Monday, March 27, 2017 | Mark Martiak
“The stock market has reached record levels since Trump’s election in anticipation of pro-growth policies”
Trump delivered his address to a joint session of Congress on March 2nd after the market’s close. The U.S. President appeared to be composed and “presidential” when he asked Congress to approve a $1 trillion investment in infrastructure spending, and promised “massive tax relief” for the middle class and tax cuts for corporations. The stock-market indices closed at record levels, with the Dow Jones Industrial Average surpassing 21,000, despite the lack of specificity with regards to his economic plans. Trump emphasized: “Another Republican President, Dwight D. Eisenhower, initiated the last truly great national infrastructure program — the building of the interstate highway system. The time has come for a new program of national rebuilding,” he said. The $1 trillion plan would be financed through both public and private capital to spur the U.S. economy by creating millions of new jobs. Trump’s plan to increase infrastructure spending is said to be long overdue and is expected to provide fiscal stimulus. His proposal looks promising for bipartisan agreement, but the timing on a vote for the plan is difficult to predict.
To accomplish our goals at home and abroad, we must restart the engine of the American economy — making it easier for companies to do business in the United States, and much harder for companies to leave,” he said in his speech.
Stocks even rose slightly higher following the release of the Fed’s Beige Book, which indicated that business confidence has calmed a bit since the election. The stock market has gained almost $3 trillion in value since the election on November 8. However, some investors still see prices for stocks climbing after reaching records levels in 2017. Substantial gains in the markets have sent valuations to highest levels in more than a decade, with some analysts warning of potential pullbacks. Will the rally continue? Investors have continued to fuel the bull trend, likely in anticipation of tax cuts and policies intended to boost corporate earnings.
“Tax Relief plan in motion”
Trump has recently said he will release a tax package as early as March. Vice President Pence pledged in a recent speech given in Fenton, MO. that that he and President Trump would deliver sweeping tax cuts “before we get to this summertime,” raising expectations that Republicans will deliver in relatively short order on a key campaign promise. Treasury Secretary, Steve Mnuchin and Speaker of the House, Paul Ryan have set an August deadline. Given the nature of the legislative process, the timing for tax reform remains uncertain. But lower corporate tax rates may yield benefits for investors, and the outperformance of companies paying high tax rates postelection suggests market confidence if this proposal ultimately becomes policy.
“Corporate tax rates – less is more”
Trump proposed his tax reform initiative during his address to Congress and focused on corporate rates, which he complained are the highest of any major industrialized nation – currently 35%. He campaigned on a plan to reduce the corporate tax rate to 15% from 35%, while House Republicans have proposed 20%. The President’s tax reform policy has helped to fuel investor enthusiasm. Trump touted: “My economic team is developing historic tax reform that will reduce the tax rate on our companies so they can compete and thrive anywhere and with anyone. At the same time, we will provide massive tax relief for the middle class,” he said. “We must create a level playing field for American companies and workers.
Trump advocates that a reduction in the corporate tax rate would help to refuel the languid economic recovery by stimulating capital investment which would create new jobs and higher wages. Moreover, an increase in corporate profits is expected to revive Mergers and Acquisitions activity, which could be a boost for banks and small to midsize companies due to increased valuations. But, the M&A focus is expected to be in the technology sector. Stock buybacks could also moderately support prices. Earnings are expected to expand in 2017 due to the combination of tax cuts, infrastructure spending and lower regulations. The perfect storm? Michael Thompson, President and Chairman of Standard & Poor’s Investment Advisory Services, and his team made a stab at estimating the impact on earnings from corporate tax cuts and hypothesized that there will be earnings boost from a tax cut. Their conclusion: The impact could be significant. But there’s a lot of “ifs.”
Trump’s Corporate tax proposal appears to be very attractive to investors, but tax reform could benefit certain sectors more than others. Per Morgan Stanley research, while the 35% tax rate does apply to most publicly traded corporations, companies typically seek to reduce their tax bill through deductions. See table below for a calculation of the percentage of pretax profits paid in taxes in the trailing 12 months. In aggregate, U.S. companies paid tax at a 21.5% rate. Consumer staples, consumer discretionary and telecom companies have paid at rates more than 25% as their businesses generate fewer deductions. These higher tax-paying sectors would realize the largest benefit from a decline in the marginal tax rate. Real estate companies that benefit from corporate tax exempt real estate investment trust structures, and utilities that have depreciation deductions related to large capital spending needs already pay lower tax rates. Accordingly, they are less likely to benefit significantly from further rate reductions.
