Wednesday, January 18, 2017

Earnings: Yes They Can Grow

A week after his election victory, I concluded that incoming President Donald Trump could succeed in stimulating economic growth, so I raised my real GDP forecast for 2017 from 2.5% to 3.0%. Since then, I’ve been keeping track of all the signs showing a revival of “animal spirits” in surveys of consumer and business confidence.

On Monday, the IMF raised its economic growth forecasts for the US, saying output could grow nearly a half-percentage-point faster than previously thought over this year and next, thanks to Trump’s plans to cut taxes and boost infrastructure spending. That would put US real GDP growth at 2.3% this year and 2.5% next year. The IMF’s move follows similar revisions by the World Bank last week.

If so, then the outlooks for the growth rates of S&P 500 revenues and earnings are improving. Both have recovered from the energy-led recession that started during the summer of 2014 and ended early last year, when the price of oil rebounded. Consider the following:

(1) Forward revenues and forward earnings of the S&P 500 have been rising rapidly since last spring into record-high territory. They are both good harbingers of actual revenues and earnings.

(2) Business sales are recovering from the energy recession. Manufacturing and trade sales rose 2.3% y/y during November, the best growth rate since October 2014. This series is highly correlated with the growth in S&P 500 aggregate revenues, which was 0.6% y/y during Q3-2016. It probably rose to about 2.0% during Q4-2016. Joe and I think the growth rate for revenues this year could be around 4%-5%.

Interestingly, the US M-PMI tends to be a leading indicator for the growth rate in S&P 500 aggregate revenues. During December of last year, the M-PMI rose to 54.7, the highest reading since December 2014.

(3) Retail sales rose 0.6% m/m during December. Chronic pessimists noted that it was essentially unchanged excluding gasoline and autos. Apparently, they weren’t impressed with December’s auto sales of 18.4 million units (saar), a cyclical high. Excluding gasoline but including autos, retail sales rose 0.2% to a new record high, and remain highly correlated with our Earned Income Proxy for private industry wages and salaries in personal income, which also rose to a fresh record high last month.

(4) Short-term leading economic indicators are upbeat. The Citigroup Economic Surprise Index rose to 40.7 on January 17. That’s near last year’s highest reading. The CRB raw industrials spot price index continues to recover from its cyclical low early last year. It was up 23.8% y/y on January 13.

My Boom-Bust Barometer continues to rise vertically in record high territory. The same can be said for the two Weekly Leading Indexes compiled by YRI and ECRI.

Wednesday, January 11, 2017

Animal Spirits

Just for fun, I compared the lyrics in the song “Physical” by Olivia Newton-John with Janet Yellen’s “Fiscal” lyrics during her press conference performance at the end of last year following the December 13-14 meeting of the FOMC. The word “physical” appears 20 times in Olivia’s song, and “fiscal” was mentioned 20 times during Janet’s press conference. In the minutes of the December meeting, the word “fiscal” appears 15 times, compared to just once during the previous meeting on November 1-2, which was before Election Day on November 8.

Prior to Election Day, a few Fed officials had called on Congress to step in to revive US economic growth with fiscal stimulus. They want to proceed with “normalizing” monetary policy so that they will have room to ease in the event of a future shock. They were looking for a way to continue to gradually raise rates without hampering economic growth, which has been slow. President-elect Donald Trump might just solve their problem with fiscal policy, included cuts in tax rates and more spending on infrastructure.

“Physical” starts with “Let’s get physical” and ends with “Let’s get animal, animal / I wanna get animal / Let’s get into animal.” That’s not appropriate or relevant language in a discussion about the Fed chair. However, President-elect Donald Trump is fair game.

After all, a Google search of “Trump and animal spirits” yields over 2 million links. They include lots of prim and proper ones such as a 1/5 FT article by Gillian Tett titled “Donald Trump unleashes business’s animal spirits.” She reported that Trump’s top eight officials (president, vice-president, chief of staff, attorney-general, and secretaries of State, Commerce, Defense, and Treasury) had only 55 years of government experience but 83 years in business. Obama’s comparable team had 117 years in government, but ONLY five years in business IN TOTAL.

As I’ve observed before, this is a radical change in governing regimes. As one of our accounts observed, government by dealmakers is about to replace government by community organizers. So far, this has all revived lots of animal spirits in the stock market. While the country may be split on Trump, his election has boosted overall consumer confidence. Purchasing managers were also more upbeat after the election, and so were small business owners.

