There is always uncertainty when a new administration takes office; this time more than most. Investors are faced with an unconventional candidate having won an improbable victory while promising an ambitious and somewhat fluid agenda. In addition, there is significant philosophical and policy space between the incoming administration and the more traditional wings of the Republican leadership in Congress.
All of this should lead to heightened uncertainty for investors, which, for now, they are ignoring as they bid stocks higher. The S&P 500 has rallied roughly 8% from the early November bottom. Value and small cap stocks have done even better, advancing 10% and 18%, respectively.
Although the rally can be partly explained by improving economic data, much of what investors are reacting to could be considered anticipatory. The market is looking forward to a combination of corporate tax cuts, a reduction in individual tax rates, fiscal stimulus and deregulation. But this is a lot, probably more than any administration can realistically achieve in one year.
Given these realities, what are the particular reforms that are likely to matter most for equity markets? From my perspective I would put corporate tax reform at the top of the market’s wish list. Here’s why:
1. Fiscal stimulus is probably going to be too small and protracted to have much impact.
Deficit hawks in Congress will want to keep any infrastructure spend modest. Practical realities dictate that any spending will also be lagged in its implementation and spread out over time. This will diminish the market impact outside of particular sectors and companies.
2. The market needs earnings growth.
U.S. equities are currently trading near the top end of their long-term valuation range, based on the price-to-earnings measure. Multiple expansion (in other words, paying more for each dollar of earnings) will be harder from here, particularly in an environment in which the Federal Reserve is tightening.
3. Corporate tax reform, therefore, is the market’s best chance of hitting earnings estimates.
The U.S. corporate sector exited a prolonged earnings recession in the third quarter of 2016, but that is no guarantee that earnings growth will meet expectations. 2017 estimates assume double digit growth, an aggressive target given already high margins and modest nominal economic growth. A reduction in corporate tax rates should close some of the gap between expectations and reality. While estimates vary, a reduction in the corporate tax rate from the current 35% to 20% would probably add approximately $5 to $7 per share to S&P 500 earnings in 2017.
Corporate tax reform is no panacea. Nor is it a win for everyone. Ancillary changes to deductions as well as a potential “border adjustment,” which would change tax treatment for both importers and exporters, will create losers as well as winners.
However, a sensible package of corporate tax reforms will improve U.S. corporate competitiveness. It will also provide a real-life tailwind, in the form of faster earnings growth, to a market increasingly driven by hope over experience.