The benefit from tax cuts may be outweighed by the damage done by tariffs
The post-election rally looks to be running out of steam. The S&P 500 SPX has quickly relinquished the 6,000 level as inflation angst stirs again. Treasury yields sit just shy of four-month highs and the Federal Reserve now says it’s in no hurry to cut interest rates.
Investors are right to be cautious, according to Peter Berezin, chief global strategist at BCA Research. He’s just raised the probability of a U.S. recession in the next 12 months to 75% in response to Donald Trump’s victory at the polls.
The essence of Berezin’s reasoning is that any benefit for the economy from Trump’s tax cuts and deregulation would not be enough to counteract the damage from targeted government spending cuts and tariffs on imports.
He expects a full extension of the Tax Cuts and Jobs Act (TCJA) and possibly the lowering of the corporate tax rate to 15% for domestic manufacturers.
Such policies may help growth and corporate earnings, but they may be counteracted by cuts to spending, with many Republicans keen to trim the cost to government of Medicaid, food stamps, housing assistance and other programs that target the poor, Berezin reckons.
“Although most of these programs are not huge in absolute terms, they generate sizable [economic] multiplier effects because their recipients generally spend whatever income or transfer payments they receive,” he says.
Then there’s Trump’s proposed tariffs, with Berezin less optimistic than many that they are mostly a negotiating tactic. “For Trump, tariffs are not a means to an end; they are the end in themselves. Trump really does want to build a tariff wall around the U.S.”
Berezin cites a recent study by The Budget Lab at Yale, which estimated Trump’s tariffs would reduce real disposable income for the median U.S. household by somewhere between $1,900 and $7,600. “Even if that money were entirely funneled back into tax cuts, the net impact on aggregate demand would be negative because tariffs disproportionately hurt lower-income consumers with high marginal propensities to spend,” he says.
Berezin recalls that the passage of the TCJA in 2017 failed to significantly boost capital spending and “this time around, the potential size of any incremental tax cut is smaller than in Trump’s first term, while the potential negative impact from a renewed trade war is larger.”
How might this impact borrowing costs? Well, according to the Committee for a Responsible Federal Budget the extension of provisions in the TCJA would likely increase the federal debt by $5.35 trillion over the next 10 years. That may be expected to require more Treasury issuance and possibly higher yields.
Furthermore, uncertainty about the inflationary impact of possible tariffs and upward pressure on wages as immigration is curtailed may make the Federal Reserve less dovish. “Having been so badly burned by the whole ‘transitory’ narrative, our guess is that the Fed would be initially circumspect in cutting rates for fear that another rebound in inflation could un-anchor inflation expectations. This could potentially exacerbate the economic downturn,” says Berezin.
This will occur at a time when Berezin believes the Fed’s monetary policy is already too restrictive given signs of a slowing labor market and a sclerotic housing sector.
In sum, Berezin says: “With the economy weaker than generally perceived, and with the spectre of a new trade war on the horizon, we are lifting our 12-month US recession probability from 65% to 75%.”