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.”