On CPI, S&P, GHG and the IRS | J.P. Morgan Private Bank U.S.

Markets and multiples. Markets are pricing a Fed Funds peak of 4% by April, followed by a decline to 3% by year-end 2024. While inflation linked to food/energy, auto parts, other goods and cyclical services are rolling over, less cyclical services and housing inflation are still rising [Ex. 1 and 2; see p.7-8]. And while business surveys suggest that wage pressures have subsided from peak levels, wage growth is still extremely high [Ex. 3 and 4] and payrolls and jobless claims have only weakened a small amount. If the Fed is committed to restoring positive real interest rates (see chart, right), I find it hard to justify an increase in equity multiples.

Dot plot shows the median FOMC Fed Funds projections from June 2022 compared to the market expectation of future Fed Funds rates as implied by the overnight indexed swaps market. Markets are pricing a Fed Funds peak of 4% by April, followed by a decline to 3% by year-end 2024

Line chart shows S&P 500 price to forward earnings ratio vs inverted US real yields from 2016 to now. The lines closely track each other, demonstrating that equity markets have been trading almost lock-step with the 10 year Treasury less anticipated inflation

The recent equity rally is often compared to two prior bear market rallies, but both involved deep recessions (1973-1975 and 2007-2009) that we do not anticipate this time. To be clear, a recession is still a significant risk over the next few months. The US avoided recession four times after prior Fed hiking cycles but each time, food/energy inflation was very low which isn’t the case today [Ex. 5]. Furthermore, new orders have declined sharply relative to production, inventories are high [Ex. 6 and 7], housing is imploding and the US dollar is at a 20-year high (hurting 30%-40% of S&P revenues which are foreign-sourced). If there is a recession, I expect it to be a milder one: private sector savings are higher than before prior recessions, and a macroeconomic projection of the US business cycle points to a less severe contraction than in 2009 or 2020.

Bar chart shows private sector savings by country from Q1 2020 to Q1 2022 compared to the median savings level across countries in the run-up to previous recessions. Current levels imply that if there is a recession, it could be milder as a result of higher savings.

Line chart shows the US Manufacturing PMI Survey vs a PMI estimate based on macro variables including short rates, EM bond yields, US$ and Business Confidence Surveys. These estimates point to a mild recession next year

Bottom line for equity investors:

While consumer price inflation may have seen its peak, it’s still elevated and wage inflation has not rolled over yet [Ex. 4]. The labor force participation rate is still below pre-COVID levels [Ex. 8], but since almost all of the gap is due to the age 54+ cohort, there’s less room for continued improvement (the LFPR for ages 25-54 is now back at pre-COVID levels). Furthermore, a measure of jobs openings plus employment vs the labor force shows the tightest labor markets in decades. So, the Fed will keep tightening. But if there is a recession, we expect it to be a milder one given the health of consumer balance sheets
Leading indicators for the PMI manufacturing survey point to a mild recession next year (see chart above). The declining PMI is also a key input into leading indicators for S&P earnings [Ex.9]. The summer rally was due to rising P/E multiples [Ex. 10] which are unlikely to rise further given positive real interest rates and more quantitative tightening. Given weakening leading indicators and declining earnings, I expect a rollover in US equity markets this fall closer to the June lows for those looking for a better entry point
The last Fed hike for the cycle, when it does occur, has historically been good news for investors; only during the 2000 cycle did the last Fed hike fail to result in a sustained rally [Ex. 11]
See the two charts below: since 2009, financial repression resulted in 20%-60% of the stock market offering dividend yields above Treasury yields, and resulted in short rates that were way below asset yields. Both trends were only sustainable if inflation stayed low forever. Some of you will miss TINA investing (e.g., “There Is No Alternative” to equities since interest rates are below inflation). I won’t. It spawned a lot of mindless risk-taking and ruined fixed income markets for a generation, negatively impacting defined benefit plans, insurers and families invested in funds that reduce risk with age. Good riddance to bad policy

Line chart shows the percent of the total market cap that consists of stocks trading above the 10 year Treasury yield. Since 2009, financial repression resulted in 20%-60% of the stock market offering dividend yields above Treasury yields, and resulted in short rates that were way below asset yields. Both trends were only sustainable if inflation stayed low forever.

