Expectations Inflating
Doug Walters
Investors celebrated fresh highs for U.S. equities this week, while the outline of a tax reform plan was unveiled. We see the potential for a showdown with the Fed.
Market Review
Contributed by Doug Walters
The S&P 500 found its way to higher ground as the Trump administration rolled out some high-level thoughts on a tax reform plan. They will be leaving it to Congress to hammer out the details. Elsewhere in politics, German chancellor Angela Merkel was re-elected, while Japan’s prime minister Shinzo Abe has called for elections.
An Interesting Dynamic
Expectations are high for tax reform, and the Trump administration took steps this week to show progress (see our Economics section). Equity valuations are above average and tax reform is part of what has the market feeling buoyant. Fed Chairwoman Janet Yellen announced this week that she does not see the Fed’s elusive inflation target as a hurdle for the next rate increase. This is creating an interesting economic dynamic. The administration, through tax reform, is hoping to stimulate GDP growth. However, there is not much slack in the economy, and the labor force is quite tight. The result could be growth and wage inflation, leading to real inflation. The Fed is undoubtedly aware of this dynamic and will want to stay ahead of the curve.
Adding intrigue however is the fact that Yellen’s term as Chair of the Board of Governors ends in February. The next Chair will be appointed by President Trump. Not only that, as we discussed in “Three’s a Crowd”, there are four Fed vacancies that need to be filled by the administration. Given Trump’s high aspirations for growth, we would not be surprised to see the President populate the Board of Governors with growth-friendly, dovishly-inclined members. Perhaps that elusive inflation is not so far off.
| Indices & Price Returns | Week (%) | Year (%) |
|---|---|---|
| S&P 500 | 0.7 | 12.5 |
| S&P 400 (Mid Cap) | 1.5 | 8.2 |
| Russell 2000 (Small Cap) | 2.8 | 9.9 |
| MSCI EAFE (Developed International) | -0.7 | 16.6 |
| MSCI Emerging Markets | -2.7 | 24.4 |
| S&P GSCI (Commodities) | 0.5 | 0.5 |
| Gold | -1.3 | 10.9 |
| MSCI U.S. REIT Index | 0.4 | 0.6 |
| Barclays Int Govt Credit | -0.1 | 1.0 |
| Barclays US TIPS | -0.4 | 0.4 |
Economic Commentary
The Trump Rally Continues
President Trump this past week proposed to have the most sweeping tax reform in decades, broadly offering tax cuts in an effort to stimulate higher GDP growth. The new framework would simplify the tax code into three or possibly four tax brackets. As with any legislative reform, there will be winners and losers as the details are negotiated in Congress. The most obvious winners may be:
- individual tax payers that live in low-tax states,
- tax payers that currently do not take deductions,
- small businesses benefiting from a lower corporate tax rate
- large companies with material amounts of money overseas that may be given a tax break on repatriating the money, and
- heirs of large estates including farm owners with vast amounts of land as the estate tax may be repealed.
Possible losers from the tax reform plan may be:
- salaried workers in high-tax states, as the state tax may not be deducted from Federal taxes,
- people with large medical expenses that currently deduct them,
- future generations, if GDP growth forecasts are too optimistic and the tax cuts lead to greater government deficits.
The promise of tax reform has kept business owners in good spirits of late, as shown by the Small Business Optimism index. The index has generally been increasing since the Financial Crisis, but has popped during the Trump presidency.
Week Ahead
Not Time to EJECT
Earnings from Costco (COST) and Pepsi (PEP) will kick-off the quarter’s earnings season.
- Estimated earnings for Costco (COST) are expected to increase by nearly 13.5% from a year ago.
- PepsiCo (PEP) is expected to post 2% earnings growth from the previous year, as the company works through the secular decline in carbonated beverages.
Jobs report from ADP payroll and The Non-farm Payroll report are expected to report soft hiring numbers.
- Analysts estimate the U.S. economy will add 75,000 jobs in September based on the non-farm payroll survey. Hurricane related disruptions may be to blame.
Economic data for September will be focused on the health of the service and manufacturing sectors.
- The ISM Manufacturing Index is expected to remain near a 10-year high level while the Non-Manufacturing Index is expected to be in the ball park of the 5-year average.
Chinese National Day will start this Sunday on October 1st and will be celebrated for the entire week, also referred to as a “Golden Week”.
- The holiday commemorates the founding of The People’s Republic of China, which is celebrated by travel and activities around the country.
Trade Balance is expected to decline slightly, bringing the deficit down to almost $43 billion in August.
- The 5-year monthly deficit average is about $61 billion.
Strategy Updates
Contributed by Max Berkovich ,
STRATEGIC ASSET ALLOCATION
A Small Fire
Small capitalization stocks have been on the sidelines much of this year, but recent discussions about tax reform and cash repatriation have reignited these stocks. This is because investors anticipate that small domestic businesses should reap most of the rewards from the proposed tax reforms.
- The Russell 2000 Index is up nearly 10.8% year-to-date, gaining nearly 10% since August 21st.
- According to FactSet, earnings of the Russell 2000 Index are expected to increase by almost 13% in 2017.
- For the record, the Russell 2000 Index was up 21.3% in 2016, with almost half of that return coming post-election.
- The Health Technology and Industrial Services sectors were the best performers within the index.
STRATEGIC GROWTH
M&A Winds
Energy was the leading sectors for the quarter as the WTI Crude price jumped from $46 to $52 per barrel. The big laggard, the Discretionary sector, continued to receive blows from Amazon’s (AMZN) relentless disruption of retail. Some of the bigger news stories for the quarter include…
- EQT Inc.’s (EQT) acquisition of Rice Energy (RICE) and an activist investor’s objection to the deal.
- United Technologies (UTX) acquiring Rockwell Collins (COL) for $30 Billion.
- Qualcomm Inc. (QCOM) continues to peruse fellow strategy holding NXP Semiconductors (NXPI), but shareholders of NXP and activist investors continue to push for a higher take-out price.
STRATEGIC EQUITY INCOME
Health Check
The Telecom sector was the leader for the quarter due to Verizon’s surprise earnings report, but The Technology and Energy sectors were not too far behind. Health Care was a laggard, mostly due to a medical device maker taking a breather. Some of the notable news stories for the quarter include…
- Verizon Inc. (VZ) ending the pursuit for a cable and or media company and refocusing back on Spectrum.
- Boeing Co. (BA) reporting 2nd quarter results that blew away expectations. In addition, the aerospace company is starting to muscle into the lucrative aftermarket business.
- Apple Corp. (AAPL) releasing the newest versions of the iPhone. While announcing iPhone 8 and 8s, the company also announced the much-awaited version X.
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