When Donald Trump became president US stocks jumped in anticipation of tax cuts and higher spending. Investors' ardour cooled as the supposed dealmaker's inability to pass legislation of any kind became apparent. But now the "Trump bump" has returned.
"Markets are moving to price in the chance of a tax cut again," says John Authers in the Financial Times. Last week companies that pay a high effective tax rate began to outperform those whose actual tax rate is lower (because they have worked out how to exploit various loopholes more effectively). Small caps, which would benefit most from fiscal stimulus because they earn most of their profits at home and tend to pay higher effective corporation-tax rates, hit a new record.
The administration's tax-reform proposals, unveiled last week, include reducing the seven existing income-tax brackets from seven to three: 12%, 25%, and 35%. As far as equities are concerned, the key points are the cut in the corporate-tax rate from 35% to 20% and a reduction in the taxation of overseas profits in order to encourage firms to bring their big overseas cash piles back home.
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The corporate tax cut "would give a significant jolt" to after-tax profits, says Randall Forsyth in Barron's. One estimate suggests that the average effective rate is 27%. A drop to 20% would add $10.50 to S&P 500 earnings per share (EPS). To put that in context, S&P 500 EPS for 2018 are expected to total $145. Meanwhile, the overseas profits could fuel plenty of buybacks and dividends.
However, Wall Street is "counting its tax-cut chickens early", continues Forsyth. What the final package will look like is hard to gauge, given the wide array of interests that need to be reconciled. Nor will tax reform come to anything if the administration can't pass a budget resolution for next year first. In the mean time, don't expect miracles from repatriated foreign earnings.
In a sense, they may already have been spent. Consider that Apple, Oracle, Microsoft and Cisco have increased their debt by a collective $174bn in the past three years, spending much of it on buybacks. That figure eclipses the $168bn in cash they added to their balance sheets.
The market's enthusiasm for tax cuts is a symptom of its general complacency, says Justin Lahart in The Wall Street Journal. Consumer spending slipped in real terms in August, highlighting the uncertain growth outlook, yet investors are behaving as if growth "is about to take off". Overconfidence and high valuations are hardly a compelling combination.
Where will the next crisis come from?
Deutsche Bank's annual Long-term Asset Return Study always provides some interesting perspective. This year's edition makes grim reading: "We're quite confident that there will be another financial crisis/shock pretty soon."
The bank defines a crisis as one of the following: a 15% drop in the equity market, a 10% fall in the currency, a sovereign default, a 10% fall in government bonds, or double-digit inflation. Crises have become far more frequent since the collapse of the Bretton Woods system in the 1970s.
The Bretton Woods system of fixed exchange rates linked to gold meant that there was a natural check on credit creation.The money supply had to be matched with gold. But once that system ended, and a fiat currency system took its place, the world embarked on a cycle of credit creation and collapse that continues to this day. The path of least resistance has been to combat a downturn with yet more stimulus.
This has just exacerbated imbalances, making future crises more likely. Today many asset prices are at extreme levels, and central banks have virtually no stimulus measures left in their lockers, making the financial system ripe for another crash that could spread losses and panic far and wide.
Deutsche Bank highlights several potential causes of the next crisis, ranging from a meltdown in China to populist politics. Perhaps the prime candidate, however, is central banks' attempt to normalise interest rates especially if Deutsche is right to suggest that inflation may have bottomed, in which case prices, and the cost of money, could rise quickly and trigger a collapse in asset prices and confidence.
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