2017 Outlook: Let's take it easy

12-27-2016

(Editor’s Note: Linda is breaking with her usual weekly update to delve into the implications of the GOP sweep for the market and economy in 2017. Her regular missive returns Jan. 6. Happy New Year!)

This year’s GOP sweep promises a lot of change. Repatriation and lower tax rates for businesses, a tax cut for individuals, ramped-up spending on defense and infrastructure, financial and environmental deregulation, the end to the Affordable Care Act (ACA) as we know it. All of this should be good for growth and equities, which have reacted accordingly, with the major indexes consistently setting new records in this last month of the year.

But here’s the thing: Trump didn’t run as a typical Republican, was not embraced by party regulars and has differed with them on such key issues as trade, entitlements and foreign policy. So there’s a lot of uncertainty over what his actual impact and influence will be. In fact, there are no clear answers about what’s next, only questions.

Even using the speediest process available, special budget reconciliation that requires only simple House and Senate majorities to pass, Evercore ISI thinks it could take until the traditional August recess for any legislative priority to be achieved. Washington Analysis doesn’t think tax reform will take effect until Jan. 1, 2018. That even may be optimistic. It took almost 2 years after Reagan won 49 of 50 states for 1986 tax reform to become law.

Tax cuts may come in stages
This doesn’t mean the economy won’t get any tax cuts in 2017. Under ACA-repeal legislation passed this year by Congress and vetoed by Obama, a replacement plan must be adopted first before repeal can actually occur. However, ACA taxes including a 3.8% tax on investment income would end immediately. If Congress follows through and passes the bill as is and President-elect Trump signs it as his first action, the resulting tax reductions could add $65 billion of stimulus to the economy, Strategas Research estimates. This would buy Congress time to get a larger fiscal policy package passed for 2018 that includes actual tax reforms for businesses and individuals.

At 39% (35% federal plus state & local), the U.S. statutory corporate tax rate ranks among the highest in the world. The proposal by Trump to lower it to 15% would place the U.S. tax rate among the lowest globally, while the House Republican plan of 20% would still rank below the global average. Although the median company currently pays an effective tax rate far below the statutory rate, the impact of an even lower rate could lift S&P 500 earnings by more than 10%, Goldman Sachs estimates. Even a statutory rate of 25% (roughly 29% including state and local taxes), which is more likely given deficit projections, could still boost earnings ex-financials by 8%.

How much will deficits matter?
A lower statutory rate will likely come with sizable offsets. For example, to spur investment, there’s talk of allowing immediate and full expensing of capital expenditures, but with removal of the deductibility of net interest expenses. At a 25% rate, this change could diminish the anticipated earnings tailwind by half. The House plan also redefines foreign and domestic income based on where sales, rather than production, occurs. This “destination-basis cash-flow tax” would reduce the tax rate for net exporters but increase it for net importers. The goal is deficit-neutral legislation, which is at odds with Trump’s agenda. His plans, albeit vague, would appear to increase the deficit as a percentage of GDP from 3.2% in 2016 to 5% in 2017 and 6.1% in 2018. In dollar terms, we’re talking $960 billion in 2017 and $1.2 trillion in 2018. In sum, the most likely impact of potential corporate tax reform may be a modest boost to earnings that is smaller than many investors expect.

Beyond a lower corporate tax rate, some form of repatriation tax change is likely, though budget rules could complicate matters. It’s OK to use reconciliation for tax cuts, but not so much for real tax reform. Both House Republicans and Trump propose that the new statutory rate apply only to domestic income, with foreign income going completely untaxed under the House Republican plan and bearing a 15% tax, less foreign credits, under the Trump plan. Currently, companies keep the vast majority of foreign income abroad and therefore already pay a minimal effective rate on those earnings. The beauty of repatriated foreign earnings is it lets money come into the U.S. fairly quickly. In 2005, a repatriation tax holiday recouped half of $600 billion companies were holding overseas. Since then, overseas earnings have quadrupled but repatriations have barely increased, raising the possibility that as much as $1 trillion could return over a 12-15 month period—money that could be used as an offset to other tax cuts or to help fund infrastructure.

