The revival of the "Trump trade" -- the possibility, no matter how remote, of Congress passing corporate tax cuts -- underpins much of the euphoria in the stock markets, but traders may be pricing in too much of a good thing.
As Wall Street stock market indices hit record highs seemingly on a daily basis, analysts casually talk about boosts to corporate earnings of 7% to 12% due to the tax cuts and dream up share buybacks by companies repatriating the cash they are keeping abroad to protect it from the U.S. taxman.
The Trump plan also will encourage capital spending, the thinking goes, which in turn will boost revenues and profits.
The Trump administration tax reform proposal envisions cutting the corporate tax rate to 20% from the current 35% and levying a one-time tax on repatriated profits. It also would allow full expensing of capital expenditures, which further would reduce the amount of tax payable by companies because expensing rather than capitalizing spending generally lowers taxable income.
The total tax cuts under the plan amount to something like $6.0 trillion, so the first hurdle will be getting approval from Congress. The national debt exceeds $20 trillion, and it is hard to believe lawmakers will want to add to that to finance the plan.
Even if, as the plan's supporters argue, the economic growth generated will boost tax collection and therefore offset its effects on the budget, there are other reasons to doubt that it will send stocks on another skyward trip.
The tax cuts certainly would boost the U.S. corporate sector's cash flows significantly because companies would be paying less tax, which in theory frees up resources for capital expenditures. But "the link from tax cuts to higher capex isn't automatic," as Ajani Sivapalan and Gaurav Saroliya, two analysts from Oxford Economics think tank, wrote in research published on Thursday.
The U.S. corporate sectors with the highest cash flow surpluses are tech and health care; they also have the highest cash hoards abroad, accounting for more than two-thirds of the $2.3 trillion held overseas, the Oxford Economics researchers noted. But these two sectors have very low capex levels because they are not as capital-intensive as others, so it is unlikely more cash will boost their spending.
For most other sectors, debt levels are high. They are particularly high for sectors such as utilities, energy and real estate, which are among the most investment-intensive sectors. They account for almost half of all the S&P 500 capex and would not be able to increase capital spending without increasing debt to "dangerously high levels," the Oxford Economics analysts wrote.
The analysts said the prevalence of share buybacks in recent years suggests that it was not a lack of money that held back capex, but rather more fundamental considerations, such as worries about demand growth.
Does this mean the money saved through not paying as much tax as before or that is repatriated following the introduction of the one-time levy will be used for share buybacks instead?
Unfortunately, the analysts doubt that a share buyback spree would happen. The chart they compiled, shown below, illustrates why:
The chart shows that buybacks already have accounted for a significant increase in corporate debt since the financial crisis of 2007-09. Indeed, they are part of the reason why U.S. stocks currently are among the most expensive in the world.
Buybacks contributed to the fact that weak earnings in 2015-16 were not mirrored by a bear market in equities, but this also means companies may not rush to buy back their own, expensive shares with repatriated earnings.
Share buyback bulls draw parallels with 2004, when a tax holiday led to a surge in buybacks. But the Oxford Economics analysts noted that this time it's different, because repatriation may be much slower as there is unlikely to be a deadline.
Wall Street already has priced in a lot of the Trump tax cuts. When and whether the plan will deliver is now the big question.