Line chart shows developed world asset yields vs developed world short interest rates which were very similar prior to 2009. Since 2009, short rates have been below asset yields, but that gap is closing

What it would take for the energy bill’s projected GHG reductions to actually occur, and why it matters

I read a piece in the Atlantic entitled “The Best Evidence Yet That the Climate Bill Will Work” [August 3, 2022]. The author writes: “First we got the bill. Now we have the numbers”. Really? What you have are projections from three energy modeling teams estimating that the bill could reduce GHG emissions by ~40% by 2030 vs 2005 levels, implying a quadrupling in the pace of decarbonization. There’s no discussion in the Atlantic article of what would actually have to happen to get there.

I looked at the detailed assumptions made by one of the modeling teams. These analysts are very smart and very well informed on energy transition dynamics. But: their models often assume perfectly optimal behavior by businesses and individuals based on prevailing incentives, and usually ignore frictional issues such as battery and critical mineral supply chain constraints³, interconnection delays of wind/solar power and the difficulty in siting new transmission. On the latter, House Democrats may block passage of the infrastructure project siting bill that Senate Democrats agreed to in exchange for Manchin’s Inflation Reduction Act support⁴.

The next page compares their assumptions and ours. The reason this is important: if you believe the energy bill modelers, the US could start enacting policies to constrain the natural gas industry since the US will need a lot less gas in 2030, and even less after that. But if you believe that the future could be closer to our assumptions, you would do no such thing for fear of ending up like Europe: energy-dependent and facing a difficult winter. With gas reserves headed for 90% by November it looks like Germany will be able to make it through the winter without Russian gas, but only if they continue to cut consumption by 15% vs normal levels.

Line chart shows estimates of greenhouse gas emissions declines resulting from the Inflation Reduction Act vs projections based on current policy. Current policy would result in a 27% decline, whereas projections of declines resulting from the IRA are between 31% and 44%.

Line chart shows the historical rate of US greenhouse gas emissions declines (0-2%) compared to the assumed annual reduction resulting from the Inflation Reduction Act.

Line chart compares Europe electricity prices to Europe natural gas from 2019 till now. The chart conveys that both prices have reached all-time highs in 2022 and continue to rise.

Line chart compares various natural gas supply-and-demand scenarios for Germany. Although Germany could reach a 90% reserve capacity by November 1st, if Russia cuts natural gas imports, Germany could run out of natural gas between January and March 2023.

Understanding the table. The table compares our assumptions for the year 2030 with one of the three modeling groups that analyzed the energy bill on behalf of the Senate. The color-coded column highlights the greatest differences between our assumptions and theirs; red = very different, green = very similar.

I emphasized the natural gas share of primary energy since it is a critical policy issue. It affects decisions on pipelines, electricity transmission, energy storage, export policy (European demand for LNG is expected to rise by 2.5x by 2030), winter heating regulations and decommissioning policies affecting coal/nuclear.

2021	Assumption	JPM 2030	Group X 2030	Comments
	Energy consumption
	Final energy delivered, growth vs 2021	0%	-2%	Many forecasts of US energy demand are roughly flat, reflecting increased efficiency and reduced energy intensity offsetting population growth
	Electricity consumption growth vs 2021	4%	25%
20%	Electrification of final energy delivered	21%	26%
17%	Electrification of industrial energy use	17%	18%
	Fossil Fuels			Primary energy figures based on EIA/BP convention of grossing up renewable energy generation by a 35% thermal equivalent
34%	Natural gas share of primary energy consumption	32%	20%	Excludes any US natural gas produced and exported for economic/NATO reasons
39%	Natural gas share of electricity consumption	31%	15%
10%	Coal share of primary energy consumption	4%	5%	Despite potential for CCS to extend life of coal plants, shares of generation/primary energy still projected to decline
NA	Decline in gasoline/diesel consumption vs 2021 level	-10%	-28%
6%	Biodiesel and renewable diesel share of diesel production	8%	??	Renewable fuel credit only extended to 2024

Source: Modeling Group X, EIA, BP, JPMAM. 2022.

