Donald J. Trump became our 45th President today. On this historic day we paused to watch the ceremony and now we move on to speculate what investors will do as the policies of this new administration take form. Time will tell if the Trump administration can implement all the changes promised since November.
Ronald Reagan said the most dangerous words in our language are “I’m here from government and I am here to help”. Reagan believed less government is better and government gets in the way of individual progress and economic growth. Donald Trump agrees and promises to reduce regulation, lower taxes and rebuild America. Trump’s unorthodox communication style and threat to change the way business is done in Washington has many on edge.
The longer the changes are debated before enacted, the greater the uncertainty and the more volatile the stock market. To offer a precise outlook is virtually impossible. We do not know what Donald Trump will say next or what legislation is likely to get passed in 2017. Both will impact stock prices as the dramatic change in administrations presents uncertainty. What we do know is that corporate earnings and profits ultimately determine stock prices. Rhetoric from Washington and legislation that impacts corporate earnings will play a large role in determining stock prices this year.
What is the case for a strong stock market? The market, meaning the S&P 500 Index, is not undervalued, trading at 17 times 2017 expected earnings. It is doubtful the market will have a positive year if corporate earnings remain where they are today. However, tax cuts would give an immediate boost to most companies’ earnings, which in itself could be the impetus to move stock prices higher.
A corporate tax cut, with a reduction in Federal spending or increased revenue elsewhere, would be positive for the market and provide opportunity for further stock price advances. Trump and the Republicans vow to take aim at some deductions and tax imported goods. We don’t know how all this will play out, but less taxes overall is good for stocks and reduced taxes tend to get passed on to shareholders in dividend increases and share buybacks.
Many US, multinational companies hold a high percentage of their cash and trillions of dollars outside the US to avoid paying tax if they bring it home. If the tax rate on the balances brought to the US were reduced by tax reform it would be an incentive to bring the funds home. For example, Microsoft would save over $20 billion if their overseas cash was taxed at 10% versus today’s rate of 35%. This repatriated cash is likely to go towards increased dividends, share buybacks, mergers and capital expenditures. There seems to be wide spread agreement that this would benefit our economy and shareholders.
Taxes are only part of the earnings story and other Trump comments and promises, as well as legislation, will play a role. If we rebuild America’s infrastructure then material, energy and construction companies should do well. These stocks have risen since the election on this promise but could move higher if spending to rebuild America becomes reality. On the other hand, companies such as Caterpillar and Boeing have been strong and will be at risk if the spending does not materialize.
Trump often compares himself to Ronald Reagan. Reagan took office as interest rates were poised to decline from very high levels. The economy tends to do better as rates decline when borrowing is more affordable. Trump takes office as historically low interest rates begin to climb, the opposite of the Reagan era. This could dampen economic activity and make it more difficult to cut taxes and boost the economy as promised.
Debt levels in the 1980’s were relatively low. This is not true today. Trump inherits a government debt level at historic highs! The budget deficit today is over 100% of GDP which means that if lower taxes are not offset by spending cuts elsewhere our county’s debt level will be unmanageable. We have too much debt for Trump or the Republican Congress to offer meaningful tax cuts without a plan to reduce spending. This will set in as Trump’s election promises and initiatives are debated. Trump wants to tax like a Republican (lower taxes) and spend like a Democrat. He might get what he wants or reduce spending but the uncertainty created by the debate could cause stock market volatility.
Banks are beneficiaries of less regulation which Trump promises. Legislation limits banking activities such as lending and is costly in terms of compliance. Relaxed legislation at the same time interest rates rise, which increases profits on loans, would be a catalyst for increased earnings and higher stock prices. This wasn’t lost on investors after the election and these stocks have moved 11.5% higher since then. It is likely banks and financial services stocks will continue to do well if the legislative changes materialize and interest rates rise. CNBC says we will have “financial crisis amnesia” as rates move higher and banks ink strong results.
