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Brian Andrew, CFA

Too Early to Tell

Investors and pundits are enthusiastic about the acceleration of economic growth and the potential benefits of tax reform. The stock market has continued the rally from 2017, and despite the fact that we finally saw some volatility this week, returns look more like a months' long rally rather than just four weeks. We think it is important to consider the longer‐term impact of fiscal policies such as tax reform before letting our enthusiasm run away.

The U.S. Tax Reform and Jobs Act presents a similar scenario for the economy, businesses large and small, and consumers. Approved in December, the reform cut the federal corporate tax rate from 35 percent to 21 percent, and already has prompted many companies to propose expanding their operations or to pass their expected savings on to employees via one‐time bonuses or wage increases. And, as the stock market has built upon its remarkable gains in 2017, fourth quarter earnings are reportedly up at many companies. In addition, consumers may benefit from their tax cut and those higher wages.

However, although the reform is in effect, the IRS has yet to finish writing the tax code, which will interpret the legislation and how it will be applied. In the meantime, we can assess the economic landscape and provide some guidance for the reform's potential impact in 2018.

Central Bankers Get Help

Since the financial crisis, global central banks have increased the size of their balance sheets by buying assets and reduced the level of interest rates to stimulate the global economy. All the while, they have admonished their government counterparts to do more in the form of fiscal policy (taxes and spending) to help. This year, global central banks' balance sheets, including the Federal Reserve, European Central Bank, Peoples Bank of China and Bank of Japan, indicate year‐over‐year quarterly growth will decline from its 2017 peak. The early estimate is 2.5 percent growth by the end of 2018, which is the lowest growth rate since the financial crisis. This indicates a hand‐off from central bankers to government policy makers. And this comes at a time when global growth seems stable and inflation is rising slightly.

Government policy makers in many parts of the world are reducing the tax rate, passing labor reforms and eliminating the amount of regulation that businesses contend with. These steps may result in better visibility into the future, which could aid business capital investment and consumption.

Euphoria

U.S. economic growth has averaged about two percent per year since the financial crisis, hitting a peak of nearly four percent at the beginning of 2015. Growth then declined each quarter until the second quarter of 2017, when it climbed and held at three percent or higher until Q4. While it appears that Q4 2017 growth dropped below three percent, expectations for 2018 are for growth to again sustain three percent, driven by solid after‐tax profit increases, more willingness among banks to make loans to both businesses and individuals, consumption and business investment.

Why the strong expectation for continuing growth? Investors believe the U.S. tax and policy changes were needed to create an environment that will speed economic growth. As anticipation of the tax and policy reforms built in the last quarter of 2017, the stock market continued to increase. The tax changes were approved in December and now, as companies begin their Q4 earnings reports, they are talking about the tax benefit to their earnings for 2018. That reinforces investors' belief that earnings throughout 2018 will continue to grow at an accelerated rate.

Here is where we need to pause and take a sky‐high view. There's a bit of euphoria in the markets because people are seeing the positives — the tax cuts, less regulation, higher corporate earnings, wage and benefit increases. We applaud the market's momentum; however, we must keep an eye on potential risks and problems that could change things.

Tax Benefits

First, a breakdown of the tax reform. Under the legislation, the total tax cut will be about $1.4 trillion over 10 years. For 2018, the cut is $181 billion, which represents 0.9 percent of GDP. Of that, $76 billion will benefit individuals — tax savings equal to 0.5 percent of the nation's disposable personal income [DPI]. Among the $105 billion in tax cuts to businesses, $80 billion will benefit corporations, equal to 4.6 percent of after‐tax corporative profits; and $25 billion will benefit small businesses, equal to 1.8 percent of small business profits and 0.2 percent of DPI. [Small business income is included in personal income.]

The drop in the effective corporate tax rate is expected to boost profit margins in 2018. Initial estimates for after‐tax corporate profits for 2017 were $1.777 billion, with a forecast of $1.920 billion for 2018 — an expected increase of eight percent. With the tax cut, the forecast for 2018 has jumped to $1.993 billion, a 12% hike.

However, although the total tax cut for 2018 equals nearly one percent of GDP and is expected to drive economic growth, the impact could be less because not every dollar in tax savings to individuals will actually be spent and not every dollar that goes to businesses will become capital investment. For example, if individuals or businesses use their tax savings to pay off debt, that's not a bad thing, but it may not add to economic growth. If people buy homes, cars or make other consumer purchases, or businesses buy equipment or otherwise expand their operations, the economy will see a boost.

In addition, interest rates have begun to rise for two reasons. First, the Federal Reserve is reducing the stimulus we talked about earlier. They do this by lifting the Fed Funds rate, which they've done once this year and are expected to do so at least two or three more times. Secondly, as expectations for economic growth move higher, inflation expectations move up also. Bond investors fear inflation and sell off bonds, which increases interest rates. As an example, the 10‐year Treasury yield is near a four‐year high.

Over time, higher rates may slow the economy due to higher borrowing costs. It remains to be seen just how high rates may go and what impact this could have on growth later this year.

As we focus on what's ahead in 2018, it's clear the overall news is good so far and is likely to move the economy forward — how much we won't know until we get down the road. We need to be careful not to overestimate the impact and benefits of the tax cut before we have an opportunity to see how those benefits may come to fruition.

Euphoria is a good feeling; however, we need to temper it with patience to see how the economy progresses this year.

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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.