2021	Assumption	JPM 2030	Group X 2030	Comments
	Wind and solar
109	Solar plus wind watts per capita per year of new capacity, 2022-2030 annual average	162	302	The largest amount of annual new electricity generation capacity ever installed in the US was 197 watts per capita, achieved in 2002 due to a surge in natural gas capacity
	Solar capacity additions (annual) 2022-2030 vs 2019-2021 pace	3.4x	6.9x
4%	Solar share of electricity generation	18%	30%
25%	Solar capacity factor	25%	25%
	Wind capacity additions (annual) 2022-2030 vs 2019-2021 pace	1.7x	2.7x
9%	Wind share of electricity generation	22%	28%
35%	Wind capacity factor	35%	35%
	Electric vehicles			EV category includes battery electric vehicles (BEVs) and plug in hybrids (PHEVs), excludes hybrid electric vehicles (HEVs). Any forecast must incorporate domestic/allied sourcing requirements for critical minerals and batteries included in the energy bill for $7500 subsidies to be available
4%	Passenger car/light truck/SUV EV share of sales in 2030	25%-40%	100%
1%	Passenger car/light truck/SUV EV share of fleet in 2030	10%-15%	23%
2.8	Passenger car/light truck/SUV EV miles per kWh in 2030	3.3	3.3
0%	Medium duty truck EV share of sales in 2030	28%	88%
0%	Medium duty truck EV share of fleet in 2030	10%	33%
1.7	Medium duty truck EV miles per kWh in 2030	1.9	1.9
0%	Heavy duty truck EV share of sales in 2030	28%	92%
0%	Heavy duty truck EV share of fleet in 2030	10%	28%
0.5	Heavy duty truck EV miles per kWh in 2030	0.5	0.5

Source: Modeling Group X, EIA, BP, JPMAM. 2022.

2021	Assumption	JPM 2030	Group X 2030	Comments
	Other assumptions
22.9	Passenger car/light truck/SUV ICE car miles per gallon	27.5	29.5
19%	Nuclear share of electricity consumption	15%	17%	Many unprofitable nuclear plants assumed to remain open due to IRA production tax credits
5%-10%	Cumulative transmission grid growth, 2021-2030	10%	37%	The historical 2021 figure of 10% represents the trailing 10 year grid expansion level, measured in GW-miles. Highly dependent on changes in Federal/state siting policies and eminent domain
6%	Electric heat pump share of residential and commercial heating	22%	21%	Significant grid implications depending on whether backup thermal heating systems remain, or if generation/distribution systems will have to handle coldest days of the year when electricity demand surges
0.8%	Hydrogen share of final energy consumption	1.0%	1.5%	Hydrogen is an energy carrier, not an energy source; projected increases vs 2021 are assumed to be from green hydrogen (renewable electrolysis), blue hydrogen (steam reformation of natural gas + CCS) or turquoise hydrogen (gasification or pyrolysis of MSW)
27.1	Electricity stored and consumed later via pumped storage and other utility scale storage (batteries, flywheels, etc), TWh	136.9	46.3	Energy storage can reduce the need for gas peaker plants, transmission investment and smooth intraday demand imbalances
21	US carbon sequestration, million metric tons per year	150	200	While 45Q tax credits have catalyzed greater industrial interest in CCS, as of 2021, less than 1% of US CO2 was geologically sequestered. A forecast of 200 MMT per year would represent 10x growth but still represent just 3%-5% of current and future US CO2 emissions

Source: Modeling Group X, EIA, BP, JPMAM. 2022.

What will all those new IRS agents be doing?

The Inflation Reduction Act will dedicate $45 billion for tens of thousands of new IRS agents focused on tax enforcement, which the CBO estimates will raise $203 billion in additional revenues over a ten year period for a ~4x return. Sounds easy, doesn’t it? Not so fast; a May 2022 report from the General Accounting Office suggests this could be difficult to do, particularly if the IRS directs new agents to only audit taxpayers with more than $400k in income as requested by Treasury Secretary Yellen and as reiterated by IRS Commissioner Rettig.

