US market indices are at all-time highs in anticipation of tax and regulatory reform. Corporate income taxes and regulations affect the current and future earnings or cash flows (earnings after accounting distortions are removed) of companies, while investor taxes (i.e. dividends and capital gains) affect how much investors are willing to pay for those cash flows. With respect to the first part of this statement, taxes and regulatory compliance costs are expenses, so reducing them results in a direct increase in cash flows. As for investor taxes, it is helpful to consider that investors discount these cash flows. Future dollars aren’t worth as much as current dollars, so they are discounted. The rate at which they are discounted is sometimes referred to as investors’ required rate of return. This required rate of return encompasses the fact that investors want to be compensated for (1) the taxes they will have to pay, which are primarily dividend and/or capital gains taxes, (2) inflation (if they are paid back in dollars that are worth less, they will require more of them), and (3) risk. With President Trump elected with a platform of lower corporate taxes and less regulation, and a Republican congress making that more likely, it makes sense that investors would bid up stock prices in anticipation of lower corporate taxes and less regulation. And since markets were probably expecting Hillary Clinton to win, and Clinton’s platform contained slightly higher investor taxes (dividend and capital gains), it makes sense that the market would be re-pricing that (i.e. incorporating lower dividend/capital gains taxes) as well.
There are risks out there, which the market sees as well as you and I, but right now it looks like the market is not weighing those risk too heavily. Another way of saying that is that right now the markets aren’t expecting (and pricing) that the risks will disrupt production and exchange, upon which wealth creation depends. Chief among these risks, I would say, include (1) the risk of a global trade war, (2) the risks of further disunity in Europe (i.e. French presidential elections in April, Brexit fallout, resurgent debt problems, etc.), (3) the risks of increased belligerence from countries such as North Korea and Iran (as accurately predicted by former US Secretary of State Condoleezza Rice here in San Antonio a few months ago). I think a lot of people would put the potential for impetuous actions on the part of President Trump as a fourth risk.
Market Update Questions: Answers to Specific Questions From Our Clients
Each year we give market updates in San Antonio, Austin, Houston, and Corpus Christi, and we take as many written questions as we can to answer for the audience at the end. Here’s a few that I thought might be of interest to Kee Points readers:
What about the economy keeps you up at night? To be honest, tax and regulatory ambiguity are highest on my list, because I think the best way to achieve a dynamic and innovative economic environment is through a relatively clear and stable tax and regulatory environment. External “shocks” are always a concern (North Korea/Russia/Iran events, China economic/financial shocks, European election/debt events), but overall I think economies can deal with those uncertainties if policy (tax and regulatory) uncertainty isn’t thrown into the mix. That doesn’t mean we won’t have recessions, which are caused by unforeseen shocks, it just means that recessions shouldn’t turn into prolonged depressions if policy “churning” is limited. And prolonged depression is what would keep me up at night.
What will be the economic impact on Texas with border wall construction? I would say it will be similar to any other large public works project, i.e. a positive for the state/region where the project takes place, negative (or at the expense of) for the other states paying for it. So I look at it as a zero-sum affair in which Texas gains what the other 49 states lose in payments. Economic benefits would likely be highest for border towns and materials/engineering firms in Texas in general and south Texas in particular. Like most public spending projects, I think the impact will be positive but transient. That’s over-simplifying a bit, as there are positive and negative spillover effects (the negatives of reduced cross-border flow of goods and services, but also the positive of perhaps more property rights security, etc.), but that’s how I look at it.
How long after implementation will it take for trade protection to be felt in the system? Think about it like this: prices lead quantities. All trade restrictions have winners and losers, so I expect the winners (companies that compete with imports) will see stock price movements fairly quickly, as will losers (i.e. companies that source goods and services from overseas). But it really depends upon what legislation is actually passed and implemented, and that should take a while. As for the impact on the actual flow of goods and services (i.e. quantities), that depends upon markets (i.e. supply and demand responsiveness or “elasticities”) in the sectors affected. Sometimes companies can pass on higher import prices to customers; other times they can negotiate with foreign sellers who push the burden backward to their own workers and suppliers through lower wages/prices. Believe it or not, economists don’t know this in advance…it reveals itself over time, sometimes over a year or two depending upon the nature of the industry (i.e. the amount of fixed costs, asset specificity and mobility…things that take as too far afield!).
Are you expecting higher inflation in the future? As far as inflation goes, the concern is that, as the economy expands, the excess reserves in the banking system (created “out of thin air” through the fed’s asset purchase or quantitative easing programs) will get loaned out too quickly. That is, the money supply will expand because each dollar loaned out increases the money supply by a multiple of that dollar due to the nature of fractional reserve banking (you borrow $100 to purchase something, the seller deposits that $100 in her bank, which then holds some on reserve and loans the rest out, say $90, to someone else who then buys something else, the seller of which deposits that into his bank, which holds some on reserve and loans the rest out, etc.). So whether or not we get too much inflation (above 2 or 3 percent core inflation for a sustained period) depends upon the ability of the Federal Reserve to control or hold in place those excess reserves (which are held on account at the fed). Ben Bernanke asked Congress for and received in 2008 the ability for the Federal Reserve to pay interest on bank reserves held at the fed for just that reason, i.e. so the fed could control the excess reserves and the rate at which they are loaned out. Specifically, banks won’t loan out excess reserves if they can receive the same interest payments risk-free from the fed. That’s a degree of control over the money supply that the fed didn’t always have, and that’s why I have above-average confidence that the fed can keep inflation from breaking out in a damaging way. However, it is true that we have never been in a situation quite like this (with $trillions in excess reserves due to asset purchases), so no one can say that they know for sure what the outcome will be. But my confidence is supported by experience thus far - inflation has been below target for 8 years, and many economists had forecasted hyperinflation during that period which never materialized. They didn’t get the “interest on reserves” part.
What about the national debt? I think the better research (including research I was involved with in the 1990s) indicates that government debt itself is a poor predictor of economic performance. It is the incentives in the economy that matter the most. That’s why you’ve had countries in trouble and debt default with varying debt burdens. Demographics will push our unfunded liabilities (debt burden) up substantially in 5 years or so due to Medicaid and Social Security obligations. But I expect that it will be worked out through things like means testing, (the more you have the less you get, regardless of how much you have paid in), alternative inflation adjustment mechanisms for future obligations, and adjustments to age and other eligibility requirements.
Posted on Tue, February 14, 2017
by Danny Aleman