Trump's World: Head-Spinning Policies.
I’ve said it before: There has never been a President with policies so simultaneously bullish and bearish as Donald Trump! He is stepping on the economy’s accelerator and brakes at the same time.
Deregulation and tax cuts are bullish for the US economy as well as for corporate earnings and stock prices. On the other hand, the ballooning federal deficit—attributable to the tax cuts and spending increases—is putting upward pressure on bond yields at the same time that the Fed has moved to raise interest rates and taper its balance sheet.
No President has ever provided this much fiscal stimulus at this stage of the business cycle. In the past, such stimulus was provided during recessions or early recoveries, when the unemployment rate was at a cyclical high, not when it was near previous cyclical lows as it is today. Trump is making a very big bet on supply-side economics. The idea is that tax cuts will boost growth by boosting productivity, so inflation should remain subdued. That could work as long as growth isn’t weighed down by rising interest rates. If inflation does come back, then the latest supply-side experiment will end very badly indeed. (I expect that inflation will remain subdued, and I am open to the possibility that supply-side economics might work as advertised by its promoters.)
Trump’s geopolitical policies may eventually be bullish. But for now, they are bearish. His sanctions against Iran have caused oil prices to rise. The higher cost of gasoline will offset some of the benefits of Trump’s tax cuts for consumers. Higher energy costs will also squeeze profit margins, which were significantly boosted by Trump’s corporate tax cut.
Also on the bearish side, Trump’s worldwide tariffs on aluminum and steel and on Chinese imports may be disrupting US multinational supply chains and earnings, especially in the short term. But longer term, Trump’s policies may force more companies to move their production out of China and into the US or countries that have signed bilateral trade deals with the US.
On the whole, Melissa and I continue to believe that Trump’s polices are bullish for the US economy. We remain optimistic on the outlook for earnings and expect the stock market to recover from its latest selloff and make new highs next year. Nevertheless, we are very aware of the downside risks attributable to Trump’s head-spinning policy initiatives. Let’s update some of the top effects of Trump’s policies so far:
(1) Bullish corporate tax cut boosting earnings. S&P 500 earnings got a big boost from Trump’s tax bill passed at the end of last year. The Tax Cut and Jobs Act (TCJA) lowered the federal statutory corporate tax rate to 21% from 35%. Since its enactment, analysts have continued to raise their earnings expectations for this year and next: Forward earnings—i.e., the time-weighted average of analysts’ consensus 2018 and 2019 earnings expectations—for the S&P 500/400/600 are up 20.1%, 20.2%, and 32.3%, respectively, since the week of December 15. They rose to record highs during the 10/11 week (Fig. 1).
During Q1 and Q2 of this year, S&P 500 operating earnings in aggregate jumped 25.9% y/y to $1.25 trillion and 25.3% y/y to $1.31 trillion, respectively (Fig. 2). For Q1 and Q2, S&P 500 operating earnings per share (using Thomson Reuters data) jumped 23.2% y/y and 25.8% y/y, respectively. S&P 500 revenues per share increased impressively for the same periods, by 9.4% and 10.3%. Looking at the difference in the revenues-per-share and earnings-per-share growth rates for Q2-2018 implies that Trump’s tax cut might have added as much as 15 percentage points to earnings growth (Fig. 3).
This effect can also be seen in the profit margin, which jumped from a record 10.9% during Q4-2017 (before Trump’s tax cut) to a new record high of 12.3% during Q2-2018 (Fig. 4).
(2) Bullish deregulation boosting small business confidence. It’s impossible to measure the impact of Trump’s deregulation of business on S&P 500 earnings. Our guess is that deregulation, which started early last year, might amount to $4 per share in additional earnings.
The monthly survey conducted by the National Federation of Independent Business (NFIB) shows that significantly fewer small business owners have been reporting concern about government regulation and taxes since Trump was elected (Fig. 5 and Fig. 6). After all is said and done, the earnings component of the NFIB survey is the highest on record since the start of the data during 1974. This series is highly correlated with the NFIB’s “expecting to increase employment” series, also at a record high (Fig. 7).
