December 18, 2017

Stocks continued to rally on Friday, and it appears the rally will carry through this morning.  Republicans released the final version of their tax reform proposal late on Friday, and to date, no Senators and only a handful of Representatives have come out against the bill.  Even with Senator McCain returning to Arizona for health reasons, at the moment it seems highly likely that the bill released on Friday will pass into law sometime this week.  I suspect the obvious impact of the bill will be largely priced into the stock market before year end.

Note that I used the word obvious above.  The final version of the bill took some of the corporate benefits and moved them to individuals.  The child care credit was restored to $2,000, the top marginal individual rate was lowered to 37%, and the corporate rate was raised to 21%.  In order to get the bill to stay at a 10-year cost of under $1.5 trillion, many of the changes are not permanent.  Republicans hope that between now and the time these provisions sunset, future Congresses will make them permanent.  Of course, if Democrats regain control of Congress and the White House in either 2020 or 2024 the changes will be quite different.  There are a few items that were made permanent.  Most prominent is the reduction in the corporate tax rate to 21%.  In addition, the tax on cash and related assets held overseas will take effect in 2018 regardless of whether the cash is returned home or not.  From that point forward, foreign earnings will be taxed territorially as they are in the rest of the world, meaning companies will pay taxes in the country where the business took place.  Cash can then be moved around the world without additional taxes, making it much easier for companies that make money abroad to return free cash to corporate U.S. headquarters either for investment or to be returned to shareholders.

One of the unknowns is what companies are going to do with the extra income derived by lowering the corporate tax rate.  Ideally, they will increase investment to improve productivity and to meet future demand.  Republicans generally want to characterize the tax reform package as an important accelerant to economic growth.  Clearly, at least in the near-to-intermediate term, there will be some benefit.  Middle class tax payers will get some relief on balance and some corporations will increase investment spending.  But we live in an economy where 70% of GDP is consumption.  It will be the growth in consumption that will drive any increase in economic growth.  One of the keys will be the withholding rates set for workers in 2018.   While there are some who wished to equate tax reform with tax simplification, except for those individuals who can benefit from a doubling of the standard deduction, what awaits a Congressional vote and a White House signature is hardly something that anyone could label simplification.  It will take until April 2019 for most Americans to determine whether the new law works in their favor or not.  While the Alternative Minimum tax disappears for corporations, it still exists for high income individuals.  I would contend that if individuals don’t understand their 2018 taxes and if there is no meaningful change in their withholding, then what we are likely to see is a nudge upward in consumption and not a heck of a lot more.

The last time there was a foreign tax holiday on repatriated earnings, companies took most of the incremental cash returned home and gave it to shareholders in the form of stock repurchases and higher dividends.  I expect the same this time around.  The one added factor this go-around is that many companies borrowed heavily over the past several years at low rates to fund domestic repurchases of stock rather than pay a high tax to repatriate offshore funds.  Now that the tax on offshore cash is to be made mandatory, some of the after-tax cash coming back to the U.S. will be used to repay that debt.

Other items in the tax bill directly impact investors and high income individuals.  Many of you should contact your tax advisors immediately to see if you want to make payments in 2017 or 2018.

  • The alternative for individual alternative minimum taxes for individuals was raised. Thus, individuals caught in the AMT in 2017 could escape it in 2018.  Under the AMT, certain preferred items like property tax, state and local income taxes and a portion of capital gains are not deductible.  Thus, if you will have to pay in 2017 under the AMT but could escape it in 2018, you might want to defer your fourth quarter estimated tax payment, for instance, until after January 1.
  • 529 plans can be used for education purposes starting with kindergarten. Current law prohibits their use until college.
  • If you have substantial medical expenses, next year you can deduct out-of-pocket expenses that exceed 7.5% of income. Today the barrier is 10%.
  • Moving and tax preparation expenses will no longer be deductible.
  • Child care credits are raised to $2,000 from $1,000. 70% of that cost is refundable.  It is possible that low income Americans who spend up to $2,000 on child care can actually receive a check without paying any income taxes.
  • The estate tax threshold is to be increased to $11.2 million, double what exists today. For husband and wife, that unified credit is doubled.

Note that these provisions are not an exhaustive list.  Everyone’s tax situation differs.  To repeat, you should contact a tax professional before taking action. 

One question we get a lot is how the tax law changes will impact the stock market in 2018.   As I have noted several times, markets discount ahead what they already know.  Markets reflect consensus expectations.  The current strong rally clearly relates to the increasing likelihood that tax changes are coming.  Moreover, markets also know that growth is solid and synchronous worldwide.  As a result, valuations are high to reflect all this optimism.

Not to try and throw a bucket of water on the parade, however, let me make a few points.

  1. The easiest earnings comparisons in 2018 are likely to be in the first half of the year.
  2. A lot of what happens in the stock market in 2018 depends on the future course of inflation expectations and interest rates. Should the 10-year Treasury rise to 3-4% amid concerns of rising inflation, depending on how fast rates move, that could easily stop the rally in its tracks.  I am aware that this sounds a bit like Chicken Little predicting the sky will fall.  Observers, including myself, have warned of pending inflation for some time.  But clearly, we are operating at or near potential GDP and unemployment, now close to 4%, can’t fall a whole lot further without triggering some inflation.
  3. I am not going to even try and predict political mood swings. But as the 2018 mid-term election season approaches, concerns could rise that Republicans might lose control of one or both chambers of Congress.  After the Alabama election and the seating of Senator Jones, most likely in January, the Republican lead in the Senate is just 51-49.  However, 25 Democratic seats are up for election in 2018 versus just 8 Republican seats.  To gain control of the Senate, Democrats will have to hold virtually every one of their seats and take 2 or more Republican seats.  That’s a hard task.  In the House, Democrats would have to pick up 31 seats.  Perhaps 60 seats could be labeled contestable.  That means Democrats will have to win 46 of the contestable seats, again an uphill battle.  While a lot will depend on how politics plays out in Washington between now and then, a lot also depends on the individual candidates.  One only needs to look at Alabama to understand my point.
  4. Central banks will most likely be less accommodative as 2018 progresses. The Fed will be selling more bonds as the year goes on, and the ECB should end its bond buying program either late in 2018 or in 2019.
  5. The Fed will likely increase short term rates to about 2% by year end.

Thus, while I believe stocks can move higher next year if 10-year Treasury bonds yield less than 3% throughout the year, the first half of the year should have fewer storm clouds to deal with than the second half.  Since valuations are rich, any unpleasant surprise can result in a sharper correction than might be the case if valuations were closer to historic norms.  While I see no need to disturb long term positions, stay true to your asset allocation and weed out companies not performing to expectations.  Given the benefits of lower taxes and synchronous worldwide growth, companies that fail to execute well should rightfully be punished in 2018.

Today Christina Aguilera is 37.  Brad Pitt is 54.  Steven Spielberg turns 71.  Keith Richards is 74.  Finally, Cecily Tyson is 93.

James M. Meyer, CFA 610-260-2220

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