Weekly Markets Commentary — March 28, 2017
David Joy – Chief Market Strategist, Ameriprise Financial
With Healthcare Shelved, Tax Reform Takes Center Stage for Investors
The burden of proof for U.S. equities just got a little higher. The failure of healthcare reform means that the job of tax reform has now been made more difficult. And that is what the market cares more about.
The Congressional Budget Office (CBO) estimated that the original House Republican proposal would have reduced the budget deficit by $337 billion over ten years. After certain amendments were subsequently made to the original bill’s tax proposals, the CBO lowered its estimated impact on the budget to a savings of $150 billion. That may not sound like a lot over ten years when the annual budget is approximately $4 trillion. But the procedural requirement of passing tax reform without Democratic support requires that it be revenue neutral. Every lost dollar makes meaningful tax reform a little harder.
The other large revenue producer under the House plan also appears to be losing support. The so-called border adjustable tax (BAT) that taxes imports while exempting exports was being counted on to raise $1 trillion in tax revenue, enough to allow the corporate tax rate to be reduced to 20 percent from the current statutory maximum of 35 percent.
In April of last year, the Government Accountability Office (GAO) estimated that the effective Federal tax rate for large U.S. corporations between 2008 and 2012 was close to 26 percent, although estimates of the effective tax rate vary by the universe of companies included, and the methodology employed.1 But if the BAT is eliminated, it becomes extremely problematic to find that revenue elsewhere. If it cannot be found, then the size of the tax package would have to be reduced. And if the corporate rate can’t be reduced much below the current effective rate, then the impact on earnings will fall short of expectations.
In early December, assuming an effective tax rate of 29 percent, Standard and Poor’s, among others, preliminarily estimated that a 5 percent reduction in the effective corporate tax rate would increase 2017 corporate earnings by 5.6 percent, with a potential 10 percent reduction obviously doubling that amount.2 That meant if everything fell into place, tax reform could result in a sizeable boost to earnings that were already expected to grow by a strong 11.8 percent. Investors took note, and since the election the S&P 500 is higher by 10 percent and its forward price earnings ratio has risen to 17.5X, compared to 15.9X in November, just prior to the election.
The question is how much of that 10 percent climb is attributable to expectations for corporate tax reform, and are those expectations too optimistic? For starters, 2017 earnings are no longer expected to grow by 11.8 percent. Factset calculates that earnings estimates have declined 2.5 percent since early December.3 This pattern is not unusual, but it does lower the base upon which tax reform would exert a boost. And now, in addition to questions surrounding the likelihood of border adjustability surviving, we have the defeat of healthcare reform, and new questions about the ability of the Republican Party to quickly pivot to tax reform and rally behind a package that can be passed without Democratic support.
Markets rallied on Friday after the healthcare reform bill was pulled, not because reforming healthcare was unpopular, but rather because this bill was unacceptable to too many and had become a distraction. Once it became clear that it could not pass, investors seemed relieved that it would be shelved and the path cleared for work on tax reform.
But the sense of momentum has slowed. And as investors reassess the chances for robust tax reform, and when it might take effect, will they conclude that their expectations have been too optimistic? The Trump Administration can take a different route. If it feels too constrained by the reconciliation process, it could chose instead to pursue tax reform despite its impact on the deficit. But given the fiscal hawks in the Republican Party, the chances of success are questionable.
The economic data of late has been generally solid. Job growth has been strong and wages are growing, and housing is firm. Inflationary pressures are firming. The global economy is also improving. Nevertheless, first quarter growth estimates have come down. The GDP Now model of the Atlanta Fed sees growth of just 1.0 in the first quarter, down from 2.3 percent at the end of January.4 Other consensus surveys have also seen estimate reductions, but still anticipate growth near 2.0 percent. Ameriprise Senior Economist Russell Price anticipates first quarter growth of 1.9 percent, and full-year growth of 2.6 percent, followed by 2.7 percent in 2018. That pace should be enough to deliver good earnings growth this year, even without a meaningful impact from policy changes.
If there is to be a rethinking of equity valuations, it should be limited on the downside by these improving fundamentals. But, there is still room for disappointment if tax reform fails to impress.