Fuzzy Tax Reform Math

Much is being made of the GOP’s fiscal policy because of the shift in monetary policy towards hawkishness and because there’s a high amount of uncertainty over what legislation will be passed and when it will be passed. The chart below is Barclay’s estimation of when various policies will be passed along with some key dates. I showed a Gantt chart of Trump’s agenda a few months ago. It’s safe to say many of those goals were not met. This is partially because it’s a new administration which is trying to get many things done, but still must iron out the kinks. The other issues were caused by disagreements within Congress. That may be an ongoing theme of the next two years. The President will need Congress’ help in getting the budget issues resolved and tax reform done. Notice how an infrastructure plan isn’t even on the 2017 potential agenda. That’s bad news for manufacturing and materials stocks.

The Barclays slide below shows a summary of the issues with tax reform. As I have mentioned, while the GOP Congressional members may be more philosophically together on tax reform, the math behind getting tax cuts done is fuzzy. You can argue this gets back to the philosophical differences because some in the GOP won’t care if tax reform adds to the deficits and others will want it to be deficit neutral. With healthcare, the Congressional GOP members agree on repealing Obamacare and not much else. With tax reform, the Congressional GOP members agree on cutting taxes and differ on how that goal should be achieved.

The slide shows that the GOP is aiming to be done with tax reform by August, but as I have mentioned in a past article Mitch McConnell has stated tax reform will get done by October at the earliest. Barclays has an estimate for early 2018 which would mean the economy will have to rely on animal spirits for the next three quarters. That seems to be a dubious situation. The chart shows the fuzzy math I was referring to. Trump’s November 2016 plan will increase the debt as percentage of GDP to 105% in 2026. The fiscal hawks won’t approve of this which means the corporate tax rate may not be able to be lowered to the 20% rate promised by Trump. It could also shrink the size of tax cuts for individuals. The size of the tax cuts will depend on whether the boarder adjusted tax is enacted.

Either way there is going to be a tax; neither situation would lead to a goldilocks outcome. At this point, the only clear win besides regulation cuts is the repatriation tax holiday because firms can use the money for buybacks which will boost stocks and the government can use the money to invest in infrastructure when it gets a plan in place possibly as late as mid-2018.

Speaking of fuzzy math, the chart below shows the changes in 2016, 2017, and 2018 earnings estimates. Investors in Q4 2014 were pricing in $137.50 in earnings for 2016; they ended up receiving $106.26. Even with this big decline, stocks went up during that period. The clear takeaway is aggregate earnings have not mattered to investors for the past few years. The original estimate for 2017 earnings was $141.11 which is slightly more than the original 2016 estimate. Both estimates were fantasies as actual results have and will show. The S&P 500 trades at expensive trailing PE of 22.2 and an expensive forward PE of 18.18. Considering the cycle peak margins we’re at now, stocks are a clear sell.

The chart below looks at twelve year average annual returns starting from historical gross value added multiples. When the gross value added multiple is below one, the following twelve year returns are solid. Returns diminish the higher the multiple gets. The current multiple implies a less than 2% return per year for the next twelve years. The best-case scenario would be a flat market for twelve years and the worst-case scenario would be one that crashes and then rebounds. Neither scenarios sound exciting to me.

Studying the current shape of the economy is more important than the bulls let on since the fiscal stimulus won’t be coming for a few quarters. For that I’ll look at the latest Richmond Fed surveys. The Manufacturing Activity Survey was off the charts positive. It seems almost nonsensical that manufacturing in the Richmond Fed’s district is by far the strongest in five years. The composite index hit 22 which is the highest reading since April 2010. The current conditions index for employment doubled from last month reaching 20. The wages index increased from 15 to 21. Overall it was a fantastic report.

The services survey had more mixed results than the manufacturing one. As you can see in the chart, the revenues index declined from 15 to 9, but the three-month rolling average improved. The employment index improved from 7 to 17 and average wages paid increased from 14 to 23. The retail sector has been weak, so it’s interesting to see the results from this survey. The shopper traffic index increased from -7 to 18 which is a big positive swing. The expected demand for goods index decreased from 69 to 59. According to this survey, I’d say retail improved in the 5th district month over month, but it’s still down from January since February was such a poor month.


In this article, I reviewed the potential pitfalls which the GOP will need to avoid to get tax reform passed. The biggest potential boost to stocks now appears to be the repatriation tax holiday. Firms certainly need this holiday because buybacks have dwindled lately. I also showed the Richmond Fed surveys which give us a taste of how the economy is doing. It’s not a major report, but I think it’s important to review every data set. Not every report will change your mind on the economy, but they’re all worth nothing. The next Atlanta Fed GDP Now update is on Friday. I think the sub-2% Q1 GDP report will knock the market lower when its released in a few weeks.

Spread the love

Comments are closed.