The U.S. economy – and indeed, that of the world as a whole – finished 2017 on strong footing. In December, we learned that unemployment was at a multi-year low, and consumer spending from retail stores to automotive dealerships to online venues surged in November. And business investment in equipment increased at a solid clip. These are but a few examples of the sturdy macroeconomic foundation upon which 2018 can progress.
Looking ahead, what might we expect? What the Administration hopes is that the tax cut package just passed by Congress will bolster companies’ finances, enhancing their cash flow to afford them additional funds to deploy on hiring more, investing more, or both. We discuss these, and a number of other issues, in our short paper on our Outlook for 2018.
However, there really is no way to model human behavior and psychology. Making more funds available to a company to invest or hire is one thing; whether they intend to use those funds in that manner remains to be seen. While not limited to the following, we’ve identified three main components to a possible outcome:
In reality, it may be some combination of all three, particularly because low unemployment may require that companies raise wages to enable them to hire and expand. After all, in an alternate scenario – that being without a tax cut – companies may simply not hire at all, if they could not raise prices enough to pay whatever wage rate would be required for the additional worker on the margin. Thus, in that alternate situation, low unemployment could potentially limit expansion, not fuel more inflation.
The likely outcome entails several components, though the actual mix of these scenarios depends on each company and its competitive landscape. One component of this outcome is based on economic theory that says that “excess” profits – those profits greater than what shareholders require when investing in a company – are competed away. That means that, given more available cash flow – and a desire to acquire more customers and a greater market share – companies may simply lower their prices. Their competitors then follow suit, and prices – and profits – may return toward their previous equilibrium.
If it is profitable to do so, a company may pay its workers more in the second component of this scenario, noting anecdotal evidence of a shortage of labor being a growing problem for employers. That would benefit at least some employees. The key phrase, however, is, “if it is profitable to do so.” Companies will only cut prices and/or pay workers more if it maximizes profits, so not all of the tax cut will benefit customers or workers.
It may be profitable, however, for a business to invest in equipment or technology that extracts more revenues from its existing employees. This can immediately benefit the economy through purchases of machines, computers or structures, especially given tax incentives to do so. It can also benefit the economy in the long run if it more-permanently increases productivity. And with each worker producing more with the same hour of labor, employers may be able to offer their employees higher wages at the same time profits grow.
A third possible component of this scenario is that some of the tax cut proceeds could be returned to shareholders, in the form of dividends, share repurchases, and debt reduction. Cynical observers may opine that much of the tax cut will flow to the owners of capital more than labor. If companies cannot find profitable opportunities to expand their business by reducing prices and/or hiring and investing more, shareholders would more directly (and immediately) receive the benefits of the tax cut. But many companies have a longer-term view than some investors might think.
What actually happens with the tax-cut proceeds is difficult to predict. Likely, some combination of each of these three outcomes will occur. However, as the year progresses, companies may announce their intentions after thoughtful consideration and securities analysts will update their models accordingly.
In the end, we’ll leave you with the cliffhanger, the question on every investor’s mind is: how much do share prices already reflect these considerations, and what is the upside from here? The answer is that it depends on which analyst you ask and the assumptions they use when attempting to forecast the effects of the tax cuts. As analysts update their models with the latest comment or poll, the performance of individual stocks may diverge more notably from that of the overall market.
The upshot is that the markets may be focused on an outcome that may not occur in exactly the way some might expect – after all, complicated feedback loops often inherently have unintended consequences.
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