ECONOMIC COMMENTARY

CIO Note: Washington wakes up

Challenges with the Chinese economy and U.S. GDP are countered by new legislation and low unemployment.

Key takeaways

  • The Build Back Better Act appeared to have lost its way within the halls of the Capitol, but several legislative initiatives reappeared as part of the Inflation Reduction Act, pointing to some changes for U.S. companies and consumers. 

  • Recession talk is at an all-time high after a second consecutive quarter of negative GDP in the U.S. However, there are still areas of the economy that have yet to slow meaningfully. 

  • Economic recovery in China has been delayed by the pandemic and there may be little political will to change the current course. 


The impacts of new clean energy and prescription drug legislation

In a somewhat surprising turn of events, the Senate and the House passed the Inflation Reduction Act in August and, at the time of this writing, the legislation is headed to the White House for signature. 

The current legislation, a form of which has been floating around Washington for almost a year as the Build Back Better Act, earmarks over $300 billion for energy and climate reform, including spending to improve transportation and electricity generation, as well as enhancements to renewable infrastructure. Coupled with tax credits for electric vehicles and energy efficiency enhancements for housing, the bill is expected to reduce greenhouse gas emissions to 60% of their 2005 levels by 2030.  

The bill also tackles the rising cost of prescription drugs by allowing the federal health secretary to negotiate certain drug prices on behalf of Medicare patients. The bill caps out-of-pocket prescription drug costs at $2,000 per Medicare patient and provides a three-year extension to healthcare subsidies offered through the Affordable Care Act, which meaningfully reduces premiums for those receiving federal insurance. With the appetite for fiscal stimulus quite low; however, the bill also includes revenue generation, in order to simultaneously offset the spending and lower the deficit. As such, the bill increases the minimum corporate tax rate to 15% for companies reporting more than $1 billion in income and levies an additional 1% tax on stock buybacks beginning in 2023. 

In order to pass the vote, Senators Joe Manchin and Kyrsten Sinema pushed for the removal of two objectives which were part of the original Build Back Better plan: an extension of the child tax credit and an end to the carried interest loophole. Also excluded from the bill were changes made to the SALT deduction, which had been cited as a requirement for passage initially from a group of legislators representing high tax states.  

The bill is likely to be a platform staple for November’s mid-terms, with Republicans arguing that more spending will only prolong inflation, while Democrats will cite the support provided to families struggling to pay health care costs as well as enhancements to infrastructure that should lower energy costs in the future. For investors, it is prudent to consider the implications. 

First, planned share buybacks are likely to increase through the end of the year, as the 1% tax does not go into effect until 2023. The impact of taxing net buybacks prospectively is more difficult to forecast. Given the additional cost, it will likely modestly decrease the volume of buybacks over the next several years as corporations reset to the new tax. 

There is evidence that the tax change may increase dividend payouts to shareholders as an alternative means to engineer shareholder return, but management teams are loathe to increase their dividend payouts at a rapid pace, as dividend cuts typically result in stock price pressure; special dividends are often the result of this concern.  


Source: Tax Policy Center 

Longer term, there is a broader question regarding additional increases to this tax in the future. With almost $1 trillion in buybacks forecast for this year, based on the pace during the first half, there could be pressure over time to increase the tax, removing it as a lever for management to return capital to shareholders. 

While buybacks are a tool used by many public companies, the number of companies paying less than a 15% effective tax rate on over $1 billion in revenue represent a smaller universe. This portion of the legislation is likely to generate meaningful tax revenue; however, as it is estimated that 19 companies in the Fortune 100 paid little to no tax in 2021, and even more paid zero federal tax in 2020.  

Overall, our view is that a recommitment to cleaner, more efficient energy production including more effective decisioning practices on natural gas production and distribution will help stabilize prices in U.S. energy supplies over time. In addition, while there are limitations to the number of drugs that fall under the scope of negotiation for the federal health secretary, the significant increases in pricing for insulin and Epi-Pens, for instance, could be avoided via this new process. Both developments may ease pricing pressures over time. However, in terms of reducing inflation, a continuation of the shift in supply and demand experienced over the last several months is key. 

Unpacking the latest economic indicators

With recession talk dominating the dialogue throughout much of the second quarter, it was not entirely surprising that U.S. GDP for the second quarter came in lower than expected, declining -0.9% and marking the second straight quarter of negative growth for the U.S. economy. While the first quarter print was dragged down by net exports, second quarter GDP was lower on decreased residential and non-residential investment, government spending and, most notably, slower inventory build. While consumer spending was positive for the quarter, goods spending was significantly lower, and services spending did not grow robustly enough to offset the declines in other areas of the economy.  

