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Economic Insights

While the anticipated fiscal policy moves that fueled investor optimism seem likely to be delayed, economic and business conditions continue to improve.

 

In Brief

  • For various reasons, proposed economic growth initiatives that sparked a U.S. stock-market rally following the November 2016 U.S. election may not happen as quickly as initially believed—or at all.
  • And yet, U.S. stock prices recently reached new highs, even as prospects for the fiscal initiatives that supported the so-called “Trump trade” are less certain.
  • One interesting aspect of the current market strength is the relative underperformance of sectors seemingly poised to benefit most from tax-reform and infrastructure-spending proposals.
  • What, then, is driving investor optimism? We believe it is the ongoing improvement in U.S. corporate profits, fueled by stronger current economic and business fundamentals.
  • The key takeaway:  While markets await the ultimate fate of current (albeit stalled) stimulus proposals, economic growth and corporate profitability seem likely to sustain securities prices for the balance of 2017. 

 

The higher U.S. stock prices that followed the 2016 presidential election seemed supported by expectations that fiscal initiatives out of the White House, such as tax reform, infrastructure spending, and regulatory rollbacks, would improve U.S. economic growth and enhance corporate profitability.  The impressive appreciation in the equity market was quickly dubbed “the Trump trade” in recognition of the then-president-elect’s economic stimulus agenda. Following the election, there was an intense focus on the new administration’s first 100 days, especially how much progress could be made toward implementing those stimulus policies in that short time.

We are now one month beyond the 100-day mark, and those policies seem legislatively “doable” only in 2018, not 2017.  For various reasons, including a contentious political environment and uncertainties engendered by ongoing investigations into Russia’s alleged role in the 2016 U.S. election, the fiscal initiatives that sparked investor hopes in November may be delayed, diluted, or unable to muster sufficient support for passage by the U.S. Congress at all. 

And yet, stock prices recently reached new highs, even as prospects for the fiscal initiatives that supported the so-called Trump trade wane.  Are investors misguidedly optimistic as they hold onto hope that the stimulus proposals will get back on track? Or are there other factors at work that support equity valuations and expectations of improving economic growth?     

Tax-Rate Turnabout
An analysis of the current markets that could benefit an investor by incorporating the hypothetical consequences of different fiscal policies is to consider that stock prices may reflect something other than the prospective passage of fiscal policies.  Tax-reform proposals, for example, appear to be providing little support for current equity-price levels.  High-tax-paying companies in the S&P 500® Index, which should benefit from corporate tax reform, outpaced other S&P 500 companies in the first few months after the election. Yet as of early April 2017, shares of these companies had given back all of those relative gains, according to a Goldman Sachs report. 

Similarly, Business Insider reported that a Jeffries analysis of the S&P 1500 (the combined S&P 500, MidCap 400, and SmallCap 600 indexes) showed not only that companies with high tax rates have underperformed their counterparts with lower tax rates since the election but also that the lowest-tax quartile was the best performing.  If investors were counting on tax reform, the opposite appears to be true:  high-tax-paying companies, with the most to gain from a shift to lower taxes, would be favored.  At least with regard to tax reform, it seems that something else is driving favorable investor sentiment toward equities.

And what of the White House’s proposed boost to infrastructure spending?  As a proxy for expectations of an infrastructure boom, especially given White House proposals of $1 trillion in spending, the S&P Supercomposite Construction and Engineering Index jumped 25% during the month after the November election, while the broader S&P 500 was up a hair less than 5%.  Since that time, the Construction and Engineering Index has lost almost three-quarters of that gain (through May 25, 2017), while the S&P 500 continued to climb an additional 7.5%.  Since the election, the S&P 500 increased nearly 13%, while the Construction and Engineering Index returned just less than 7%. 

The bottom line from this discussion is that, at the moment, investors do not seem to be counting on a trillion-dollar infrastructure program.  That same conclusion is reinforced by comparing the MSCI Infrastructure Index to the MSCI USA Stock Index.  Since the election, the Infrastructure Index has appreciated 3.8% (through May 25, 2017), compared to 14.8% for the broader MSCI Stock Index during the same period.                                   

Fundamentals, Foremost
Although the media continue to push the narrative that the stock-market improvement is a consequence of the “Trump trade,” the relative underperformance of those sectors that are poised to benefit most from proposed policies suggests, instead, that the actual catalysts likely are current corporate and economic fundamentals.

First-quarter S&P 500 corporate earnings are on track for a year-over-year improvement of 13.6%, according to FactSet—the highest growth rate since the third quarter of 2011.  As important, earnings improvement appears to be more a function of rising revenues and controlled costs and less related to financial engineering. Indeed, share buybacks, a preferred method of boosting earnings per share, are down 18% from a year ago, according to S&P Dow Jones Indices data.

Economic fundamentals, too, suggest potential for earnings growth to continue.  Though the May employment report was somewhat disappointing, U.S. job growth remains persistent, averaging 162,000 per month since the beginning of the year, well in excess of estimates of an 80,000-per-month trend in labor force growth.  Continued job gains, in an environment with only 4.3% unemployment, suggest recent average hourly wage growth of 2.5% could accelerate as employers increasingly struggle to find and retain qualified employees. The combination of job growth and wage increases has been accompanied by strengthening consumer confidence, reflecting appreciation of home prices, improvements in equity portfolios, and relatively high savings rates. This implies that increased consumer spending could further contribute to improving U.S. economic growth.

If consumption accounts for 70% of U.S. gross domestic product, the remaining 30% is largely made up of business investment and government spending, both of which show signs of increasing, even without potential fiscal initiatives.  Business spending—expressed as nonresidential investment in structures, equipment, and intellectual property—grew at a pace of 11.4% in the first quarter of 2017, according the Bureau of Economic Analysis.  While about half of that increase was related to oil and gas drilling, nearly all investment categories showed gains.  Spending of this nature not only supports economic growth but also suggests high confidence on the part of businesses that chose not to wait for any kind tax reform to see if they would benefit from better treatment, but instead went ahead with expensing capital investment.  Government spending, too, is poised to increase.  After years of budget constraints (mostly due to the after-effects of the financial crisis of 2008–09), both political parties seem willing to increase government spending in 2017, promoting economic growth and potentially, corporate profits.       

While We’re Waiting
Although the “Trump trade” may have been a catchy description to use immediately following the 2016 election, it is, however, misleading to use it to accurately describe market movements in 2017.  Corporate earnings and broad-based U.S. economic growth seem, as we have said, more likely to be the drivers of higher equity prices over the past several months and over the balance of 2017, rather than any policy proposals the White House may have in mind.  Growth outside the United States also is a likely contributing factor.  Leading economic indicators in the eurozone and Japan suggest convergent global growth that could further buttress U.S. and international corporate earnings.

Washington may believe it earns some credit for market upside owing to a rollback of regulations that selectively improve profitability among oil drillers, pipelines, coal companies, and potentially some financial institutions. However, the widely hailed benefits of tax reform and infrastructure spending—dependent upon a legislative consensus that has thus far proved elusive—seem largely absent from current equity valuations, but could be the catalyst for securities prices in 2018.  Until then, partisan politics appears incidental to economic growth and corporate profitability, which seem currently more than adequate to sustain securities prices for the balance of 2017.

 

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