How the new tax law could ripple through 2018

What might the massive overhaul of the U.S. tax code mean for the American economy, job growth, wages and the stock market in 2018? While it's way too early to say for sure, some outlines are already coming into view.

In the simplest view, the new tax law will result in more after-tax income for most American households, beginning in February, when employers start using the new payroll withholding tables. Longer term, those cuts could disappear after 2025, but for 2018 at least, most workers' take-home pay will see some increase.

According to a recently released report from JPMorgan, tax cuts for individuals in 2018 will total approximately $100 billion, and it assumes 60 percent of that amount will flow into higher consumer spending. The result could be a gain of 0.3 percent to real GDP growth in 2018. It's possible that the economic impact could be higher, if more consumer spending leads to rising growth, increased employment and higher wages.

However, those trends could also cause the Federal Reserve to increase interest rates faster than most analysts now expect if inflation rises more than forecast in 2018. Those reactions would be a headwind for the economy.

The other major leg of the tax overhaul is the reduction of the U.S. corporate tax rate to 21 percent from 35 percent. The net benefit for businesses in 2018 is projected to be approximately $80 billion, about half of which could be spent on capital spending for new buildings, equipment and so on, and on labor -- hiring new workers and raising wages. In this scenario, the other half would be spent on share buybacks and dividend increases. These benefits could add another 0.3 percent in real GDP growth in 2018.

All told, the tax cuts could result in additional real GDP growth of 0.6 percent in 2018. With the U.S. economy already growing at about 2.7 percent, this would be pushed up to about 3.3 percent.

As more consumer spending increases the need for more workers, U.S. unemployment could fall from November's 4.1 percent to below 3.4 percent by the end of 2018.

With unemployment that low, employers would face stronger competition for workers, which suggests that wage growth could finally exceed 3 percent in 2018 (next year may be the best time in a while to ask for that long overdue raise).

Faster economic growth, rising wages and lower unemployment would give the Federal Reserve a clearer path to normalizing interest rates. Four federal fund rate increase are possible in 2018, which would leave the fed funds rate at about 2.5 percent and the yield on the 10-year Treasury at about 3 percent by year-end 2018. That would be good news for savers because as money market fund yields could exceed 2 percent (many are already offering yields of over 1 percent), with similar rate increases for certificates of deposit.

If this happens, investors should patiently hold excess cash in money market funds and wait to buy bonds. Some forecasts call for bond funds returning 2 percent to 3 percent in 2018, but it's very possible see losses in bonds next year. So if your money market fund can give you a return of half that with no losses, it makes perfect sense to keep excess cash in money market funds.

But homebuyers looking to get a mortgage would be wise to move quickly because rising interest rates could mean new mortgage rates over 5 percent in 2018. Also, it makes more sense to favor a fixed-rate mortgage over an adjustable rate loan at a time of rising interest rates.

The path for the U.S. stock market in 2018 isn't so certain. After back-to-back years of double-digit gains, stock prices are looking lofty. Also, the last 18 months have seen record low volatility with no meaningful corrections.

Still, it's reasonable for stock investors to expect to see prices push higher through 2018. But also expect to see some choppy stock performance on the way up. It may be a good strategy to keep some cash on hand ready to invests when (and if) stock prices see a tumble. But with bonds under pressure, the "TINA" principle that worked over the last two years -- There Is No Alternative -- should continue to benefit stocks.

But when bond yields exceed 3 percent, and the Fed signals an end to its rising interest rate cycle, all bets on stocks and TINA are off.


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