Euphoric expectations over the new Administration’s proposed economic policies are encountering a difficult implementation process. Also, the concept that policy actions will have second-order effects is catching on particularly as the downsides of protectionist rhetoric and a potential border tax are weighed.
Once pencils are put to paper, it is looking like the math behind some of the proposals is underwhelming. We think that a corporate tax cut might be worth just $5-10 to S&P 500 earnings if it comes to fruition and that will likely be reduced by other items such as the potential for the elimination of interest expense deductibility.
Other elements of the agenda seem like they face major roadblocks. Controversy is erupting over a new border tax that would help pay for corporate rate cuts because certain industries and consumers would be losers under that plan. Of course, our trading partners would respond to new tariffs and that creates risks. The entire tax package is in a state of flux to say the least. Most importantly, the fact that a large portion of Congress was sent to D.C. to reduce deficits, not increase them, seems to be tying some hands, as well it should.
The expected slow pace of the legislative process is not the only cause for second thoughts. Reversing positions on some campaign rhetoric and other incongruences are beginning to dismay important constituencies. We are not the only investors that remember 2008. Obviously one firm that was at the center of that historic skullduggery on Wall Street now has quite a number of former employees driving the thinking at 1600 Pennsylvania Avenue where some “swamp draining” is supposed to happen. Anger and dismay over that alone may shrink Trump’s political capital more than he realizes and we are not even getting into the Obamacare repeal and replacement issues that are another growing firestorm.
We think these uncertainties and growth doubts are being expressed in some key markets even as equities remain in their own world. We reiterate yet again that the flat Treasury yield curve and inflation break-evens do not match the Trump reflation narrative of the equities market. In addition, the curve conveys that the Fed is clearly mistaken in its optimistic views even as it supposedly looks to tighten policy three times this year.
We think poor economic growth is not being properly recognized simply because stock prices are high. The Fed does need to raise rates to get a handle on speculation in a lot of areas besides equity markets. For instance, cap rates in commercial real estate are quite toppy as that sector has rocketed higher in a desperate grasp for yield. However, because it has dragged its feet and the equity market has been willing to ignore obvious risks, the Fed is in danger of tightening at point when historically it would have been easing based on much of the economic data.
The over 15% collapse in the U.S. monetary base since the end of QE3 in 2014 has been among the major drags on growth. In addition, the rapid buildup of debt across the globe only served to bring demand forward and is now restraining growth as the cycle ages. Plus, all that debt must now be serviced. It is the fly in the ointment that the Keynesian economists are being forced to recognize. We remain doubtful that new fiscal policies can overcome these impediments to growth even over the medium term.
These factors are not just theoretical discussions. They do have impact on the economy and the investment world. We mentioned earlier in the month that 2016 U.S. GDP growth was an anemic 1.6%, although pundits told us all year that things were great and soft data like the ISM surveys indicated strength. Most of the hard data like industrial production and retail sales painted a completely different picture all year.
With slow growth across the globe, it is no wonder earnings have been pressured. The dominant marginal equity buyers have simply been corporation themselves as they levered up to try to maintain EPS expectations. In March of 2015, S&P 500 operating earnings (the “massaged” non-GAAP numbers) for 2016 were expected to be $135.03. It now looks like the final number will come in at $107.29. That’s a decline of 20% over the last two years versus those earlier estimates. In spite of all efforts to create growth and all of the hoopla, that is what transpired. It demonstrates why basing investment strategies on earnings expectations is often so foolhardy.
While the rally in indices may well continue for a while, we suspect that investors being led by a President prone to hyperbole will be disappointed in the end. Growth is painfully slow, valuations are extremely high, and hope is enormous as prudence is tossed aside. From an investor’s perspective, valuations will trump Trump over the long term, just like they would have if anyone else had won the election.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.