Will the Fed Only Stop When Something Breaks?

By Paul Hoffmeister, Chief Economist

October 2, 2018

·      With real GDP growing at +4.2% in Q2 2018, the ISM Manufacturing Index at 59.8, and jobless claims now running at nearly 206,000 and apparently still in a downtrend, the US economy is arguably strong.

·      While the economy is being boosted by fiscal and regulatory levers, the Federal Reserve is pulling back on its monetary lever. At what point will the Fed stop raising interest rates? Will the Fed “thread the needle” and end its rate increases before any serious economic consequences emerge? Or, will it continue this prolonged, gradual rate hiking cycle until something breaks in the economy?

·      Chairman Powell’s statements during the recent FOMC press conference suggest to us that the Fed will continue raising rates until the economy cracks slightly, or breaks.

·      Given that statistical inflation is low, the Treasury curve is close to inverting, and the strong dollar seems to be creating stresses in emerging markets, we believe the Fed should pursue monetary policy like it did in 1995, by stopping short of inversion. It could be the best decision for stocks and the economy. Otherwise, the continuation of the current interest rate cycle will likely limit equity gains and create economic tail risks. 

Economic Update

The US economy is, in our view, performing very well. According to the Bureau of Economic Analysis, real GDP has accelerated from +1.9% during the third quarter of 2016 to +4.2% as of the end of the second quarter 2018. The Manufacturing Index from the Institute for Supply Management stood at 59.8 in September, compared to nearly 50 during the third quarter of 2016. Furthermore, the Department of Labor reported that, as of late September, the 4-week moving average for jobless claims was almost 206,000, compared to nearly 250,000 during the third quarter of 2016, signaling a continued downtrend in the number of people receiving unemployment insurance benefits.

The economy is growing strongly, and the robust manufacturing and employment environments suggest that a significant economic slowdown isn’t on the near-term horizon. For instance, each of the last five recessions since 1980 began when the ISM Manufacturing Index was less than or equal to 50.1. And, each of the last five recessions was preceded by an upward sloping trend in jobless claims.

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Arguably, improved incentives to produce spurred by lower corporate tax rates (signed into law in December 2017) and less corporate regulation (underway since January 2017) are driving much of the upturn in the economy.

Prior to last year’s reduction in the corporate tax rate to 21% (from 35%), the United States had the fourth highest statutory corporate income tax rate in the world, according to the Tax Foundation. Today, it is pegged almost two percentage points below last year’s world average of 22.96%.[1] More competitive American firms and the more attractive after-tax return potential of corporate investments are likely driving more business activity. 

Also, the pace of regulation is significantly slower today than any other period since 1970. According to the Program for Economic Research on Regulation at George Mason University, federal regulations grew 0.65% during the first year of the Trump Administration. This compares to the 2.1% annual average between 1970 and 2016.[2]

Even more, the pace of reviews for significant new regulations has at the same time slowed. The Office of Information and Regulatory Affairs reviewed 60 rules deemed “economically significant” between January 21, 2017 and January 20, 2018. According to the New York Times, the last time so few rules of this kind were considered was in 1984 under President Reagan.[3]

But of course, with the economy being boosted by fiscal and regulatory levers, the Federal Reserve is pulling back on its monetary lever. The predominant question facing investors today is, at what point do higher interest rates offset today’s positive economic environment and become a serious headwind?

We appear to be getting closer to the point that Fed policy is meaningfully detrimental, and it could be signaled by today’s flattening yield curve, which is close to inverting.

An inverted yield curve has often preceded economic contractions. The New York Federal Reserve Bank, which conducts some of the leading research on the relationship between credit spreads and economic activity, states on its website: “The yield curve has predicted essentially every U.S. recession since 1950 with only one ‘false’ signal, which preceded the credit crunch and slowdown in production in 1967.”

All the more, in their seminal research in 1996, economists Arturo Estrella and Frederic Mishkin found that the spread between 10-year and 3-month Treasuries significantly outperformed other financial and macroeconomic indicators – namely the NYSE Stock Price Index, the Index of Leading Indicators, and the Stock-Watson Index – in predicting recessions two to six quarters ahead.[4] Quite simply, a narrowing of the 10-year/3-month Treasury spread could reliably signal a greater likelihood of recession.

According to the New York Federal Reserve, the narrowing of the 10-year/3-month Treasury spread from 106 basis points at the end of 2017 to 82 basis points at the end of August has increased the probability of a recession by the end of August 2019 to 14.61%. This is the highest level since late 2008. This estimate of recession starting within one year was just 4.06% at the end of December 2017.