The audit rate of individual income tax returns fell from 0.90% in 2010 to 0.25% in 2019. This decline is mostly attributed to reduced IRS funding and attrition of IRS agents. Audit rates decreased the most for those with incomes over $200k, although audits are still skewed towards incomes of $1mm+ (chart, left)
From 2010 to 2019, incremental taxes raised were highest for audits of those earning less than $200k (chart, right); the average percent change in the amount owed was highest for this category as well
In contrast, higher incomes had the highest rate of “no change to taxes owed” after audit
Let’s assume that the audit rate for those earning more than $400k reverts back to 2010 levels (i.e., it increases by a factor of 7x). We estimate that this would raise $8-$10 billion per year in 2031 based on data in the GAO report, far short of the $35 billion estimated by the CBO

So, I’m not sure how the Act will raise the assumed revenues if new agents only focus on wealthier taxpayers. In late August, the CBO sent a letter to the House Ways and Means Committee indicating that they had already cut their estimate of revenues raised from $203 billion to $180 billion.

Bar chart shows audit rates by income for the tax year of 2019. Individuals earning $5 million or more have a higher rate of auditing at ~2.5% than individuals who earn less than $500k at ~0.4% or lower.

Bar chart shows the estimated additional tax revenue from audits by various income levels. The majority of additional tax revenue from audits comes from individuals earning $200k or less.

Also: is the tax gap as large as advertised? What may be driving this initiative are estimates of a $300-$600 billion “tax gap” per year according to the Treasury⁵: the difference between what should be paid and what is paid. Most of the gap is due to underreporting of income rather than non-payment or non-filing. However, analysts at the Brookings Tax Policy Center cite several issues that result in tax gap overestimation⁶:

The tax gap cited above includes additional taxes recommended by examiners even if the amount could be reversed on appeal or court challenge. And such reversals can be large: only 63% of additional taxes recommended from 2015 through 2019 were ultimately assessed after administrative appeals and abatements. That figure is likely to be even lower after further reductions following judicial review
The IRS uses “detection controlled estimations” in its compliance studies to scale up the recommendations of all examiners to match those with the largest upward adjustments in personal income. In other words, the process is leveraged to revisions made by examiners with the largest estimates of income under-reporting. This “highest common denominator” approach is estimated to account for two thirds (!!) of the entire individual income tax underreporting gap
The Treasury’s estimate of the tax gap is partially based on a 2007 study citing $1 trillion in US taxpayer offshore wealth and non-payment of taxes on offshore interest and dividends. However: the IRS ramped up offshore enforcement efforts in 2008 after financial institutions in Switzerland, Liechtenstein, Israel and the Caribbean turned over thousands of names to the IRS, resulting in $6 billion in penalties paid. Since then, another $11 billion in penalties were paid by 56,000 taxpayers entering into the IRS Offshore Voluntary Disclosure Program. The Foreign Account Tax Compliance Act of 2010 made it even harder for US taxpayers to hide assets, and the IRS/Justice Department have consistently prosecuted FBAR violations over last decade, penalizing financial institutions that harbor violators. Bottom line: a lot has changed since 2007
The Tax Cut and Jobs Act of 2017 caused more taxpayers to claim standard rather than itemized deductions, and the C Corporation tax rate declined from 35% to 21%; both are likely to reduce the degree of underreporting of income
Some components of the tax gap reflect taxpayer-IRS disputes regarding the timing of depreciation deductions. While their resolution could increase taxes due in a given year, they do not imply perpetual underreporting of income since taxes due in future years would be lower in these cases

Whatever the tax gap is, new IRS agents are likely to focus on partnerships, sole proprietorships and owners of commercial and residential rental properties⁷. The Treasury believes that income underreporting could be 50%-60% for these entities given less withholding and information reporting (see chart). The Brookings paper also cites underreporting of pass-through income as a factor resulting in tax gap underestimation.

