January 8, 2018

Stocks rose Friday for the fourth day in a row and closed at another record high. Bonds remained in a tight range. The optimism over equities flows primarily from the improved impact on earnings from the new tax legislation and strong synchronous worldwide economic growth.

The obvious question is how far can this rally go? Another way to put it is how long does it take for equity investors to discount the impact of the cut in corporate taxes? Maybe a corollary question would be what possible bad news is there out, on, or over the horizon that can derail this rally?

If one assumes markets are efficient, then it would make logical sense that they should be discounting the impact of the tax cuts quickly. Granted the tax changes are complicated. Factoring in a drop in the corporate rate for U.S. related earnings from 35% to 21% is fairly straight forward. But that isn’t the only factor at work. Corporations with cash trapped overseas will have to pay an immediate tax on those earnings, but in return, will subsequently be allowed to move that cash around the world freely. International companies will have shifting mixes of business due in part to changing relative tax rates. Certain prior deductions will no longer be allowed. A lot of this will be clarified as companies report fourth quarter earnings in the coming weeks. As that occurs, analysts will tweak estimates and investors will tweak valuations. Thus, the process of recognizing the impact of a reduction in corporate taxes will probably be fully factored in within a few weeks. On the other hand, to the extent that any of the benefits are long lasting, the impact on long term valuations may be felt over a longer period of time.

The other obvious question is how the changes in the tax code change corporate behavior. One aspect of the new tax law allows instant expensing for tax purposes of capital investment. Many features of the new law have sunset provisions that were made necessary by the fact that the total cost of the bill had to be under $1.5 trillion over 10 years. Expensing of capex is in a provision that will sunset in the mid-2020s. One would think, therefore, that the impact of this change will be to pull investment spending forward into a 2018-2023 window presuming there isn’t an intervening recession, admittedly a big if. Perhaps more than any other factor, the impact of tax law changes on investment spending will be the biggest determinant of future growth.

Republicans want everyone to believe that the current version of tax reform will mirror in impact the tax reform of 1986 done during the Reagan administration. But times are different today. We are now almost a decade into an economic recovery. In 1986, recovery was just beginning. Today, gross Federal debt is near $20 trillion, close to 10 times what it was in 1986. In 1986, interest rates were falling as was inflation. Today, interest rates are slowly rising and so is inflation. The prospect of hundreds of billions of dollars of additional debt service costs are a consideration that wasn’t on the table 30 years ago.

Economic growth is a function of the growth of the labor force times gain in productivity. Four factors work against growth in the labor force. First, today we are close to full employment with an unemployment rate at 4.1%. You know we are getting close because wage increases are starting to rise, and the time necessary to fill a job opening is lengthening. Second, demographics work against growth in the labor force. The number of retiring baby boomers exceeds the number of new entrants to the work force. Third, President Trump is anti-immigration. With the exception of an influx of Puerto Ricans as a result of the damage caused by Hurricane Maria, the number of immigrants is declining, and that decline could accelerate particularly if Congress can reach a conclusion relative to the “dreamers.” Fourth, our birthrate is slowly declining. Thus, if population growth is decelerating, any acceleration in overall economic growth has to come from a rapid and permanent acceleration in productivity. For that to happen, investment spending must accelerate. It has been for several months, an encouraging sign. But it will have to accelerate further for the 3%+ growth so many in the administration predict to become a reality, and not just a short term blip due to a one-time change in tax rates for corporations. While most working Americans will get some tax relief, for most, that relief will be relatively modest. Obviously, some of the one-time bonuses corporations are paying will show up in GDP growth over the next quarter or two. But bonuses aren’t pay raises. The one-time benefit they create today will make for a tough comparison next year when no bonus is forthcoming.

While there was a lot of political news over the last week, mostly centered once again on President Trump’s behavior, we are about to enter a period of more substantive events. In less than two weeks, current government spending authorizations will run out, and the government faces a January 20 shutdown unless Congress once again extends spending via a continuing resolution. This can go on for some time, but there are a few flies in the ointment that will force Congress’ hand. Perhaps the most important one is the March 5 date where Congress either has to pass legislation that extends the rights of dreamers to stay in the U.S., or they will become illegal immigrants subject to deportation. While like so many issues in Washington this is a divisive one, there are many Republicans who don’t want to be forced to defend a picture of some bright educated kids who know no other country than the U.S. being shipped out and separated from their natural families. President Trump is not against keeping the dreamers here, but he wants money for his Mexican wall (I guess those Mexicans aren’t going to cooperate and pay for it after all) as well as other security considerations.

Last year, Republicans sought major legislation initiatives unilaterally using a reconciliation process that required just 50 Senate votes. In 2018, very little can be passed in the Senate with just 50 votes. That means that nothing will get done without some Democratic support. That means gridlock once again. Gridlock may be fine at times, but gridlock won’t solve the dreamers’ issues, it won’t get infrastructure renewal started, it won’t increase defense spending, it won’t fix the flaws in Obamacare, and it won’t fund a wall across the Mexican border. Of course, if none of those happen, Wall Street must not care all that much. However, if interest rates do rise and debt service costs rise, the budget deficits will balloon. At some point, gridlock will lead to big problems. We don’t know how President Trump will act in a world where some Democratic support and compromise are required. But we will start to get a lot of hints over the next few weeks. Not only will the dreamers move front and center, but there will be a State of the Union Address, a preliminary budget for fiscal 2019, an outline of an infrastructure plan and even a possible roadmap for entitlement reform.

As we learned from the last six years of the Obama Administration, agendas don’t necessarily reflect reality. The same may hold true for the Trump administration. But for the last few weeks, investors have been feasting on all the good tax and economic news without considering some of the problems that may lie ahead. Once we get past earnings season toward the end of this month, the difficulties of getting anything else done will become a more sobering reality. It has never been more difficult to figure out the mood of the nation than it has over the past 12 months. As I have often cautioned, we shouldn’t mix political and economic moods. The latter has clearly been persistently brighter. But the two aren’t mutually exclusive. Until now, there was no need for Republicans to even listen to anyone else. Right now, growth is good at 3%+, inflation is low, the dollar is weak, and no political hotspots around the world are threatening to explode. The question is whether or how long that set of conditions can hold. It is hard to imagine things getting a whole lot better. But, of course, they can stay the same for a long time. It isn’t time to get bearish, but I think it is time to get cautious. Weeks like last week can make us too complacent. Steady 3% + growth with no inflation isn’t automatic. If that picture changes, the mood of financial markets will change as well.

Today Kim Jong-Un is 34. Stephen Hawking is 76. It is also the 83rd anniversary of the birth of Elvis Presley.

James M. Meyer, CFA 610-260-2220

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