you're also going to see the dollar do well as well.
And the dollar will do well because a lot of speculative bets against the dollar are starting to reverse, and I think that you will see a little bit of a bid over the next six months.