Stocks rose yesterday after two down sessions on a day when Congress finally passed tax reform. Bond yields showed little change. Overnight bitcoin prices fell as much as 25%. Is that the beginning of the end for this craze? Probably not. But it clearly demonstrates the volatility and risks associated with an asset class that has absolutely zero intrinsic value. Its only value, at least today in its present form, is what the next guy is willing to pay you for whatever you offer for sale.
President Trump could sign the tax bill into law as soon as today. Technicalities could delay the formal signing until after the first of the year. While the IRS has yet to publish withholding tables for 2018 (heck, the bill hasn’t even been signed yet), that is all irrelevant. The law will take effect on January 1, and most Americans will pay less taxes on the same level of income in 2018 than they did this year. While approximately $5 of every $6 of benefits in the bill go to corporations, both C and S corps, there is still some leftover to spread around. Yes, not everyone will pay less in taxes, and for most of us, the differences will be small. But for corporations this is a windfall. Stock prices reflect the present value of future cash flows to public companies. You can look at the new law from the eyes of Donald Trump or a left wing liberal who can argue all day long about income inequality. I’ll leave that argument, a very valid one, for others. But there can be little doubt that in 2018, corporations are going to make a lot more money than they did in 2017.
Market watchers ask whether that is now fully discounted in stock prices. The root answer is of course it is. Markets are efficient, and they are a very effective discounting mechanism for both the present facts and consensus future expectations. However, the real question is whether markets have properly discounted various nuances or second derivatives of the new law. For instance, almost immediately we have seen a handful of high profile companies including AT&T# and Comcast# state that they would pay collectively 300,000+ workers bonuses of $1,000 each. That is very real money, and we all know the recipients are going to spend a large portion of what they receive. That is $300 million from just two companies.
Corporations have choices relative to these new substantial tax savings. Look at some of the options:
- They can pay employee bonuses or raise employee salaries, sharing the newfound wealth within.
- They can reward owners via stock repurchases and higher dividends.
- They can repay debt.
- They can increase capital investment. This presumes investment opportunities exist that will allow future returns to exceed cost of capital by an adequate amount.
- They can make acquisitions.
- They can stash the money for now and look at opportunities later.
- They can cut prices to gain market share.
That’s a lot of choices and I doubt my list is complete. There isn’t a right answer for all. Companies that borrowed heavily in recent years to make acquisitions or increase share buybacks would probably be smart to consider debt reduction. Companies in industries without pricing power will be tempted to cut prices, while others that sell products into global commodity markets (e.g. oil producers) have little control over their selling prices. These are some of the nuances I was suggesting earlier that might either not be fully discounted or may be discounted improperly. Will, for instance, the tax cuts escalate the level of M&A activity? Historically, acquisitions increase as an economic cycle matures, with or without newfound wealth.
With all that said, most of the above options are favorable from a shareholders’ perspective. Presumably acquisitions enhance value. Certainly higher dividends do. More money for workers will lead to more consumer spending. Investment will yield higher future returns.
But if only life were that simple. By now you are probably asking what’s the downside to all this. And there are two obvious ones. First, overheating a solid economy ultimately leads to economic imbalances. These imbalances show up in different ways. Bitcoin speculation is one way. Higher prices for all financial assets is another. If demand rises faster than supply, inflation can’t be far away. If you have to pay more for the same goods and services, then inflation serves as a tax. When imbalances become too great, the Federal Reserve has to step in and slow down the economy by increasing interest rates. We all know who won the race between the tortoise and the hare.
The other obvious downside is a buildup in Federal debt. The budget deficit for fiscal 2017 will increase by almost $100 billion to well over $500 billion. The new tax package is expected to increase the cumulative deficit by $1 trillion over the next four years unless, as Trump acolytes believe, growth of 4%+ generates so much new revenue that deficits won’t grow at all. The Federal Reserve, at the same time, is going to reduce its balance sheet by $1 trillion or more, adding to the total of debt not held by Federal entities. Take $16 trillion in new debt today, add $3 trillion in accumulated budget deficits over 4 years, add another $1 trillion from Federal Reserve sales and $1 trillion related to the tax bill and by 2020 our government will have to service $20 trillion in debt. Today, due to very low interest rates, annual debt service costs are around $300 billion. One of the reasons the deficits are starting to accelerate this year is higher debt service. Short term Treasuries now yield 1.25% or a bit more; a year ago it was half that or less. Every 1% increase in the cost of debt service adds $200 billion to the deficit. In January, Paul Ryan wants to start a discussion on entitlement reform. Mitch McConnell and President Trump, however, do not. Debt service and mandated entitlement cost increases can easily add $100-200 billion per year to the deficit, and that doesn’t count any costs associated with the tax bill.
If you borrow $50,000 to take your whole family on a special vacation, no one doubts you will have a very good time. But, at some point, you have to either make more money or cutback in some way to repay the loan. Living beyond your means can have nasty consequences. But you might also win the lottery. Or get a big raise at work. Or you could make a killing in the stock market.
Thus, when I say the obvious consequences of tax reform are priced into the market today, I mean that investors have adjusted stock prices in recent months to reflect higher earnings in 2018. Note as well that the 10-year Treasury market has barely budged. Inflation expectations today are no different than they were a year ago. If we assume markets are efficient, if the added stimulus from the tax cuts was going to result in higher inflation, the 10-year Treasury yield would likely be a lot closer to 3% than 2.5%.
Maybe the answer is that we know earnings will rise, but there is less consensus about the impact on inflation or deficits. Maybe that still has to play out. If earnings rise rapidly, and a year from now, Treasuries still yield 2.4% with no hint of inflation, then 2018 is likely to be another good year, perhaps a very good year, for investors. But if that elusive inflation suddenly starts to emerge as the current capacity elements of our economy are stretched, the good news on earnings will be offset, at least in part, by the damage inflation and deficits can cause.
President Trump wants to double down and increase infrastructure spending next. In private life, he never shied away from using debt and leverage to the max. But despite his desires, he is running out of room. There are enough deficit hawks in Congress who will want to know how infrastructure spending is going to be paid for. One of the problems that is likely to emerge is that after the tax cuts, fiscal flexibility is less. Many of the fundamental issues, like aging infrastructure, haven’t been solved and Congress isn’t going to address entitlements until crisis forces action.
In that sense, we now have the good news. Earnings are strong. Economies worldwide are accelerating without more than a hint of inflation. I suspect in the months ahead, some of those storm clouds will get a bit more ominous. In the stock market, it is the second derivative, the change in future expectations, that drives the changes in stock prices. There are scenarios that point to more pleasant news in 2018. But as the year progresses, concerns are likely to rise as well. Strong earnings are still a dominant theme, and hopefully, increased investment spending can raise productivity. But nothing in this world is free. Spending $20 trillion more than you have, at some point in time, will have nasty consequences. This isn’t a time to be complacent. Perhaps that is one reason stocks stopped soaring as Congress passed tax reform.
Today Meghan Trainor is 24. Ted Cruz is 47. Diane Sawyer turns 72.
James M. Meyer, CFA 610-260-2220
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