Tax Reform and Sky High Market Expectations, Why Should You Care?

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Blog Updated, Monday March 27, 2017 at 7:50am ET

Minutes after their hopes of undoing Obamacare unraveled, the White House and top Republicans shouted from the rooftops (in careful coordination); they’re moving on to another ambitious goal — overhauling the U.S. tax code for the first time since 1986.

S&P Futures Sunday Night, March 26, 2017

S&P Fut new

The S&P futures ES1 opened down at 2331.75, just through last week’s low.  Look for the bulls to defend this level overnight as the White House shifts gears on fiscal policy initiatives. 

“We will probably start going very, very strongly for the big tax cuts and tax reform, That will be next.”

President Donald Trump, after the House bill was pulled from a scheduled floor vote on Friday, March 25, 2017

Stocks in the U.S. suffered their worst week since the November election of Donald Trump.  Investors turned to bonds as U.S. Treasuries rallied for the second week.

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Wall St. was All Beared Up on Bonds Heading into 2017

Bonds Election

Since early March, the S&P 500 is off 2.6% while bonds are nearly 4% higher in recent weeks.  Coming into 2017, the policy execution bar was too high for the White House, equity markets are starting to price in a reality check on expectations.  After the monster bond rally, the yield on the U.S. 10 year Treasury bond is down near 2.37%, while Wall St’s year end yield target is 3.25%.

Near Record U.S. Treasury Shorts

CFTC Shorts

They’re piling out of U.S. Treasury shorts this morning as the “reflation trade” unwinds in a big way. 

Since December 15, 2016

Gold Miners $GDX +21.2%
Mexican Equities $EWW: +16.1%
Emerging Markets $EEM: +13.1%
Dow Jones Utilities: +11.1%
S&P Consumer Staples $XLP: +8.8%
Nasdaq 100 $QQQ: +8.2%
Long Term Zero Coupon Bonds: +6.1%
Long Term Treasury Bonds: +4.5%
S&P 500 $SPY: +2.5%
Financials $XLF: +0.5%*
Russell 2000 $IWM: -2.1%*
Regional Banks $KRE: -4.5%*

Dow Jones Transports: -4.8%
Oil Producers $XLE -12.1%

Bloomberg data

*Consensus Wall St’s “Overweight” Sectors for 2017’s Reflation Trade

Year after year we witness the same story.  Wall St. crowds their clients into glorious theme trades.  Each year, the road less traveled captures the honey pot.  When you hear a heavily bought in consensus from this mob, run – don’t walk – the other way.   Nearly all of Wall St’s “overweight” sectors for 2017 are underperforming this year.  The much heralded “reflation trade” has been put on hold as markets rethink the upside of Washington policy’s impact. 

U.S. 10s Touch 2.37%, Sunday March 26, 2017

10s new 15U.S. 10 year Treasury yield is through its hundred day moving average (see the green line above), the first time since October 4, 2016. 

Fed Rate Hikes?

Futures Market Probability

Rate Hike In?

June: 51%
September: 114%
December: 155%
Fed Dots: Two More Hikes in 2017

The futures markets are currently pricing in 50% probability of a move by June, 115% probability of a move by September, and 155% probability of a move by the end of the year.   A look at the Fed’s “Dots” (Fed governors public forecasts for interest rate direction) are currently projecting two additional moves this year, 31% more than what’s currently priced in.

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Q1 Returns of the iShares 20+ Year Treasury Bond $TLT ETF*

2017: +5.2%
2016: +13.5%
2015: +12.8%
2014: +7.3%

*from the December low to the Q1 high.

It’s nothing short of pure comedy, Wall St’s been the gang that can’t shoot straight on bonds year after year.  Each December, they’ve obnoxiously lectured investors about reasons to get out of bonds.  They come up with pathetic themes to corral the masses; the “great rotation,” the “reflation trade” and “life after liftoff” focused on Fed policy and “higher interest rates.”   This year it was Trump’s growth agenda, wrong again.  Every year it’s been a different excuse to get out of fixed income securities.  But so far in 2017, bonds, utilities, and defensive stocks have been the place to be.

Euro’s Dominance in 2017, Came After a Pan from Wall St.

Euro vs bbdxyWall St. was confident in December, they argued the ECB is in the middle of a $2.5T asset purchase program, while the Fed is hiking rates 3-4x, stay long the dollar.  Wrong again.  The dollar is at the same level is was during the week of the election of President Trump, it has given back all its gains.

We’re Hosting a Policy Call for Clients

Join Our Team in Washington, ACG Analytics and the Bear Traps Report will host a policy call on Monday, March 27, 2017 at 10:00am ET.

