Jerome Powell says it’s time to cut rates … is a huge bull beginning? … the prospect of a doubling of capital gains taxes … a tax on unrealized capital gains?
Welcome to the next rate-cutting cycle!
This morning, speaking at the Kansas City’s Fed’s annual conference in Jackson Hole, Wyo., Federal Reserve Chairman Jerome Powell stated, “the time has come for policy to adjust.”
Though he didn’t mention “September” specifically, the message was clear…
Rate cuts have arrived.
Remember, the qualification for rates cuts was getting inflation on a sustainable path to 2%. Well, here’s Powell: “My confidence has grown that inflation is on a sustainable path back to 2%.”
The question now is what happens beyond September. Will the Fed pause at its following meeting in late-October/early-November to evaluate the economic data? Or should we expect quarter-point cuts at each Fed meeting through the end of the year?
On these questions, Powell reverted to his traditional “let the data decide” stance:
The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.
Behind this shift in policy is the Fed’s growing focus on the weakening labor market
From Powell:
The unemployment rate began to rise over a year ago and is now at 4.3 percent—still low by historical standards, but almost a full percentage point above its level in early 2023. Most of that increase has come over the past six months…
…The cooling in labor market conditions is unmistakable… We do not seek or welcome further cooling in labor market conditions.
The upside risks to inflation have diminished. And the downside risks to employment have increased…
We will do everything we can to support a strong labor market as we make further progress toward price stability.
So, welcome to rate cuts!
While the specific path and speed going forward is unclear, “down” is the overall direction for the foreseeable future.
Now, as you’d expect, the market is partying given the news. And it prompts a question…
Are we now about to see that huge stockpile of “cash on the sidelines” flood the market?
Perhaps. But even if so, it may not result in the massive leg higher in the market that many investors are hoping for.
To make sure we’re all on the same page, for the last two years, we’ve heard about a gargantuan stockpile of “cash on the sidelines” that’s ready for deployment into the U.S. stock market. The implication has been, “if you think the market is doing well now, just wait until that cash on the sidelines floods in.”
Here’s MarketWatch expressing this sentiment back in March:
A record pile of cash is sitting in U.S. money-market funds. Some Wall Street pundits say this money represents dry powder just waiting to be deployed in the stock market.
Now, this “record pile of cash” does exist, and if it moves into the market, we should see a bump…but the size of that bump might underwhelm.
To begin unpacking this, let’s rewind…
Since October of 2022, about $1.2 trillion has flooded money-market funds. This has pushed the nominal value of this “cash on the sidelines” to more than $6 trillion.
Yes, that’s a record. And yes, it’s a lot of money.
The issue is that focusing on this $6 trillion figure ignores some important context – the swelling size of the overall stock market. When we add in this context, this $6 trillion figure appears less like a mountain and more like a molehill.
We can see this in the chart below…
The white line is the size of this “cash on the sidelines.” And as the headlines trumpet, it has jumped higher since 2022, now hitting more than $6.2 trillion, an all-time high.
But the blue line shows this cash pile as a percentage of the S&P 500’s value. You’ll see that it’s near average-to-low historical levels.
In the same way that a $100K down payment on a home went a lot farther 10 years ago than it does today, $6 trillion of cash would have gone a lot farther in boosting the S&P’s percentage gains 10 years ago than it will today.
Here’s commentary from analyst Kevin Gordon:
There might be a lot of “cash on the sidelines” in terms of total money market fund assets, but relative to the size of the equity market, the firepower just isn’t what it used to be … and in fact, cash as a percent of S&P 500 market cap has been trending lower for the past year.
Also, notice that the blue line has a rough “floor.” In other words, there’s never a time in which the entire stockpile of cash floods the market. Some investors will always want to hold some of their assets in cash. And as you can see above with the blue line, today’s level of the ratio of “cash-to-S&P” isn’t that far above this floor level dating to 2007.
Here’s more color from Morningstar:
Assets in money funds as a percentage of long-term assets peaked at 63% at the height of the global financial crisis in 2008, and they have averaged about 20% since 2011.
At 23% of long-term assets at the end of January, US money market levels are not extraordinary, even after 2023′s cascade of inflows.
Keep in mind, the chart above comes from January. The market is up about 18% since then, which means the cash on the sidelines is even less “extraordinary” today than it was then.
