Paulsen: Tax Cut May Lead to Overheating, Help to End Bull Market

Wed, Oct 18, 2017 - 9:12am

Jim Paulsen, Chief Investment Strategist for the Leuthold Group, discusses his outlook on the US stock market and the economy with FS Insider. He is still bullish, citing 3 basic pillars holding up this bull market, but also explains why a tax cut at this point in the cycle will likely do more harm than good in the short-term, even though tax reform is important long-term for US competitiveness.

See podcast Jim Paulsen: Tax Cut Will Probably Do More Harm Than Good

No Need to Panic on Rate Hikes

Though the Fed has been raising rates, real rates are still negative. Historically, the three-steps-and-a-stumble rule says that once the Fed tightens three times, that signals the end of the recovery and the beginning of the bear market, Paulsen stated.

However, with unprecedented levels of stimulus and debt, “monetary policy [is] so far out of bounds from anything it used to be,” Paulsen said, and getting back to normal may take quite some time.

The Fed has already raised interest rates four times since 2015, and yet the Fed funds rate is still about a half of a percent or more below consumer price inflation. As a result, rate increases haven’t had much impact as the economy and stock markets continue to accelerate.

Basically, “there’s too much attention being devoted to the Fed,” he said. “I would pay more attention to what private policy officials are doing. … I think they might be having more of an impact right now than Fed policy.”

Global Growth and Tax Cuts

The US has been the sole engine of growth for most of this cycle. Now, global growth has picked up with foreign stocks seeing major breakouts.

A big reason for the turnaround has been the shift from austerity to easy liquidity policies.

There’s also been an expectation for tax cuts, but Paulsen doesn’t see this as a necessarily good thing at this time.

“At most any other point earlier in this recovery, what we’re talking about today would have been a wonderful policy,” he said. “To bring a fiscal stimulant at a time when you’re at full not necessarily all good.”

It would be odd to have the Federal Reserve tightening monetary policy due to concern about overheating conditions, while at the same time have Congress consider a massive fiscal stimulus, Paulsen noted.

Cause for Concern on the Horizon?

Every recovery in post-war history has ended in some semblance of overheating conditions, Paulsen noted. We normally see upward pressure on costs that have resulted in rising yields and rising interest rates, followed by policy tightening, ultimately brining in the next recession.

“I think this one’s going to end the same way,” he said. “I don’t think we’re going to have runaway inflation like in the 1970s, but I think we’re already headed towards overheating conditions.”

If inflation picks up, we could see conditions that create a panic among bond investors. We’ve also seen the bear watch spike this year, Paulsen noted. The perception is that valuations are too high, the VIX volatility index is too low, the recovery is too old overall, and the Fed is already starting to tighten.

However, nothing is traditional about this recovery or bull market.

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