Investment Strategy

What the Inflation Reduction Act could mean for the economy

Aug 19, 2022

Sustainable goals should get a boost, but will the new law meaningfully curb inflation? Probably not.

Our Top Market Takeaways for August 19, 2022

Market update

The dog days of summer

 

As we close out the week, markets seem to be feeling the end-of-summer jitters. Stocks have been wobbling back and forth, but if the S&P 500 manages to close the week higher, it’ll mark its fifth straight week of gains—a feat not achieved since November 2021. Bond yields have also seesawed, and some of the biggest moves have come from commodities as the energy crisis in Europe wears on.

With the dog days of summer behind us, here is what we learned this week, as told by investor fears we’re hearing:

  • We’re already in a recession.
    While U.S. growth has “technically” contracted the last two quarters, the labor market tends to provide a better signal for the state of the economy (having a job is the largest determinant of whether a consumer is likely to spend money). And from this lens, workers are still on strong footing. The latest jobless claims print actually fell, signaling there were less people seeking unemployment benefits last week than the week before. Add that to July’s blockbuster jobs report (which said the U.S economy added 528,000 new jobs), and you’re looking at a pretty healthy labor market. Recession risks are real, but we don’t think we’re already in one.
  • Okay, but the Fed’s going to cause a recession.
    It’s possible, but the July FOMC meeting minutes released Wednesday revealed that Jerome Powell and the Federal Reserve are well aware of the risk of overtightening now that the policy rate is in the neighborhood of “neutral” (nebulous as that may be). We look forward to seeing how Powell wrangles the monetary policy message coming out of Jackson Hole next week, especially given that the recent risk asset rally has helped undo overall tightening—which could galvanize a more hawkish stance ahead.
This chart shows the GS Financial Conditions Index from January 3, 2019, until August 17, 2022. The first data point came in at 100.22 and quickly declined to 98.55 by February 2, 2019. Here, it spiked to 101.69 by March 23, 2020. Then, it dropped to a trough of 96.92 on November 9, 2021. From there until recently, it rose to 99.85 by June 17, 2022, before dropping to 99.06. A higher print translates to tighter conditions, while a lower print means looser conditions.
  • The consumer is cracking!
    This week’s data suggests otherwise. For one, the latest retail sales print was pretty solid. Stripping out more volatile measures such as gasoline and autos, sales increased +0.7% in July (and with a big thanks to online shopping from Amazon’s Prime Day). Second-quarter earnings from big retailers are telling a similar story. Walmart showed it’s working through its inventory glut, even as consumers shift their preferences to services over goods, and Home Depot noted continued strength in home improvement projects.
  • Inflation is just going to keep on climbing.
    The evidence is compounding that price pressures are peaking. Following on Last week’s U.S. CPI report, this week brought word that existing home prices and auto prices are falling at their swiftest pace since the pandemic shock. Fed policy is well at work. Oh, and U.S. gas prices have now fallen for 64 straight days.
This chart shows the Manheim Used Vehicle Value Index from January 2018 until July 2022. The first data point came in at 131 and rose to 143.5 by February 2020. Here, it declined to 125.8 by April 2020. Then it rose to a peak of 236.3 by January 2022. From there until recently, it declined to 219.6.

That said, inflation is still way too high, and it’s the thorn in everyone’s side, even to the point of inspiring the Biden Administration to memorialize its climate, healthcare and tax package as the Inflation Reduction Act. Read on for what it means and how it might affect you.

Spotlight

Need-to-knows: The Inflation Reduction Act

 

It was a long, uphill battle, but the President signed a landmark bill focused on climate, healthcare and corporate taxes earlier this week. The below table summarizes the provisions of the Inflation Reduction Act, and is followed by three key takeaways on what it means for the prevailing economic backdrop, earnings outlook and sustainability.

