16 Jan 2017
Looking ahead with Optimism about the US Market in 2017
Early in 2017 we will all start grappling with the connection (or possible lack thereof) between campaign promises and policy reality. President-elect Trump has elevated tax cuts/reform, increased fiscal spending, and regulatory overhaul to the top of the priority spectrum—all laudable pro-growth policies. However, the continued pressing of his isolationist, anti-trade, and pro-tariff promises could serve as a detrimental offset to the pro-growth agenda, highlighted below.
Even unpacking what appear to be the more economically-beneficial proposals yields concerns about whether reality will resemble the promises. Having served on President Bush’s bi-partisan tax reform commission in 2005, I am personally thrilled that comprehensive tax reform—or at least corporate tax reform—is on the agenda. However, the devil—as always—is in the details.
History has shown that when it comes to tax reform, what is ultimately legislated can vastly differ from what was originally proposed. The other rub is the cost: According to the Tax Policy Center, Trump’s tax plan would add about $6 trillion to federal debt over the next ten years, and more than $20 trillion over the next 20 years. Even with rosy growth assumptions applied (i.e., "dynamic scoring"), the math around deficits/debt is fairly ugly.
The benefit of corporate tax reform is bit clearer. The U.S. marginal corporate tax rate is nearly 39% when including state/local taxes; ranking it highest among all global industrial countries. The median rate for the other 34 OECD countries is less than 25%. An important caveat though relates to ample deductions offered in the U.S. tax code—such that the actual effective tax rate for U.S. non-financial companies averaged about 25% as of 2016’s second quarter. But even from that base a move down to somewhere in the 15-20% range could help corporate bottom lines immensely.
Much of U.S. infrastructure is either busted or significantly aged. As presently detailed, the Trump administration favors private/public partnerships as opposed to federally-funded spending. Given the lessons learned in 2009 about just how "shovel ready" projects actually were, these plans are likely to take some time to put together; meaning this component of fiscal stimulus could be more of a 2018 story.
Could the bull market in corporate compliance be coming to an end? Fewer regulations means lower compliance costs for companies—certainly among financial companies which might see a lessened burden from changes to the Dodd-Frank legislation. As my friend Ed Yardeni—one of Wall Street’s best economists—noted in his final missive of the year:
"This could lead to another wave of destructive crony capitalism, the kind that contributed to the financial crisis of 2008. Or else, combining the talents of America’s smartest dealmakers, savviest business executives, and high-powered technology leaders could boost growth in America, especially if lower corporate and personal income tax rates revive animal spirits…"
I am hoping for the latter.
Optimism, with a dose of caution
We share the optimism as it relates to the U.S. stock market in 2017 and believe it will outperform developed market international equities. But the trajectory of gains will likely not be as fierce as witnessed immediately post-election; and we do expect bouts of volatility for several possible reasons, including: The transition between Trump’s candidacy and Trump's presidency; inflation or growth could heat up enough that the Fed would have to be more aggressive than expected hiking rates; continued U.S. dollar strength would tighten financial conditions and hurt multi-nationals’ earnings.
I was pleased to see the consolidation occur in the final couple of weeks in 2016. That is a healthier pattern for equities than a "melt-up" with no pauses. As I often opine, investor sentiment (as a contrarian indicator) may hold the key to the shorter-term volatility we might witness.
Investor optimism on the rise
But with the surge in the market has come the commensurate surge in investor sentiment. Two of the more popular sentiment measures come from American Association of Individual Investors and Investors Intelligence (the latter being the sentiment of investment newsletter writers). Heading into and in the early weeks of 2016, bullish sentiment was plumbing the depths of despair. But the finale of the year was an entirely different story.
We remain optimistic that this is an ongoing secular bull market in U.S. stocks; and the risk of it ending swiftly is low. Bear markets tend to sniff out economic recessions and with growth accelerating from its below-trend pace, the risk of that is also low. Sentiment-related economic indicators have recently soared, including the stock market itself—and specifically financial stocks; consumer sentiment, the Housing Market Index (HMI), the Small Business Optimism Index. In addition, credit spreads have behaved well and the yield curve has generally steepened. All of this suggests improving growth and low near-term recession risk.
Ironically though, one of my concerns is that the market’s rally could become more of a "melt-up." As good as they feel (for investors in the market) while they're underway, they don’t tend to end well; so keep an eye on investor sentiment for overt signs of excess optimism. Remember the power of discipline and periodic rebalancing. Enjoy the ride, but don't get greedy.
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.