The 2017 Market: Winds of Change: Headwinds and Tailwinds
The dynamics of this market year look to be some of the most interesting in many years. Let’s take a look at some of the issues that may provide tailwinds to propel the markets forward as well as the headwinds that may restrict market progress. We are unconcerned with politics since any major changes in the policies of a governing body throughout history will bring divergent rhetoric. The winds of change can create extreme swings in our nation’s politics and policies. The markets prefer smooth tailwinds in policy to aid in pushing the markets forward with occasional gusts to provide the volatility that creates opportunity. The goal is to stay focused on the health of our portfolios.
An overriding theme for many of the tailwinds that initially appear positive will be the “unintended consequences” of major policy changes and how these changes work in concert with each other. While each may have pros and cons when viewed in isolation, the key is that all are coordinated to provide balance to U.S. economic policy. While there are many, we will look at three in particular in this Market Report.
- The U.S. has one of the highest corporate tax rates in the world at 35%. According to KPMG, the average global tax rate in 2016 was 23.62%. We believe it is reasonable to lower corporate tax rates to a competitive or even advantageous level. A concern is a reduction in tax revenue which would impact government programs and inflate our already high debt levels. The concept of lowering tax rates is that the subsequent lowered rates will spur economic growth. The more that is taxed provides revenue to offset the lower rate. Both the Kennedy and Reagan administrations were successful with this formula, although rates were significantly higher prior to those tax cuts. The key is determining the right level and whether an incremental approach or a clear and immediate reduction will be appropriate.
- An estimated $3 to $4 trillion dollars are held overseas by U.S. companies in large part to our 35% corporate tax rate which reduces incentive to repatriate these funds. A repatriation tax holiday in 2004 brought billions home at a 5.25% tax rate. This can be a very positive move, if done correctly. The concern is the use of those assets when back on U.S. soil. We have expressed concern throughout out past commentaries of the effect of stock buybacks by U.S. firms. The problem is significant now and would be exacerbated by trillions of dollars in cash held by publicly traded companies with a desire to reward shareholders. The pervasive trend has been to buy back stock and increase dividends rather than invest in corporate growth.
To give a brief explanation of corporate stock buy-backs: When a publicly traded company purchases its own stock, it is removed from the public markets thus less shares are available for public trading. Typically, the public likes this, since a lower supply of shares and hopefully higher demand can push the stock price higher. It’s a good use for a small percentage of accumulated cash, however it may be more beneficial to see cash used for capital improvements – building facilities, upgrading equipment, technology infrastructure and expanding research & development. Buying back too much stock clouds the financial metrics of corporate success.
For example: The Price to Earnings -per share- ratio, or P/E, is a standard measure of value, which is price divided by earnings. Generally, a lower P/E typically equates to a better value. The key here is earnings per share.
So the bottom line:
- A company makes $1.00 in earnings and has a P/E of 10
- The company makes the same exact $1.00 in earnings but has bought back half its shares taking them off the market and out of the calculation
- The P/E is now 5 which makes it appear to be more valuable but it’s earnings are exactly the same
To summarize, repatriation of overseas profits is an extremely positive tailwind in any circumstance but would prefer a limit on stock buy-backs and special dividends.
- Regulatory headwinds for businesses of all sizes is on our radar, and certainly worker safety, environmental safety, and financial protections are areas for government oversight.
According to the Office of the Federal Register, in 1970, The Code of Federal Regulations totaled 54,834 pages. The code now stands at 175,496 pages. For those that see this as a partisan issue – it is not. The federal government under multiple administrations and legislatures has added to the burdens faced by small and large business. Again, while basic issues of health, welfare and financial protections are critical, many new regulations simply overlap those already on the books.
For large business, this impacts their ability to compete internationally and so we see jobs move out of the U.S. The cost of compliance for a U.S. firm can be significant – while other nations may ignore the expense and long-term consequences of oversight. For small businesses, the cost in both expenses and human resources can be the difference between survival and success. For both the burden of devoting resources to comply with multiple regulations addressing similar issues is a most powerful headwind. The problem is systemic within a government bureaucracy that has continuously expanded since World War II. The headwinds are significant in this area and while the government certainly may not abandon important regulatory responsibilities, the duplication should be reduced, and there should be have sensible implementation time tables to address both regulatory concerns and global competition in a balanced way.
An example of this is the Dodd-Frank Law of 2010 which was passed in response to the financial crisis in 2008. While the goals are simple and make sense such as improving transparency in large financial institutions and reducing risky trading, the complexity is staggering. Almost 400 mandates exist of which roughly 40% have yet to be finalized six years later. One part, the Volcker Rule, includes 383 questions which break down into another 1,400 additional questions. The addition of local and state regulations compound the burdens exponentially.
While political rhetoric will cloud many issues facing the business community, we have addressed only three here. Both publicly-traded firms and small businesses must thrive for our markets to move forward with confidence. In future reports, we will address additional issues which affect portfolios such as personal tax rates, the economics of our healthcare system, a rising interest rate environment, the future of the European Union, Asia, and emerging markets, to name a few.
We begin the year with a positive outlook for the markets but remain vigilant. Look for a special Affinity Capital Market Report focusing on our portfolio construction and re-balancing strategies. As always, please feel free to call us with any questions. We appreciate the opportunity to serve you.
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