December’s survey of small business owners by the National Federation of Independent Business (NFIB) was released on Tuesday. It was full of animal spirits. This group tends to be conservative. They generally don’t like government. When they are asked about the “most important problems small businesses face,” taxes and government regulation tend to be at the top of their list. They were still the top concerns in December, but Trump’s victory was clearly reflected in the extraordinary ascent in the Small Business Optimism Index from 98.4 during November to 105.8 in December, the highest since the end of 2004.

There’s more: The net percentage of firms expecting the economy to improve soared from 12% during November to 50% last month, the highest since March 2002. The percentage saying now is a good time to expand jumped from 11% to 23%, the highest since June 2005. The net percentage expecting to increase employment rose to 16%, the highest since January 2007.

So who cares? Aren’t these just a bunch of anti-government conservatives who are running minor little businesses and are looking forward to paying less than their fair share of taxes under the new Trump administration? Not so fast: Small businesses account for a very significant portion of jobs and hiring. Consider the following:

(1) Small business is big employer. ADP, the payroll processing company, compiles data series on employment in the private sector of the U.S. labor market by company size. At the end of 2016, the shares of employment attributable to small, medium-sized, and large firms were 40.5%, 37.7%, and 21.8%.

(2) Small business drives jobless rate. There has been a very high correlation between “poor sales” reported by small business owners and the national unemployment rate. If Trump succeeds in boosting their sales by cutting personal income tax rates, the jobless rate should remain low.

There is also a high correlation between the earnings of small businesses and the inverse of the poor sales. Trump’s proposed tax cuts would boost their earnings, which are inversely correlated with the national unemployment rate.

(3) A new problem for small business. Before I put any more twists in this pretzel, I expect that the biggest problem facing small business owners in 2017 is likely to be finding workers. Indeed, during December, 29.0% said that they have openings for jobs that they aren’t able to fill.

By the way, the term “animal spirits” was popularized by none other than John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936) in the following passage:
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
This passage has been widely discussed and interpreted. Cutting through the jargon, I think Keynes was saying that the business cycle is driven by the instability of human nature. He seemed to agree that booms might reflect “spontaneous optimism,” which cause instability in a similar fashion as speculation, setting the stage for a bust. Keynes added: “Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.” Of course, his book heralded the idea that government spending could stabilize the business cycle by at least minimizing the downside of the cycle. How is that working out so far?

Wednesday, January 4, 2017

Who’s Afraid of the Big Bad Wolf?

The answer to the question posed in the title of this piece is certainly not “stock investors.” Hopefully, the complete answer is “lots of little piggies afraid of what President-elect Donald Trump might do to them.” Maybe they will cease and desist before they show up in one of the Big Bad Wolf’s tweets. He has already had some success in getting Boeing and Lockheed to review their costs so that they will lower the prices they charge the government for their high-end products.

Now let’s see if Trump can make some progress in reducing personal and corporate tax rates while eliminating many of the exemptions and deductions that make the tax code a slush fund for lobbyists and their patrons. Let’s see if he can reduce onerous regulations on businesses. Can he do all that while keeping a lid on federal spending given that there are so many little piggies feeding in the government trough? Let’s hope that the Progressive ones aren’t simply replaced by the crony capitalist variety.

The big question is whether he will succeed in bullying our trading partners to be fairer without instigating a trade war. An even bigger question is whether he can curb the nuclear ambitions of North Korea’s Lil’ Kim and Iran’s Supremes. Then there are China’s ambitions to turn the South China Sea into a secluded lake for their navy. We should also hope that Trump’s reset with the Russian Bear will be more successful than was Obama’s attempt to normalize relations with the beast.

This is a long wish list, and may be biased toward too much wishful thinking. However, we can’t rule out the possibility that Trump will succeed. He certainly has so far, upending the predictions of all his detractors. Betting against him has been a bad bet so far.

That seems to be the message of the stock market. The S&P 500 is up 4.6% from Trump’s Election Day (T-Day) through the end of 2016. That seems impressive, but it isn’t unprecedented. Here are the comparable performance figures for past presidents just elected to their first terms: Hoover (8.2%), Eisenhower (8.0), Kennedy (5.4), Reagan (5.2), Carter (4.2), Clinton (3.8), Bush I (0.9), Nixon (0.7), Johnson (-0.5), Roosevelt (-4.8), Bush II (-7.8), Truman (-9.0), and Obama (-10.2). So Hoover, Eisenhower, Kennedy, and Reagan trumped Trump. Perhaps Trump would have done better if the S&P 500 weren’t already nearly nine years into a bull market with valuation multiples at nose-bleed levels.

