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Brian Andrew, CFA

Stocks and the Freedom Caucus

With the removal of the health care bill from the House floor on Friday, Speaker Paul Ryan acknowledged that the system of governing has gotten more complex. In his press conference, he noted that Republicans have been an “opposition party” and now they have to learn how to “govern.” Sunday, the president used his Twitter account to lay blame at the feet of the Freedom Caucus, saying, “Democrats are smiling in D.C. that the Freedom Caucus . . . saved . . . Ocare!”

The bill’s defeat and these comments emphasize the fact that U.S. politics are not really about two parties any longer. Rather, there are factions within each party that have become more organized and vocal. Democrats, too, have a similar divide between moderates and the more liberal faction led by Senator Bernie Sanders and like–minded colleagues. Because the potential for a new fiscal policy assisted in pushing the stock market to new highs earlier this year, it is worthwhile to look at how the health care legislation’s demise may impact stock prices going forward.

The stock market took Friday’s news in stride because investors believe that the administration and Congress can now move on to tax reform more quickly. Stock investors are looking for new fiscal policies that lower taxes, potentially resulting in better economic growth and stronger corporate earnings. Where we go from here isn’t exactly clear, but there are likely implications for stock investors as a result of last Friday’s political outcome.

Tax Reform

With the demise of new health care legislation, tax reform seems to be the next big policy issue the president and Congress will take on. Stock investors are enthusiastic about the benefits of tax reform. In fact, estimates suggest that there is $8 to $10 per share in additional earnings for the S&P 500 Index companies in the first year after the reform. Multiply this by the index’s forward multiple near 18 and you get an additional 144 to 180 points in the index. The S&P 500 Index closed Friday at 2344, up from 2085 the day before the election.

Whether looking at President Trump’s tax reform plan or that of the House Speaker, there are some similarities. They would both like to reduce the tax rate on corporations and individuals. They would both like to simplify the tax system for individuals by reducing the number of rates and deductions. However, the biggest difference between the two now takes on more significance with the defeat of the health care legislation before it even came up for a vote.

During his campaign, President Trump offered a tax reform proposal that provided for a reduction in individual and corporate taxes that would add up to $6.5 trillion over 10 years. However, it did less to reduce or eliminate deductions and was predicated on the belief that lower taxes will raise the economic growth rate enough to pay for the reform. Trump’s plan provides offsets to the reduction of only $1.2 trillion, leaving a deficit of $5.3 trillion, or $530 billion per year for 10 years.

Unlike the president’s plan, which relies on economic growth, the House Speaker’s plan reduces taxes by providing for more reform measures that would ultimately help pay for the tax cuts. This includes eliminating some deductions and adding a border–adjustable tax (BAT). The plan proposes a reduction in taxes of $8 trillion over 10 years. Through the elimination of deductions and the new BAT, it raises revenue by $5.6 trillion and results in a net deficit of $2.4 trillion, or $240 billion per year — less than half of President Trump’s proposal.

One of the other major proposals in the Speaker’s plan is the ability to allow companies to expense 100% of a business investment in the first year. The hope is that this would increase their interest in investing back into their businesses, creating more growth and jobs. This proposal alone is estimated to be worth over $220 billion per year. Proposals like this and the elimination of the alternative minimum tax for individuals are meant to reform the tax code, not just reduce taxes.

And that’s the rub. Is it possible that the fractious nature of the Republican and Democratic Parties makes it more difficult to reach meaningful compromise on reform? Does the fact that one of the Republican Party’s most important pieces of legislation can’t even make it to the floor for a vote suggest that tax reform won’t happen? Does it make it more likely that taxes are reduced, however not by as much as either plan suggests?

We think that as new fiscal policy regarding taxes happens, the likelihood of greater reform probably diminishes. Deeper tax cuts will be difficult to get past the fiscally conservative Freedom Caucus. Still, most Republicans and some moderate Democrats are in favor of a reduction in taxes and a simplification of the system for corporations and individuals.

It is possible that Republicans approach tax reform more carefully and therefore the size of it becomes smaller. One bit of good news is that the likelihood of getting something done before the August recess is now higher. There is also some chance that the taxes associated with health care reform are addressed in any tax legislation that comes out.

All this could mean that the $8 to $10 in additional earnings is a bit optimistic for the S&P 500 and so prices may have become too optimistic. We will have to see how Congress picks up the pieces in the weeks to come.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.