Last point: if you hold a lot of crypto, they may be coming for you as well if you exchange crypto for goods and services without recognizing appreciation as capital gains⁸.

Bar chart shows the underreporting of income by various entities. The percent of income not reported could be ~50% - 60% for entities with income subject to little or no information reporting.

Exhibits

Exhibit 1: inflation trends

Exhibit 2: housing inflation

The indexed chart shows the rise in US home prices, US observed rent and US housing CPI from 2018 till now. Currently, all three indices are at all-time highs.

Exhibit 3: wage expectations

The chart shows the US Business Leaders Survey Wage Expectations from 2005 till now. Currently, US business leaders expect wages to decrease in the future.

Exhibit 4: consumer price and wage inflation

Line chart compares the employment cost index to PCE core from 1980-2022. The two lines follow a similar trend until the early 1990s, when the employment cost index increases; this gap closes in 2005, 2008, and 2020.

Exhibit 5: the only time the US has avoided recession when the Fed hikes is when food/energy inflation is low (as shown in the red bars)

Exhibit 6: leading indicators

The line chart shows ISM manufacturing PMI new orders less the production index from 2015 to July 2022. The line typically oscillates around 0 for this period until it spikes up to +6 in 2021, then dives down to -6 in 2022.

Exhibit 7: inventories

The line chart shows ISM manufacturing PMI inventories from 1980 to July 2022 and demonstrates that inventories have risen and are expanding

Exhibit 8: labor force

The line chart shows the labor force participation rate for the percent of the US population aged 25-54 and for the percent of the US population aged 55 and over from 2010-2022. The labor force participation rate for the 25-54 age group is 82.8% and for the 55 and over age group is 38.6% as of August 2022.

Exhibit 9: leading indicator for earnings

The line chart compares a leading indicator earnings model to actual trailing earnings growth to suggest that there is a modest year-over-year downtrend ahead.

Exhibit 10: price-to-earnings ratios

The line chart shows that forward price-to-earnings ratios for the Megacap 8 (GOOGL, AMZN, AAPL, FB, MSFT, NFLX, NVDA, TSLA), the Russell 1000 Growth Index and the Russell 100 Index declined from all-time highs in 2022, but still remain elevated relative to history.

Exhibit 11: equities and the last Fed hike

The line chart shows S&P 500 returns in the 12 months before and 18 months after Fed hikes in the following years: 1995, 1997, 2000, 2006, 2015, and 2018. S&P 500 returns are indexed to 100 = most recent Fed hike for the respective year.

¹ Short covering. From the June lows, the S&P 500 rose by 12% while an index of the most shorted stocks rose by 35%.

² Rob Portman (R-OH), a Senator I admire greatly and whose retirement is another sign of institutional decay in the Senate, released a report this year on how China's government targeted Federal Reserve employees in a decade-long infiltration campaign aimed at stealing US monetary policy secrets. My question: wouldn’t the Fed’s very poor track record in anticipating future inflation and policy rates dissuade people from wanting to steal its secrets and copy it?

³ Domestic content requirements for EV subsidies in the energy bill. Critical mineral minimum extraction/processing percentages for US/Free Trade Area countries start at 40% in 2024 and rise to 80% by 2027. Battery component requirements for manufacturing or assembly in North America start at 50% in 2024 and also rise to 80% by 2027.

⁴ “Prospects dim in House for Manchin’s federal permitting measure”, Rollcall.com, August 17, 2022

⁵ “The Case for a Robust Attack on the Tax Gap”, US Treasury, September 7, 2021

⁶ “The Tax Gap’s Many Shades of Gray”, Hemel, Holtzblatt and Rosenthal (TPC), September 30, 2021

⁷ A partial list of what the IRS looks for: allocations of ordinary income to tax-exempt partners, and allocations of deductions/long term gains to partners in high tax brackets, that are not in accordance with ownership interests; S corporations that do not pay sufficient wages to shareholder-employees, or which provide them with large non-wage distributions; work arrangements improperly structured as independent contractors so as to benefit from expanded pretax deferral options and qualified business income deductions.

