The Party Is Not Over

One of the lead articles in the weekend Wall Street Journal was entitled “Declines in Stocks, Junk Bonds Reveal Cracks in Global Rally”. Really? The market has risen for 8 straight weeks and declined less than 1% last week. All this is after the Senate released its version of tax reform postponing the effective date of implementation until 2019 while offering carrots in 2018 such as full deductibility of capital expenditures.

The key question for investors is whether there will be major tax reform in the foreseeable future, not when it will begin. And the answer is a resounding yes. Here’s why. Besides being the right policy decision that both parties should support in one form or another, the Republicans’ risk losing control of both the Senate and House having made tax reform the cornerstone piece of legislation to “Make America Great Again”. So, self-interest will prevail in the end. This message was reinforced by the elections this past Tuesday where the Democrats won most elections.

Both bills will pass in their respective chambers and then work will begin on a reconciliation process to weave them together. Then, it would be voted on in each chamber and placed it on the President’s desk to sign into law. Let’s hope that the final bill will incorporate the best parts of each respective bill.

Business tax reform should be effective in 2018 reducing the corporate rate to 20%; pass-throughs would be limited and mostly benefit small- to medium-size businesses; offshore earnings would be taxed at 12% on cash and 7% on non-cash holdings; carried interest tax breaks would be cut back and the holding period extended to 3 years; interest deductibility would be limited to 30% of adjusted taxable income penalizing excessive leverage even though it could hurt the weakest parts of the junk bond market; municipal bond financing would be limited; and finally, capital expenditures could be totally written off against income for at least 6 years.

Individual tax reform should include: 4 tax brackets with the highest at 39.6%; property tax deduction up to $10,000; maintaining interest deductibility on primary homes up to $700,000; doubling the exclusion for estate tax; preserving medical and student loan interest albeit with caps; doubling the standard deduction; eliminating the alternative minimum tax and raising the child care credit to $1600 per child.

The final bill must limit tax cuts to $1.5 trillion over 10 years without dynamic scoring. Clearly tax reform will benefit our economy in many ways even though its impact may not be as pronounced as many think. Tax reform, regulatory reform plus Trump’s trade policy will benefit economic growth here. Remember that we invest at the margin looking for both positive changes for our longs and negative changes for our shorts.

Trump’s trip to the Pacific was the other important event of the week. While I was disappointed that nothing substantive came out of the meetings in Japan, South Korea, China, Thailand and finally Vietnam, it was important that Trump solidified his relationship with world leaders including Putin.

Let me say one thing about global trade and the U.S. position versus almost all others. When your country is running a $500 billion trade deficit, you have little to lose demanding a level playing field and more balance. However, if you were running a multi-hundred-billion trade surplus, I also would be calling for more openness in all markets. Now can you understand Trump and Xi Jinping’s speeches on multilateralism and globalization at the Pacific Rim summit? Again look at the margin for change. Who is apt to benefit and who is apt to lose? Can China really offset lost trade with us with the rest of the world? Over time perhaps, but not quickly. And what is a TPP deal without its most important partner, the U.S.? Think about it! The U.S. can only improve its trade deficit, which will add to growth. Think at the margin.

Let’s take a brief look at specific economic data points to see if they support or detract from our current positive investment thesis: global economic growth continues to accelerate without the normal inflationary pressures; interest rates remain incredibly low for this stage in a global economic recovery; the yield curve flattened somewhat and weakened after the Senate issued their tax reform bill postponing implementation until 2019 and earnings reports continue to knock the ball out of the park.

1.) Virtually all economic indicators support that 4th quarter economic growth in the U.S. will exceed 3%: consumer sentiment was 97.8 in November, slightly below the previous month which was a 13-year high; the indices of consumer comfort, personal finances and buying intentions remained at multi-year highs; and the Consumer Conference Board Employment Trend index bounced back in October to 135.6 after being hit by the impact of the hurricanes in August and September.

Earnings reports continue to exceed most estimates and managements’ remain optimistic that the best days are ahead.

2.) The EU officially raised its forecast to 2.2% in 2017, 2.1% in 2018 and 1.9% in 2019, all above previous forecasts while lowering its inflation forecasts to 1.5% in 2017, 1.4% in 2018 and only 1.6% in 2019. It was interesting to note that Eurozone budget deficits will fall below 1% in 2019. A measure of job creation rose to its highest level in 10 years while new orders expanded at its fastest pace in more than six years.

It’s interesting to note that eastern European growth is at its fastest pace since 2008 and its growth will exceed that of Western Europe.

3.) I am sure that all of you are following events in Saudi Arabia along with the continued move up in the price of crude. While I expected oil prices to rise into the monetization of Aramco, I did not expect the ruling family to consolidate power and arrest many of its influential and wealthy family members. Big change is in the air as the 32-year-old crown prince, Mohammed bin Salman, assumes more control.

So where does this all leave us and what, if any, changes are we making to our regional emphasis, capital allocation and specific investments?

We see nothing on the horizon that will shift our current investment view so lag as the wind remains to our back. The global monetary authorities are providing more capital to the system than needed by the economy thereby supporting financial assets. While growth is accelerating, inflation is not and interest rates remain remarkably low. We still expect the yield curve to steepen and the dollar to strengthen as passage of a huge tax reform bill gets closer. Individual and businesses like certainty and finally passing tax reform will unleash spending that has been held up not knowing whether a bill would be passed and what it would include.

The bottom line is that the party is not over.

We continue to emphasize financials, global industrials, low cost, financially strong industrial commodity stocks including domestic steel and aluminum, technology at a fair price to growth and special situations, which will be revalued over time due to internal dynamics. Our shorts include those companies penalized by the disruptors.

So remember to review all the facts; step back, pause and consider mindset shifts; analyze our capital allocation with risk controls; do independent research and …

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

 

 

 

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