(3) Bullish depreciation allowances boosting capital spending. Thanks in part to Trump’s tax reform, there has been plenty of cash flow to finance capital spending, share buybacks, and dividends. Progressives have argued that corporations are not making productive use of their resources. They say that firms are using incremental cash flow for the short-term benefit of shareholders rather than investing in future earnings potential. It is true that buybacks and dividends have been about the same as after-tax operating profits for the S&P 500 in recent years (Fig. 8).
However, focusing on this fact overlooks the record amount of corporate cash flow, provided by depreciation allowances, that has been fueling corporate capital spending. The data show that nonfinancial corporations’ (NFCs) capital expenditures are at a record high (Fig. 9). Private nonresidential fixed investment in real GDP rose solidly by 8.7% (saar) during Q2, following an 11.5% gain during Q1. Thanks in part to Trump’s tax cuts, there has been plenty of cash flow to finance capital spending, share buybacks, and dividends. In addition, TCJA helped to boost NFC’s capital consumption allowance by 19.4% y/y during Q2 to a record high (Fig. 10).
(4) Bearish federal deficits worsened by Fed’s monetary normalization. In addition to gradually raising interest rates, the Fed started tapering its balance sheet during October 2017. Since the start of that month through September, the Fed’s holdings of Treasuries and mortgage-backed securities have dropped by $152 billion and $86 billion, respectively (Fig. 11). The pace of tapering was upped this month for Treasuries from $25 billion per month to $30 billion. In effect, the Fed is adding $360 billion at an annual rate to the federal budget deficit. In the past, I’ve found that a supply/demand analysis of bond yields isn’t very useful. However, given that the Congressional Budget Office is projecting federal deficits averaging roughly $1.0 trillion per year, deficits may be starting to weigh on the bond market.
(5) Bearish impact of higher oil prices resulting from sanctions on Iran. Although they may be earning more lately thanks to Trump’s tax cuts, consumers are also paying more at the gas pump. The price of a barrel of Brent crude has been soaring ever since President Trump withdrew from the Iran nuke accord on May 8 (Fig. 12). At that time, the US announced it would reinstate sanctions against Iran and any companies doing business in Iran, leading to potential oil production decreases from Iran in the future. Iran is the third-largest OPEC producer, behind Saudi Arabia and Iraq. That’s bad news for consumers and businesses that must pay more for fuel. Of course, higher oil prices may also depress economic growth around the world, which seems to be happening already among emerging economies.
(6) Bearish superpower rivalry between US and China. Our 10/1 Morning Briefing was titled “China’s Syndromes.” I wrote that the Chinese government is scrambling to expand its overseas military and economic power to counter structural weaknesses at home, mainly related to aging demographics. I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. Trump’s endgame is that the US would no longer be financing China’s ascent with our trade deficit and providing technological knowhow that has been either stolen or extorted. To that effect, I covered recent harsh words and accusations spoken against China by the President and Vice President in the 10/9 Morning Briefing.
The bottom line is that the US’s relationship with China is not good and might get worse. In a worst-case scenario, Trump could up the ante by placing 25% tariffs on all imports from China indefinitely. That would be bad for US multinationals, depending on Chinese supply chains, especially in the short term. But I expect that US companies will reconfigure their supply chains outside of China accordingly, which would be bad for China’s foreign-demand-fueled economy.
Trump also has the power to limit US trading partners’ ability to do business with China. As I’ve noted before, the so-called “new NAFTA” agreement gives Washington the ability to veto any of Canada’s and Mexico’s trading partners that don’t abide by free-market principles—a veritable “poison pill” aimed at China. He could place such limits on other US trading partners as well.
Even though the escalating trade dispute with China is getting uglier by the day, I doubt it will be the event that ends the bull market in the US. However, it may mark the beginning of a severe and prolonged bear market in China.
(7) Bearish consequences for emerging economies. Most signs point to a “Stay Home” investing strategy right now. That’s because capital will likely continue to flow away from emerging economies. When that happens, greater demand for dollars relative to emerging market currencies raises the relative value of the dollar. Emerging market economies with lots of dollar-denominated debt get hit with a one-two-punch: weakening local currencies and rising interest rates.
Furthermore, China could fall hard because of the escalating trade dispute. That could contribute to further challenges for other emerging economies that depend on China for trade. It’s no wonder that the IMF recently warned about a potential slowdown in global growth. For some time, the IMF has been warning about the vulnerabilities in emerging economies as interest rates rise in advanced economies.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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