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The Days Ahead:
Winding down the earnings season. Consumer credit.
One of the busiest weeks of the year: Mueller indictments, Fed meeting, new Fed chair, tax proposals, rate hike by Bank of England (BOE), tech earnings and payrolls. But markets barely reacted with stocks remaining high (up 16% YTD) and Treasuries rallied. Bonds had priced in a concern that John Taylor, who tilts hawkish on monetary policy, would get the nod for the chair. So, when Jerome Powell was announced, bond yields fell to 2.32%. Long-term bonds are up 7.23% this year, which in a year of Fed tightening points to a disconnect between policy intentions and market expectations. Even U.K. stocks rose after the BOE raised rates for the first time since September 2007.
The U.S. market is almost entirely driven by earnings. We haven’t seen the stock market multiple higher in over a year. In other words, this is a market going up because of earnings, cash and dividends. It’s no more expensive. Here's what it looks like:
The bottom right hand shows sales of the S&P 500 increasing by around 5% and earnings by 7%. We haven’t seen two successive quarters of earnings growth since 2014 and that’s all down to the rebound in energy. They may not be the best loved of stocks but they're still 6% of the stock market and 7% of sales and their earnings growth is up 135% over the year.
1. Tax Cuts:
The House proposals came through:
- Repatriated tax (discussed in blogs): 12% vs 35%
- Corp tax: 35% to 25%
- 3 tax brackets: 12%, 25% and 35%
- State and Local Tax deduction eliminated
- Property tax deduction capped at $10,000
- Mortgage interest relief capped at a $500,000 house value
- Standard deduction doubled
- Alternative min tax scrapped
- No change on 401(k) deductions
- Estate tax threshold doubled and then phased out
- Tax on university endowments at 1.4% if assets >$100,000 per student.
We won't spend a lot of time on analyzing these because we’re a long way from a final bill. We would note that the corporation tax cut seems to be very much in the air and we’d be surprised if some final version did not survive the process. Interestingly the NFIB, who lean right and to lower taxes, will not support the bill because the vast majority of U.S. businesses do not incorporate. They're pass-through businesses where profits are passed untaxed to owners which are then taxed as income. So, they get no benefit. The plan may also hit multi-national companies with a tax on overseas earnings and transactions, even if neither are repatriated.
The corporate tax and the administration has become like a dog with a bone. The 35% rate sounds high, but companies pay around 20%. It’s also 2.4% of GDP, down from 3% two years ago, and 3.5% 10 years ago. So if legislators expect a big boom in capex, wages or employment from lowering taxes, experience suggests they are sadly mistaken.
Anyway, stay tuned and expect lobbyists to release the hounds.
Only one more jobs report before the December meeting of the Fed. There’s little in it to change their minds.
The headline number is a big bounce from the storm-driven September number. But the average of the two months is still way below prior months. The bottom line shows the earnings growth slowing to 2.4% and some earnings fell in nominal terms.
We know the NFP report is the biggest single trading report of the month. We also know it’s wildly unreliable, subject to revisions and with all sorts of caveats as to what day of the month the survey falls. It was not a strong report but is unlikely to derail the Fed.
3. Home Ownership:
We have a slightly different view on interest rates from the accepted wisdom. For most of the post-recession period, commentators either thought rates would bounce quickly as demand came back or were freaked out by QE and thought hyperinflation was around the corner. Even the Fed has consistently over estimated long-term Treasury rates.
But a careful look at bonds suggested that rates are far more likely to stay low for longer. Why? In no particular order 1) more boomers de-risking portfolios and investing in debt instruments 2) unfunded pensions that need to asset match long-term liabilities 3) international capital account surpluses that recycle into U.S. dollars 4) very low inflation and 5) a shortage of high quality assets (there are only two AAA rated companies in the U.S.)
The dark blue line third from the bottom is all home ownership at 63%, a 30 year low. But what we’re seeing is that for many renting is a permanent strategic choice. For those aged 35-44, ownership plunged from 69% to 58% and for those starting out on their careers (the bottom line), from 43% to 34%. The strategic choices include affordability, student debt, slow household formation and the whole urban lifestyle. Depressingly, in western states, only 25% of renters think they are “very likely” to become homeowners, compared to 40% just a few years ago. There’s nothing in the tax proposals to reverse any of these trends.
How does this affect rates? Well, if the younger cohorts aren't buying and the older group are looking to downsize by renting, then the supply of houses will increase and demand for mortgages decline. So, score one more for a low rate environment.
h/t David Ader at Informa.
Stocks are hovering around all-time highs and bonds still expect no change in long-term rates. As we’ve noted before, it's an earnings driven market right now and companies are turning in good numbers.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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