Taxing Into 2018

Wednesday, January 24th, 2018

Whatever the cause, the S&P and especially growth stocks are reaching new heights causing no shortage of concern among the talking heads in the investment world. Much of the chatter concerns President Trump and whether he’s responsible for the surge, will cause its demise or has little to do with it. Although sitting Presidents often get both the credit or the blame, the historical record shows that who’s in the Oval Office matters less for stock market returns than most people realize. Every President going back to Abraham Lincoln has seen pronounced declines and upturns during their administrations, and unlike the current White House occupant, most Presidents commented little and selectively about the performance of the stock market during their tenures. For example, during Theodore Roosevelt’s second term the stock market boomed in 1906 then crashed during the Bankers Panic of 1907. In 1906 with the market soaring Roosevelt spoke of the country’s “ new great prosperity,” but cautioned against “overzealous speculation.” His warning reflected his great antipathy for Wall Street, which he did not disguise, famously referring to JP Morgan and other bankers as “ malefactors of great wealth.” During the 1907 Panic when the market crashed and outraged citizens rioted and broke down the doors of banks and trust companies in New York, President Roosevelt was on an extended hunting trip in Louisiana. When questioned by reporters about the financial tumult, the trust busting President preferred to talk about the animals he had shot, “three bears, six deer, and one wild turkey.” Nevertheless, despite his disagreements with JP Morgan, upon his return Roosevelt put country first and did not stand in the way of his least favorite banker’s bold and successful actions to rescue the country’s banks and the economy. After he left office few years later, in a letter he wrote to a friend in London, Mr. Roosevelt noted that, “during the Panic here many people lost their heads; but of course that is what happens during a Panic.”

Not unexpectedly, Trump gives himself credit for the rally, and the market has roared to a 20%+ gain since the election. Having a Republican in the White House with the party holding a majority in Congress does prompt both Democratic and Republican voices in the investment community to talk about a “more business friendly environment.” But the forces of global earnings growth, low inflation, an accommodative Federal Reserve and a weaker dollar are the more significant contributors. Those forces were in play before Trump was elected and would have continued with a different occupant in the Oval Office. Maybe the time is ripe for an extended Presidential golfing trip and some tweets about his scores.

In the meantime, Trump tweets and shouts superlatives about the tax reform bill, which sadly passed along polarized party lines with no collaborative input. Senator Mark Warner (D-Virginia), a well-known centrist with extensive business experience, told CNBC, “folks like me who spent years being interested in the subject were not invited into the room.” Several conservative economists point out that significant tax reform for individuals is nowhere to be found in the package and an analysis by Trump’s alma mater, the University of Pennsylvania Wharton School showed that federal revenue would decrease by $1.75 trillion in the first decade. The Governors of California and New York believe that the Republican bill targeted their states and predict that people with higher incomes will leave. That echoes a prediction that did not pan out made by Republicans in both states when taxes on high earners were raised in 2012. Most of the changes pertaining to individuals are at best largely an exercise in re-arranging deck chairs, and the carried interest exemption benefitting investment partnerships remains in place despite many calls to remove it. Trump the candidate said he’d remove it once in office: “The hedge fund guys are getting away with murder,” he shouted because their earnings from money management are taxed as capital gains instead of income. It should be noted that when there was a Democratic majority in Congress, there were repeated calls to remove the carried interest exemption from both sides of the aisle, but the process never got beyond the banking committee chaired by Democrats Dodd and Schumer who both received large donations from the hedge fund managers based in New York and Connecticut. There are some different congressional players, but new regime has not changed this dynamic.

There will be a lot of talk and no shortage of predictions, but most of the effects of the tax legislation on individuals will not be fully known until April 2019 when the IRS collects 2018 taxes. However, more agreement exists on the benefits of reducing the US corporate tax rate from 35% to the low 20’s as a significant accomplishment. Besides lowering the rate to be in line with countries like Holland and France, the bill also ends the incentives for US corporations such as Apple, Pfizer and others to set up tax evasion subsidiaries in havens such as Ireland and the Cayman Islands. Instead there are now incentives to repatriate the billions of dollars currently sitting in those accounts and put the formerly foreign held cash to work in the US. Apple, Amazon, Boeing and other companies have already announced plans to do this.

As for the markets, predictions are all over the map and will remain so; predictions most often reflect the bias of the predictor. The real test for the financial markets will come after the euphoria of getting the tax bill through a polarized Congress fades. Global economic growth ticked up in 2017 and is strengthening more in 2018 so we shall soon find out if rising equity markets and strong economic growth go hand in hand. While the blast-off proportions of 2017 will likely recede, an important element favoring a continuance of the current market trajectory is the continuing impact of historically low interest rates, with Treasury yields below 3%. This keeps the cost of servicing US Government debt now at a staggering $20 trillion at about the same level it was in 2000 when the total debt was at $6 trillion and Treasury yields were 6%. It also means that bonds will not pose much of a threat to stocks until rates are much higher. These factors favor an investment allocation bias to global equities, the White House occupant and his tweets notwithstanding.

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