The broad strength of the US stock market since the election of Donald Trump has been remarkable to say the least. Since election day, the S&P 500 has rallied more than 10% (10.48% to be exact). Investor enthusiasm coupled with a US economy that seems to be improving on several fronts have combined with a very low interest rate environment to drive stock prices to record levels. Thus, these moves to all-time highs have largely been driven from greatly improved sentiment and confidence. And while these elements are incredibly important to a functioning marketplace, they can only take things so far. At some point, sentiment and confidence need to be reinforced by reality, less they deteriorate as quickly as they materialized.
Therefore, it is imperative at this juncture to evaluate the likelihood that this renewed sense of confidence and improving investor sentiment can transform into real economic strength, higher investment levels, higher productivity, higher employment, and ultimately stronger corporate earnings. After all, earnings and cash flow are the primary determinants of a company’s value (and its associated stock price).
Certainly, the simplest path to drive aggregate corporate earnings higher would be higher US GDP growth rates. The new Trump administration is keenly focused on this concept as a key goal of their policy agenda is to raise growth from the relatively stagnant 1.5 - 2.0% level of the past several years into the more robust 3.0 – 3.5% level. The strategy adopted by the Trump administration will be a very substantial tax cut, deregulation, and very substantial investment in the country’s infrastructure. This paper will focus on the likely effects of, in our opinion, the most plausible of these three strategies, that being tax cuts.
To the extent that tax cuts target the corporate tax rate and make US companies more competitive in the global economy while also freeing up cash (that is, cash flow) for investment in more productive capital, higher growth rates would be the natural result. Cutting the corporate tax rate will likely take two forms, both of which we view favorably towards spurring investment and productivity. The first tax cut would be an outright reduction in the marginal tax rate applied to the US operations of businesses, including pass-through income of most small businesses. Currently, the top corporate tax rate is 39%. Under Trump’s plan, that rate would be cut to 15% on all corporate income.
The second tax cut along these lines would be to apply a 10% repatriation tax to the profits generated by US companies in foreign countries and held abroad. After which, all foreign earned profits would be allowed to be repatriated without any US taxation.
Our opinion is that any combination of these strategies will obviously generate more profits and cash flow for US companies, both publicly traded and privately held. We further assert that these
types of tax cuts, especially if coordinated with an accelerated capital depreciation allowance, would spur tremendous capital expenditure by US companies. This type of spending would be expected to generate a lot of growth, both in nominal measures like total revenue and payrolls, but also in the growth rates associated with capital and labor productivity. Improvements to productivity growth rates are ultimately what drive higher living standards and the creation of real wealth. Consequently, we would be very optimistic about the US economy and investment in general if the Trump administration can target and implement these tax cuts.
We are not so optimistic, however, about the positive impact to GDP growth rates from cuts to personal taxes. Typically, the average US consumer spends around 95% of their income on general consumption goods and services and commits the difference to savings. In contrast, the US Government typically spends around 120% of its income (thus the federal deficit each year). While it’s true that private consumption accounts for the lion share of US GDP (approximately 65%), the US Government is still the much more efficient spender. Certainly, we can debate how we define “efficient,” but in the purest sense, 95% consumption as compared to 120% consumption is less money flowing into the GDP calculation. Therefore, a shift of more national income to consumers in the way of personal tax cuts will generate less GDP than if it were consumed through the government channel, and therefore generate less growth.
It is possible that much of savings generated from a cut to personal tax rates will be directed into investments. Obviously, more liquidity is always good for stocks and this scenario should work to drive prices marginally higher, even if we fall short of the higher GDP growth rates. However, higher prices without higher earnings and cash flow is not necessarily a good thing. That is the simple recipe for an asset bubble which we will have to guard against. Consequently, we are not quite so optimistic about the positive impact to growth rates from a cut to personal taxes.
Finally, there is the trillion-dollar question hanging out there in respect to how all these tax cuts ultimately impact the Federal deficit and by extension, the US dollar and interest rates. Obviously, if these tax cuts are legislated into place without any offsetting revenue increase, either from new tax revenue or higher growth rates or both, the effect will be to expand even further the US Federal deficit. At this point, that’s about all we can say with any confidence. It’s hard to say what would happen to the US dollar or interest rates without considering all the other variables that tug on those prices levels, that is the supply and demand for money (MV=PQ) from the Monetarist perspective.
For now, and until we see some progress towards passing any growth inducing legislation, whether it be corporate tax cuts, deregulation, or infrastructure spending, we are going to fall back on our baseline growth estimate, that being US Real GDP capped at 2.0%.
With aggregate growth in US Real GDP stuck at 1.5% - 2.0%, we will likely need to continue our more active strategy of taking profits where individual issues appear over-bought and rolling into issues that appear over-sold. In such an environment for growth, holding on to over-bought securities awaiting underlying valuations to catch up usually necessitates intolerably long periods of underperformance in those specific issues.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
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Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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