Orlando's 2018 Outlook: Can the new year top 2017?

12-22-2017

Bottom Line In an early Christmas present this week, Congress passed its most sweeping tax reform in more than 30 years. For investors, that’s the cherry on top of a superb year. The S&P 500 has rallied nearly 30% over the past 14 months, with almost 20% of that coming year-to-date in 2017, largely due to strong underlying fundamentals. Economic growth of more than 3% during the second and third quarters is running at its best pace in three years, and double-digit corporate profit growth over the past nine months is the strongest we’ve seen since 2011, as long-dormant animal spirits have been unleased.

While we have a constructive outlook for 2018, our 3,000 forecast for the S&P 500 implies that potential returns of 12% or so could be roughly half as good as this year, with much higher levels of volatility likely, given the uncertainty of the midterm elections next November as a growing market risk. Thanks to the operating leverage associated with successful corporate tax reform, S&P earnings per share should grow to $150 in 2018, a 15% increase over our $130 estimate for this year.

We believe that both GDP growth and benchmark 10-year Treasury yields will approximate 3% over the next year, with core PCE inflation grinding up from 1.5% at present to the Federal Reserve’s 2% target over time. So with historically low interest rates and relatively benign inflation, we continue to believe P/E multiples should expand to about 20 times in 2018 from 18 currently.

Many of the business and consumer confidence metrics we monitor are sitting at or near multiyear cycle highs. The unemployment rate (U-3) is at 4.1%—a 17-year low—and likely headed to 3.5% in 2018. And we expect wage inflation to rise from 2.5% now to 4% over the course of the next year or so, as the demand for skilled labor remains tight.

We expect that the Fed’s leadership transition from current Chair Janet Yellen to Jay Powell will go smoothly, and we expect the Fed to continue to gradually withdraw monetary policy accommodation over the next few years. Despite the flattening yield curve, we do not envision the possible risk of recession any earlier than 2020.

We wish everyone a blessed Christmas and a happy, healthy and successful New Year!

Corporate tax cut is key The centerpiece of President Trump’s tax reform is the right-sizing of corporate tax rates. At a combined 39% statutory rate (and 35% federal) now, the U.S. has the highest corporate tax rate in the world. The global corporate average among the 35 OECD countries is 24%, with Hungary at 9% and Ireland at 12.5% at the other end of the spectrum. Quite simply, this disparity defines the so-called corporate inversion problem here in the U.S., as companies moved manufacturing plants, intellectual property and jobs overseas to fulfill their fiduciary obligation to achieve higher rates of returns, all of which reduced economic growth here at home. This week’s cut to 21% makes the U.S. globally competitive on taxes again, and also re-establishes the U.S. as a magnet to attract foreign companies to domicile here.

Repatriation important With $2.6 trillion in cash sitting on their overseas balance sheets, U.S.-based multinational companies that wanted to bring their cash home simply refused to do it at a 39% statutory rate. So to definitively fix the inversion scourge, Trump introduced a territorial tax system and levied a deemed repatriation tax of 15.5% on these companies’ cash holdings and 8% on their invested foreign assets. That could generate about $300-400 billion in federal tax revenue, which we’d like to see earmarked for and levered up to $1 trillion to pay for much-needed infrastructure spending (airports, roads and bridges) over the next decade, to improve productivity, create high-paying jobs and boost economic growth. The remaining $2.3 trillion would then come home, which we believe companies will spend in several areas: dividend increases and share repurchases, which would boost the financial market; merger & acquisition and research & development activity; more hiring and higher wages; and desperately needed corporate investment.

Corporate capex could soar From 2011 through 2016, corporate capital investment fell off a cliff, as companies stopped investing in themselves. But with a new, more business-friendly attitude in Washington, Trump will allow the full and immediate expensing of investments in equipment (but not buildings) over the next five years, instead of forcing companies to slowly amortize the expense over the useful life of the asset. With $2.3 trillion of newfound cash to spend, we expect companies will seize this window of opportunity to upgrade their technology platforms and purchase new equipment, which should increase productivity and the demand for labor, thus boosting wages and economic growth.

