Equities : Will Tax Reform Difficulties Halt U.S. Equities?

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10/16/2017 | 11:37 am
It’s a dangerous game to speculate that any negative event will halt the rally in U.S. stock indexes.
It’s a dangerous game to speculate that any negative event will halt the rally in U.S. stock indexes. Consider the following list of “cataclysmic” events that were supposed to have caused an equity market correction:

• Brexit
• Frexit
• Grexit
• Italian referendum
• Rise in interest rates
• Cessation of QE
• Terrorist attacks
• Trump election
• Trump inauguration
• Investigation into Trump’s Russian dealings
• Failure of healthcare reform
• Market not trading on fundamentals
• Low volatility
• Record high margin debt
• Hindenburg omens
• Syrian missile attack
• North Korea
• Record hurricane damage in Houston, Florida, and Puerto Rico
• Catalonia independence

While the fate of Trump’s “greatest tax reform of all time” is very uncertain, a market participant observing the daily record highs on the U.S. indexes would have a hard time deciphering the risk of tax reform failure being price in by the markets.

This past week Trump took to Twitter to insult Bob Corker, a Republican senator whose vote is needed for tax reform to pass. Already, assuming that Democrats in the senate will remain solidly against anything Trump does, the upcoming vote can only lose two Republican senators. Congressional Republicans are going to fast track tax reform legislation to force the bill through Congress. We saw how successful this technique was with healthcare reform: senators John McCain, Rand Paul and Susan Collins opposed the bill which became dead on arrival.

Currently, Corker has emerged as a harsh critic of the president, and said he doesn't want the tax package to add to the deficit, a fiscal hard line that may be tough to comply with. Rand Paul has also signaled his concerns with the plan.

No bill has been released as of October 13, and Trump told reporters that the plan would be adjusted over the coming weeks. We already know that the 15% corporate tax rate is scrapped (Trump is now hoping for 20%, and the markets seem okay with this). Here are some of the possible changes to the federal tax code:

• Collapse the current seven tax brackets into three, paying marginal rates of 12%, 25% and 35%. The framework does not specify what income levels these rates would apply to. It also leaves open the possibility of adding an additional top rate "to ensure that the reformed tax code is at least as progressive as the existing tax code."

• Raise the standard deduction to $24,000 for married couples filing jointly (from $12,700 in 2017 under current law) and to $12,000 for single filers (from $6,350). There is no mention of the standard deduction for those filing as heads of household (currently $9,350), meaning the filing status – which benefits single parents – could be eliminated, as the Trump campaign proposed in its revised 2016 tax plan.

• Scrap the personal exemption ($4,050 per person, subject to phaseout at higher incomes).

• Introduce a "more accurate measure of inflation" for tax indexing. The Internal Revenue Service (IRS) currently uses the Consumer Price Index for all Urban Consumers (CPI-U), which both the Tax Policy Center and the nonpartisan, right-leaning Tax Foundation assume would be replaced by the chain-weighted CPI-U. The latter takes account of changes consumers make to their spending habits in response to price shifts, so it is considered more rigorous than standard CPI. It also tends to rise more slowly than standard CPI, so substituting it would likely accelerate bracket creep. The value of the standard deduction and other inflation-linked elements of the tax code would also erode over time.

Our two cents says that there is a double risk for equities with tax reform. First, we get another healthcare reform debacle. Either no bill is forthcoming or some watered-down comprise bill, far from Trump’s campaign promise, is voted. It’s hard to imagine equities not selling off, at least to some degree.

The other scenario is that the Republican tax plan is passed in the form Trump has advertised (seemingly an unlikely outcome at the moment). Given how tax reform has been priced into equities over one year (we assume that the Dow is up +30% since the election mainly due to the prospect of tax reform) the “buy the rumour, sell the news” outcome would seem likely.

In sum, the risks facing tax reform seem to out-weigh the additional upside equity market potential from a successful passage of the bill. Tax reform has be so discussed and analyzed by the markets that we can not imagine adoption of a new tax code becoming a catalyst for another equity rally.

More Disbelievers

Tax reform aside, this week we read that two more high-profile nay-sayers are warning about equity risks, and in the meantime adding more fuel to the equity fire.

First, famed bank analyst Dick Bove is saying that the market is just as dangerous as the late 1990s and that bank stocks could coming crashing down.

According to Bove, "If you go through the different products that the banks sell, just about every one of them are flat to lower in growth than they've been for at least a couple of years". Nevertheless, he maintains a buy rating on many banks and says that investors need to go with the flow. Sounds like he is covering his you know what.

Next, recent Noble Prize winner Richard Thaler said that “we seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” He admits to not understanding it.

Thaler, who has made a career of studying irrational and temptation-driven actions among economic actors and won the Nobel for such contributions to behavioral economics, expressed misgivings about the low volatility and continued optimism among investors. His comments on tax reform seem logical (to us) and are worth repeating:

“I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market and if the gains are based on tax-reform expectations, surely investors should have lost confidence that that was going to happen. The Republican leadership does not seem to be interested in anything remotely bipartisan, and they need unanimity within their caucus, which they don’t have. And the president’s strategy of systematically insulting the votes he needs doesn’t seem to be optimizing anything I can think of, but maybe he’s a deeper thinker than me.”

We agree that it is curious where anyone would get confidence that tax reform is going to happen. But the markets really seem believe that the Trump tax reform is a sure thing.

Thaler half-jokingly said that “Trump’s ratio of certitude to knowledge is nearing record highs”. If this stock market rally is mainly predicated on Trump’s tax plan, then watch out!

In Case You Blinked

While investor focus has been on the high-flying Nasdaq Index and Dow Jones Industrial Average, the S&P Oil & Gas Equipment & Services index (XES) is quietly enjoying a bull market, rising +28% over the past month. This is little cause for rejoicing if you are been playing these oil stocks since the beginning of the year, down -45% before the recent rally. Oil stocks may have lots of upside potential to return to 2014 highs, but until the long-term trend turns up oil bulls will need to get used to sharp rallies followed by sharp declines.



And for those hoping to buy the oil sector and ride the market back up to 2014 levels, think again. An economist this week warned that oil’s long-term target price is $10/barrel. His reasoning – with more and more countries adopting legislation to phase out combustion engine cars by 2030 or 2040, oil demand will drop off. Recall that over 70% of oil is used in transportation. Just something to keep in mind.

Trump Knows Stocks?

One final tidbit that irks us is Trump taking credit for the stock market rally when in the presidential debates he identified the stock market as being in a bubble. Trump knows real estate development, healthcare, jobs creation, and tax reform (among many other things, undoubtedly). But unlike Bo (who admittedly does not know hockey), does Trump really know the stock market?

The president is marveled by the rally in the U.S. stock market since his election! Trump is even bemoaning that the media is not focusing more time on his stock market rally. On Wednesday Trump tweeted:

“It would be really nice if the Fake News Media would report the virtually unprecedented Stock Market growth since the election. Need tax cuts”

The chart below compiled by Bloomberg seems to refute Trump’s “unprecedented” claim.



Going by the pace of gains, the 19% increase in the S&P 500 since Trump’s victory trails six previous cases. While the $4.4 billion in market value created is indeed a record, this is also a function of the size of the overall market value at the time of the president’s election. The rallies after the elections of Kennedy, Roosevelt, etc would have created more market value if they had inherited a stock market with a capitalization of $24 trillion. But we’ll say that Trump knows stocks to make him happy.
Owen Williams
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