Then again, those valuations may not be too high if Trump delivers all the supply-side magic of personal and corporate tax cuts, and they work like a charm. Reagan did the same, but the economy was heading into a severe recession after his first 100 days. Back then, Fed Chairman Paul Volcker was intent on breaking the back of inflation by breaking everyone’s backs with burdensomely high interest rates, and Reagan supported Volcker’s tough love.

Now Trump might do what Reagan did, but with an economy that clearly is growing with no recession in sight. There certainly isn’t enough inflation to cause the Fed to precipitate a recession by tightening monetary policy too aggressively. Volcker raised the federal funds rate to over 20%. The FOMC’s dot plot suggests that the members of the committee expect to raise the federal funds rate this year three times at most, by 25bps each time, to 1.50%. The implications for corporate earnings could be awesome, as Joe and I discussed last month. If so, then valuation multiples are simply getting ahead of earnings, but rightly so.

Tuesday’s WSJ included an article titled “Earnings, Not Donald Trump, Are Stocks’ Best Friend in 2017.” That’s not news to us: Joe and I have been predicting since last summer that the end of the Energy-led earnings recession would boost stock prices. The subtitle of the article is “Continued rebound in corporate profits should prop up share prices regardless of Washington policies.” Actually, given that valuations were high before Election Day, and went higher after Trump’s sweeping victory (with his party winning control of both houses of Congress), we believe that his policies will matter a great deal.

If for some unanticipated reason he fails to implement his tax cuts and to cut regulations, stocks would take a dive. They might even crash if he manages to start a trade war. If he succeeds in his plans, then the S&P 500 earnings growth could more than double from 9% this year to 19%, as Joe and I explained last month. So Washington matters a great deal this year.

After Reagan was elected to his first term, the forward P/E of the S&P 500 rallied to 7.7 in February 1981 from a Jimmy (“Malaise”) Carter low of 7.0 during November 1979. During 1982, it dropped to a low of 6.3. During Reagan’s second term, it rose to a high of 14.8 during August 1987. On Tuesday, the S&P 500’s forward P/E was 16.9, well above the 13.8 average from September 1978 through December 2016. The forward P/Es of the S&P 400/600 were even closer to the sun at 18.7 and 19.8.

For the S&P 500, if the index price remains unchanged at the current level through the end of the year, a 10% increase in earnings this year would lower the multiple to 15.4, while a 20% increase in earnings would lower it to 14.1. So, yes, the multiples are high, as investors have gotten ahead of earnings. But earnings could do some significant catching up if Trump’s program boosts earnings as much as Joe and I expect. If the multiple stays put and earnings increase 20% as a result of tax cuts, then the S&P 500 would rise to 2700. For now, we are sticking with 2400-2500 as our target for this year.

Tuesday, December 20, 2016

Votes of Confidence

Once again, the election results demonstrate that “It’s the economy, stupid!” Stock investors are certainly giving the President-elect not only the benefit of the doubt but a big tailwind for his economic program, as the market capitalization of the S&P 500 has increased by $1.0 trillion since Election Day to a record high. In fact, the votes of confidence since that day have been overwhelmingly positive, suggesting that Trump may have unleashed some animal spirits that might very well boost economic growth. Consider the following:

(1) Financial stocks. Leading the way among the S&P 500 sectors has been the Financials sector. In the past, leadership by this sector tended to be bullish for the overall market. REITs were removed from this sector on September 19, so it hasn’t been weighed down by their relative weakness. Instead, the sector has soared as the yield curve has steepened and credit spreads have narrowed. Financial stocks have also been buoyed by the prospect of less government regulation.

Here is the S&P 500 sector performance derby since Election Day through Friday of last week: Financials (17.2%), Telecom Services (10.8), Energy (10.3), Industrials (7.7), Materials (7.0), S&P 500 (5.5), Consumer Discretionary (5.3), Health Care (2.0), IT (2.0), Real Estate (0.5), Consumer Staples (-0.9). and Utilities (-1.2). (See table.)

(2) Credit markets. In my meetings with our accounts in Toronto and Chicago last week, I opined that November 8 might have marked the end of the New Normal, or secular stagnation, and comeback of the Old Normal. That’s certainly reflected in the 10-year US Treasury bond yield, which jumped to 2.60% on Friday, up from 1.88% on Election Day.

So far, the credit markets aren’t signaling that the backup in bond yields might cause a recession. On the contrary, the yield curve has steepened by 42bps since Election Day, based on the spread between the 10-year US Treasury bond and the federal funds rate. The yield curve spread is one of the 10 components of the index of leading indicators, and it usually turns negative before a recession. It had been narrowing prior to the election, but has turned more positive since then.

