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Looking ahead to the fourth quarter, we can focus on three things which will impact the financial markets: the Trump tax plan, corporate earnings, and the Federal Reserve.

Trump’s administration has undergone huge turnover in its first nine months, including his first national-security adviser, the deputy national-security adviser, his original chief of staff, a press secretary, two communications directors, his chief strategist, the director of the FBI, the acting head of the Justice Department., and the head of the Department of Health and Human Services.

These are only the highest level impediments to Trump’s credibility, but the list is long as the reader may be aware. The relevance to investors, among other things, is whether the Trump tax plan will be passed, since the Congress has not passed any of his initiatives to date.

The key changes in the proposed tax plan, which could add as much as $5.8 trillion to the existing $20 trillion deficit within 10 years, are as follows:

1) Corporate tax rates would be cut from 35% to 20%.
2) Individual tax rates of 12%, 25% and 35% instead of 10%, 15%, 25%, 28%, 33%, 35% and 39.6%.
3) S corporations, partnerships and sole proprietorships would have their tax rate cut to 25%. Currently, shareholders, members or partners pay the tax at an individual rate. Instead of a top individual rate of 39.6%, Trump’s plan would cap the rate owners pay on business income at 25%.
4) Businesses would be able to immediately expense the cost of certain assets, instead of depreciating them over time.
5) Most itemized deductions would be eliminated, including state taxes, property taxes, and medical expenses. The only deductions that might be left are home4 mortgage interest and charitable contributions.
6) Alternative Minimum tax would be repealed.
7) Estate tax would be repealed.
8) U.S. companies to pay taxes on their profits to the U.S. only for amounts earned in the U.S.
9) A one-time tax holiday on the $2.5 trillion of overseas corporate profits which have been stockpiling abroad. This tax level might be 10%.
10) A repeal of Obamacare would mean that the net investment income tax, which imposes a 3.8% tax on income from investments, would go away.

One of the most important items on the list is number four.
By enabling businesses to immediately depreciate assets, instead of over a period of years, there will be an explosion of capital expenditure by businesses. This “front-loading” of capital expenditure would theoretically rally the market into the congressional elections next November and help the Republican Party maintain its hold on power, despite the nearly record valuations in the stock market. In particular, industrial stocks would be favored by a rebound in capital expenditure.

With the rally in the stock market are these tax cuts now built in? Not necessarily, since a lot of investors don’t believe that they are going to happen. This is borne out by the fact that the highest tax paying companies in the U.S. haven’t rallied much since the tax plan was announced, and in fact have underperformed the market. But to some extent, overall price action has been driven by hopes for tax reform. If it does not occur, or if it does not resemble what is expected, there will be negative consequences for stocks. The tax plan is not revenue neutral and also is predicated on deficit finance and unrealistic spending cuts, so it may not pass muster with the Congress. On the other hand, if Trump succeeds in a full tax reform package, it would result in an estimated 8% increase in aggregate S&P 500 earnings.

The Federal Reserve believes in “signaling” their intentions on interest rates. Right now, they have signaled one rate hike in December, and three more in 2018. The market does not believe that there will be more than one next year, according to the futures market. If the Trump tax plan does pass, it is likely that all three rate hikes next year will in fact materialize. Since 1950, there have been 13 rate tightening cycles, 10 of which ended in recessions. If the Fed raises interest rates four times between now and the end of 2018, it would produce a situation known as “inversion” where short term interest rates are higher than long term interest rates. Whenever the bond yield curve inverts, a recession always follows.

Bond yields may also be going up because of the end of “quantitative easing” at the Fed, meaning that there will be $600 billion per year less of overall bond buying by the central bank. Higher bond yields mean that utilities and REIT’s would suffer in the short term, as well as housing. If housing slows, consumption could be hit by a “negative wealth effect”, something the Fed needs to consider.

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Currently, corporate profit margins are at historic highs. We are already arguably at full employment.
We are entering a period of structural shift, where after decades of a trend that benefitted corporate profit margins at the expense of labor (as a percentage share of total income), the trend may be about to reverse.

