2018 Outlook: Tax bill, the Christmas gift that should keep on giving

12-20-2017

One of the four drivers of our bullish stance on the markets for this year and beyond (see “2018 Outlook: Still riding the secular bull”) has been our out-of-consensus expectation that a significant tax-reform package would be passed into law this quarter.  Now that this has occurred, and analysts are scrambling to determine the impact, many clients are asking: “How much of this has been discounted?”  Our quick assessment: not a lot—maybe 25%. Here’s how we get there.

Multiple drivers
First and foremost, the American economy and U.S. stock market are driven by many factors, all of which are currently flashing bright green: a suddenly faster-growth trajectory under President Trump’s plan of cutting regulation and taxes and cheering for businesses instead of declaring, “You didn’t build that!”; a recovery in corporate earnings growth from the 2015-16 earnings recession, during which S&P 500 earnings bottomed at around $115—they are motoring toward $135 for this year, with no tax cuts whatsoever; the dovish stance of the world’s central bankers, most of whom (excluding the Fed) are still pumping in liquidity, albeit at a slower pace; the “long cycle” (see "Market Memo: Summer storms won't derail the long cycle), with structural, disruptive and demographic forces colluding to keep inflation restrained and central banks on easy street; and of course, the promise of tax reform.

With these many positive forces at work, it’s not easy to decipher how much of the market’s 22% rise this year was driven by any one of them. However, our perch here at 101 Park Ave. in New York is a pretty good one to judge consensus thinking—we speak to many other big investors, and Wall Street economists on a regular basis. And until late November, I can assure you that few of them thought this reform would pass, and were it to, few believed it would be little more than what one strategist labeled as “small ball,” i.e., a token, one-off tax cut so that Republicans could say, “We did something!” On this basis, one could argue that only the S&P’s December return (1.4% at this writing) was driven by the expectation of the current tax bill passing.  At best, we could attribute all of the return this quarter (6.5% so far) to the tax bill.

Multiple skeptics
Another reason we believe little of the tax reform is in the market is the vast number of skeptics out there ranting against it. In my attempted discussions with most of them (I emphasize attempted as in most cases, discussion is not possible and I end up playing the role of psychotherapist/empathetic listener), my conclusion is that the skeptics simply are using an alternative (and I assert wrong) framework to analyze the question. This is a fundamental error, since the wrong framework can pop to a very different conclusion from the same set of facts as someone using the opposite framework. In this case, the framework of the skeptics is rooted fundamentally in the quote above from a former president, “You didn’t build it.” Under this framework, only the government can stimulate the economy, and even so, barely; the pie is not growing and therefore needs to be carved up by the political elite; productivity is permanently low and therefore any stimulus will unleash inflation and therefore the Fed; and any bill with the words “tax reform” is easy to analyze—just add up the pennies that the government is sprinkling on the population, assume everyone goes out to dinner that night with a spouse or friend, and you have an estimate of the one-time jump in GDP that will occur.

This is the Keynesian model that we all learned in Economics 101, and is reiterated regularly by some of the “smartest” people in the world that appear on many of the daily news shows. And given that so many in the country believe in this model, it is no surprise that little of the tax reform bill has been discounted. President Trump and his colleagues that passed this bill are suffering, or enjoying, a different perspective. They think the economy is built by small business people, and if you let them loose via less regulation and lower taxes, you will improve their after-tax returns on prospective investments. And if you do this, they will invest in projects and activities and businesses that newly achieve their capital return hurdles in a lower-cost, lower-tax environment. Over time, this should produce more investment, more growth, and eventually, more jobs.

Multiple horizons
The third reason this bill’s impact on the markets to date is so difficult to determine is that it is designed to work over two different horizons: near-term (2018) and longer-term (2019 and beyond). In both periods, the bill should affect the two key drivers of stock market returns, earnings and valuations. Let me explain:

  • Impacts are partially, not fully, discounted for 2018, when the first wave from the tax bill hits. Even if nothing at all happens to the economy, after-tax corporate earnings will rise due to the corporate tax rate dropping from 35% to 21% on Jan. 1. Our estimate is that this cut alone is worth $10 in earnings on the S&P. Some of this earnings impact has been bleeding into analysts estimates through the course of this quarter, as their 2018 estimate rose from about $145 in late August to $147 today. Through the course of Q1 2018, as companies issue better guidance now that the bill has passed into law, we expect at least another $3 to be tacked on by Wall Street analysts, with the rest more likely to come through fully in 2019, hence our $150 and $160 S&P earnings estimates for 2018 and 2019, respectively. So, only about 25% of the direct after-tax earnings impact of the bill has been factored into numbers. At present multiples, this yet-to-be-discounted earnings improvement should be worth about another 5% rise in the S&P 500.
  • Another driver of stock market returns likely to happen in 2018 is the immediately improved economic growth that comes with the extra cash being handed by the government to individuals and companies as a result of the tax cuts. This short-term stimulative effect is probably relatively modest in the scheme of things, in the 0.1 to 0.5 percentage points range. But a lot of this stimulus should flow into corporate revenues, and from there, profits, and could produce upside to even our bullish 2018 earnings forecast. While some Wall Street firms, as well as the Atlanta Fed, have recently bumped their 2018 GDP forecasts closer to our above-consensus number (3.0%), we doubt seriously that this near-term impact is in the market yet. As it bleeds in, we think this could get us the rest of the way to our 3,000 target for next year on the S&P, which is 12% away from current levels. In sum, if we only consider the tax bill’s short-term impact and assume that all of December’s up-move and some of the quarter’s to-date 6% return is due to the bill alone, it would seem that about 15-30% of the bill has been discounted.

Longer-term impacts that are driving our bullishness have been largely ignored and underappreciated. These include:

  • Rising investment. One of the key reasons for the moribund recovery over the decade since the Great Recession has been the failure of corporate investment to kick in. While a variety of reasons are given for this trend, a key one has to be the regulatory environment and the tax code. With both now more favorable, we anticipate a rising level of corporate investment over the next several years, both from within the U.S. and coming in from abroad. That should continue to stoke the growth engine of the economy and with it, corporate earnings.
  • Rising productivity. Another important aspect of this tax reform is the likely impact it will have on economic productivity. As capital investment rises, the ratio of labor to capital should decline, allowing companies to raise wages without necessarily raising prices or reducing profits. With unemployment already relatively low, a tax reform that stimulates investment more than spending, which this does, is in some ways the perfect “late-cycle stimulus.” In fact, it may be just what the economy needs to keep this long cycle moving forward, while keeping inflation, and the Fed, at bay.
  • Rising valuation multiples. Finally, a third driver of this reform should be rising P/E multiples. As the yield curve re-steepens and the threat of another recession soon recedes, investors should grow more confident in long-duration assets such as stocks. So contrary to consensus, Federated expects the S&P multiple to expand in the quarters ahead, not contract. Indeed, we think a 20 P/E on the market is quite likely.

When you add all this up, and combine it with all the other positive forces currently at work for stocks discussed above, the odds of this tax reform prolonging the recovery and leading to earnings numbers on the S&P of $175 and even $180 seem quite good. Earnings like this with a 20 P/E could eventually see this bull head above 3,500, a good 30% away. Against this target, this quarter’s 6% to-date rise seems like little more than a modest down payment against a Christmas gift that could keep on giving! So, Happy Holidays, and may you enjoy many more Merry Christmases!

Stephen Auth
Stephen Auth, CFA
Chief Investment Officer, Equities, overseeing all of Federated's equity and asset allocation products globally