Another upbeat signal from the credit markets is that the spread between corporate bond yields and the 10-year Treasury yield continues to narrow after peaking during February. The spread widened significantly during the second half of 2014 and during 2015 on fears that the plunge in oil prices might trigger a financial contagion. Instead, it caused a recession that was contained within the energy sector, which has been recovering since early this year along with the price of oil. Most encouraging is that the corporate high-yield credit spread has narrowed from a peak of 844bps on February 11 to 363bps last Wednesday, the lowest reading since October 6, 2014.

(3) Business surveys. Among the most spectacular votes of confidence for a “New Morning” scenario for the US economy are December’s business surveys for the Fed’s Philadelphia and New York districts. The average of their two composite indexes jumped from 4.6 during October to 15.3 this month, the highest reading since November 2014.

The NFIB Small Business Optimism Index jumped from 94.9 during October to 98.4 last month, the biggest one-month increase since April 2009. The NAHB Housing Market Index rose this month to the highest reading since July 2005 thanks to a sharp increase in traffic of prospective home buyers. This is happening either despite the jump in mortgage rates or because of it as potential buyers scramble to purchase before rates go still higher.

(4) Consumer sentiment. As we noted last week, the Consumer Sentiment Index has increased from a 14-month low of 87.2 during October to 98.0 during the first half of December. At the end of the month, the final number will be reported in addition to the readings for December’s Consumer Confidence Index. November’s results for the latter showed that confidence was especially strong among survey respondents who are under 35 years old. If Trump can make young adults happier, maybe we will see an increase in household formation, marriages, babies, and home buying.

(5) Still ahead. There are still plenty of post-election surveys ahead, including those of the other three Fed districts that will be reporting their December business surveys. Business Roundtable conducts a survey of corporate CEOs. The quarterly index that is compiled from the survey is a leading indicator for capital spending.

The Q4 survey was taken between October 26 and November 16. However, CEOs remained cautious, as their Economic Outlook Index didn’t change much from Q3. “America’s business leaders are encouraged by President-elect Trump’s pledge to boost economic growth,” said Doug Oberhelman, chairman and CEO of Caterpillar Inc. and chairman of Business Roundtable. “We will work with the incoming Administration and Congress to enact pro-growth policies such as modernizing the U.S. tax system, adopting a smarter approach to regulation, investing in infrastructure and focusing on the education and training people need to thrive in the 21st century economy.”

He added, “It’s telling that for the fifth year in a row CEOs name regulation as their greatest cost pressure. We are encouraged by the promise of a renewed focus to usher in a smarter regulatory environment that promotes job creation and economic growth and also protects safety, health and the environment.”

Our sources among our institutional accounts tell us that many CEOs are becoming increasingly exuberant about the prospects for Trump’s policies. That should show up in the Q1 reading of Business Roundtable’s CEO survey and in better capital spending next year.

(6) Commodities & currencies. Remarkable votes of confidence since Election Day are also visible in the CRB raw industrials spot price index and the JP Morgan trade-weighted dollar. The former is up 3.3%, while the latter is up 4.7% since the election. The nearby futures price of copper is up 7.7% over this same period. In the past, a strong dollar tended to depress commodity prices.

So far, Donald’s Trumpland seems a bit like Alice’s Wonderland. In any event, financial and survey indicators suggest that while Clinton’s supporters may remain in mourning, it may very well be a new morning for the economy.

Wednesday, December 7, 2016

Corporate Taxes In Trump World

President-elect Donald Trump’s tax plan will be the “largest tax change” since Reagan, Steven Mnuchin told CNBC in a 11/30 interview. That was the day after Trump officially cast the former Goldman Sachs banker and Hollywood movie financier in the role of US Treasury Secretary. During the interview, Mnuchin confirmed the Trump campaign’s promise to cut the federal statutory corporate tax rate to 15% from 35%. In addition, overseas profits will be brought back to the US, he said, obviously referring to the one-time 10% repatriation tax that the administration intends to implement. Overall, cutting corporate taxes should stimulate spending and jobs, he argued. Mnuchin also emphasized that taxes are “way too complicated” and people spend “way too much time worrying about how to get them lower.”

