Looking Past the Detox

OBBBA is not TCJA, Shaky Small Business Sector, Weak Employment Internals, the Rally Rolls On

OBBBA is not TCJA

The holiday shortened week was packed with economic and policy developments; the net effect was an economically sensitive cyclical sector led robust rally in stocks despite modest bear flattening in Treasuries, led by marginally higher breakeven inflation rates. The rally in equities was impressive, small banks led a breakout in small caps, followed by transports, materials and industrials. The internals of the equity rally were consistent with our forecast for a 2H25 recovery in capital investment that persists throughout the business cycle. As we discussed last week in Not So Solid, the key difference between the Tax Cuts & Jobs Act (TCJA) and One Big Beautiful Bill Act (OBBBA) is the impact on capital investment. While TCJA introduced corporate tax incentives, they were secondary to the reduction in the top marginal tax rate and were derailed by the hit to business confidence associated with the US/China trade war. The Senate’s change to the House version of OBBBA that made the investment provisions permanent, and the sequencing of trade policy in the second Trump administration, implies the impact on capital investment will be larger and more persistent.

Figure 1: Both capital investment and buybacks increased following the passage of TCJA, but the ratio fell as more of the increased cash flow was returned to shareholders than invested in the capital stock. As we show later in the note, wage growth accelerated as well. This cycle, led by the AI boom, capital investment momentum was already robust prior to the passage of OBBBA. We expect the effect to be broader, more persistent, capital investment.

Despite the long list of budget think tanks warning that OBBBA is going to increase the deficit and debt, the Treasury market reaction suggests there are no supply related concerns. The 5s30s flattened this week, 30-year real rates, 10-year term premium and 10 & 30-year swap spreads edged lower. At the expense of appearing to be a graduate of the redundant school of redundancy (credit Monty Python), the post-war median of receipts to GDP is 17.1% with a 0.8% standard deviation by each 4-year administration. Following major tax cut acts, receipts returned to the longer run median within a year or so. Consequently, markets are more focused on spending and the cuts in the mandatory spending programs that were the largest contributors to spending increasing from the 1981 to 2019 median of 20.3% of GDP to the current 24% path, primarily Medicaid, are a reasonable first step to stabilization of the debt and deficit. If this is the end of the process the bond vigilantes will return with a vengeance, and in our view, the Treasury issuance and Fed balance sheet rate suppression strategies are short term measures that are masking the longer run problem. One note on issuance, at this point we, and as far as we can tell the Treasury market, are taking the President seriously, not literally with respect to his threat fund all of the debt in the front end of the curve. We did not expect any extension until later in the year at the earliest, however the President’s comments will make the next quarterly refunding announcement more exciting.

In this week’s note we will discuss the struggles of the small business sector in light of the strong performance of small cap stocks. We then dig a bit deeper into the financial sector and conclude the note with a review of the labor market data this week.