Tax Reform and the 2018 Market Outlook
Clients of the Firm,
A new US tax bill was signed into law just before Christmas in 2017, bringing with it a myriad of questions and considerations as we enter 2018. The impact of the tax law on the stock market, bond market, and Fed is still uncertain at this point, but initial indications is that it is positive. Entering 2018, the stock market is at all-time highs. We continue to see the prospect of future potentially positive economic news fueling further gains, although at a more measured pace. Finally, the likelihood of higher inflation and higher interest rates has increased for the coming year as synchronized global growth and the Fed’s tightening policy begin to have impact.
Stock Market Impacts of the Tax Bill
The market began to price in the likely prospect of lower corporate tax rates in November of 2017. At this time, we saw a trading shift towards equities, particularly those with higher tax rates, away from fixed-income. This rotation should not be a surprise as the highest corporate tax rate was previously 35% and is now 21% under the new law. To put the impact simply, this means that most companies that paid the top rate will, by definition, have improved earnings due to the lower rate, all else equal.
In addition, repatriation of overseas profits will likely result in a combination of share repurchases, dividend increases and increased domestic capital expenditures, due to the accelerated expensing provisions in the law.
To be clear, the domestic stock market has priced in a good amount of these positives into the earnings forecast for 2018. As a result, the forward P/E ratio of the S&P 500 stands at 20.02. Normative valuation for the forward P/E tends to be around 18 times. Therefore, current levels imply investors' willingness to either pay up for earnings or their expectation that earnings will be considerably higher than current forecasts.
The risk that investor expectations for earnings are wrong should not be ignored. That said, the macro backdrop is supportive of future earnings growth and certainly of maintaining current forecasts. We should never make investment decisions based upon the assumption that multiples will expand. The multiple for earnings is a gauge of market sentiment and not of intrinsic value. Often in a multiple expansion environment, like we see today, it is easier to find investments to sell than it is to find securities to buy.
Breaking with sound valuation methodology can result in investing mistakes, especially if one chases ideas on the basis of the bigger fool theory. This is the theory that I can buy something at any price as long as there is a bigger fool willing to purchase it from me at an even higher price.
These concerns aside, it remains to be seen what the impact of the tax bill will be on consumer behavior and corporate spending. It is our view that these potentially positive impacts are not yet fully priced into the stock market.
The Fed and the Bond Market
The Fed raised rates again in December, as expected, and the range of Fed Funds now sits at 1.25-1.50%. This rate increase has moved short-term bond yields considerably higher. For example, we now see a 2-Year Treasury yielding 1.93%. The longer end of the curve has not moved as much yet, as overseas demand for positive yielding risk-free assets continues to be overwhelming. This fact has kept the 10-Year Treasury at 2.45%. We expect the Fed to raise rates 3 more times in 2018 which would bring short-term rates above 2% for the first time in many years.
In addition, the Fed upgraded its economic forecasts to reflect the likely positive impact to short-term economic growth as a result of the tax bill passage. Risks to this forecast are that the economy unexpectedly slows or fails to produce the necessary velocity to warrant continued rate hikes. Another risk is that inflation fails to achieve the Fed’s 2% target or even falls. Finally, there is a risk that the Fed raises rates too fast, inverting the yield curve. That said, the Fed has the tools to help avoid an inverted yield curve by slowing the pace of rate hikes or accelerating the reduction of its $4 trillion balance sheet, thereby increasing supply of long-term bonds and impacting yields.
Strategically, our forecasted scenario sets up well for short-term bond ladders and short-term US money markets. Under this strategy, as yields rise short-term laddered bonds mature and are redeployed at higher rates, while avoiding duration risk and principal risk. Until the yield curve normalizes at the longer end, this will remain our primary strategy for principal protection and fixed income strategies to benefit over time from higher rates.
Outlook for 2018
The world economy continues to outperform expectations with consensus now between 2.6% to 4% Global GDP growth expected. We are currently experiencing sustained synchronized global growth for the first time since the 2008 financial crisis. This fact bodes well for continued domestic growth, albeit at a lower than “rest of world” pace. GDP growth for the US is expected to be in the range of 2.6-3.0% in 2018. Consensus is the US dollar will likely continue to weaken in 2018, but at a much slower pace than in 2017 as Europe and EM continue to improve. Commodities are likely to increase in price as well as the lag effect of coordinated global easing of monetary policy begins to trigger an inflationary cycle. Commodity prices will also likely see upward pressure due to the increase in demand from synchronized global growth.
This economic backdrop remains supportive of equity fundamentals. There continues to be significant momentum in equity markets with the melt-up happening post tax reform that we predicted should tax reform pass. Our view here is that we will see more measured moves higher in equities unless we see a significant acceleration in economic activity and earnings per share growth. It is our view that there will likely be a correction in equities prices at some time during 2018. This event will likely be a buying opportunity. That said, it may be swift and sharp given the rapid increase in prices we have seen over the past several months. A patient approach, holding some reserve capital, will be prudent to take advantage.
As we said in our last letter, investors often encounter the risk of getting caught-up in market psychology, whether that be overly bullish or bearish. Value investing focuses on making investment decisions based on the fundamentals of an investment and its projected future earnings. We then determine a reasonable price to pay for those earnings that would likely yield a positive investment result. As prices rise, so do the risks of making a bad investment decision. We must remain disciplined on security selection to try not to make one.
As we enter 2018, we do so with the lessons of many years of investing money filed away in our psyche. It is easy to get caught up and even as Alan Greenspan once said get “irrationally exuberant”. We should refrain from doing so and use the market psychology simply as a tool to buy investments when prices are low and to sell them when prices are dear. This measured approached will serve us well when market psychology shifts and opportunities abound as a result.
Peter C. Wernau
Wernau Asset Management
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