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To us, this simple yet powerful model suggests that current Fed policy is substantially increasing risks to the economy. And it begs the question, at what point will the Fed stop raising rates? Will the Fed effectively “thread the needle”; that is, will it end its rate increases before any serious economic consequences emerge? Or, will the Fed continue this prolonged, gradual rate hiking cycle until something breaks? We may have recently gotten some clues to the answer.

Fed Chairman Powell was pointedly asked this question by the Wall Street Journal’s Nick Timiraos during the FOMC press conference on September 26.

Nick Timiraos (Wall Street Journal): “Chairman Powell, given the lags of monetary policy, I want to know how you think about ending the tightening cycle. How will you know when to stop? And do you need to keep going until something in the economy breaks?”

Jerome Powell: “So the tightening cycle, as you know, is a reflection of the strength of the economy. And it’s, it’s almost three years now that we’ve been gradually increasing rates. And I think the fact that we have moved quite gradually, in a way, allows us to carefully watch incoming data in the real economy and in the financial markets to see how the economy is processing higher interest rates. And the fact that we’re moving so gradually, I think, I think it limits the long and variable lags problem because, you know, we’re being able to raise rates and wait and see how the economy absorbs these rate increases. And so far the economy has performed very well and in keeping with our expectations.”[5]

It seems, based on this answer, that Powell and the Federal Open Market Committee, in general, are counting on their gradual rate increases to both softly acclimate the economy to higher interest rates and give the Committee enough lead time to monitor how the economy and financial markets are handling them.

In a follow-up question, Paul Kiernan from Dow Jones asked Powell about what precisely Fed policymakers will be looking at to gauge the impact of rate increases.

Paul Kiernan (Dow Jones Newswires): “…I’d like to just kind of ask again. You mentioned earlier the gradual pace of rate increases will make it easier to react. But specifically what are you going to be looking to see because you’ve also mentioned, you know, that monetary policy operates with a lag, so any kind of specific sign posts that maybe we’ve reached the end of the tightening cycle or where we should stop?…”

Jerome Powell: “…Some of the things we’d be looking at to tell us whether we’re getting close to supply-side limits would be, first, does job growth slow down? A slowing down in job growth would be an indicator. You know, an unexpectedly sharp increase in wages or inflation could tell you that you’re reaching those points. You know, if headline growth slowed down, that’s another one. So all of those things would be worth taking into consideration. I think also, though, we’ve seen sometimes sharp tightening in financial conditions as we saw at the beginning of 2016 can have a substantial effect pretty quickly on our economy, if it’s a broad and significant tightening. So we would be looking for those kinds of things and many other things…”[6]

Based on Powell’s answers, it seems that Fed policymakers will choose to abandon their rate-hiking cycle when certain negative conditions, such as a deteriorating job market or tightening financial conditions, present themselves. And such conditions, arguably, present themselves when real cracks in the economy are occurring.

As a result, the Fed is likely to continue raising interest rates until the economy either cracks slightly, or breaks. This foreboding trajectory of monetary policy, we believe, will limit equity gains during the next 12-24 months.

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It appears that the Federal Reserve is not giving sufficient deference today to the yield curve signal, nor the stresses that the strong dollar is creating in emerging markets, which threaten to create currency crises similar to 1997-1998.

Why raise interest rates further and threaten to invert the yield curve, especially when the overall PCE inflation rate for August was 1.3% annualized?[7]  

With the 10-year/2-year Treasury spread trading at nearly 23 basis points in September, it is not far from inverting. In our view, the Fed should treat interest rate policy as if it were 1995, when the Federal Reserve, by ending its rate hiking cycle, stopped short of inverting the yield curve. This policy shift coincided with a strong equity market rally and likely laid part of the foundation for the economic success of the late 1990s. Unfortunately, from Chairman Powell’s recent statements, it appears that the Fed will ominously pursue a policy course more similar to 2000 and 2007.

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).


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Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

•       A672

[1] “Corporate Income Tax Rates around the World, 2017”; https://taxfoundation.org/corporate-income-tax-rates-around-the-world-2017/

[2] “Trump Says ‘No President Has Cut So Many Regulations’. Not Quite”, by Linda Qiu, February 23, 2018, New York Times.

[3] Ibid.