Will Trump talk tough on trade but carry a little stick?
Trump’s selection of Iowa Gov. Terry Branstad as ambassador to China eased some worries over the president-elect’s threat to impose taxes on Chinese imports. But some think the market may be taking Trump’s protectionist rhetoric too lightly. It actually would be quite easy for the president-elect to follow-through on his campaign promises without congressional approval. And there is a lot of bipartisan support in Congress for his views, which sounded remarkably similar to those of Bernie Sanders during the campaign.

At a minimum, Cohen & Co. believes Trump will have to take some action on trade in his first 100 days given its high profile in his campaign and the fact his margin of victory in the Electoral College came from the Rust Belt, where trade is a four-letter word. As an alternative, the GOP Congress as outlined in the aforementioned destination cash-flow tax would prefer a different tack, using broader tax reform to achieve trade adjustments by incentivizing exporters and manufacturers to return to America. Detractors view such an approach as a hybrid tariff/value-added tax that abets dollar strengthening, is inflationary and in reality is a regressive consumer tax.

Smoot-Hawley’s costly lessons
However it all plays out, Empirical Research sees protectionism’s potential revival as a mortal threat to the so-called Bretton Woods II world order that's centered around a framework of market-based global exchange rates—an approach that has led to exceptional profitability as freer trade effectively has imported deflation into the cost of goods sold by manufacturers. The current era of free trade began in the early-1990s and accelerated in 2001, after China joined the World Trade Organization and the U.S. granted it permanent normal trade-relations status. So a dust-up with China that leads to a U-turn in globalization—potentially worsened by Trump’s stated desire to limit immigration even though immigrants represent a quarter of U.S. entrepreneurs and a like share of start-up employees—could endanger free-cash-flow margins and undermine market P/E multiples.

There are eerie similarities to Trump’s rhetoric and that of the late 1920s. “One of the most important economic issues of this campaign is the protective tariff,” President Herbert Hoover opined in an October 1928, speech. “The Republican Party stands for protection ... designed to give adequate protection to American labor, American industry and the American farm against foreign competition.” Hoover signed the Smoot-Hawley Tariff Act 1½ years later and world growth ground to a halt, with U.S. GDP shrinking 33% (!) in 4 years.

Trump is not Reagan
No one’s suggesting we’re on the verge of another global trade war. But Cornerstone Macro sees the potential for a tit-for-tat downshift in trade. So don’t be surprised if the pace of returns slows as the calendar turns to 2017 and the equity market shifts from euphoria over a business-friendly Washington to concerns about potential trade headwinds as well as the mechanics and timing of what actually can get done. Trump is no Reagan, after all, in manner or in circumstance.

When Reagan proposed his individual income tax cut, the top rate was 70%. Lowering that to 28% was an incredible achievement, as well as a strong incentive to work and increase income. A drop from 39.6% to 33%, as being discussed today, is unlikely to have the same kick. Moreover, the macro-environment was much different. Inflation and interest rates were soaring, the dollar was weak, unemployment was very high and a major bear market was just starting to end, allowing Reagan to take aggressive steps to strengthen the dollar and create jobs without driving up inflation. Today, the situation’s almost entirely opposite.

Honeymoons end
More to the point, honeymoons end. History tells us that as opposed to the first 100 days in office during normal transitions, when there’s regime change, i.e., from Democratic to Republican control and vice versa, the biggest post-election move tends to be between Election and Inauguration Days. As of this writing, we’re two-thirds of the way there. We would expect some consolidation soon and over the course of 2017 as the policy sausage gets made.

We’re also in the back-half of this economic cycle, a period when rising interest rates and inflation can erode economic and earnings growth. We’re not there yet. Despite an expansion that turns 91-months-old in January, rates and inflation are still very low. It’s also expected the new regime’s pro-growth medicine will perk up growth and push recession back a few years. At Federated, we have a 2,350 target for the S&P based on $130 earnings-per-share (EPS) and 2,500 based on $140 EPS by year-end 2017 and 2018, respectively. We haven’t changed this forecast all year or after the election, although we did lift EPS expectations at the expense of P/E multiples.

Let’s all just take it easy.