Not all companies are expected to benefit post Trump’s inauguration. Concerns exist for healthcare and biotech companies if drug prices are reduced as feared. However, the healthcare sector was down before the election as Hillary Clinton promised even more controls and concerns were heightened that we were moving toward a single payer system. The unknown replacement for the Affordable Care Act adds uncertainty, another headwind for these stocks. However, it is entirely possible the fears around the healthcare sector are priced into the stocks and any sign that worries are overblown, together with promising drug approvals, could lead to positive stock price performance. Demographics also support this sector. The oldest baby boomers turn 70 this year and spending on healthcare is expected to rise dramatically.
Retail stocks are under pressure and the dialogue over taxation of imports adds to the existing weakness as the industry shifts to an on line distribution model. If all goods imported to the US were taxed on entry then a good deal of merchandise sold by such retailers as Wal-Mart and Best Buy would be taxed. This would significantly increase their costs which would reduce their profits if these costs could not be passed on to consumers. Like healthcare stocks, retail stocks may already reflect the worst case scenario. It is unlikely there will be agreement on taxation of imports any time soon because Donald Trump and the Republicans do not agree on how best to encourage more US manufacturing. Taxation of imports would be a major departure from our traditional tax program. It is possible but any change of this magnitude would likely be debated for some time.
Stock Market Outlook
Stocks prices are reacting to the latest headline or Trump tweet but company fundamentals will always play a critical role. The truth is that the stock market started to move before Trump won the election. Domestic corporate profits moved higher by over 9% in the third quarter 2016 vs. the second quarter and we are now moving into the reporting of fourth quarter 2016 results which look OK. Our economy is beginning to show real signs of strength, with unemployment at 4.6%, wages moving higher and consumer confidence high. The market move since the election has been dubbed the “hope rally”. Promises of higher growth, more infrastructure spending and lower taxes follow strength in the economy and a stock market rally that began last summer.
This is indeed a rosy picture! What are the roadblocks to another double digit year in the stock market? The Federal Reserve raised interest rates and has promised to continue to raise rates multiple times in 2017. Many years of very low interest rates have fueled growth in the stock market as investors took more risk in the pursuit of yield. Corporate earnings were relatively weak in late 2015 and early 2016 due primarily to problems in the energy and financial services sectors and both are now stronger. If corporate profits reverse and are again weak the stock market will react negatively. This isn’t likely.
We can’t predict what will happen when interest rates on cash and bonds move back to more normal levels because we have never seen such an extended period of Fed easing. Low interest rates have clearly boosted returns on risky assets. Will higher rates reverse this trend? The common thought is that if the economy is strong, corporate profits will be strong and the market will continue to do well on fundamentals. Tax reform is an added incentive for stocks to do well but higher interest rates will be a problem if corporate earnings don’t hold up.
Another risk to higher stock prices is the value of the US dollar which has been at the highest level since 2002. Weaker corporate earnings in recent years demonstrate that a higher dollar is not positive for US companies with global revenues. 48% of the revenues for S&P 500 companies come from outside the US. These revenues from overseas are “translated” into US dollars for accounting purposes and have the effect of reducing reported earnings if the dollar is high. If the dollar stays high then corporate profits will be lower. This will dampen stock price performance.
The US stock market is in unchartered waters. There are many reason to believe stock prices will react positively to Trump’s agenda if implemented. There are also reasons for concern. When there are crosscurrents and no clear direction in the market it is best to maintain a disciplined, unemotional approach. Our stock market has climbed a wall of worry, investors hold large amounts of cash which is positive and mutual funds own less stocks than in the past. Positive news, tax reform or a dip in the market would be catalysts for investors to put cash to work and buy stocks.
It is highly possible stocks will continue to be favored in 2017 over bonds as higher interest rates drive bond prices lower. Our stock market should hold up if our economy continues to grow, corporate profits do well and tax reform is debated or enacted. There are a lot of “if’s” here. It is virtually impossible to “call” a stock market with so many competing influences but exiting the market out of fear is not advised. As we said last January, “fear is not a strategy”.