To be clear, a sustained, major melt-up in stocks could be starting today. I hope it is. But if so, it’ll need some help beyond the deployment of this $6 trillion cash stockpile.
In discussing this with our Editor-in-Chief Luis Hernandez, Luis asked a good question: What happens in light of this? Does the cash join the rotation out of the Mag 7s stocks and funnel into small- and mid-caps?
My hunch is that Luis is correct, and we will see greater relative gains from small- and mid-caps. But this is a topic worthy of its down Digest.
Switching gears, if you’re sitting on a boatload of investment profits, you might consider locking in some gains now
The suggestion is based on the lead that Kamala Harris has in the presidential race polling data, combined with what we’ve learned this week about her plans to tax investment gains.
To be clear, we’re talking about a proposal. And even if Harris wins the White House, the proposed tax changes would have to go through Congress. Right now, it appears the House and the Senate are leaning Republican, according to the Cook Political Report.
So, this is hardly etched in stone. That said, let’s evaluate the proposal.
From Robert Frank on CNBC’s Squawkbox:
Vice President Harris proposes to double the tax on capital gains, and taxing unrealized capital gains for the very wealthy. Her campaign endorses a plan that calls for increasing the top tax rate on long-term cap gains from 20% to 44.6%. That would be the highest rate ever in U.S. history.
Harris is also calling for a tax on unrealized capital gains for the ultra-wealthy (net worth of more than $100 million). This would show up as a minimum tax of 25% on unrealized gains. So, even if you didn’t sell your company, you’re still on the hook to pay Uncle Sam his due.
There’s a workaround for private, illiquid companies. They would be taxed at their last valuation event, plus some annual increase. However, “illiquid taxpayers” (people with less than 20% of their wealth in tradeable assets) would be able to defer payments until their death, though with interest charges attached at the time of payment.
While the temptation is to shrug this off as “rich people’s problems,” let’s rewind to our Digest earlier this week about “second-level thinking”
With first-level thinking, this tax plan seems to be a great way to raise revenues for the government while making the rich “pay their fair share.”
Okay, but what about second-level thinking?
Specifically, if you’re ultra-rich, how does your incentive structure change with this tax plan?
Well, you’ll want to avoid having your wealth in public, tradable assets like stocks…
This elevates the potential of selling these assets now (at a 20% cap gains rate) instead of when the policy becomes effective (at a 44.6% tax rate) …
And you’ll want to avoid a mark-to-market valuation for your business that enables the IRS to tax you on unrealized gains…
This increases the attractiveness of taking your company private.
In both cases, this increases the odds of money flowing out of the stock market.
Now, consider that the top 1% of richest Americans own 54% of the public equity markets. If they’re suddenly incentivized to rotate out of stocks to protect their assets, that risks a significant downward move in asset prices, not to mention a “new normal” going forward where there’s simply less capital in the public markets.
That’s not good for the stock portfolios of retail investors.
But let’s continue with our second-level thinking…
Consider the venture capital world. Entrepreneurs will have less incentive to take their companies public. After all, the new incentive structure would reward maintaining a vague, private valuation.
But if you do go public, think about the impact on growth and R&D.
Now, it’s unclear whether a corporation itself would be subject to this same tax on unrealized gains. Let’s assume it is, since the current laws consider a corporation to be a person.
If a corporate manager must pay a 25% tax on the unrealized appreciation in her company, that appreciation is only on paper – it’s not cash in hand. Yet the tax bill is very real.
So, that tax represents 25% less cash now available to invest in growth initiatives, hire new employees, pay bigger salaries/bonuses, and/or invest in R&D.
It’s a massive drag on economic growth. And we haven’t even discussed the Harris plan to increase the corporate tax rate to 28%.
Bottom line: Yes, the tax is targeted at the wealthiest Americans. But the idea that it wouldn’t filter through and have negative financial ramifications for millions of regular Americans (and their portfolios) is shortsighted.
Now, to be objective, Trump’s tax plan would likely elevate the risk of a resurgence in inflation. It also would exacerbate our government’s national debt and fiscal deficit because Trump’s tax plan wouldn’t bring in the same revenues. So, he doesn’t get an “A” grade here either.
As we’ve detailed in prior Digests, it’s a bit of a “pick your poison” tradeoff. Whether it’s Uncle Sam or inflation, something is coming for your money.
But for now, let’s ignore that and welcome the new era of rate cuts.
Have a good evening,
Jeff Remsburg
