Oil prices, business investment, and the tax cut remain the top three variables in the economic outlook. The good news is you can expect all three to move in a favorable direction in the coming months — adding to stock prices at the expense of Treasury bonds. Let’s look at each variable.
Lower oil prices. Oil prices will fall sharply as Iraqi oil comes to market. It’s not likely that the U.S. will let the United Nations block Iraqi oil sales, and OPEC (particularly Saudi Arabia) isn’t likely to cut oil production enough to make up for the oversupply. So, oil prices should fall once oil inventories build.
Growth in business investment. Low interest rates, low inventories, the prospect of a tax cut, and less Iraq-related uncertainties should improve “animal spirits” — the willingness of Americans and American businesses to take risks. This translates to an increase in business investment. Investment in business equipment should grow 7.7% in 2003 (fourth quarter over fourth quarter), up from 3.3% growth in 2002. This is modest by the standards of previous recoveries, but it reflects caution after the investment boom of the late 1990s.
Big, growth-oriented tax cut. There is a lot of pessimism about the size and impact of the upcoming 2003 tax cut. There’s little reason for it. All signs point to the enactment of a tax bill this year that will have a major, positive impact on the economic and market outlook.
The recent congressional budget resolution provides protection from a Senate filibuster for at least $350 billion of reduced tax receipts. And these congressional “scoring” estimates are notoriously inaccurate, are commonly manipulated during the drafting of the legislation, and bear no relationship to the legislation’s economic, employment, or market benefits.
In particular, reducing taxes on stock market assets — in this case by way of the dividend tax cut — will have a positive impact on stock market asset values. The scoring estimates ignore this benefit completely, yet the gains to the economy and employment would be real.
Taxing dividends reduces the value of corporations, while encouraging tax-deductible debt. Reversing that would cause higher stock prices, more capital gains, more capital-gains taxes, a lower cost of equity capital, and a more efficient allocation of capital. None of these benefits is reflected in the “scoring” process. And these benefits could add up to $1.5 trillion to $2 trillion in stock market equity gains up front with large collateral benefits — the “cost” of which Congress scores at $30 billion per year.
More, even the reduced $350 billion “cost” allocation may still be enough to include most of the pro-growth tax proposals. There are many ways to make this work. For example: 1) Senate procedures may allow the Senate to work with a number greater than $350 billion. 2) Some of the less growth-oriented tax proposals could be scaled back or moved to separate legislative vehicles. 3) Congress might decide to consider the added growth (and capital gains) from the tax cut, reducing the cost estimate. 4) For scoring purposes, the tax bill might include a distant phase-out in some of the tax cuts (as in 2001) or imbed tax (or fee) increases in the late part of the 10-year budget horizon. Congress would be satisfied with the 10-year scoring totals, while the economic and financial market outlook concentrates on the near-term improvements in the tax code.
No, the bubbly 1990s — or 3.8% unemployment, a high-flying dollar, and regular double-digit equity returns — are not on their way back. Instead, we’re in for a multi-year reflation process and a challenging environment for corporate profits. Still, this is a decided improvement over deflation. Count on oil prices, business investment, and tax-cuts to work in favor of economic growth.
— Mr. Malpass is the Chief Global Economist for Bear Stearns.