Lower tax and interest rates have boosted the stock market for the past several decades, a formula that is ending and will keep returns low in the future, a Federal Reserve research report concludes. Michael Smolyansky, principal economist at the Fed, argues in a white paper released recently that reduced tax rates and borrowing costs accounted for nearly half the real growth in corporate profits from 1989 to 2019. But with surging inflation that has boosted interest rates and rising budget deficits that have curbed the appetite in Washington for lower taxes, an investing formula that produced 5.5% ex-dividends real growth in the S & P 500 during the period is in trouble, he writes. “The boost to profits and valuations from ever-declining interest and corporate tax rates is unlikely to continue, indicating significantly lower profit growth and stock returns in the future,” Smolyansky says. Part of the thesis is a gap between the stock market average return and the 2.5% rate of real economic growth. “What accounts for this enormous discrepancy? And is it sustainable? I argue that it is not,” he writes. One reason for the unsustainability is that profits during the period grew at 3.8%, about double the typical rate. At the same time, interest and tax expenses as a share of earnings ran at a 27% pace, about half the norm. To sustain the relationship, both interest and taxes would have to continue to fall, the paper states. In fact, Smolyansky expects profits to grow at just a 2% pace, with GDP around the same . Perhaps more importantly, that 2% rate also is likely to apply to annual stock gains. “If real earnings growth is not likely to exceed 2 percent per year over the long run, then the outlook for stocks is bleak,” Smolyansky wrote. “Stock price performance above this 2 percent real rate could only be accomplished by the perpetual expansion of P/E multiples. Clearly, this is unsustainable.” The paper has not been peer reviewed, is not an official Fed position and notes that it “is circulated to stimulate discussion and critical comment.” DataTrek research co-founder Nicholas Colas wrote that the paper’s general assumption about taxes and interest rates and their correlation to stock market returns is “obviously true, but only to a point.” Colas noted that interest rates in particular have been on the decline around the world, but global stock returns have been flat since 2008. Instead, he countered that “return on capital, reinvestment rates and competitive advantage matter far more” than earnings and rates. “We continue to see the US system of capitalism, with its focus on venture capital and relatively free markets for capital and labor, as the one best positioned to prosper in what will no doubt be a world of higher interest rates,” Colas added.
