Are hopes for a tax-cut boost to US corporate earnings simply (American) pie in the sky?
All four leading US stock market indices – Dow Jones Industrials, S&P 500, Nasdaq Composite and Russell 2000 – racked up a string of record closing highs in 2017 and one key reason for this was what, ultimately, became President Trump’s first major piece of Capitol-Hill-approved legislation, namely December’s Tax Cuts and Jobs Act.
The tax changes are designed to drive US GDP growth to more than 3% a year on a sustainable basis. That rate does not look too impressive when compared to many post-war decades other than this one but – if achieved – it would represent a healthy uptick on the fairly turgid rate of progress we have seen since the end of the Great Financial Crisis in 2009:
President Trump’s campaign promise was to reinvigorate US GDP growth
Source: FRED - St. Louis Federal Reserve database. *Q3 2017 only
The idea is to cut corporate taxes, boosting corporations’ ability to invest in assets at home and offer higher wages to staff, which sounds good in principle, although the rules are more complicated than they first seem.
Advisers and clients will get their first feel for how companies are responding to the changes as we enter the latest round of quarterly reports from US companies.
In sum, analysts are looking for 14% growth in earnings per share on a year-on-year basis from Q4 2017 and 17% from all of 2017, for the S&P 500’s members, according to research from Standard & Poor’s.
The S&P 500’s members are expected to show 14% earnings per share growth in Q4 2017
Source: Standard & Poor’s research
If met, these growth rates would take US corporate earnings to all-time highs on a quarterly and annual basis. This helps to explain why US equities trade at record highs, too, but stock markets are forward-looking discounting mechanisms so any guidance given for 2018 will be more important than the 2017 numbers, especially as this will give some insight into how companies see the tax changes affecting them.
For the record, Standard & Poor’s research sees a huge increase of 26% for 2018.
The S&P 500’s members are expected to show 26% earnings per share growth in 2018
Source: Standard & Poor’s research
This suggests a lot of the good news may already be factored in, especially as US stocks trade on lofty valuations relative to their history – although high valuations became higher ones in 1999-2000 and 2006-07 as US stocks throbbed toward their peaks.
How the US Federal Reserve responds to this fiscal laxity remains a key variable, as higher interest rates, and thus tighter monetary policy, have historically acted as a brake upon US share prices.
Six taxing issues
While the ins and outs of individual firms’ reports will be of less relevance to advisers and clients, their appointed fund managers will be poring over these comments. In addition, advisers and clients should be able to keep an eye on the key trends in corporate commentary.
The six key issues to watch are:
- Are American companies going to pocket any earnings boost provided by the tax gain, or use it to cut prices and take global market share, especially as they also have a weaker dollar on their side?
- If they do keep the extra income, are companies going to increase wages and spend more, to the potential benefit of the economy, or will they devote the extra cash to share buybacks, acquisitions and financial engineering?
- Will consumers truly be better off under the new tax regime?
- Will the planned $1.4 trillion long-term increase in US government debt that will result from the tax cuts plan mean that US growth disappoints in the long term as the extra liabilities become an interest-bearing burden?
- Will the tax cuts sufficiently rejuvenate growth in the economy and corporate earnings to justify the strong run in US equities witnessed since President Trump’s November 2016 election victory?
- Will the tax cuts become so effective that the US Federal Reserve is forced into raising interest rates more quickly than expected, potentially negating at least some of the benefits, particularly from the perspective of those advisers and clients who hold US financial assets?
In this column’s view the answers currently seem to be:
- We don’t know.
- Possibly. The early indications are positive, looking at statements on pay from JP Morgan Chase, Wal-Mart and others, while the decrease in tax reliefs related to interest payments on debt could curb buyback and acquisition activity – but it is too early to tell.
- To some degree, at least initially. Figures released by the Joint Committee on Taxation suggest that the answer is yes out to 2019 but by 2027 only those earning more than $75,000 will benefit – although President Trump will have left the White House by then, even if he serves two full-terms, and his successor could have rewritten the tax rules by then.
US tax changes seem to favour the wealthier by 2027
Source: US Joint Committee on Taxation. *No tax due for payment in 2019E, 2023E although in 2027E $3.1 billion is now due against rebates previously.
- Possibly. With the Federal deficit exceeding $20 trillion, debt-to-GDP is already more than 100%, which is not a good sign, so growth (or inflation) will need to accelerate to stop the extra borrowing from becoming a burden. America’s ballooning debts could still hold back growth and threaten deflation, if the Japanese experience since 1989 is any guide, especially as federal debt, student debt, auto debt and pension liabilities mean that borrowing at state and consumer level has also never been higher.
US federal-debt-to-GDP ratio already exceeds 100%
Source: FRED - St. Louis Federal Reserve database.
- We don’t know.
- We don’t know. But we do know that it has historically taken an average of eight to nine rate hikes of one-quarter point each to stop US stocks in their tracks, looking at all of the Federal Reserve’s monetary policy cycles back to 1970. The US central bank is currently planning three interest rate increases in 2018, according to its dot-plot, and that would take the total to eight hikes in this up-cycle, which began in December 2015.
Since 1970 it has, on average, taken eight rate hikes to halt a US equity bull market
Source: Thomson Reuters Datastream, US Federal Reserve
Price must be right
Admittedly, that is a lot of ‘ifs’, ‘buts’ and ‘maybes’ – but there is the rub.
On a market-cap-to-GDP and Shiller Cyclically Adjusted Price Earnings (CAPE) basis, US stocks look expensive relative to their history. Neither indicator has been useful as a short-term timing tool, even if both have foretold of weak returns over the following ten years – the sort of time horizon over which many advisers and clients will be operating (as a minimum).
Using market cap to GDP, the US stock market has never been this expensive and the last time it was anywhere close was 2000, when the brutal bear market of 2000-03 swiftly followed.
US market cap to GDP ratio stands at record highs
Source: FRED - St. Louis Federal Reserve database, Thomson Reuters Datastream
On a CAPE basis, US stocks have only been more expensive, post-war, once and this was in 1999, when again the 2000-03 bear market soon followed. Pre-war, US stocks exceeded the current multiple in 1929 and it’s hard to think of a less encouraging precedent than that, given the Crash and Great Depression that followed.
Shiller CAPE multiple stands near record highs too
Source: www.econ.yale.edu, Thomson Reuters Datastream
Such valuation concerns may help to explain why the US stock market underperformed on the global stage in 2017.
US stocks’ performance in 2017 looked less good relative to other geographies
Source: Thomson Reuters Datastream
High valuations also set a lofty bar of expectations for 2018, so those advisers and clients with a value bent or who have a nervous disposition may seek to address their US exposure on a tactical basis for this year – but do so in the knowledge that US stocks have yet to see the sort of vertical melt-up which tends to conclude a bull market in rousing style (but with potentially debilitating consequences to follow).