Tax reform polls poorly It appears that Republicans who passed this tax reform measure along a strict party-line vote have done a poor job of communicating its intended benefits to the American people. According to a new Wall Street Journal/NBC News poll this week, only 24% thought the plan was a good idea, 41% said the plan was a bad idea, 66% thought corporations were getting most of the tax-cut benefits (and that companies should be paying higher tax rates, not lower rates), and 56% felt that wealthy Americans were getting all the tax cut benefits among individuals, at the expense of the poor and middle class. If the Republicans’ tax reform strategy, which is intended to result in stronger economic growth, more jobs and higher wages, doesn’t pan out, and if these perceptions persist into next November, then we could be looking at a wave election to benefit the Democrats in the congressional midterms.

Out of consensus forecast for GDP growth In our view, one of the biggest mistakes investors have made over the past year has been to allow their political biases to influence their investment judgment. To that point, there’s no question that Federated’s more optimistic 3% GDP forecast for 2018 is out of line with the Blue Chip consensus at only 2.5%, largely because we have been firmly within the 30% minority which believed that tax reform was actually going to happen. Over the past two months, we’re pleased that many top economists have shifted toward our point of view:

  • Martin Feldstein, chairman of the Council of Economic Advisers (CEA) under President Reagan and president of the National Bureau of Economic Research (NBER), wrote an op-ed in the Wall Street Journal (WSJ) in early November, arguing that Trump’s tax plan will boost GDP, create good jobs and raise real wages.
  • Just after Thanksgiving, a team of nine prominent economists (including Michael Boskin, Douglas Holtz-Eakin, Glenn Hubbard, Lawrence Lindsey and John Taylor) drafted a letter to Treasury Secretary Steven Mnuchin (reprinted in the WSJ), confirming that Trump’s corporate tax cuts will likely boost GDP by 3-4% long term.
  • In recent weeks, the top two economists on Wall Street (Ed Hyman of Evercore ISI and Nancy Lazar of Cornerstone Macro) have similarly raised their GDP estimates for next year to 3%. 

Where was the moral outrage last cycle? Critics of Trump’s plan argue that it won’t boost GDP growth meaningfully and that it will raise the federal debt by $1.5 trillion over the next decade. Trump inherited an underperforming economy that had grown by only 2.2% annually, from the end of the Great Recession in June 2009 through the end of 2016, largely due to poor fiscal-policy choices on taxes, spending and entitlements. Moreover, that GDP growth pace had slowed more recently to an annual average of only 1.5% over the seven-quarter period from mid-2015 through the first quarter of 2017. At the same time, federal debt had doubled to $20 trillion from 2009 to 2016.

But GDP growth has since rebounded to 3.1% and 3.2% in this year’s second and third quarters, respectively, due to the unleashing of animal spirits. And we’re forecasting a 3.2% rate of growth in the current fourth quarter, in part due to our forecast for a strong Christmas. The Congressional Budget Office (CBO) points out that for every 1% marginal increase in GDP growth (moving, say, from 2% to 3% annually) in a $19.5 trillion U.S. economy, federal tax revenues will increase by about $270 billion each year, and by about $2.7 trillion over a decade. Therefore, if we can actually achieve trend-line GDP growth of 3% over the next decade, then Trump’s tax cuts will not only pay for themselves, given their projected pre-growth deficit of $1.5 trillion, but they may actually begin to reduce the federal debt. Talk about an out-of-consensus opinion!

That’s the difference between static analysis, which is a Keynesian method of analyzing the economy, and dynamic scoring, which is a more pro-growth, supply-side methodology. That said, where was the concern from within the economic community from 2009-2016, when GDP growth was limping along at a sub-trend 2.2% and the federal debt had doubled to $20 trillion? We do not believe that we are destined to suffer through a prolonged period of economic secular stagnation, if we can reverse those policies with more pro-growth ones.

Moreover, we need to make these pro-growth corporate tax cuts permanent, much like JFK and Reagan, to ensure that businesses and consumers permanently change their spending and investment behavior. The Bush and Obama tax cuts, in sharp contrast, were unsuccessful because they were temporary. People used the short-term benefits to pay off bills and increase their savings, but they did not significantly increase their spending and investment.

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