“S&P index earnings are forecast to grow more than 20%” says Bloomberg. US consumer confidence is at a 17 year high, according to the Conference Board. US federal taxes have been cut, for corporations and most households. Foreign investors are piling into US stocks. Surely this is all great news? Not so fast…
Two big (financial) things have happened in the US in recent months. Federal tax rates have been cut and, combined with spending plans, the federal government budget deficit could reach US$1 trillion a year in 2019 and beyond, or around 5% of GDP.
In particular, the tax cuts have given already-pricey US stocks another leg up. But I’ll explain why I think the optimism is overdone. In fact, there are lots of reasons to think that investors are suffering from a severe infection of irrational complacency.
Today I’ll attempt to connect some dots. There are some huge risks lurking in the background that everyone seems to have collectively forgotten.
The tax cuts
The headline federal corporate tax rate has plunged from 35% to 21%. Most corporations paid less than the headline rate already.
That was either because they have overseas operations in lower tax jurisdictions, or because of all the hard won special deductions that they bought with their lobbying efforts and political contributions.
The average post-tax profit margin for S&P 500 companies is running at 8.9%. I worked this out by dividing the price-to-sales (P/S) ratio of 2.25 into the price-to-earnings (P/E) ratio of 25.34, using data from multpl.com, and expressing it as a percentage. (The result is E/S, which is profit margin.)
If a company used to pay a 35% tax rate in the US then it kept 65%. If it now pays 21% then it keeps 79%. That means, all else being equal, that net profit would increase by 21.5% in the US business.
Assuming 70% of S&P 500 profits come from the US, in line with the revenue split (according to Factset), post-tax earnings should increase by 15%. In turn, that would take post-tax profit margin from 8.9% to 10.2%, up 1.3 percentage points.
Most analysts seem to expect less tax-derived profit increase than this, typically in the 5-10% range for the S&P 500. But let’s run with this optimistic 15% scenario for a minute.
There’s still huge operating leverage. Each $1 of net profit still requires $10 of top line revenues, after taking off $9 of business costs and taxes.
This means only small adverse changes to revenues or expenses would completely eliminate the benefit from the tax cut. In fact, a drop of just 1.3% in revenues or an increase of just 1.5% in expenses would take the post-tax profit margin back down to where it was before, at 8.9%. Later on, I’ll look at what might cause that to happen.
Another change is that it’s much cheaper for US corporations to repatriate cash earned overseas. Previously, the US had a ridiculous system where companies faced additional taxes if cash profits were repatriated.
To keep up dividends and stock buybacks, many corporations ended up in a stupidly artificial situation. They borrowed huge amounts of cash in the US, even though they had vast cash piles sitting elsewhere.
With trillions stockpiled offshore, the hope is that a lot will now come home and be used for either investment in US business expansion, or to pay off debt, or for one-off distributions to shareholders, such as special dividends and big stock buybacks.
Again, this all sounds like good news. But certain supposed benefits are non-existent and the real benefits come with consequences. Again, I’ll explain that in more detail later on.
At the same time, households face lower federal income taxes. According to Business Insider, the changes mean someone earning $20,000 will get to keep an extra $200 a year, and someone earning $85,000 could be $900 better off.
That said, high earners could pay more. Someone earning $270,000 a year would be $6,000 worse off, again according to Business Insider. But the bulk of the populace should have a bit more spare cash.
This also sounds like great news. If people have more money in their pockets then they’ll probably spend more. Again, this is seen as good for stocks. However, once more there are consequences…
The deficit, debt and the dollar
With all these tax cuts, it should be no surprise that the federal budget deficit is set to rise. It was $665 billion in the fiscal year to September 2017. Many expect it to get close to or exceed $1 trillion by 2019, which is about 5% of current GDP.
This means more borrowing to fill the shortfall. A trillion dollar deficit would add almost 5% a year to the current federal debt of $20.5 trillion.
On top of this extra borrowing, the US government also has to refinance a vast amount of existing debt each year, as treasury bonds and bills mature.
Almost 28% of US federal debt comes due in 2018, according to M&G, the fund management company. That’s well over $3 trillion. In fact, over $1 trillion comes due in the first quarter, and $1.5 trillion in the second quarter.
