Gradual Corporate Tax Cuts Might Be Coming

Stocks Don’t Like Gradual Tax Cut

Stocks fell slightly on Monday on the prospect that corporate tax rates could be lowered gradually. The small caps are affected the most by this legislation because they have the highest percentage of domestic earnings. This caused the Russell 2000 to fall 1.15%. We are in the lead up period prior to the announcement of the plan, so there will be many reports of various potential policies. Sometimes the media is used as a leverage point to make changes to the bill. For example, the border adjusted tax was eliminated after it was floated in the media because retailers lobbied that it would hurt them unfairly. Therefore, it’s important to take every report with a grain of salt. The latest report cites the tax writing committee which is discussing cutting the corporate tax rate to 20% by 2022.

When looking at the cost of tax cuts over 10 years, having less tax cuts over the first few years, helps bridge the funding gap. I don’t think this is bad news because it simultaneously lowers the benefits corporations will get and increases the chances that it will pass. This makes it a wash. The concept that a plan with goodies for everyone can pass is farcical. Tough decisions need to be made to bridge the funding gap. The tough decisions being made, which have previously been discussed, means progress is being made. Currently, the PredictIt odds show a 32% chance of a corporate tax cut in 2017 (up 8%) and a 26% chance individual taxes will be cut in 2017 (down 1%). I think passing a corporate tax cut without an individual tax cut, makes the GOP look bad politically, but it makes sense the phase in of the corporate tax cut would increase the odds of it passing. It would probably be politically impossible and inefficient to phase in individual tax cuts. The point is to simplify the tax code for individuals. I can’t think of many things more complicated than rates constantly changing.

Q3 Earnings

The earnings growth is now expected to be 4.7% in Q3 which is the lowest growth rate since 2.8% in Q3 2016 according to FactSet. The chart below illustrates the weakest industries. This weakness isn’t like the earnings recession because it’s being led by the insurance industry which was hurt by the hurricanes which are non-recurring events. If you exclude the insurance industry, earnings growth would be 7.5%. In the beginning of the quarter, I asked the question why earnings estimates fell so much in Q3. As you can see, the main reason for the weakness was the weather. Also, keep in mind that the earnings results are blended meaning estimates and actual results are included. When the earnings season is over, the growth rate will improve by a couple of points making it look like a normal earnings quarter when you exclude insurance companies.

The bears don’t like the concept of excluding the weak industries. They would rather exclude the strong parts to make the total look worse. The chart below breaks down each sector. Energy is still seeing triple digit earnings growth because 2016 was filled with losses as oil prices were low. If you exclude energy, earnings would only be up 2.5%. This is a fair retort to this entire year’s earnings growth. However, it’s not a direct response to the insurance weakness. The energy weakness lasted over a year while the insurance industry is having only 1 weak quarter. It also had the potential to last longer if oil prices remained low this year, meaning it’s more cyclical than a one time event. Traders looking at frackers after the collapse of oil didn’t know when a recovery would come, while insurance stock traders know that these losses are temporary, so it’s easier to price in the change.

You can do this analysis where you separate the performance of any sector to see how the results would differ without that sector. A common analysis would be to look at earnings without tech. I don’t think it’s worthwhile to look at that because the improvement isn’t temporary.

The future earnings growth estimates changed in an interesting manner. Because of improvements from Q3, the estimates for 2017 and 2018 earnings improved. However, as you can see from the chart below, the estimate for Q4 earnings declined. The year over year earnings reports I’m most concerned about are Q1 and Q2 2018 because the first half of this year makes the comparison tough. Even with this decline, I’m not worried about Q4. It should have high single digit year over year growth.

Now let’s look at the S&P Dow Jones numbers to see how the earnings season is going so far. The operating margins are still at a record high which is 10.31%. That’s a 17 basis point increase from last quarter despite the weakness from the insurance firms. The quarter is off to a remarkable start. 75% of firms which have reported so far have beat earnings estimates and 65.9% have beat on sales. That earnings beat rate would be the highest rate since at least Q2 2013 if it continues to the end of the quarter. With 57.9% of firms reporting earnings, the as reported blended total is $28.33. This will be a new record if it’s reached. The current record is Q3 2014 which saw $27.47 in as reported S&P 500 bottom up earnings. The trailing twelve month results are also expected to reach a record as the blended result is currently $106.96. Technology is expected to have 11.53% year over year sales growth and a 21.33% increase in operating margins.

Conclusion

Stocks sold off slightly because there’s a possibility the corporate tax cut might be gradual. I think this shouldn’t affect stocks because the amount it hurts corporations is equivalent to the increase in the chance of the bill passing. On the bright side, this quarter is looking like another spectacular one for earnings when you exclude the insurance industry. For the first time in years, earnings are coming close to the initial estimates. Considering how stocks were able to rally when earnings missed by a long shot earlier in this bull market, it’s not surprising to see stocks doing this well when earnings are great.

Comments are closed.