Whether or not the U.S. economy is in an official recession remains up to the National Bureau of Economic Research, and with history as a guide, that official pronouncement will not come anytime soon – or not at all as the NBER’s definition of recession is, “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” 

Important to note, the NBER puts significant emphasis on the state of the labor market and wages, both of which have not yet reflected the softness indicated by the GDP print. In fact, non-farm payrolls for the month of July came in much better-than-expected, as the U.S. economy added +528k jobs in the month versus expectations of +258k jobs, and has now recovered all of the payroll jobs lost during the 2020 recession. In addition, the unemployment rate fell to 3.5% - the lowest level since 1969 - while the labor participation rate fell slightly from 62.2% in June to 62.1%. Wage growth was also higher, up +0.5% month-over-month and +5.2% year-over-year, which still points to only nominal rather than real wage growth with CPI at 9.1%. 

Higher wages represent an ongoing challenge for businesses as, unlike other costs of production, they tend to be quite sticky, and efforts to cut wages tend to be successful only during significant and sustained recessions. What is likely to begin to cap the increase in wages is a decline in demand for workers, but with the JOLTS report still reflecting 10.7 million open positions, the pendulum has yet to swing in any meaningful way back towards supply-demand equilibrium.  


Source: YCharts, August 12, 2022, 9:48AM EDT

In addition, the ISM PMI reports on business activity in the month of July released showed signs of improvement. On the manufacturing side, while the overall figure was down slightly from June due to slower new orders and production, prices paid were SIGNIFICANTLY lower, down nearly 20 points month-over-month. New exports and inventories were both up as well, pointing to potential improvement for the latter which was a meaningful drag on GDP as noted above. The services index was even more surprising, as it actually accelerated on business activity and new orders, while prices paid came down modestly; however, not to the extent seen in the manufacturing print. However, inventories remain challenged, so it may take a few more months of stronger services demand for these to grow meaningfully. 

Perhaps most importantly, CPI and PPI for the month of July were lower than expected. CPI was flat on a month-over-month basis and was up +8.5% year-over-year, down from +9.1% in June. PPI actually declined by -0.5% month-over-month, and grew +9.8% - which is the slowest rate of increase since last October.  

Admittedly, employment is a lagging indicator, and when it comes to calling a recession, there are few who would disagree that a slowdown is here. The improvement in inflation could be short lived, and consumers are going to be bombarded with messaging around the higher cost of living as we move into mid-term season. When it comes to determining if we are indeed in a recession, one must consider the depth and persistence of the decline, which is significantly more impactful to the markets than a discussion around the definition – and that is still an open question.

Examining China's recent political and ongoing Covid challenges

While inflation and monetary policy topped our list of concerns in 2022, China is facing internal and external challenges that also have meaningful implications for the global economy. From an economic perspective, supply chain improvements and a reacceleration of the global economy were supposed to support a Chinese economic recovery. However, the country’s zero Covid policy and subsequent rolling shutdowns have likely made the country’s GDP 5.5% target unattainable for 2022, and yet there does not seem to be any acquiescence coming from President Xi Jinping on the path forward. 

In addition, U.S.-China relations are back on the front burner after Speaker Nancy Pelosi traveled to Taiwan in early August, and Chinese military officials responded with a new round of live exercises in the Taiwan Strait and Taiwanese air space. Chinese officials also cited Pelosi’s visit as justification to halt formal talks regarding engagement in the region. While it is not likely that a full-scale conflict will arise directly from these events, the importance of coordinated communication between the U.S. and China regarding Taiwan is critical to the prevention of an escalation of the conflict such as a live exercise misconstrued as an act of war. 

While the U.S. maintains its commitment to Taiwan’s sovereignty, the communication breakdown with China coupled with  a lack of transparency in Chinese military exercises may have severe consequences, and could weigh on further efforts to improve economic coordination – further depressing the recovery of the world’s second largest economy.  


Source: Tradingeconomics.com | National Bureau of Statistics of China

We encourage you to reach out to your Wealth Advisor for a deeper discussion on the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals. 

Shannon Saccocia, CFA, CIMA®

Shannon Saccocia serves as Chief Investment Officer at SVB Private, and is responsible for setting the overall investment strategy for the firm. She oversees the asset allocation, research, portfolio management, external manager search and selection, portfolio implementation, trading, and investment risk management functions.

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