December Investment Comments

How Important Is Tax Reform to the U.S. Markets?

The U.S. economy and the rest of the world look generally healthy.  That’s something we haven’t been able to say since before the 2008-2009 global financial crisis.  Since that time, major parts of the world have either been in recession or teetering on the edge of recession, unnerving investors.  This deters the planting of long-term seeds for future economic growth.

In the U.S., Gross Domestic Product grew at a rate of 3% or better for the second straight quarter in Q3.  This used to be the typical rate of growth, but we haven’t seen back-to-back quarters of 3% GDP growth rates in three years.

Consumer spending appears fairly strong.  Auto sales were expected to decline in 2017, but through October, are almost on par with last year’s record number.  Personal income has been growing steadily, in particular the month of September (the most recent month for which data is available).  Consumer confidence surveys reflect significantly higher figures, particularly for consumers’ assessment of the current situation.  These measures are the underpinnings of a consumer-led economy.

Turning to the industrial sector, industrial production has been strong through the first nine months of the year although hurricanes put a noticeable dent in August’s figures.  A rebound in September suggests that August was just a blip.  Recent strength was confirmed by a popular barometer of the industrial economy, the Purchasing Managers’ Index put out by the Institute for Supply Management.  This measure has reached multiyear highs in recent months.

And it isn’t just in the United States.  Europe appears to have finally awoken from its slumber, as has Japan.  Emerging economies in Asia have been doing well for some time, although those in Latin America generally have not participated.  This kind of broad, global economic growth expands the pie for everyone.

Global economic improvement has helped corporate profits for several quarters.  It appears that higher corporate profits have raised investor sentiment even though some hoped-for items from the U.S. political agenda have yet to be accomplished.

Tax reform has been at the forefront in Washington for many weeks.  Mixing corporate and personal tax reform has proven to be a tough nut to crack.  The U.S. corporate tax rate is the highest among the G-20, the 20 largest economies in the world.  Some companies, particularly multinationals, pay far less than the statutory rate.  Purely domestic companies frequently pay close to the full 35% rate.  Surprisingly, corporate taxes make up only around 10% of total federal taxes.

In addition to the highest tax rate, the U.S. is also fairly unique in attempting to tax the global profits of companies headquartered here.  This vain attempt has had two unfortunate side effects: tax considerations have led to the takeover of some U.S. companies by foreign companies who could outbid U.S. competitors due to their more favorable tax regime, and U.S. multinationals have been incentivized to keep foreign profits overseas rather than invest them here.  Estimates are that roughly $2.5 trillion of cash is “trapped” overseas. Many political leaders from across the spectrum acknowledge that this arrangement hurts U.S. economic growth and the income of American workers.

Personal income tax considerations are a source of disagreement among many Americans and certainly among their political leadership in Washington.  Tax reform hasn’t been tried since 1986 because people facing higher taxes seem to shout over the voices of those benefitting from tax changes.  We’ve all seen the bickering back and forth on TV, on editorial pages, and online.

Recently, we’ve witnessed moderate declines in the U.S. stock market on days when investors have questioned whether tax reform will even happen.  These reactions seem more significant than when the Republican makeover of the Affordable Care Act was being debated, suggesting that investors may feel the stakes are higher this time for the economy and the stock market.

With other countries taxing business at around 20%-25%, the U.S. corporate tax rate of 35% and other rules surrounding our corporate tax system are simply uncompetitive.  At one time the U.S. had the lowest corporate tax rate.  Reducing it to 20% would not only restore tax competitiveness, but would tell the world the U.S. is open for business.

Does failure to accomplish tax reform doom the U.S. economy or the markets?  Probably not, but investors would be disappointed in the failure to address a corporate tax system that many acknowledge is out of step with other countries’.  With growth moving forward, but equity valuations being stretched, a shot in the arm from tax reform might give this bull market some extra vitality.

Scott D. Horsburgh, CFA