President Trump Looks Set for a Major Victory on Tax Reform: Market Recon

 | Dec 04, 2017 | 7:37 AM EST
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"My No. 1 priority is growth in the economy. Tax reform will be our first and most important part of that." -- Steve Mnuchin

Now

It took until the wee hours of Saturday morning, but Senate Republicans finally did pass their version of a tax reform bill, by the narrowest of margins. The Grand Old Party lost just one of their own, after the bill had morphed several times throughout the day on Friday, as only Tennessee's Bob Corker joined 48 Democrats in voting against passage.

Now, both the House of Representatives and the Senate have passed bills that revise the U.S. tax code.

Now, for the first time, the administration of President Donald Trump looks poised to clinch a first major legislative victory.

Now, party leaders will have to work toward merging the two versions of tax reform into one final bill, which the two bodies can then pass and turn into law by getting that version of the bill to the president's desk prior to the Christmas holiday.

What's Inside?

Congressional leaders will get back to work on Monday to unify the two bills. They actually do have much in common, though there are some stark differences. For instance, where does the corporate tax rate end up? Both bills set this rate at 20%, which would be a drop from 35%. This is the one key item in these bills that I think almost all agree will boost the economy the most. Yet, while each percentage point that this nominal rate drops adds in theory to aggregate corporate earnings, each of those same percentage points in theory pares about $100 billion of revenue from the revenue side of the budget over a decade.

Even the president, who originally had targeted a 15% rate, seems willing to pay ball with a couple of percentage points to the upside if this would soothe some of the deficit hawks. Both bills set any repatriation rate for liquid assets held abroad at 14%, which is a little higher than I would have liked to have seen. This only works to bring home substantial cash, in my opinion, if major corporations truly believe that the current trajectory of monetary policy succeeds in raising rates. That would make it that much more difficult to leave cash abroad to use as collateral, while commencing with stock repurchases and dividend payouts through low-cost debt issuance.

The two bills also differ to varying degrees on how pass-through businesses are treated (of major importance to this guy), which leads us to how individuals will be treated. This gets messy, and seemed to grow from the intention of being able to file one's return on one side of a postcard to something nearly as complicated as what we have now. There are many small differences in this space regarding different tax credits, but the most profound work will have to be done in deciding just how many tax tiers we need to have, and where to put the highest bracket. That last item will be highly politicized.

Then, there will be the treatment of mortgage interest, which is capped differently in both bills, and the treatment of state and local taxes. Huge. This, in particular, will be much more difficult to merge into passable legislation when the stakes are for real than they were in this early go round. Both bills allow for a $10,000 deduction for property taxes, while providing no break whatsoever for state and local income tax. Expect not only Democrats, but Republicans from high-tax blue states to haggle over this.

Without some kind of increase in this deduction, or movement on local income taxes, it may or may not be likely that the affluent will look to flee to states where they can find more favorable treatment. Clearly, property values in the states they leave would decline. How much? That's hard to say, but some highly leveraged folks will find themselves in over their heads.

Where To?

From a markets perspective, what we are all trying to figure out at this point is what exactly is priced in? Equity markets roared on Thursday when they caught wind that the Senate was making progress on this bill. Friday became extremely sloppy, as markets did not know which way to turn, as what we now know to be a misleading news story that had to be corrected made the rounds only to be countered by the president's lawyer.

Monday morning, equity index futures markets are signaling a much higher opening at 11 Wall Street. We all know that the Transports and the Small Caps have underperformed throughout 2017. However, both the Dow Jones Transportation Average and the Russell 2000 had started to make this ground up quickly as the month of November progressed.

Small-caps stand to gain the most in a lower corporate tax environment. These firms tend to be domestic in nature, thus benefiting the least from this year's weaker dollar, and as smaller firms they also end up paying net effective tax rates very close to the headline rate. As for the transports, these stocks depend on economic growth. So, let's go there.

Growth

I think we all know that stock prices are impacted by policy, both monetary and fiscal. This is what sets up the macro-economic environment that in turn propels corporate earnings. Earnings are what drives fundamentals. Fundamental analysis combined with technical analysis is how equities are priced. At least, that's how I derive my price targets.

The U.S. economy just printed back-to-back quarters that sported seasonally adjusted, annualized growth rates (SAAR) of 3.1% and 3.3%. Much better performance than almost anyone expected. Right now, the Atlanta Fed's GDP model for the fourth quarter is predicting SAAR growth of 3.5%. No doubt that this data was pushed along by hurricane recovery efforts, but still, confidence by all measures is flickering at or near millennial highs.

Manufacturing has made a comeback in this country. Core capital spending has been inconsistent in recent months, but after many years of slumber is finally showing signs of improvement. Consumer level inflation and wage growth have lagged, but by most accounts, the consumer has come back to life this holiday season. We'll know more shortly.

Charts of the Day: S&P 500 versus Russell 2000 and Dow Jones Transports

Using the S&P 500 as a proxy for broader market performance, and thus rendering that index as a constant, one can easily see the under-performance of both the small caps and the transports as the year 2017 has progressed.

Condensing the chart to just the last month, one can easily see how these two indices came to life in the last week or so, as the Senate made significant progress toward tax reform. Illustrated here as well is the underperformance of the two areas most likely to benefit from tax reform versus the broader market on Friday, as fears of that now corrected news story impacted investor expectations for the entire Trump agenda.

The question now is, with that story put seemingly away for now, how much more needs to be priced in?

Before You Go

The House was busy on Saturday as well. Seemingly under the radar this morning, House Republicans gave birth on Saturday to legislation meant to keep the government running for a couple more weeks when funding expires this Saturday. The full house should vote on this bill by Thursday, at the latest. This is a two-week patch that itself will expire on Dec. 22.

Lawmakers are clearly having trouble agreeing on a fiscal 2018 budget. The fiscal year actually began with October, but at least if the lay of the land regarding the nomenclature of the tax code is a known, then something concrete can be done on this front. This is probably being taken as a mild positive by overnight futures markets, adding to the morning's risk-on feeling. My gut feeling? We probably go through putting together another short-term patch in two weeks.

Sarge's Trading Levels

These are my levels to watch today for where I think that the S&P 500, and the Russell 2000 might either pause or turn.

SPX: 2688, 2675, 2662, 2650, 2642, 2634
RUT: 1566, 1559, 1551, 1542, 1534, 1528

Today's Earnings Highlights (Consensus EPS Expectations)

Before the Open: (GWPH) (-$1.16)

After the Close: (COUP) (-$0.11)

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