⁸ The IRS reportedly believes that there is a large degree of non-reporting by crypto holders. Recent new rules include Executive Order 14067 instructing the IRS to focus on non-compliance; enhanced Form 1040 disclosure on crypto sales, exchanges and receipts; and Notice 2014-21/Rev. Rule 2019-24 providing guidance on crypto tax treatment. What may come next: comprehensive field exams of digital asset funds, principals and investors; enhanced information disclosures piercing some bearer aspects of crypto holdings; and assessment of economic and possibly criminal penalties which are well publicized in order to raise the bar for non-compliance.

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FEMALE VOICE 1: --podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information which can be found in the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST: Good afternoon, and welcome to the Labor Day "Eye on the Market" podcast. I haven't recorded something in awhile, so welcome back to everybody who listens to this podcast, and I hope you had a nice end to your summer.

So, there are three sections in the market this month. A general discussion of what's going on in equity markets, inflation, and the federal reserve, what it would take for the energy bill's projected GHG reductions to actually occur, and why I think that matters so much, and then lastly a look at what all those new IRS agents might be doing, because that was another big part of the inflation reduction act.

To get started, let's talk about what's going on in the markets. Earlier in the summer I wrote that while there might be a hurricane coming for the U.S. economy, a lot of the damage had already been done in the equity markets, and in May and June we showed all sorts of these charts on how the average NASDAQ stock was down 45%; a third of them were down 70%. How in prior recessions the equities bottom way before GDP and earnings, and by the time GDP and earnings are rising again, equities have already rallied a lot. We looked at some measure of investor capitulation that were pretty compelling.

So, I wasn't surprised to see a bounce from the June lows, and particularly since there was a lot of hedge funds that had some short positions they had to cover. That said, I was a little surprised at the breadth of the rally, because we really don't know where the terminal funds rate is going, and all it took was a tiny little speech from Powell after Jackson Hole to kind of usher in another little mini correction here.

So, here's where things stand right now. The markets are pricing in a peak fed funds rate of around 3.9% by next April, followed by a decline to 2.9% by the end of 2024. In other words, funds are at peaks next April and then gradually start declining. I don't know about that. Inflation that's linked to food and energy and auto parts and used cards and certain things, they're starting to roll over.

The less-cyclical service and housing inflation numbers are still rising, and some of the business survey suggests that the wage pressures have peaked, but the actual wage growth numbers are still really high and unrelentingly rising. Then payrolls and jobless claims have only weakened a small amount. As a result, what you get is the equity markets trading almost lockstep with the tenure treasury less anticipated inflation, in other words, every time you get an increase in anticipated inflation, and in increase in the real rates, equity multiples go down, and then the reverse is true as well.

There's a chart here showing this, and the reason it's so important is those wacky forward earnings multiples of 20 to 22 that we had from the beginning of COVID until a few months ago was taking place because real 10-year yields were negative. So, as long as you believe that real interest rates are positive now and going to stay positive, I find it hard to justify an increase in PE multiples.

Bottom line is consumer price inflation may have seen its peak but it's still elevated. Wage inflation hasn't rolled over. The labor force participation rate has stalled which is adding to tight labor market conditions. So, I still think there's a one-in-two chance that we have a recession next year. That said, I think it's a mild one. Consumer balance sheets are much stronger than they were across the developed world, not just in the U.S., compared to prior recessions.

When we look at a bunch of models on leading indicators for how severe a recession we might have, it doesn't look anything like 2009, and it looks like a milder version of what we had in 2020. That said, those leading indicators are suggesting a decline in earnings, and so given those weakening leading indicators and what looks like earnings declines, I think we're going to have a rollover in equity markets sometime this fall, closer to the June lows for anybody looking for a better entry point.

We have a whole bunch of charts in here that walk through all of this, but the bottom line is we're coming out of a decade where across the developed world you had financial repression and short rates and long rates, particularly after you adjust for all the quantitative easing that were way below, abnormally below, the returns on financial assets. That gap is now closing which creates less incentive for leverage, less incentive for risk taking, most incentive for a resetting of portfolios to less-risk assets, and I think that process is going to be something where you don't want to be too aggressive as that's taking place.

