The economy follows an inexorable pattern of peaks and troughs and the transitions between those points, expansions and contractions. Our current condition puts us in one of the longest expansions in US history. The US economy began its expansion in June of 2009 and will mark its ten-year anniversary at the end of June 2019. At that point, it will be the longest expansion in US history. The average post-WWII expansion has been about 58.4 months. This expansion, however long it lasts, will likely be at least twice as long.
There are clear commonalities among the 11 prior post-WWII recessions. All 11 had Fed funds rate increases prior to recession. Each instance saw a drop in the unemployment level prior to recession. Five recent recessions had a spike in oil prices (1973, 1980, 1990, 2000 and 2008). Let’s look at some prospective differences:
The Fed Has Two Wrenches. In the past, the Fed’s chief tool of monetary policy has been the Federal Funds Rate. The Fed remains vigilant, watching inflationary trends, and raises the Fed Funds rate to slow the economy and (hopefully) forestall inflation. Short-term rates drive the direction of lending rates, so this tool works, albeit with a noticeable lag. The lag tends to cause the Fed to ‘overshoot’ the rate increase. Historically, Fed rate increases have preceded recessions. The Fed has stopped short-term rate increases and engineered a ‘soft landing’ about three times in its history.
The Fed now has a new tool in its toolbox, thanks to the bond-buying program of Quantitative Easing. As of May 1, 2019, the Fed had total assets of $3.9 trillion, compared to $800 billion at the start of the last recession. The Fed currently holds about $1.575 trillion in Mortgage-backed securities and about $2.1 trillion in Treasury securities. The Fed’s position with those securities was to ‘roll off’ those securities at a rate of about $50 billion a month. This means the Fed would simply allow the securities to expire. Theoretically, and only in theory because this has never happened before, the roll-off would raise longer-term rates. The Fed must choose a course of action in terms of its balance sheet: it can increase its securities holdings (stimulate) or do nothing (neutral).
The Fed has announced that it will cease balance sheet normalization in September 2019. What will the outcome of this decision be and how will it affect the economy? We don’t know…yet.
We Export Oil Now, We Didn’t Then. In five out of the six most recent recessions, oil prices rose either prior to, or commensurate with, the recession. In December of 1973, oil prices doubled in a month, thanks to an OPEC oil embargo. From March of 1979 to March of 1980, oil (WTI) rose from $15.85 a barrel to $38. The same scenario arose in 1990 when WTI went from $16.87 in June to $35.92 in October. Oil tripled before the 2000 recession and similarly moved from $54.57 in January of 2007 to $133.93 in June of 2008. US Oil imports peaked in 2008. In August of 2008 US oil imports for the month were about 320 million barrels, compared to 186 million barrels in February of 2019. Simply put, in the past, oil price spikes hurt the US economy more than they do now. If oil prices rise now, US producers see higher returns and money flows in, not out.
We’re Bloated with Debt. We are awash in debt, more so than in all other post-WWII recessions. Gross public debt is nearly 105% of GDP, in contrast with about 68% of GDP at the start of the 2008 recession. Add to that an $800 billion dollar budget deficit, and we have a debt tsunami. Typically, debt increases in a recession as the government tries to stimulate the economy with spending. Is the answer to just keep borrowing?
China. In all post-WWII recessions, the US has clearly been the dominant economic superpower. Today, China’s GDP as measured in Purchasing Power Parity (PPP) is over $27 trillion, versus just over $21 trillion for the US. China’s trade with the US in 2018 was $737 billion. China GDP in 2009 was around $5 trillion, it is now estimated at $14 trillion. By contrast, the US GDP in 2009 was $14.4 trillion, with a 2019 estimate of $21 trillion. China was unaffected by the 2008-09 slowdown. How will the interface of the two economies play out? What does a protracted trade war do to the relationship?
The new unknown: The tax cuts aren’t built for downturns. The Tax Cuts and Jobs Act (TCJA), the massive fiscal stimulus from 2017, initiated major changes in tax planning for businesses and individuals. The aftershocks continue to be felt by tax professionals and their clients. The TCJA brought sweeping changes in corporate and individual income taxes. TCJA cut the corporate tax rate to 21% and cut most of the brackets for individuals. It also provided a significant cut for small business owners of ‘pass-through’ entities. However, there are some significant changes that will be of importance in a downturn.
Net Operating Losses (NOLs) – Under prior law, if a business had a net operating loss, they could carry-back the loss two years and carry-forward the loss up to 20 years. This allowed a ‘smoothing’ of losses and provided some stimulus in a down year where the prior returns could be amended, and a refund applied. NOLs were formerly 100% applied against taxable income. As an example, Amazon (AMZN) currently has about $627 million of NOL carry-forwards.
Under TCJA, NOLs may not be carried back but can be carried forward indefinitely. However, an NOL now only offsets up to 80% of taxable income. If XYZ company generates a $100 million loss, in the past they could carry the loss back and offset it against 100% of the prior two years’ taxable income and carry any remainder forward 20 years. Under the new law, XYZ gets no current benefit for the NOL and can only offset it in the future and only then at 80% of future taxable income. By the Joint Committee on Taxation’s (JCX-67-17) estimates, this is a tax increase of about $200 billion. For corporations, the TCJA basically establishes a minimum tax on income in post-NOL years of 4.2%.
Compound this with full-expensing rules. TCJA allows ‘bonus depreciation’ of up to 100% of the cost of an item. However, if purchasing a piece of equipment runs our company into an NOL, we end up deferring the tax benefit of the purchase. This may thwart some purchases if a business perceives a downturn.
Excess Loss Limitation – A second aspect of TCJA that will have a significant effect in a downturn is the ‘Excess Loss Limitation’ provision for noncorporate owners of pass-through entities. Under the prior law, business losses from a non-passive business were deductible against other income from any source. Under TCJA, the excess business losses are limited to $510 thousand for a married couple filing jointly and $255 thousand for all other taxpayers. Any excess losses are carried forward and treated as an NOL.
Suppose Cindy is single and has a start-up software business with $510 thousand in losses. She also has $250 thousand in other income (note: there are some questions on what constitutes ‘other income’), $20 thousand in dividends and $150 thousand in capital gains. Under the previous rules, Cindy would have income of -$90 thousand, which she could carry back against the previous two years’ income. Under the current rules, Cindy would have income of $165 thousand ($250 + $20 + $150 – $255). The remaining losses would be carried forward and then offset against 80% of future income. Professor Steven Dilley, Ph.D., CPA, JD of Michigan State University thinks the ELL rules have a wide reach. “A considerable number of CPAs will be seeing these rules impact their clients because many start-up businesses are pass-through entities and have initial year losses,” said Dilley. “This will be of greater consequence if we have an economic slowdown.”
The last compounding factor is the complex networking of new tax provisions. The new pass-through rules interface with the NOL and ELL provisions and those interface with the full-expensing provisions. J. Michael Kolk CPA, Tax Partner at Cohen and Company in Akron, Ohio, foresees a considerable expansion of new tax planning. “The average business owner will now have several new tax considerations in planning. A change in economic circumstances to a business loss can have some big implications.”
Bottom line? We will, sooner or later, see an economic slowdown. In each of the last eleven recessions, we heard ‘this time it will be different.’ We shall hear that prediction again… and it will likely be correct.