[4] “The Yield Curve as a Predictor of U.S. Recessions”, by Arturo Estrella and Frederic Mishkin, June 1996, Current Issues in Economics and Finance, Federal Reserve Bank of New York.

[5] FOMC Press Conference, September 26, 2018.

[6] Ibid.

[7] Source: Bureau of Economic Analysis

Will Stocks Crash if Trump Is Impeached?

September Market Commentary

By Paul Hoffmeister, Chief Economist

·      As of September 4th, betting markets suggested a 45% probability of President Trump being impeached by the end of his first term.

·      In 1998, prospects of President Clinton’s impeachment and possible removal from office arguably caused a nearly 15% selloff in the S&P 500.

·      As we see it, the Federal Reserve’s tightening campaign and strong dollar, and the stresses they create on emerging markets, are some of the most important macroeconomic risks today. A Presidential impeachment process is an additional tail risk to consider.  

 

Thinking about Market Implications of a Trump Impeachment

As of September 4th, Predictit betting markets suggested a 68% probability of Democrats regaining control of the House in 2019, and a 45% chance of President Trump being impeached by the end of his first term.[1]

While the House has the power to impeach the President, only the Senate can remove him from office.[2] And at the moment, Predictit markets suggest a 78% probability of Republicans maintaining control of the Senate next year.[3]

But despite the expected Republican foothold in the Senate, some political observers see a real possibility of the President being impeached if Democrats take back the House. Underscoring the seriousness of this possibility, if betting markets today are accurate, then the probability of an impeachment process in the coming years is virtually a coin flip.

This forces the question, what could happen to financial markets if President Trump is impeached? In an interview with Fox & Friends’ Ainsley Earhardt, aired on August 23, President Trump said: “If I ever got impeached, I think the market would crash, I think everybody would be very poor, because without this thinking, you would see — you would see numbers that you wouldn’t believe in reverse.”[4]

To think through the market implications, the only precedent we can examine in the modern era is the Clinton impeachment proceedings in late 1998, early 1999.

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[1] “Trump Declares ‘Market Would Crash’ If Democrats Impeached Him,” by Brooke Singman, August 23, 2018, Fox News.

Based on the timeline of events in those Clinton years, it appears that much of the stock market pain occurred between the announcement of Monica Lewinsky’s immunity deal on July 28, 1998 and the release of the Ken Starr report on September 9, 1998. Based on the closing prices for the S&P 500 on July 27 (the day prior to the deal announcement) and September 10 (the day after the report’s release), the S&P 500 fell 14.6%.[5]

As CNN reported at the time, the plea deal followed a meeting between Lewinsky and Starr, in which Lewinsky admitted to having a sexual relationship with President Clinton. This reportedly contradicted sworn testimony from both Lewinsky and Clinton in the Paula Jones sexual harassment case where both denied having such a relationship.[6]

President Clinton’s impeachment process was initiated in December 1998 after the Republican-controlled House passed two articles of impeachment, for perjury and obstruction of justice. By January 1999, the trial commenced in the Senate where Republicans controlled 55 seats.[7] Given that Clinton’s removal from office required the support of two-thirds of the Senate, it seems that by late 1998, it was increasingly assured that, as many Democrats defended him, the President would not be forced out of office. Ultimately, 50 senators voted to remove Clinton on the obstruction of justice charge, while 45 voted to remove him on the perjury charge.[8] The vote didn’t come close to the required 67.

Arguably, the selloff in the S&P 500 between July and September 1998 occurred because the market was digesting the initial information of Clinton’s perceived perjury and the possibility of his removal. And over time, between September and year-end, the market seemed to assess (correctly) that the probability of Clinton’s ultimate impeachment and removal from office was very low – allowing stocks to regain their previous highs.

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Credit conditions in 1998-1999 also appear to show a correlation to the Clinton impeachment events, but in a slightly different way. While stocks seemed to discount the worst of Clinton’s prospects between July and September 1998, the credit market represented by the spread between Baa and Aaa-rated corporate bonds widened almost consistently until late January, early February 1999 when Clinton’s acquittal was almost certain; and then the credit spread began to narrow.

Of course, financial markets aren’t driven by one factor alone, and there were other macro variables impacting markets during the Clinton impeachment period – namely the Russian debt default and currency crisis.

Of the critical dates associated with the Russian Crisis, two dates especially stand out.