So, bottom line is looks like a mild recession for the United States is in the cards. Earnings will probably decline. Look for a rollover in the equity markets sometime this fall. Part of that's already happening. Then let's just see how far those leading indicators go down. Of course, the actual wage and consumer price inflation prints over the next few months are going to be really key drivers of just how high rates have to go.

There's a couple of pages of exhibits here. Some of the exhibits that are worth looking at are exhibits on the collapse of new orders versus production, how inventories are extremely elevated, the leading indicator model that we use to look at what earnings are up to, that kind of thing.

Then there's also a table in here, every time the fed has hiked rates since 1965 you've had a recession sometimes, and not other times. When you haven't had a recession, the common factor or at least one of the common factors have been food and energy inflation in single digits of 4-5%. So again, when you haven't had a recession after fed hikes it's happened in those times when food and energy inflation was very low. That's not the case this time around, and that's why I think you've got a one in two chance for recession next year.

Okay, so let's talk a little bit more about the energy bill and why it's so important to try to understand what's going on with it. When there's a bill that affects taxes and spending, the CBO comes out with projections of what they think happens to the deficit, growth, inflation, things like that. There's no government agency to make GHG or climate projections.

When Manchin and Schumer were working on their energy bill they consulted with three outside energy modeling firms to ask them, hey, if we put these policies in place, what are the GHG reductions going to be. I find in all the breathless support for the bill, and I think it's a good bill, I would have voted for it, but for all the articles talking about a 40-45% decline in GHG emissions resulting from this bill, there's not a single article I've seen to talk about the actual assumptions made to get there.

I took a look at the detailed assumptions by one of those modeling teams. These people are very smart, they're very well informed on energy transition dynamics, but the models they build assume perfectly optimal behavior by every business and every individual based on economic incentives.

So, in other words, if it makes sense for somebody to buy an electric car economically, everyone will do it. They ignore the frictional issues related to supply chains for battery and critical minerals. There's limited acknowledgement of the actual interconnection delays of wind and solar power, and the difficulty in siding new transmission to support that wind and solar power.

Notice that House Democrats, by the way, may already block passage of the infrastructure projects siding bill that Manchin was trying to get them to agree to in exchange for his support.

I looked at a long list of our assumptions versus this modeling group's assumptions, and there were some kind of remarkable differences in there. They've got a pace of solar and wind additions that would represent the fastest pace of any kind of electricity generation capacity added in history, and by a wide margin. They have a seven-times increase in the pace of solar installations, 100% EV penetration of sales in 2030 for passenger cars and light trucks.

What's kind of more amazing is a 90% EV share assumed for medium-duty and heavy trucks, even though those don't exist today. They've got a 30% expansion in the transmission grid over the next few years, even though over the last 10 years it's been closer to 5-10%. Anyway, we walk through all the assumptions. Some of the assumptions that we made are similar to theirs. The reason this is so important is, forget about the GHG issue for a minute, if you accept their presumptions, right now natural gas represents about a third of all primary energy consumption in the United States. Under their assumptions it drops to 20% in just eight years, and falls rapidly after 2030.

So, if you believe those assumptions you would already be taking steps today to curtail the viability and profitability of the natural gas industry because you don't need it in the future, so you might as well start putting it in wind-down mode, similar to what's being done with coal and parts of nuclear. Under our assumptions, the primary share for natural gas is only down a couple of percent in 2030, and so you would not take those steps to constrain the growth and viability of the natural gas industry.

So, even more than the GHG emissions, these policy assumptions of how these bills work is really important, because they drive decisions that are going to be made as it relates to a lot of things about which industries are supported and which aren't. If you take a look at what's going on in Europe right now there's and abject lesson in if you get that wrong it's extremely expensive. I'm sure you've seen this, but we have chart in here on what's happening with the energy prices in Europe and how Germany could actually run out of gas this winter depending upon what Russia does with supplies.