This table summarizes the provisions of the Inflation Reduction Act: Energy and Climate: -$386 billion Clean Electricity Tax Credits: -$161 billion Air Pollution, Hazardous Materials, Transportation and Infrastructure: -$40 billion Individual Clean Energy Incentives: -$37 billion Clean Manufacturing Tax Credits: -$37 billion Clean Fuel and Vehicle Tax Credits: -$36 billion Conservation, Rural Development, Forestry: -$35 billion Building Efficiency, Electrification, Transmission, Industrial, Department of Energy Grants and Loans: -$27 billion Other Energy and Climate Spending: -$14 billion Healthcare: -$98 billion Extension of Expanded Affordable Care Act Subsidies (three years): -$64 billion  Part D Redesign, Low Income Subsidies, Vaccine Coverage: -$34 billion Total, Spending and Tax Breaks: -$485 billion Health Savings: $322 billion Repeal Trump-Era Drug Rebate Rule: $122 billion  Drug Price Inflation Cap: $101 billion  Negotiation of Certain Drug Prices: $99 billion  Revenue: $468 billion 15 Percent Corporate Minimum Tax: $313 billion IRS Tax Enforcement Funding: $124 billion Methane Fee, Superfund Fee, Other Revenue: $18 billion Total, Savings and Revenue: $777 billion

Whether misnomer or marketing magic, we don’t expect the Act to have much impact on inflation.

An optimist might point to the Inflation Reduction Act’s provisions aimed at lowering the cost of things such as energy, pharmaceuticals and healthcare, and the ~$300 billion estimated deficit reduction as disinflationary tailwinds. But over the course of the next year, we don’t expect the bill to have much of an impact on inflation at all:

  • Energy costs are expected to be lowered mostly through tax credits aimed at adoption of clean alternatives and conservation practices. We think they will be effective, but not overnight.
  • Medicare’s ability to tamper down prescription drug costs won’t have much oomph until renegotiated prices take effect in 2026.
  • The included subsidies for healthcare costs are just a continuation of the ones enacted through the American Rescue Plan (they were set to expire in the coming months, but the IRA expands them for another three years).

For the government’s 2023 fiscal year, the total deficit reduction from changes in direct spending and revenues looks likely to be less than 0.1% of GDP (~$18 billion). That’s a drop in the bucket when it comes to macroeconomic impact. We continue to think inflation will be mostly driven by commodities, cooling labor and housing markets, and improving supply chain dynamics in the coming months.

A chunk of S&P 500 companies will help pay for the provisions, but the potential market impact looks modest.

The Inflation Reduction Act has two major tax provisions, both of which apply to corporations: A 15% minimum tax for companies with more than $1 billion of book income per year, and a 1% excise tax on stock buybacks.

First, on the buyback excise tax: The change could prompt some companies to pull forward buyback plans to this year before the excise tax takes effect. It could also shift some degree of focus toward dividend payouts.

As for the minimum tax, the Joint Committee on Taxation estimated that up to about 150 companies could be affected. A little less than half of the assumed-to-be-effected companies are in growth sectors such as tech, consumer discretionary and communication services; healthcare accounts for about a third. Those sectors may feel earnings per share headwinds to the tune of 1–2%.

For the S&P 500 as a whole, the net earnings impact looks to be relatively small (~1%) and isn’t enough to prompt our Equity Strategy Team to revise its 2023 $233 earnings per share expectations lower. That said, this could be an additional impetus for the Street’s consensus estimate (currently $244) to converge toward ours.

The bill does offer a long-term boost for a long-term investment theme: The clean energy transition.

Over $380 billion will go toward advancing clean energy and climate initiatives, with the goal of reducing U.S. carbon emissions by 40% by 2023.

They say you can catch more flies with honey than vinegar: The plan heavily emphasizes sustainability rewards rather than pollution penalties. Companies making things such as solar panels and wind turbines can tap into ~$60 billion of allocated tax credits; households might be allured by expanded tax credits for electric vehicles, efficient appliances and clean home energy sources.

As a means of getting the bill over the finish line, there were some bones thrown at the fossil fuel industry as well. Federal property used for renewable energy will also be available for new oil and gas drilling, and producers can earn incentives for improving efficiency and developing carbon capture solutions.

All in all, the bill at least steers the United States back in the direction of the goals outlined in the Paris Agreement. Our multi-year conviction in sustainability themes such as renewable energy, battery storage, green real estate and clean infrastructure is bolstered by these policy advancements.

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Our Top Market Takeaways for August 19, 2022.

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. 

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