Weekly Update: It's important to know what you're paying for

10-27-2017

I spent the first part of the week in West Virginia, where in a meeting with advisors, there was a discussion about what is priced into stocks as it relates to tax reform. Everywhere I go now, I am asked about this. It’s hard to say when you don’t even know what the package is. One source estimates the S&P 500 may be 3% overvalued based on the hype of an expected tax cut, while another estimates the market has only moved about a tenth of the way toward a possible 25% corporate tax rate, which wouldn’t be much lower than the current effective rate of about 27%. Strategas Research sees no evidence that reform has been priced into the market. As the S&P has been rising, the companies most levered to tax reform have been underperforming, suggesting the equity market is being driven by other factors such as stronger global growth, higher earnings and possibly less regulation. So despite all the talk of a massive tax cut the likes of which this country has never seen, the market currently appears to be looking for little more than a watered-down, drawn-out version—if it happens at all. I finished the week with a client event in Old Greenwich, Conn., one of the wealthiest cities in that state. A very gracious and sophisticated group, they appreciated my outlook and asked some tough questions—to include my least favorite—what’s your view on ETFs? As a strategist for an active manager shop, I rue the day these three letters were put together in this order. But, seriously, I have done a serious review of the positives and negatives which I will share in future weeklies. After my presentation, the gentleman who brought up ETFs and had retired after 50 years in our business, implored me to take them seriously.

With the House’s narrow approval of a budget resolution, we should find out a lot more about tax reform in coming days. As soon as next week, House Ways and Means Committee Chair Kevin Brady may begin the markup of an actual tax-reform bill. This is a long-awaited moment. The House likely will pass it by Thanksgiving, but the Senate—where there’s a razor-thin majority with some strong Republican Trump detractors—is where the action really is. Along the way, inevitably, the actual contents of the bill will be made public. It is then that all hell will break loose on K Street, where Republican lobbyists reside in D.C. With so few real details and no actual bill available, the K Street crowd has had little to train its gun sights on. The hard compromises to limit the size of the tax cuts to $1.5 trillion, as called for in the budget resolution, have yet to be made explicit from the $4+ trillion framework unveiled in September by the "Big Six”—Republican House and Senate leaders along with Treasury Secretary Steve Mnuchin and President Trump’s chief economic advisor Gary Cohn. One that we have seen, the state and local tax deduction, already is under fire and almost sure to be scaled back. Same for potential limits on 401(k) contributions. The tax rates for corporations relative to both pass-throughs and individuals are a tremendously complex area that has largely been glossed over in the press. They matter a great deal to a lot of companies on both sides of the divide. Big changes are likely but Republicans have their eyes on the prize and are not going to let tax reform easily slip through their fingers if it's at all possible to get something—anything—done. Forget the Democrats. They’ve made clear they’re a big “no.”


The problem for Republicans is they are far from united. Sen. John McCain voted against the 2001 Bush tax cuts, Sen. Corker is a deficit hawk and Sen. Flake is now a free agent who seems on a mission to stop Trump. There are no votes to spare. Moreover, a significant number of players think the $1.5 trillion is a ceiling, not a target. These Republicans would rather see a bill that doesn’t increase the deficit at all, and only signed off on the budget resolutions for the sake of expediency. Believing that permanence is essential for hoped-for economic impacts to materialize, they will push for a package that balances. Their intransigence, on top of heated debates that already have started over what deductions stay and go, could drag out the process into December, when Congress faces another continuing resolution deadline that is certain to gum up the works. Even if a compromise on a $1.5 trillion tax package is reached, it’s unlikely to be a significant fiscal jolt, amounting to about a half-point bump to annual GDP, according to various Wall Street projections. It would be more about symbolism than stimulus, reinforcing the pro-growth animal spirits unleashed by Trump’s victory. Our D.C. sources expect tax writers will settle on a corporate rate around 25% and a foreign minimum tax of 12-15%, with a tax of at least 10% on repatriated overseas earnings that have never been taxed by the U.S. This and a temporary 100% expensing of equipment could represent the biggest boosts to the markets and economy. The details over the next few months will be critical. In the meantime, investors are forced to guess at those details as they attempt to figure out what already is priced into the market. Because, no matter what you buy, it’s important to know what you’re paying for. Every time I spend a ridiculous amount on shoes, I know exactly what I’m paying for. My feet will hate me but I will be fabulous.

