How does the Inflation Reduction Act affect the stock market?
Not too much, but it's a big deal for Climate Change
Wednesday, August 17th, 2022
The Market fell today as investors weighed the increased probability that the Federal Reserve would not begin slowing interest rate hikes. All major market indexes fell.
The S&P 500 lost -0.72%
The DOW fell by -0.5%
The NASDAQ slid by -1.25%
The Russell 2000 dropped by -1.64%
The Market Takes a Breather
Compared to Spring, Summer is proving to be more favorable for stocks after a sustained rally since mid-July. Since June 1st, the S&P 500 has been up 4.1% versus a -4% loss from March through May. Yet despite the improving sentiment on inflation, the Market shed some of its gains today as Wall Street pumped the breaks on a four-day rally.
Underpinning the change in tide is the growing belief that the Federal Reserve ("The Fed") will stick to its plan of raising interest rates by an additional 0.75% in September. Although inflation was flat between June and July, prices remain elevated by 8.5% from a year ago. And until inflation cools meaningfully, the Fed will continue its credit tightening policies.
Separately, Congress is trying to reduce costs through legislation. But don't expect its fresh bill to have an immediate impact.
New Bill, Who Dis?
Yesterday, President Biden signed the Inflation Reduction Act (IRA) into law, which signifies a landmark piece of legislation that begins the arduous fight against climate change.
But after a year of negotiating, high inflation and opposition from moderate Democratic Senators Manchin and Sinema have dramatically diminished the proposed $3.1 trillion Build Back Better bill into the more modest $485 billion IRA.
Despite the bill's downsizing (and convenient renaming), it's still a pretty hefty piece of legislation that carries with it both spending and deficit reduction measures. And with any spending bill, there's an impact on the economy that can affect stock market performance.
Let's unpack the IRA's immediate impact on society and what it could mean for stocks.
What's in the bill?
The Inflation Reduction Act has three major components: 1) Energy Security and Climate Change, 2) Extensions to the Affordable Care Act (ObamaCare), and 3) measures to mitigate the drought in the American Southwest.
Energy and Climate investments total $386 billion, making up the lion's share of the IRA, and primarily consist of credits for clean energy, building efficiency, and electric vehicles, along with grants and loans to support new technologies.
Congressional Democrats hope the bill will provide the basis for the US to reduce 40% of its carbon emissions by 2030. If achieved, this reduction would help the US meet its targets pledged towards the Paris Agreement on Climate Change.
In terms of healthcare, the IRA commits another $64 billion towards extending benefits and credits for the Affordable Care Act. More significantly, the act allows the government to negotiate the price for certain prescription drugs covered under Medicare and Medicaid for the first time. While this authority is severely limited, it does set a significant precedent for price controls in the pharmaceutical industry.
Lastly, the bill also provides funding for the US government to intervene in the ongoing drought in the Southwest, which has threatened the water and food supplies for some 40 million Americans. The bill could introduce centralized management to coordinate conservation efforts across seven states that share the Colorado River.
How can it affect the Market?
From a spending standpoint, the bill significantly impacts cleantech companies, which see a fresh infusion of subsidies and incentives that can make their technologies more cost competitive with fossil fuels.
Since Senator Schumer and Manchin announced the bill's framework on July 27th, ICLN, an ETF that tracks cleantech companies, has gained more than +20%. Similarly, IDRV, an ETF that holds electric car companies, is up 10% over the same period.
Cleantech is having a good month
But the more widespread impact on the Market comes from the IRA's tax provisions that seek to raise upward of $737 billion in revenue for the US Government through 2030. In particular, the IRA introduces a 15% Corporate Minimum Tax and a 1% Stock Buyback Excise fee.
But are these measures that bad for business?
The 15% minimum tax would force some profitable companies that use tax loopholes to bring their taxes close to zero to pay a fixed amount. Famous companies, such as Amazon and GE, which have used tax accounting to even generate tax credits, would now have to pay up.
The Congressional Budget Office projects that these measures will bring in $222 billion in corporate taxes over the next eight years. In terms of stock market impact, companies would make $27 billion less in yearly earnings if taxes are levied linearly.
At a 19x price-to-earning (P/E) multiple, the decrease in earnings would mean a $527 billion reduction in market cap, which is between 1% and 1.5% of the US's total ~$35 trillion total market capitalization. All of this calculation goes to say that the minimum tax is not a value destroyer.
Additionally, the 1% Stock Buyback Excise fee has a marginal impact on the Market.
Over the past few decades, stock buybacks have become an increasingly popular way for companies to improve their earnings. Essentially, a company can do three things with its earnings. It can return profits to shareholders through dividend payments, invest them back into the business, or use them to buy its own shares from the public market in a share buyback.
When a company executes a share buyback, it decreases the number of shares with a claim to the company's profit, causing its earnings per share to increase. While the practice generally increases companies' market values, it has come under fire from politicians who want companies to re-invest the money and create jobs.
But the new excise tax, which forces companies to pay 1% of the buyback amount in taxes, probably won't dissuade companies from continuing stock buybacks. The CBO estimates that companies will pay just $9.25 billion against $925 billion in stock buybacks annually through 2030.
Overall the IRA is generally market neutral as it adds very little in added costs to companies, which will undoubtedly come up with new ways to maximize profits.
But the bill is called the Inflation Reduction Act. Will it cause prices to come down? Yes, but later.
See ya later, savings
Despite the name, the Inflation Reduction Act will impact consumers most in the years to come versus the immediate present. Many of the IRA's cost-reducing provisions are investments that will take at least a couple of years to materialize. For example, the US Government's authority to negotiate drug prices only begins in 2024 and applies to a limited set of off-patent drugs.
The bill does not address the primary drivers of the price inflation we see today: oil prices, rising rents, and heightened labor costs. But outside of some measures already taken, such as releasing oil from the Strategic Petroleum Reserve, there isn't much the US Government can do but wait for the economy to cool down.
Nevertheless, the act is a landmark in terms of its focus on fighting climate change and reducing the deficit by $300 billion over the next eight years. Given how much extreme weather already disrupts business operations and daily lives, the IRA could be a critical piece of legislation to secure the US economy's future.
And that may be a trade that the Market is willing to make.
Stay Frosty,
Alex with TAI