Anyway, take a look. I think it's important for all of us to be fluent as possible in the widgets of what drive these GHG assumptions so that we can identify Panglossian articles when they appear on energy.

The last topic for this month's "Eye on the Market" is the other component of the Inflation Reduction Act is $45 billion dedicated for tens of thousands of new IRS enforcement agents. The CBO did score that part of the bill, and they assume a 4:1 return. In other words, 45 billion invested in new agents and they're going to generated around 200 billion of additional revenues over a 10-year period. Not so fast.

Audit rates have come down over the last 10 years, but are still highly skewed towards people with incomes of a million or more. So, let's assume that the audit rate for those earning more than--let's even it out at 400,000. Let's assume that the audit rate goes back up to seven times what it is now and goes all the way back to what it was in 2010. Based on some information from the general accounting office on how much additional revenue you raise from those kind of audits, that would raise about $8-10 billion a year in 2031, which is way below the $35-40 billion estimated by the CBO.

This all sounds like boring IRS math until you think about the implications here, because Treasury Secretary Yellen and the IRS Commissioner are saying don't worry, we're only going to direct these new agents to focus on wealthier taxpayers, but if focusing on wealthier taxpayers only raises, let's say, 20-30% of the projected revenues they're going to have to look much more broadly at a broader group of taxpayers to raise the money that was assumed here by the CBO and the House Ways and Means Committee.

We have some data in here on audit rates by income and how much money you make by auditing people and things like that. I think part of what's driving this initiative is that the Treasury has published a document suggesting hundreds of billions of dollars of a tax gap every year, which is the difference between what should be paid and what is actually paid. I think a lot of those numbers are vastly overestimated and we walk through some of the computational issues as to why that estimate is way overstated.

But look, that's how we're looking at it. Other people look at it differently. The bottom line is whatever the theoretical tax gap is, it looks like these new IRS agents are going to be focusing intently on a broader group of taxpayers involved with partnerships, sole proprietorships, and owners of commercial and residential property. The clue there is there was a chart from the Treasury that they published this year that showed the percentage of income not reported, in other words, underreporting of income.

For people and entities that are subject to information reporting and withholding, they assume almost a zero percent noncompliance rate, and even when there's no withholding and partial reporting, the noncompliance rate is 15%. But where they're really going to be looking is they assume a 55% noncompliance rate for certain kinds of partnerships, proprietorships, and owners of commercial and residential rents and royalties and things like that. So, that really is where it looks like they're going to be focusing here.

We have a couple of pages explaining all of this, and then just to round things out, the IRS also believes that there's a very large degree of noncompliance and nonreporting by crypto holders. There's been a whole bunch of new executive orders focused on that.

There was a widely publicized on Twitter enforcement announcement of someone you will have heard of for tax evasion related to crypto that took place last week, and so that's what we think is going to come next. A lot of comprehensive field exams of digital asset funds, principals, and investors, and some economic and other kinds of penalties that are going to be very well publicized to raise the bar for people that are noncompliant.

If you didn't get a chance to see it, in July in the last "Eye on the Market" we had a great chart on Bitcoin according to Shakespeare, so if you haven't seen that, please take a look. It's a chart with different Shakespeare quotes depending on what the price of bitcoin was actually doing.

So, thank you very much for listening. We are having a Zoom webcast of some kind with Henry Kissinger in September that a lot of you will receive invitations to, to talk about what's going on. Henry's almost 100, so it'll be interesting to hear what he has to say. Thank you for listening. Bye.

FEMALE VOICE 1: Michael Cembalest's "Eye on the Market" offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JP Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for JP Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the "Eye on the Market" by contacting your JP Morgan representative. If you'd like to hear more, please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only and is a communication on behalf of JP Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information which can be found at https://privatebank.jpmorgan.com/gl/en/disclosures/legal-disclaimer.

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Exhibit 1: inflation trends

Exhibit 2: housing inflation

Exhibit 3: wage expectations

Exhibit 4: consumer price and wage inflation

Exhibit 6: leading indicators

Exhibit 7: inventories

Exhibit 8: labor force

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