That all sounds good to me, but there’s a catch. Trump’s corporate tax cut might not be as bold as suggested by the 20ppt reduction in the tax rate. That’s especially true if the tax code is simplified to close tax loopholes, as Mnuchin implies. Furthermore, there’s no guarantee as to how corporations will spend any of the tax benefits that are realized. Consider the following:

(1) Statutory vs. effective. The headline corporate tax rate of 35% isn’t what companies actually pay. That’s the statutory federal tax rate. It’s more meaningful to consider the corporate effective tax rate (ETR) after all credits and deductions are taken into account. A March 2016 Government Accountability Office report highlighted a range of ETR estimates by different methods, including one for profitable large corporations at just 14%. However, a more comprehensive ETR measure includes both profitable and unprofitable large corporations. And that was 25.9% of pretax net income in US federal income taxes, excluding foreign and state and local taxes. Obviously, however you slice it, the ETR is generally lower than the statutory rate.

My own measure of the ETR has come down significantly. It is simply corporate profits taxes divided by pre-tax corporate profits, with both series included in the National Income & Product Accounts. It has been trending down from its record high of 50.2% during Q1-1951 to its record low of 17.1% during Q1-2009. It drifted back up to 25.0% during Q3 of this year. It has almost always been below the top corporate tax rate.

(2) Simpler code? “Mr. Trump’s tax reform plan would boost incentives to work, save, and invest,” concluded a 2015 Tax Policy Center (TPC) study. That might be true. However, the study also footnoted: “It is unclear whether the 15 percent rate is a flat tax rate on all corporate income, or whether some form of graduated rate schedule is maintained.” And: “It is unclear which specific business tax preferences would be eliminated.” In other words, the ETR might not change all that much if the statutory rate change is combined with reductions to credits and deductions.

On 10/18, the TPC issued a revised analysis of Trump’s revised tax plan. It covered Trump’s policies as outlined in his speeches on 8/8, 9/13, and 9/15. It noted: “The revised framework, as set out in those speeches and campaign publications and statements, leaves many important details unspecified. We needed to make many assumptions about these unspecified details to analyze the plan.”

The revised plan seems to include the profits of pass-through businesses (e.g., sole proprietorships, partnerships, and S corps) in the 15% tax rate club along with other corporations--that is, instead of taxing owners at their regular individual income tax rates. (Different rules would apply to distributions to owners of “large” pass-through entities.) Both corporate and qualifying pass-through entities would have the option to deduct investments immediately as opposed to depreciating them under current law--a potential boon to investment spending. But then they wouldn’t get to deduct interest expenses. That might just apply to manufacturers, but TPC says it’s unclear. Some special interest deductions would also be repealed. And the corporate alternative minimum tax would be eliminated. (By the way, a 11/11 CFO.com article noted that Trump might have since backed off a bit from the 15% rate for pass-through enterprises.)

But again, a lot of open questions remain. That includes exactly what deductions and loopholes would be eliminated. The TPC observed in its revised appendix: “In his Detroit speech, Mr. Trump said his plan would ‘eliminate the Carried Interest Deduction and other special interest loopholes’ and in his New York speech that ‘special interest loopholes’ would be closed, but no specific provisions are identified. The fact sheets on tax reform indicate that the plan ‘eliminates most corporate tax expenditures’ [i.e., deductions] except the research credit.”

It seems unlikely that such a massive corporate tax rate reduction would be formally proposed without the corresponding elimination, or reduction, of more deductions. With that, Trump would still be able to keep his 15% campaign promise without adding potentially unsustainable sums to the deficits and debt. Keeping a lid on deficits and debt would be especially important in the near term before any economic benefit resulting from the tax breaks would occur. Mnunchin did say in his interview that some of the lost tax revenue from corporations would be made up on the personal income side.

(3) US versus them. A comparison of the US ETR relative to other countries obviously is important for considering US competitiveness. When measured on the basis of effective rather than statutory rates, the US corporate tax rate becomes much closer to other countries’ rates. A 2014 Politifact article reviewed several studies of the ETR across different countries. It noted: “[W]hereas the statutory rate is relatively straightforward and uncontroversial, different, reputable organizations have published very different estimates of the effective tax rate that corporations pay.” An often-cited 2014 study by the Congressional Research Service had the US effective rate at 27.1%, which was slightly lower than the OECD weighted average of 27.7%.

(4) Laffer effect. By the way, Trump tax critics argue that his plan will balloon the federal deficits and debt. However, back in 1978, economist Arthur Laffer argued that cuts could be revenue-neutral in the long term as economic activity grows. Gene Epstein updated the case for the Laffer effect in a 11/26 Barron’s article. He tested the concept using a statistical run originated by a couple of Cato researchers. He concluded: “The results not only confirmed the Laffer effect but if anything, showed that a decline in the corporate tax rate seems to bring a rise in revenue, rather than a fall. In other words, instead of being revenue-neutral, the proposed cut might even be revenue-positive.” He added: “Meanwhile, the boost to economic activity would be palpable.”