Well that didn’t last.

At the start of the year, prospects looked good for another banner year in the stock market, as the tax cuts President Trump signed at the end of 2017 boosted the outlook for corporate earnings and stock prices.

The tax cuts are still likely to boost profits, but markets are now factoring in some of the problems associated with tax cuts that Trump and his fellow Republicans never mentioned, and perhaps didn’t even recognize.

The S&P 500 stock index has fallen about 8.5% so far from its peak on Jan. 26, amid a global stock selloff triggered by worries about inflation and other factors. It’s hard, bordering on impossible, to pinpoint why markets rise or fall abruptly. But we’re seeing plenty of clues—and the Trump tax cuts are one of the suspects.

The main concern seems to be inflation, which could run a little hotter than investors have been expecting. Why might that happen? “Too much stimulus,” writes Greg Valliere of Horizon Investments. “The economy is in danger of over-heating, thanks to massive tax cuts, out-of-control government spending, synchronized global growth, and perhaps the most important factor: a U.S. labor market that’s exceptionally tight, with inevitable wage pressure coming this year.”

The tax cuts are pushing inflation expectations higher for a couple reasons. Bigger profits put more money into the economy, potentially pushing up spending, wages and asset prices. Taken together, that’s the inflationary surge, or “overheating,” many analysts worry about. There’s an optimal level of all these things (which nobody can ever pinpoint exactly), and then there are levels that are too high. The judgment of the markets right now is that these levels are heading too high, and the tax cuts are contributing to that.

Appetite for government debt

The tax cuts will also require the Treasury Department to issue a lot of new debt, since there will be less tax revenue coming in. That could push the federal deficit from about $666 billion in 2017 to nearly $1 trillion in 2018. Trump and his fellow Republicans insisted this would be no problem, since the stimulus effect of the tax cuts would make the economy grow by more than it would otherwise, generating new revenue. At the moment, however, markets seem to disagree.

The appetite for government debt isn’t bottomless, and too much debt in the market could force bond prices down, and yields up. That’s what is happening now, although it’s not clear what the exact cause is. But the abrupt increase in new government debt is clearly getting investors’ attention. Ethan Harris, global economist for Bank of America Merrill Lynch, notes wryly that the federal deficit is “the fastest growing part of the U.S. economy.”

“For the economy,” Harris wrote in a recent note to clients, “this means ‘crowding out’ of private investment, offsetting the incentive of lower tax rates. For markets, it means faster Fed hikes, rising bond yields and a stronger dollar.” And all of those things are bad news, relatively speaking, for stock prices.

It’s a myth, in fact, that tax cuts automatically stimulate the economy. That certainly can happen, but the effect would be most potent in a weak economy in need of help. The Trump tax cuts came with the economy strong. And if they don’t significantly boost growth—which few economists expect to happen—they will mostly amount to a transfer of wealth from future taxpayers, who will have to deal with all that extra debt, to current taxpayers.

There’s some good news in the market meltdown. The nature of the selloff indicates markets do not believe a recession is coming. If they did, the expectation would be for lower inflation, which normally accompanies a recession, rather than for the higher inflation the market foresees. So there’s a good chance the market will stabilize before long. But the tax-cut honeymoon may be over for good.

Confidential tip line: rickjnewman@yahoo.com. Encrypted communication available.

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Rick Newman is the author of four books, including Rebounders: How Winners Pivot from Setback to Success. Follow him on Twitter: @rickjnewman

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