On August 17, 1998, the Russian government announced a significant devaluation of the ruble, whereby the ruble would be allowed to fall by up to 50% to 6.00-9.50 rubles per U.S. dollar, compared to 6.27 rubles during the day prior to the announcement and from a previous band of 5.27 to 7.13.[9] At the same time, the government defaulted on short-term Treasury Bills known as GKO’s and longer-term ruble-denominated bonds known as OFZ’s.[10] Additionally, a moratorium was imposed on payments by commercial banks to foreign creditors.[11]  

Then, on September 2, 1998, Russia’s central bank removed the ruble corridor and effectively allowed its currency to float freely. While on September 1 the ruble traded near 9.33 per dollar, it quickly devalued to more than 20 per dollar by September 9.[12] [13]

Importantly, though, the Russian debt default and devaluation did not appear to coincide with a serious disruption in US stock and credit markets, at least in terms of the daily prices of the S&P 500 and the Baa-Aaa credit spread around those specific dates.

On August 17, the S&P 500 actually rose 1.96%, compared to the previous day’s close. And it rose an additional 1.61% on Tuesday August 18. Additionally, the Baa-Aaa spread narrowed to 61 basis points on August 17 and 18, compared to 62 basis points on Friday August 14.[14]

Furthermore, between September 2 and September 9 as the ruble devalued from approximately 9 to more than 20 per dollar, the S&P 500 rose 1.59% from 990.48 to 1006.20, while the Baa-Aaa spread traded around 64-65 basis points.[15]

Of course, this is not to say that the Russian default and currency crisis had no impact on certain segments of the market in 1998. Indeed, the investment losses at Long-Term Capital Management in August and September 1998 appeared to be related to the events in Russia, prompting the Federal Reserve to step in and facilitate a capital infusion.[16]

But parsing through the news flow that year suggests that the events leading up to the Clinton impeachment may have been a key variable behind the nearly 15% selloff in the S&P 500 and more than 40 basis point widening in the Baa-Aaa credit spread.

In this context, as we look at the market environment today, we continue to believe that the Federal Reserve’s tightening campaign and the strong dollar (and the stresses they may create for emerging markets) are some of the most important macroeconomic risks facing financial markets. And, based on the history of 1998, a Presidential impeachment process may be an additional tail risk to consider. 

Paul Hoffmeister is chief economist of Camelot Portfolios, managing member of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

 

*******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

A678

[1] PredictIt.org.

[2] “An Overview of the Impeachment Process”, by T.J. Halstead, Legislative Attorney, American Law Division, April 20, 2005, Congressional Research Service, Library of Congress.

[3] Predicit.org.

[4] “Trump Declares ‘Market Would Crash’ If Democrats Impeached Him,” by Brooke Singman, August 23, 2018, Fox News.

[5] Data Source: Yahoo Finance.

[6] “Lewinsky Strikes Far-Reaching Immunity Deal”, by Wolf Blitzer and Bob Franken, CNN AllPolitics, July 28, 1998.

[7] “Clinton Impeachment Timeline”, By Patrick Barkham, November 18, 1998, The Guardian.

[8] “How the Senators Voted on Impeachment”, February 12, 1999, CNN ALLPolitics.

[9] “Russia Acts to Fix Sinking Finances”, by Celestine Bohlen, August 18, 1998, New York Times.

[10] Ibid.

[11] Ibid.

[12] “A Case Study of a Currency Crisis”, by Abbigail Chiodo and Michael Owyang, November/December 2002, St. Louis Federal Reserve Bank.

[13] Data Source: Deutsche Bundesbank.

[14] Data Source: Yahoo Finance and St. Louis Federal Reserve Bank.

[15] Data Source: Deutsche Bundesbank.

[16] “Near Failure of Long-Term Capital Management”, November 22, 2013, Federal Reserve History, Federal Reserve Bank of Richmond.

Tax Reform 2.0, Stocks Find Their Footing

August 2018 Market Commentary:

Tax Reform 2.0, Stocks Find Their Footing

By Paul Hoffmeister, Chief Economist

• House Ways and Means Committee released outlines of another round of tax cuts.

• Key features of Tax Reform 2.0 could be to make permanent the recent individual income tax cuts and index capital gains for inflation.

• We believe, at the present macro trajectory, tax cuts can buy more growth, but monetary policy will ultimately determine the duration of the recent economic resurgence.