Sectors with highest tax rates are poised to benefit the most. Alternatively, sectors with lower tax rates could see a negative effect.
Furthermore, Trump’s deregulation plans will have an impact on banks and small businesses. If the Dodd-Frank Act becomes less strident, banks’ earnings will increase due to less constraint on their business activity. Although cutting back bank regulation could be very risky, it will be a positive for bank earnings. Small businesses and the middle class could benefit if current arduous regulations are scaled down.
“Defense Spending – Trump it up”
Trump is starting to advocate his campaign to rebuild America’s military. Last week, the Office of Management and Budget director Mick Mulvaney provided a preview of the budget blueprint that the White House plans to send to Congress in mid-March. The blueprint proposes for a $54 billion, or about a 10%, increase in defense spending for fiscal 2018. The plan proposes to offset additional costs with reductions in non-defense discretionary spending. Two of the primary targets: foreign aid, to be reduced by approximately $40 billion per year; and the EPA.
Trump’s proposed defense spending plan could pose opposition in Congress as he aims for approval of what he called an “historic increase in defense spending to rebuild the depleted military of the United States of America.” While Republicans in Congress stated it was not enough to meet the military’s needs, Democratic lawmakers have commented that the cuts being proposed to compensate for the additional military spending would have a negative impact on important domestic programs such as environmental protection and education. The proposed plan calls for a rise in the Pentagon budget to $603 billion. The increase would be slightly higher than the country’s current 2.5 percent rate of inflation.
Currently, this proposal is only the first step in a long, complex budget process. The White House just recently sent a broad budget outline to federal agencies to ask for feedback on which programs to cut. The Trump administration will then finalize a formal budget request to Congress by May. But ultimately, it will be up to Congress to set spending levels for the government. There are many questions looming regarding which specific cuts Trump will target. An even bigger question is whether those cuts will be approved by the Senate.
Medicare and Social Security will be spared from cuts, Treasury Secretary Steve Mnuchin said in late February. By March 16, the White House will publish a formal “budget blueprint.” By May, they’ll finalize a detailed budget request and send it to Congress. Spending levels will ultimately need to be approved by the House and Senate. To approve Trump’s desired increase in military outlays, Congress would need to lift the cap on defense spending that was part of sequestration in the 2013 budget deal, which would require 60 votes in the Senate — including approval from at least eight Democrats.
Stocks to benefit from a military revamp plan: defense stocks including Lockheed Martin (LMT), Northrop Grumman (NOC) and General Dynamics (GD).
“March Interest Rates hike: on the table?”
The Federal Reserve plans to raise interest rates “fairly soon” if the economy remains on track, according to minutes from the January 31/February 1 policy meeting released Wednesday. At that meeting, the Federal Open Market Committee voted to leave its benchmark interest rate unchanged, just as markets had expected. The Fed has stated that they are waiting for more progress towards its target of 2% inflation, and even more evidence that the labor market is improving. The Fed has raised rates from zero twice since the end of the recession. Due to continuing risks to the economy including the uncertainty of policy outcomes from the Trump administration, the Fed has been taking its time to slowly normalize rates.
Economic data released last week indicated that the economy is close to the Fed’s 2 percent inflation target. The Personal Consumption Expenditures index, one of the indicators used to gauge inflation, rose 0.4 percent in January, boosting the annualized gain to 1.9 percent and near the Fed’s target of 2 percent. The higher pace of inflation is another reason the Fed might be eager to go ahead with rate normalization sooner rather than later. Simultaneously, economic growth appears to be accelerating at a faster-than-expected pace. The manufacturing index from the Institute for Supply Management rose to 57.7% in February, its best level in more than two years. Meanwhile, construction spending declined 1% in January. Car sales for February were mixed.
The New York Fed’s GDP tracker most recently pointed to fourth-quarter GDP growth of 3.1 percent, a sharp rise from the 1.9 percent indicated at the beginning of 2017. The Atlanta Fed’s forecast is at 2.5 percent, but it also has been on the rise over the past few weeks.
