Tax cut could push the U.S. into recession, says Paulsen

The Republican tax cut could not come at a worse time, unnecessarily overheating an aging economic recovery that’s already operating near full employment, said Jim Paulsen, chief investment strategist at Leuthold Weeden Capital Management.

“If it is a stimulative tax cut, it will hasten inflation and prematurely bring a recession,” Paulsen said in a speech Wednesday.

Both the House and Senate tax overhaul bills under consideration would cut taxes for businesses and many individuals. Households can expect to save an average of $1,200 in 2019 based on the Senate’s proposed overhaul, as tracked by the Tax Policy Center, and the largest tax cuts will go to the highest-income earners. A conference committee is working this week to combine the two versions into what they hope will be passable legislation to send to President Donald Trump.

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“I wish they’d pass it with the caveat [they’ll] put it on the shelf and pull it out during a recession,” Paulsen said, adding there’s also a chance the final bill will be “so watered down, it won’t have much impact” on the economy.

Read: Here’s what’s next for the Republicans’ tax bill

New York Fed President William Dudley agrees that fiscal stimulus carries risk right now. He told the Wall Street Journal earlier this month that with the economy expanding solidly and the unemployment rate at a 17-year-low 4.1%, Fed policy makers, who say they expect to raise interest rates again in 2018, will be watching closely to see whether any tax changes might cause the economy to overheat.

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Paulsen thinks inflation could top 3% in 2018, well above the Fed’s 2% target, in part because wage pressures are there, but hiding for the short term, due in part to secular technology improvements and a recession-shocked workforce that stayed put. As such, the central bank could find itself behind the curve in normalizing interest rates from their ultra-low, recessionary level.

The relatively weaker dollar DXY, +0.02%  , defying calls for a higher U.S. currency based on Fed rate-hike projections, and a return for crude oil CLF8, +0.27%   to within a few bucks of $60 a gallon round out Paulsen’s higher inflation view.

What if, on top of the tax cut, “all of this comes at the same time,” Paulsen asked. Most importantly, he said, even a slight uptick for inflation could shock Wall Street, where a generation of young investors has only known relatively low inflation for a quarter of a century.

As for his investment outlook, Paulsen stressed that there have been solid earnings fundamentals and a broad, if not deep, long-running economic recovery behind the stock market’s record climb, equating to more than just a “sugar high” among investors. But even fundamentals run their course: “Economic surprises have boosted stocks and we’re running out of surprises,” he said.

Among the stock market correction warning signs he’s monitoring are already-bottomed yields on 10-year Treasury inflation-protected securities, or TIPs — just 15 basis points away from a three-year high — and the narrowing relationship between falling S&P 500 SPX, -0.01%   earnings yields and rising 10-year Treasury yields.

Paulsen thinks the lofty U.S. stock market is looking increasingly risky. In 2018, the greater upside earnings potential lies with non-U.S. companies, he said. Yet a diversified portfolio can’t entirely ignore U.S. stocks, so domestic picks should be narrowed to financial, material, technology and consumer discretionary sectors. They stand to perform better in the higher-interest-rate, higher inflationary atmosphere that he expects in 2018. He recommends overweighting mid- and small-cap stocks over large-cap offerings.

As for a bond component, Paulsen said add TIPs to holdings and expect the 10-year Treasury TMUBMUSD10Y, +0.19%   to reprice to between a 4% and 5% yield.

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