Stocks gave back a little ground yesterday after the House voted to approve the tax bill. Later, for technical reasons, that vote was voided. The Senate passed the proper bill last night, and the House should revote today, making it highly likely that the bill will get to President Trump’s desk before the weekend.
Last night FedEx# reported strong earnings that beat street forecasts. Moreover, it raised its fiscal 2018 forecast substantially, citing the impact of the tax reform bill plus a strong pace to economic growth both here and around the world. That could become the pattern over the next several weeks. If so, it should allow the rally to continue for at least another month or two. While I believe stocks have clearly reacted to the likely passage of the bill, analysts and investors may not truly understand the impact until the next set of earnings calls that accompany the earnings reports. FedEx noted that if growth continues at or above the present pace, it would take at least some of the tax savings and reinvest to grow the business to meet excess demand. It is also likely that FedEx will continue to raise its dividend and might choose to buy back more stock as well. While the reaction will be similar for other companies, the mix between investment, dividends and stock buybacks will vary from company to company. In addition, a lot of multinational companies with cash trapped overseas will now be forced to pay a repatriation tax of 15.5% regardless of whether the cash comes home or not. In the future, U.S. overseas tax policy will switch to the same territorial position used by all other countries around the world. Until now, many companies have chosen to borrow at very low interest rates to pay dividends and to fund share repurchases. With the overseas cash now freed up to return to the U.S., companies that borrowed for those purposes will use a combination of repatriated cash and tax savings to reduce debt.
As equity investors celebrated the passing of the tax bill, bond prices fell. The 10-year Treasury this morning yields 2.49%, the highest rate since March. Clearly, this bears watching. A response of a couple tenths of a percentage point won’t make a big difference, but if strong growth either continues or accelerates, inflation expectations might rise. If bond prices fall while equity prices rise, there will come a point where money begins to flow from stocks to bonds. Many conservative investors have been starved for yield for years. A 10-year Treasury yield of 3% isn’t going to make too many of us salivate. But there will come a point when rates get high enough to entice new buying and a switch from stocks to bonds. Indeed, that is probably the equity market’s biggest worry over the next 12-18 months, that strong growth and added stimulus create too much fuel that ends up igniting inflation. Stock prices are a function of earnings and interest rates. Even allowing for solid double digit growth in earnings next year (much of which has already been discounted), a bigger than expected swing in interest rates could mute much, if not all, the excitement from higher earnings.
That doesn’t make bonds very attractive yet. A sharp (100 basis points or more) rise in yields will result in negative real returns of investors in medium-to-long term investment grade bonds. A sharp rise could also create problems in Washington as debt service increases would swell an already large budget deficit. A lot of Republicans want to equate this year’s tax cut to the 1986 Reagan tax cut. But there are three very big differences. In 1986, interest rates were in the process of falling from historic highs. Today, they are rising from historic lows. In 1986, entitlements were roughly 25% of the budget. Today, they are almost two-thirds. Finally, in 1986, the national debt was slightly over $2 trillion. Today, it is about $20 trillion. While we can support a lot of debt if interest rates are near record lows, debt service requirements, which can’t be legislated away, and ongoing increases in entitlement spending can push the annual deficit to well over $800 billion within two years unless (1) there is a dramatic pickup in capital gains receipts or (2) a huge increase in personal income. While the next law promises to give the average middle class family $1,000-2,000 in added take-home pay annually, it is unlikely that any impact from more take home pay in 2018 will be enduring through future years.
In the short run, I think the stock market keeps going, recognizing that there might be profit taking by taxable investors after the first of the year, based on the likelihood that Q4 earnings will be very good as will 2018 guidance. But once everyone has finished adjusting numbers, the question becomes can earnings rise fast enough to offset the threat of higher interest rates. The answer will reveal itself in the coming weeks and months.
Today, Jonah Hill is 34.
James M. Meyer, CFA 610-260-2220
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