Implications of ACA Healthcare: Repeal Failure on the Trump Agenda:  Our team will analyze what the future holds for Healthcare and Tax Reform and how competing interests in the GOP will affect the legislative environment of Trump’s first term.

Join us here:

There’s a Colossal Tax Reform Earnings’ Premium Built into the S&P 500

S&P new

Some Wall St. analysts say corporate tax reform is now a happy meal not a big mac.  In other words, only a much smaller plan will be able to get through Congress now as revenue neutral ambitions are far more challenging.  As Washington policy execution stumbles, there’s an uneasy feeling creeping through in markets.  The hole just got deeper, now up to $2T with the border adjustment tax BAT in trouble & ACHA savings gone.  Bottom line, without key tax revenue offsets we’re looking at a corporate tax cut near 30-28%, not 20-15%.

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“There is a disconnect between the Trump stimulus execution risk and how far we’ve come in terms of expectations. An actual fiscal boost is more than 12 months away in reality, Obamacare took well over 300 days to land on the President’s desk while the Dems controlled the House, Senate and the White House. As much as well all want to believe Mr. Gridlock is dead, he’s still breathing.  As we head into 2017, gold miners, consumer staples, bonds and utilities are our favorite options as the street has unanimously bought into the crowded ‘reflation trade’ narrative.”

The Bear Traps Report, January 8, 2017

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The Road Ahead

Tax reform legislation climbs a far different mountain than the health bill. In December, we recommended clients overweight U.S. Treasuries, Utilities and Consumer Staples with a focus on “the high probability of political fumbles in Washington.”

Wall St. is Heavily Bought in to Tax Reform’s Success

We noted in December in our Bear Traps Reports, the difficulty congressional Republicans have had in reaching consensus on the health legislation can very easily lead to a pullback from their lofty ambitions on tax reform. Bottom line: the more extreme reform ingredients of the House Republican plan on tax reform are more at risk today.   Hot topics like the border adjustment and interest expense provisions that make up the destination based cash flow tax (DBCFT), will have far more uphill battle passing in an environment where near-unanimous support in the Senate will be necessary.

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Expectations from Wall St., Numbers You Need to Know
Tax Reform = S&P Earnings Boost Corp*
Earnings Premium: New Corporate Tax Bracket vs Earnings Addition to S&P 500 from Tax Reform

32% v 0% (earnings boost)

30% v +3.5% (earnings boost)

25% v +6.5% (earnings boost)

20% v +9.5% (earnings boost)

15% v +12.5% (earnings boost)

Bear Traps Report Data

*This is on top of the Street’s assumed 14% earnings growth based on economic, stock buy back and dividend payout forecasts.

S&P 500 Earnings

2017: $142*
2016: $116**

*Street’s forecast including successful tax reform
**Actual latest year (trailing four quarters to December 2016) GAAP earnings was $95.35,  latest year “operating” earnings (removes “unusual” items) was $106.45 per Bear Traps and Bloomberg.

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S&P 500 Twelve Month Forward Earnings Per Share Estimate

2017: $134.50
2016: $126.75
2015: $129.90
2014: $131.20

The forward 12-month P/E ratio for the S&P 500 is 17.5. This P/E ratio is based on Wednesday’s closing price (2348.45) and forward 12-month EPS estimate ($134.50).  Of the 111 companies that have issued EPS guidance for the first quarter of 2017, 79 have issued negative EPS guidance and 32 have issued positive EPS guidance.- Factset

As you can see, there’s 200-250 S&P handles tied to tax reform’s MEANINGFUL success.  Without the “expected” earning growth from tax reform, the current 18 PE on the S&P is far higher, well above 20 in our view.

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Wall St’s S&P 500 Targets for 2017

Best Case with Full Fiscal Policy Option: 2810*
Base Case with Partial Fiscal Policy Option: 2510
Worst Case with No Fiscal Policy Execution: 2090**
S&P 500 Today: 2343

We went through 12 different research reports from Wall St’s analysts, these are their best and worst case fiscal policy scenarios.

**Assumes no fiscal policy action (tax reform, repatriation, infrastructure) and a reversion to the mean in near record high CEO, small business and consumer confidence.

*Assumes full fiscal policy execution over the next 12 months (tax reform, repatriation, infrastructure, deregulation).

S&P 500 Sales Growth

2012-2016: 1.9%
2003-2007: 7.5%
1995-1999: 7.2%

Factset, Barclays

On the positive side, you can see why markets are so pumped up on Trump.  Sales growth found while looking at S&P 500 companies only grew at 1.9% during the mature years of the Obama economic recovery.  This data is well below normal levels and speaks to substantial upside if “animal spirits” are fully embraced in the years to come.

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