Here's how one expert says Trump's tax plan prevented a dreaded recession signal and overruled the latest yield-curve inversion

 

  • Jim Paulsen, the chief investment officer at Leuthold Group, explains how the fiscal easing that resulted from President Donald Trump's tax plan may have fended off a historically accurate recession signal.
  • He also provides data to support the idea that fiscal policy has been a better recession indicator than the yield curve throughout history.

The massive tax plan spearheaded by President Donald Trump has attracted its fair share of criticism for favoring the wealthy and spurring a rash of unpopular share buybacks.

On the other side of the argument are proponents who praise the plan's tax cuts and credit them for boosting stock indexes to record highs.

Jim Paulsen, the chief investment officer at Leuthold Group, recently offered up a third perspective that sits outside this debate. He thinks the tax plan indirectly prevented a dreaded recession signal from flashing red.

And his view isn't a partisan one. It's instead steeped in data and historical precedent.

Paulsen's take boils down to one indisputable fact: Ten out of the 10 recessions since 1950 have been preceded by fiscal tightening — which he defines as a contraction in the US federal deficit as a percentage of nominal gross domestic product. This dynamic is shown in the chart below.

That brings us to the meat of Paulsen's argument: Trump's tax plan is expanding fiscal stimulus, not tightening it. And for that reason, it doesn't match up with past recession signals.

But what about the yield curve — the recession signal that has captured everyone's attention since it inverted last Friday? Paulsen says that while it's been a reliable indicator throughout history, there were actually three instances in the 1950s and 1960s when a major economic contraction occurred without an inversion.

"A strong argument could be made that fiscal tightening is a far superior indication of recession risk than is the yield curve," he wrote in a recent client note. "The current inversion is completely unique to the post-war era because fiscal juice has been expanding, and it has been doing so since 2016."

Read more: Forget the yield curve. Morgan Stanley says investors should be focused on a superior recession signal — one that's threatening to flash by year-end.

In Paulsen's mind, those unique circumstances could be yielding a unique outcome — one that would suggest a recession is unlikely to transpire in the near term.

"Currently, it is interesting that a mild inversion in the yield curve has caused so much widespread apprehension about recession risks when the direction of fiscal policy (which has a perfect 10 for 10 record of recession forecasting since 1950) is strongly signaling a low risk of recession!" he said.

Interestingly enough, Morgan Stanley thinks the positive market impact from Trump's tax plan will start to dwindle as critical provisions approach their expiration dates.

With that in mind, investors would be wise to closely watch Paulsen's preferred recession indicator of fiscal tightening. If the US federal deficit as a portion of nominal GDP starts to shrink, it may be time to watch out — especially if other economic conditions stay unchanged.

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