Moreover, the shrinking of the balance sheet may start soon,” said Neel Kashkari, the Minneapolis Fed president, on Tuesday. Yellen was similarly vague during congressional testimony on Valentine’s Day, saying the Fed would gradually unwind its balance sheet when the process of normalizing rates is well underway 
Investors optimism in the economy is reflected in the stock market rally and the strong dollar. The increasing confidence in growth for the U.S. economy is setting the tone for higher interest rates. The announcement following the Federal Open Market Committee’s March meeting will be a focus for investors. Per the minutes from the FOMC’s February meeting, an interest rate increase in March is now on the table. The market’s reaction to the reality of upcoming rate hikes was nonchalant. The possibility of a rate hike in March is significant because it indicates the Fed is planning a more aggressive path than the market initially had anticipated. Some market strategists suggest the Fed is paving the way for three to four rate hikes per year.
Market participants know that Yellen is very conservative and would not move ahead on hiking earlier than was required unless the Fed was very confident in the outlook. Prior to March 15th, after the FOMC raised the short-term rates, traders, per the CME’s tracking tool, assigned an 86 percent chance of an increase at the Federal Open Market Committee meeting. Traders have also pulled forward the timing of the two increases they’re fully pricing in for 2017, with the first occurring around May and the second in September. At the beginning of the week prior to the FOMC meeting in March, they were still anticipating June and December.
However, the Fed has also been taking the global economy into consideration, when determining when to increase rates. Europe seems to not be on the verge of collapsing beneath its sovereign debt load and that China appears to be seeing improvements in its slow economy.
For now, Fed officials continue to indicate there will be two more hikes this year and probably three more in 2018. The committee officials said they would raise their benchmark federal-funds rate by a quarter percentage point to a range between 0.75% and 1%.
“The simple message is the economy’s doing well,” said Fed Chairwoman Janet Yellen in a news conference following the Fed’s two-day policy meeting. “We have confidence in the robustness of the economy and its resilience to shocks.”.
Ms. Yellen was careful to note that the Fed hadn’t significantly changed its forecasts for economic growth, unemployment or inflation, but it expected continued improvement.
Another reason for the decision: The Fed, in its policy statement released after the meeting, said inflation in recent quarters was “moving close” to its 2% target after undershooting that level for years.
Following a market sell-off on March 21st, some traders expressed concern that hurdles to enacting the Trump agenda of tax cuts, deregulation and fiscal stimulus in Washington could be giving bulls pause. A rancorous and prolonged fight over health-care policy could divide a Republican-controlled Congress before policies such as tax reform can be addressed, some investors said.
The S&P 500 dropped 1.2% to close at 2344.02, the benchmark’s biggest slide of 2017. It was the first time the index fell more than 1% in a day since October, the longest such stretch since 1995. The Nasdaq Composite Index, which features riskier technology and biotechnology companies, tumbled 1.8%.
 “How Corporate Tax Reform Could Affect Earnings,” Wealth Management, https://www.morganstanley.com/ideas/corporate-tax-reform-2017 (January 6, 2017)
 “How much the Trump tax cuts might help corporate profits” CNN, Zachary Apoian, Strategist, Wealth Management
http://www.cnbc.com/2016/12/01/how-much-the-trump-tax-cuts-might-help-corporate-profits.html (December 1, 2016)
  “How Corporate Tax Reform Could Affect Earnings,” Wealth Management, https://www.morganstanley.com/ideas/corporate-tax-reform-2017 (January 6, 2017)
 “Why the Fed’s almost-certain rate hike is an even bigger deal than normal,” CNBC, Jeff Cox,
http://www.cnbc.com/2017/03/06/fed-interest-rate-hike-in-march-is-big-deal.html (March 3, 2017)
 “The Fed plans to raise rates ‘fairly soon’ if the economy cooperates,” Yahoo Finance, http://finance.yahoo.com/news/come-fed-minutes-183655309.html (February 23, 1017)
 Bond Traders Race to Catch Up With Fed’s March Rate-Hike Signals, Bloomberg, Brian Chappatta and Alex Harris, https://www.bloomberg.com/news/articles/2017-03-01/bond-traders-race-to-catch-up-with-fed-s-march-rate-hike-madness (March 1, 2017)
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