Tax Reform 2.0: S&P 500 Reaches Five-Month High

More news has emerged during the last month about another round of tax cuts. On June 26, House Ways and Means Chairman Kevin Brady said in a Washington Post interview that he hoped to soon unveil a framework for additional tax relief and see votes held in the House during the fall.1 Brady expects the various tax reforms to be parceled into three or four separate bills, instead of a single piece of legislation.2 Soon thereafter, on June 29, National Economic Council Director Larry Kudlow told Maria Bartiromo:

“The President would like to see a Tax Reform 2.0 -- some of the leaders on the Hill, Kevin Brady and so forth. We’re all discussing it. We’ll wait for specifics to be released later in the year. It may be more of a guideline, a directional signal of what we intend to do. But, yeah, there’s stuff we can do. And I hope we get to it.”3

On schedule, the Ways and Means Committee released on July 24 a “listening session framework for Tax Reform 2.0”. The framework is meant to be a starting point for conversations between lawmakers and constituents about key aspects of another round of tax relief. According to the release, Brady and Republican members of the Committee are hoping to: 1) make permanent the individual income tax cuts and pass-through deductions contained in last December’s tax legislation; 2) create new retirement savings plans; 3) create new family savings plans, such as universal savings accounts and expanded 529 accounts; and 4) increase write offs for startups.4

On the heels of the framework’s release, stocks hit post-February highs. Based on the S&P 500’s closing price on July 25, the S&P 500 jumped nearly 1.4% compared to its close on July 23.

Rising Wages, Trump’s Tariffs, Economic Vital Signs

March 2018 Market Commentary:

By Paul Hoffmeister, Chief Economist

In our view, one of the most important variables that impacted financial markets in February was growing concern about the Federal Reserve raising interest rates more aggressively than previously expected. Of course, there are almost countless variables that drive markets. It’s possible investor complacency heading into February and seemingly crowded, short volatility positions contributed to or intensified the stock market panic last month.

The S&P 500 peaked on January 26th and appeared to really begin its selloff on Friday, February 2nd when the US Bureau of Labor Statistics’ release of average hourly earnings showed surprisingly strong year-over-year growth of 2.9%, compared to the median expectation of 2.6% growth.

The strength in employee earnings growth is now at a post-financial crisis high and has sparked concerns of accelerating inflation down the road that may need to be addressed by stronger monetary tightening. The concern is predicated on the theory of wage push inflation, where end market prices of goods and services are preceded by increases in employment costs.

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According to the Chicago Mercantile Exchange, futures markets estimated at the end of February a nearly 25% probability of a 2.25-2.50% federal funds rate target by December 19, which is the FOMC’s last meeting of the year. This would equate to four quarter point increases to the funds rate for 2018. At the end of January, the probability of a 2.25-2.50% funds rate target was approximately 21%; it was almost 9% at the beginning of the year.

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Confluence of Market-Friendly Variables

Q4 2017 Market Commentary:

By Paul Hoffmeister, Chief Economist

On January 16, the Dow broke through another record. The headline at CNN read, “Dow 26,000: The Stock Market Is a Runaway Freight Train”.1

Journalists and market pundits seem to be stepping over each other to herald the nearly 40% rally in the Dow since late 2016, as well as the speed of its ascent. As CNN reported, it took 14 years for the Dow to climb from 10,000 to 15,000; three and a half years to reach 20,000; and less than 12 months to rally from 20,000 to 25,000.2 Given these statistics, “melt-up” and “euphoria” are some popular terms being used today to describe the market.

In our Q3 market commentary in November, we highlighted the strong equity market performance and narrow credit spreads at the time, and suggested that the primary factors behind the sanguine environment were the prospects of tax reform and a Fed policy approach that had been looking to “do no harm”.

Considering whether the environment (or “enthusiasm”) was sustainable, our conclusion was: …[d]uring the near-term, the passage of tax reform and the continuation of moderate Fed policy could easily extend the strong market trend of the last year. If fiscal and monetary policy (the “twin pillars of productivity”) remain supportive, then the future remains bright.

We believe this has been the case, as we look back at the last two months. The major macroeconomic variables are evolving positively, and igniting investors’ animal spirits.

Of course, on December 22nd, President Trump signed the largest tax cuts in American history, including a reduction in the statutory corporate tax rate from 35% to 21%. For companies previously paying a 35% tax rate, the new 21% rate will enable them to increase corporate earnings by 21.5%, thanks simply to this change in the tax rules. For example, a company that previously paid $35 in taxes on $100 in earnings can now keep $79, a 21.5% earnings increase.

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