Unleashing Corporate America
The House Republicans unveiled their tax reform program this past week. It is clear that the cornerstone behind Trump’s pro-growth, pro-business agenda is reducing corporate taxes to unleash corporate America and all foreign corporations that build plants here too.
The main thrust will be a corporate tax rate of 20% while giving added incentives to spend on plant, equipment and research which go hand in hand with less burdensome regulations. Also there will be a tax incentive to repatriate the over $3 trillion in cash held abroad. There was an interesting proposal in the bill limiting tax deductibility of interest to 30% of a modified measure of cash flow. Interest expense is less than 10% of S&P EBITDA so the impact will be minor for most corporations.
While the House tax reform proposal clearly emphasized corporate tax reform, there were a number of changes on the individual tax side primarily benefiting the middle class. The major points were:
- Four tax brackets instead of seven, maintaining the top bracket at 39.6%
- A $24,000 standard deduction for family filers
- A top tax rate for pass-through businesses of 25% while limiting types of income that would qualify
- The alternative minimum tax would be repealed
- Deductions for state and local income tax would be repealed replaced with a $10,000 cap on property taxes
- Home mortgage interest would be capped at mortgages of $500,000, and
- The child tax credit would be increased to $1600.
The goal of the Republican tax proposal is to encourage businesses to spend on plant and equipment here, as it could be immediately expensed rather than over the life of the assets, and to hire employees to fill the new needed positions. Lowering corporate taxes and reducing regulation are meant to impact/change the U.S. and foreign corporate board/management decision-making process on deciding where to build incremental capacity. This attempt goes hand in hand with Trump and Wilbur Ross’ trade policy, which has already led to many foreign companies announcing new plants in the U.S..
The Republicans will make tweaks before the vote in the House while the Republicans in the Senate will introduce their own tax reform version this week. I am confident that both bills will move into conference and a reconciliation bill will emerge before Christmas and be passed by early next year. I doubt this bill will be retroactive to 2017.
The other major event of the week was Trump’s announcement that Jerome Powell will be the next head of the Federal Reserve replacing Janet Yellen. He was a safe choice and will follow a similar moderate path of monetary policy as did Janet Yellen who I applaud for having done an excellent job. The one area of difference is that he may accelerate financial reform to the benefit of banks. It is interesting to note that he is not a trained economist but a former partner in several private equity firms having also served in the Treasury as an attorney.
Let’s review the data points that came out last week to see if they support or detract from our view that the global economies continue to accelerate without inflationary pressures; monetary policy remains accommodative; interest rates remain unusually low for this point in an economic cycle; the dollar continues to rally; industrial commodity prices including oil continue to strengthen and finally corporate earnings in total are exceeding expectations with forecasts of better growth ahead.
1.) Economic data out of the U.S. support our contention that the U.S. will be the engine of global growth in 2018: consumer spending rose by1%, the largest gain in 8 years; consumer income rose by 0.4% while the consumer price gauge excluding food and energy rose only 0.1%; consumer confidence rose to 125.9 in October, a 17-year high; property values rose 5.9% year over year enhancing consumer wealth; the employment cost index rose 0.7% in the third quarter and 2.5% year over year; auto sales soared to an 18.1 million annual rate in October boosted by hurricane replacement sales; the ISM Manufacturers Index stood at a strong 58.7 while the ISM Services Index remained at 55.3; workers’ productivity accelerated to 3.0% in the third quarter, the fastest gain in 3 years; the U.S. trade gap expanded modestly to $43.5 billion in September also impacted by the hurricanes and finally nonfarm payrolls rose 261,000 in October while average annual earning actually declined 1 cent and are up only 2.4% year over year.
As expected, the Fed left short-term interest rates unchanged last week but strongly hinted at an increase in December. Officials continued to note that inflation is remaining below forecasts. No surprises here!
We expect the fourth quarter to exceed 3%.
2.) Economic activity continues to surprise us on the upside in the Eurozone. It appears that Eurozone GNP rose by 2.4% in the third quarter, down slightly from the 2.6% rate of gain in the second quarter. Inflation continues to remain well below the ECB target of 2% coming in at only 1.4% in October from a year ago down from 1.5% year over year increase in the previous month. Draghi, the ECB and all monetary bodies remain puzzled why inflation has not picked up as economic growth has accelerated. They just don’t get it. Change is everywhere with disruptors popping up every day in new industries causing tremendous price pressure on the more established players. This will not change anytime soon!
Finally Eurozone confidence rose to a 17-year high in October hitting 114.0 despite the ECB lowering its pace of government bond purchases.
3.) The BOE raised interest rates for the first time in 10 years to restrain inflation even though the economy continues to struggle due to Brexit. It should be noted that the BOE lowered UK’s growth potential to 1.5% a year down from its former forecast of 2%-2.25%. We would consider investing only in in UK’s multinationals, which are benefiting from a weak currency and strong growth overseas.
4.) The BOJ maintained its aggressive bond purchase program despite accelerating growth as inflation is far beneath its targets. A familiar theme everywhere!
5.) There are no surprises out of China with the Caxin manufacturers PMI coming in at 51.0 in October. Pay close attention to the government’s comments on increasing bank liquidity and capital ratios while attempting to reduce speculation and bad debts. It is the quality of growth that counts now more than the speed of growth. Notwithstanding the Chinese economy will continue to expand greater than 6% in 2018. Not bad by anyone’s standards!
I suggest that you read Alibaba’s comments last week about the strength of the Chinese consumer as spending continues to accelerate. Yes, we own the stock for the long term as the Chinese economy shifts to the consumer and technology shifting away from production.
Let’s wrap this up:
Clearly this was an event driven week led by the probability of tax reform passing Congress and being signed into law. I expect the Republicans to universally support the final bill, which will assure passage, as the party definitely needs a win going into the 2018 elections. The Democrats have a real problem if they stand together against this bill, as the party will be labeled obstructionists without offering any real alternatives as we enter the election season. I expect a large infrastructure bill to follow closely behind tax reform as we all agree that this country must rebuild to move forward and compete globally.
Finally watch closely what comes out of Trump’s trip to the Pacific. I see tremendous opportunities for him to move forward his trade agenda with Japan and China, as all sides want to avoid confrontation. I also expect China to pledge its support reducing tensions with North Korea.
The bottom line is that the path of least resistance for the global stocks markets remains up as the global economy accelerates without inflationary pressures; interest rate stay remarkably low and earnings improve as both volume and operating margin increase while fixed cost stay contained. And there is the tax bill as icing on the cake.
Just one word of caution as not all markets nor asset classes nor all industries nor all companies will participate, as change is everywhere. Remember to look through that proverbial windshield rather than at the rear-view mirror.
Paix et Prospérité continues to outperform all indices. Our portfolios are over-weighted financials, global industrials, industrial commodities, technology and special situations.
Review all the facts; pause, reflect and consider mindset shifts; consider the proper asset allocation with risk controls; do independent research and…
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