What the Inflation Reduction Act could mean for the economy
Sustainable goals should get a boost, but will the new law meaningfully curb inflation? Probably not.
Our Top Market Takeaways for August 19, 2022
Market Update: The dog days of summer
Summer is coming to an end, and not much has changed over the last week. Heading into Friday, the S&P 500 looks set for a fifth straight week of gains—a feat not achieved since November 2021. Bond yields seesawed, but look to end the week pretty much where they started. The biggest moves came from commodities, as the energy crisis in Europe carries on.
With the dog days of summer upon us, here is what we learned this week, as told by investor fears we’re hearing:
- We’re already in a recession.
While U.S. growth has “technically” contracted the last two quarters, the labor market tends to provide a better signal for the state of the economy (having a job is the largest determinant of whether a consumer is likely to spend money). And from this lens, workers are still on strong footing. The latest jobless claims print actually fell, signaling there were less people seeking unemployment benefits last week than the week before. Add that to July’s blockbuster jobs report (which said the U.S economy added 528,000 new jobs), and you’re looking at a pretty healthy labor market. Recession risks are real, but we don’t think we’re already in one.
- Okay, but the Fed’s going to cause a recession.
It’s possible, but the July FOMC meeting minutes released Wednesday revealed that Powell & Co. are well-aware of the risk of overtightening now that the policy rate is in the neighborhood of “neutral” (nebulous as that may be). We look forward to seeing how Powell wrangles the monetary policy message coming out of Jackson Hole next week, especially given the recent risk asset rally has helped undo overall tightening – which could galvanize a more hawkish stance ahead.
- The consumer is cracking!
This week’s data suggests otherwise. For one, the latest retail sales print was pretty solid. Stripping out more volatile measures like gasoline and autos, sales increased +0.7% in July (and with a big thanks to online shopping from Amazon’s Prime Day). Q2 earnings from big retailers are telling a similar story. Walmart showed it’s working through its inventory glut, even as consumers shift their preferences to services over goods, and Home Depot noted continued strength in home improvement projects.
- Inflation is just going to keep on climbing.
The evidence is compounding that price pressures are peaking. Following on last week’s U.S. CPI report, this week brought word that existing home prices and auto prices are falling at their swiftest pace since the pandemic shock. Fed policy is well at work. Oh, and U.S. gas prices have now fallen for 64 straight days.
That said, inflation is still way too high and it’s the thorn in everyone’s side, even to the point of inspiring the Biden Administration to memorialize their climate, healthcare, and tax package as the Inflation Reduction Act. Read on for what it means and how it might affect you.
Need-to-knows: The Inflation Reduction Act
It was a long, uphill battle, but the President signed a landmark bill focused on climate, healthcare, and corporate taxes earlier this week. The below table summarizes the provisions of the Inflation Reduction Act, and is followed by three key takeaways on what it means for the prevailing economic backdrop, earnings outlook, and sustainability.
Whether misnomer or marketing magic, we don’t expect the Act to have much impact on inflation.
An optimist might point to the Inflation Reduction Act’s provisions aimed at lowering the cost of things like energy, pharmaceuticals, and healthcare and the ~$300 billion estimated deficit reduction as disinflationary tailwinds. But over the course of the next year, we don’t expect the bill to have much of an impact on inflation at all:
- Energy costs are expected to be lowered mostly through tax credits aimed at adoption of clean alternatives and conservation practices. We think they will be effective, but not overnight.
- Medicare’s ability to tamper down prescription drug costs won’t have much oomph until renegotiated prices take effect in 2026.
- The included subsidies for healthcare costs are just a continuation of the ones enacted through the American Rescue Plan (they were set to expire in the coming months, but the IRA expands them for another three years).
For the government’s 2023 fiscal year, the total deficit reduction from changes in direct spending and revenues looks likely to be less than 0.1% of GDP (~$18 billion). That’s a drop in the bucket when it comes to macroeconomic impact. We continue to think inflation will be mostly driven by commodities, cooling labor and housing markets, and improving supply chain dynamics in the coming months.
A chunk of S&P 500 companies will help pay for the provisions, but the potential market impact looks modest.
The Inflation Reduction Act has two major tax provisions, both of which apply to corporations: A 15% minimum tax for companies with more than $1 billion of book income per year, and a 1% excise tax on stock buybacks.
First, on the buyback excise tax: The change could prompt some companies to pull forward buyback plans to this year before the excise tax takes effect. It could also shift some degree of focus towards dividend payouts.
As for the minimum tax, the Joint Committee on Taxation estimated that up to about 150 companies could be affected. A little less than half of the assumed-to-be-effected companies are in growth sectors like Tech, Consumer Discretionary, and Communication Services; Healthcare accounts for about a third. Those sectors may feel earnings per share headwinds to the tune of 1-2%.
For the S&P 500 as a whole, the net earnings impact looks to be relatively small (~1%) and isn’t enough to prompt our Equity Strategy team to revise their 2023 $233 earnings per share expectations lower. That said, this could be an additional impetus for the street’s consensus estimate (currently $244) to converge towards ours.
The bill does offer a long-term boost for a long-term investment theme: The clean energy transition.
Over $380 billion will go towards advancing clean energy and climate initiatives, with the goal of reducing U.S. carbon emissions by 40% by 2023.
They say you can catch more flies with honey than vinegar: the plan heavily emphasizes sustainability rewards rather than pollution penalties. Companies making things like solar panels and wind turbines can tap into ~$60 billion of allocated tax credits; households might be allured by expanded tax credits for electric vehicles, efficient appliances, and clean home energy sources.
As a means of getting the bill over the finish line, there were some bones thrown at the fossil fuel industry as well. Federal property used for renewable energy will also be available for new oil and gas drilling, and producers can earn incentives for improving efficiency and developing carbon capture solutions.
All in all, the bill at least steers the U.S. back in the direction of the goals outlined in the Paris Agreement. Our multi-year conviction in sustainability themes like renewable energy, battery storage, green real estate, and clean infrastructure is bolstered by these policy advancements.
All market data from Bloomberg Finance L.P., 8/19/22.