If higher wages due to labor scarcity leads to inflationary pressure, profit margins will begin to go down, particularly in retail, heavy manufacturing, restaurants, hotels, and any other industry where labor costs as a percentage of total costs are high.

Both assets and labor are light at technology companies, meaning that they would be relatively unscathed by higher wages. But there are reasons to be cautious here too. Currently, only four companies, (Apple, Microsoft, Amazon and Facebook), collectively make up more than 10 percent of the S&P 500. In fact technology comprises nearly 25% of the S&P 500. The so-called FAANG stocks (Facebook Amazon, Alphabet, Netflix, and Google) alone have provided 30% of the entire stock market’s performance this year. To give an idea of how expensive these stocks are, we need only look at Netflix, trading at 164 times next year’s estimated earnings, while the overall market trades at 18 times 2018 estimated earnings.

Amazon is under antitrust scrutiny, but has nonetheless just announced that they would like to compete against FedEx and UPS in logistics. The tax arrangements of these tech giants are being challenged as well, particularly in Europe. The S&P 500 is so “top heavy” that this could weigh on earnings growth.

One of the arguments used to justify the expensiveness of stocks is that “corporate earnings are great.”
If we look at second quarter earnings growth carefully though, it mostly came from the energy sector, which is rebounding from an artificially depressed state. As earnings normalize in the energy sector going forward, we will see something more underwhelming. To quantify this, corporate earnings grew overall at a rate of 6.5%. Part of that number is the 563% increase in earnings in the energy sector. Without it, earnings growth would have been far lower, around +3.6%

The contribution to eps growth from stock buybacks (financial engineering) is slowing. But it is possible that if the Trump tax plan succeeds in repatriating foreign corporate profits, corporate stock buybacks accelerate, particularly in tech and healthcare which have the most cash stockpiled abroad.

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Volatility, or the measure of fear in the stock market, is nearing an all-time low. There have been an explosion of strategies among hedge funds and institutional investors known as “systematic”, or “risk parity” strategies, which focus on volatility. As long as volatility remains low, these strategies continue to buy stocks. But as this continues, an increasingly smaller movement in volatility is required to trigger substantial selling programs by these strategies. In other words, volatility, or the perception of risk in the stock market, is like a tightly would spring, waiting to recoil.

President Donald Trump will be choosing a new Chairman to replace Janet Yellen as the head of the Federal Reserve, and candidate Kevin Warsh seems to be the first pick of Trump and Treasury Secretary Mnuchin after they both met with him last Friday. Mr. Warsh is a hawk. If he becomes Fed Chairman, interest rates will go up more aggressively.
He would:

1) Favor deregulation of the financial industry.
2) De-emphasize the Fed's reliance on its inflation target as a guide for interest rate hikes.
3) Encourage a more rapid unwinding of the Fed’s $4.5 trillion balance sheet.
4) Act less gradually than the market is accustomed to. He is quoted as saying that the U.S. central bank is a “slave’ to the stock market. He appears to care less about asset prices and more about economic data than Janet Yellen.

If it were perceived that his selection were at all political, it would result in the Federal Reserve losing credibility. As with anything Trump related, the choice would not be without some controversy. Mr. Warsh is married to Jane Lauder, whose father Ronald is a longtime supporter and friend to Trump.

Lastly, investors should be aware that the debt ceiling will be revisited by Congress soon. On September 8, 2017, President Trump signed a bill increasing the debt ceiling to December 8, 2017. If, on December 8th, the Congress does not raise the debt ceiling, as it has 74 times since 1962, the U.S. will be subject to a downgrade by rating agencies like Standard and Poor's or Moody's, just as it was in 2013.

In September, the national debt exceeded $20 billion for the first time in U.S. history.

For the first nine months of 2017, the S&P 500 was up 12.5%, and the Dow was up 13.3%

Grant Rogers

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