Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management Sep 06, 2022
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
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.
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.
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.
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.
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
Exhibit 9: leading indicator for earnings
Exhibit 10: price-to-earnings ratios
Exhibit 11: equities and the last Fed hike
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.