Second Quarter 2017 Forecast and Opinion April 5, 2017


The United States government is facing a fiscal cliff on April 28. The most recent government spending law, which was negotiated between John Boehner and Barack Obama in October of 2015, expired on March 15 of this year. Since 1960, Congress has acted on 78 different occasions to either raise or extend the debt limit, or to change its definition. In the next four weeks they must do so again or risk default. In 2011, lawmakers failed to do so on time, which resulted in S&P downgrading the US government's credit rating for the first time in history.

The reason why this issue has importance now is because of the unusual levels of contentiousness within the Congress. In order to raise the debt ceiling limit, Republican lawmakers need Democratic votes, which are unlikely unless there are considerable concessions towards the abandonment of the Trump border wall and the abandonment of the defunding of Planned Parenthood.

In what amounted to a tumultuous first 100 days in office, the Trump administration now faces the increasingly difficult prospect of pushing through a controversial agenda. The refusal by the GOP to pass a repeal of Obamacare after eight years of criticizing it, has Wall Street questioning whether the policy initiatives that caused the Trump rally will actually take place. One well-known Wall Street firm reacted with this title in a recent research piece: "Icarus, then Humpty Dumpty", demonstrating that investors are now increasingly concerned the tax cuts and infrastructure spending are looking unlikely. After initially rallying after the election, companies with the highest tax rates are now lagging the S&P, while US stocks have traded only in line with the rest of the world, and behind European stocks. There are now doubts around the scope and timing of the Trump tax plan, and we are less likely to see comprehensive tax reform and more likely to see only a few small face-saving tax cuts.

This too is important. The post-election rally was primarily based upon the belief that the Trump administration could deliver corporate tax cuts, bringing the corporate tax rate from 35% to 20%. Trump’s overall tax plan would have come with a price tag of $12 trillion over the next 10 years, according to the conservative research group The Tax Foundation. In order to fund these tax cuts, the Trump administration proposed border tax of 20% to be imposed on all foreign goods. This tariff is widely opposed by Republican senators, business leaders, and consumers, who would face an immediate increase in the price of any imported good or domestic good using foreign raw materials in its manufacture.
Without a mechanism to pay for grandiose tax cuts, they will not take place. Senate Majority Leader Mitch McConnell recently expressed skepticism over whether tax reform could take place before the August congressional recess. This is perhaps because the US tax code is nearly 75,000 pages long, and changing it "comprehensively" is unlikely in the next 120 days. Beyond that we are into fiscal 2018. At the time of this writing there is no clear White House tax plan, and there is not enough staff to even address it comprehensively.

The US dollar which rallied in the six weeks after the election has now given up half of its gains, while the Mexican peso has regained all of its losses in the same period.
As for infrastructure spending, it remains to be seen if a fiscally conservative Senate will allow it. One question that investors might ask themselves is whether or not the Republican Party actually supports President Trump off-camera.

The Federal Reserve hiked short-term interest rates on March 15 for the third time since the financial crisis, signaling two or three more hikes this year. The real test of the economy will be determined by whether the US can withstand positive "real" (after inflation) rates. Recall that on an inflation-adjusted basis, interest rates are still negative. The US central bank is finally ending its nine year period of stimulus after the 2008 financial crisis, although there are few signs of any pickup in economic growth in the first quarter.

By any number of measures, the stock market remains very expensive. The CAPE ratio, which represents inflation-adjusted stock prices divided by a 10 year average of stock earnings, is nearly twice its historical average of 15 and three standard deviations from its average. Put in a historical context, the CAPE index is at its 96th percentile of expensiveness, beyond where it stood in 2007. We can compare this number to 1929 peak valuation levels, when the stock market hit the 97th percentile of all time expensiveness.

The price to sales ratio of the S&P 500 has bypassed two standard deviations from the mean, and is approaching levels similar to the technology crash in 2001. Another red flag for investors is the ratio of corporate debt as a percentage of GDP, which is now at pre-recession highs.

For the first quarter of 2017, the S&P 500 was up 5.5%, the Dow was up 4.5%, and the Nasdaq was up 9.8%.

Grant Rogers

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