Positives

Consumers feeling good October’s final Michigan sentiment reading dipped fractionally from a few weeks ago but was still well above September and the best month in 13 years. Strength was evenly split between expectations and current conditions, with consumers unusually optimistic on the economy, expecting good times without interruption over the next five years. The latest weekly Bloomberg Consumer Comfort survey edged down but remained near its cycle high and continues to trend up on a longer-term basis, with the 52-week average at its highest level since April 2002.

Good start to Q4 Despite lingering hurricane impacts, business activity accelerated in October, with Markit’s U.S. manufacturing PMI at its highest level since January and its companion services PMI at its second-highest level since November 2015. September durable goods increased well above consensus and for the third time in four months, with nondefense capital goods orders ex-aircraft—a good barometer of capital expenditures (capex)—up the most since January. On a year-over-year (y/y) trend basis, core business orders were climbing at their fastest pace in five years. Regional Fed reports from Kansas City and Richmond also reflected continuing robust activity.

New home sales surprise They jumped nearly 19% in September to an annualized rate of 667K units and a new cycle high versus expectations for a decline. A rebound in the hurricane-affected South accounted for more than three-quarters of the increase, but strength was broad-based, with the percentage (not nominal) gain in the Northeast even higher than in the South. Inventories tightened further, adding to price pressures that pushed the FHFA gauge up nearly 7% y/y.

Negatives

Q3 GDP surprises but The headline 3% increase in real growth easily beat consensus, and combined with Q2’s 3.1%, marked the best back-to-back performance in nearly three years. But the market was underwhelmed by some of the underlying data. Capex and real consumption decelerated, possibly because of the hurricanes, while a jump in inventories could weigh on future growth. Also, residential investment weakened and inflation pressures picked up, with the latter suggesting a potentially faster pace of rate hikes than the market is expecting.

Pending home sales soft They remained unchanged in September, matching their lowest level since January 2015, as a pickup in three of four regions was completely offset by a decline in the South, primarily because of Hurricane Irma. On a y/y basis, however, pending sales were off 3.5%, with all four regions posting declines. Weakening momentum is partly due to inadequate supply, which as noted above is pushing up prices and weighing on housing affordability, particularly for first-time homebuyers.

Coming up: global synchronized tapering? With developed market unemployment rates at 35-year lows, Fundstrat believes the days of easy money via zero-rate and quantitative-easing polices are numbered. It expects the Bank of Japan and the European Central Bank to switch gears next year and join the Fed in shrinking their balance sheets, resulting in global “synchronized tapering” that will send a strong deleveraging signal to the markets. This potentially represents one of the biggest risks to the coming New Year.

What else

Where are we in the economic cycle? Growth finally reached its cyclical potential but is not enough to suggest high inflationary pressures and a need for the Fed to tighten, Ned Davis says. It notes core PCE inflation remains well below the Fed’s target, thinks it's very likely the unemployment rate overstates the economy’s strength and says only 30 states grew last month, suggesting growth could be slowing. Since the end of World War II, the U.S. has experienced 12 recessions, one every six years on average. At eight years and four months, the current recovery is only the third-longest of the post-war era. It is appealing to equate strong markets with robust economic growth; however, the absence of recessionary risk is far more important.

Political watch Republicans will need tax reform or they are going to get wiped out in the midterm election, Strategas Research says, citing the latest results from the generic ballot poll that asks voters which party they want to run Congress. Historically the generic ballot is a powerful macro indicator of midterm election results, explaining 90% of the swing in House elections. The latest update shows Republicans losing 36 seats in next year’s election, far more than the Democrats need to take the House. This also suggests the Senate is now in play.

Active vs. passive Equity fund managers delivered the strongest performance in five years with 51% of active managers beating benchmarks year-to-date (YTD) compared to 37% last year, JPMorgan says. The improvement is partially explained by record high stock dispersion, higher exposure to growth/momentum sectors and lower exposure to bond proxies and value. These factors also may explain why discretionary managers are delivering stronger performance than their more diversified quant peers who rely on computer modeling to decide what to buy and sell. Quant portfolios generally are sector-neutral with static risk budget across styles/factors, and only 30% of quant managers are beating their benchmarks YTD.