"Kee Points" with Jim Kee, Ph.D.

Okay, it is good to have a week where everything goes pretty much according to expectations. In France, Emmanuel Macron defeated Marine le Pen in the French presidential election on Sunday. Macron was the pro-European Community, pro-euro currency candidate, so his election – though expected – is perceived as a vote for stability rather than a Brexit-type shock to the system. In the US, hiring bounced in April with 211,000 new jobs created (the March number was a disappointing 79,000). Monthly data is noisy, and a rebound was expected, but again, nice to have a week with few surprises. And first quarter company earnings or profits in the US are coming in stronger than a year ago, as is sales or revenue growth. That too was expected. Business investment spending remains muted, but that should change under virtually any plausible scenario of business tax reforms being considered.

1980’s boom? Don’t let the daily business press distort your thinking on the impact of tax reform on stock market returns. It’s not that taxes don’t affect stock market valuations – they do! They affect company earnings or profits (corporate income taxes), and they affect how much investors are willing to pay for each dollar of earnings or profits (so called “investor taxes” on dividends and capital gains). To understand this last point, consider that investors in the aggregate typically discount future earnings at what is known as investors’ required rate of return, which is after tax and after inflation. Lower investor taxes and/or lower inflation lowers this discount rate and increases equity values: a dollar’s worth of earnings is worth more – you’ll pay more for it - if the taxes you have to pay on it, whether dividend or capital gains taxes, are lower. But remember, markets are forward-looking, so it is reasonable to assume that the markets have already priced in some meaningful tax reform. That wasn’t the case in the early 1980s, when the Dow Jones industrial average was 70% below nominal GDP stated in billions of dollars (Studies at Georgia Tech show that these two tend to be the same over time). But I want to re-state or reiterate what I think is a big theme for global investors going forward, one that is multi-year and in keeping  with the appropriate time horizon of equity investors:

Returns on capital far exceed the cost of capital, which should lead to strong investment spending but has not Business investment spending should be a much stronger driver going forward than it has been. On the demand (for investment funds) side, that’s largely because a decade of policy uncertainty has tended to keep cash (business spending) on the sidelines or held overseas. On the supply (of investment funds) side, some regulatory clarity and simplification on Dodd-Frank banking legislation is likely going forward, and it is fairly widely acknowledged that the evolution of this particular legislation has thwarted credit creation, or the banking system’s ability to serve as a financial intermediary matching capital with opportunity. That’s how Canadian economist Reuven Brenner described capitalism’s wealth-creating tendencies when functioning properly: “It matches brains with capital and holds both sides accountable.” 

That’s the big-picture case for optimism:  You have on the one hand a tremendous amount of global capital tied up in safe-haven fixed income instruments. And on the other and you have the majority of the world’s population still in need of massive infrastructure spending as they go from rural to urban, and from primitive to modern. In the developed world you see increasing technological obsolescence as information technology marches on while corporate and consumer spending on technology lags. At some point all of this capital should address all of these needs.