The Federal Reserve is no longer doing quantitative easing (QE), the process of creating money to suppress bond yields through artificial demand (and, indirectly, fund the government deficit). In fact, in theory it’s allowing its $3 trillion-odd of holdings to roll off over time, as they mature (at least, until the next market crisis…).
Given the huge amounts to be rolled over, the likely huge new borrowing requirements and reverse QE, it’s no surprise that treasury yields have risen, meaning that bond prices have fallen.
At 2.92%, yields on 10 year treasuries are up 49 basis points over the past year, and 26 basis points in just the last month. (A percentage point being 100 basis points.)
And yet, yields remain abnormally low. Specifically, real yields are still very poor, being the yields in excess of price inflation (although US real yields aren’t nearly as absurd as in the UK or eurozone, where they’re negative).
Back in the early 2000s, real yields on 10 year US treasury bonds were typically in the 1.5% to 2.5% range. The rate now is still only 0.79%.
Is everyone ready for yields to bump up another percentage point? Because that’s a real possibility. Not least, because the (nominal) yields on short-dated bills and bonds are already sub-inflation. You know, all those trillions that have to be refinanced this year. Will people keep buying for a guaranteed, after-inflation loss?
According to the U.S. Bureau of Labor Statistics, which I’m sure is a really fun place to work, the CPI-U price index rose 2.1% in the year to January 2018. Twelve month treasuries yielded 0.8% a year ago. Therefore investors that held them to maturity lost 1.3% after inflation (before income taxes). Three month treasuries still yield just 1.64%, or less than inflation.
In the middle of all this, there’s a new head at the Fed. Janet Yellen handed over the poisoned chalice of the Fed chair to Jerome Powell on 5th February. He’s been at the Fed since May 2012, and before that was a lawyer, a corporate investment banker, at the US Department of the Treasury and in private equity.
Powell is faced with a country that’s swamped in government, corporate and household debt. At the same time there’s the huge, new fiscal stimulus to contend with, coming from the tax cuts.
Plus, the dollar fell 8% over the past year, on a trade weighted basis. Continued falls would add to inflationary pressures.
The potential demand-supply mismatch in treasuries could certainly result in further dollar weakness. From what I’ve read that seems to be what most people are expecting, but currencies are notoriously unpredictable beasts.
It’s no surprise that inflation has increased, albeit from unnaturally low levels. Or that most people expect it to keep rising.
Nor is it surprising that the Fed has signalled three rate rises during 2018. The Fed funds rate is currently 1.5%, and projected to reach 2% by the end of 2018, 2.5% by 2019 and 3% in 2020. (Incidentally, this is the counter argument for the dollar: if rates rise then it will provide support.)
Add the potential 1% decompression of real yields into the mix and is everyone ready for the 10 year treasury to trade at a 5% yield in a couple of years? I doubt it.
Stock investors, in particular, seem blissfully unaware of how much could go wrong with their rosy outlook.
Lots of potential for disappointment in stocks
Justifying the inflated level of the US stock market requires abnormally high profit growth from here to eternity. Which, incidentally, isn’t going to happen.
(For more on where the value of stocks comes from, and why most of it derives from far out into the future, see this recent article.)
But current expectations are high. According to the latest figures from Factset, earnings-per-share (EPS) for the S&P 500 is expected to rise 18% in 2018 and 10% in 2019, after gaining 11% in 2017 (although skewed by a 265% increase in the energy sector).
Presumably, these optimistic forecasts rest on the factors I’ve outlined, driven by the tax reforms:
- A boost to corporate profits due to corporate tax cuts
- An additional boost to corporate profits from a consumer boom
- Extra profit growth due to investment of repatriated overseas cash into business expansion
- Additional stock buybacks from repatriated overseas cash
That all sounds great. But permit me to throw some potential spanners into the works.
Consumption and investment booms (points 2 and 3) are inherently inflationary. Higher inflation needs to be met with higher interest rates.
US inflation has already picked up, and interest rates are already rising. If things really get going, then current rate expectations will be left for dust.
This will have an offsetting effect on corporate profits in at least two ways.
First, input costs are likely to rise due to price inflation. In particular, if there’s a lot of activity then there will be a lot of demand for employees. This will create wage inflation.
Second, it’s no secret that US companies owe a lot. If interest rates rise then so will corporate interest expenses. That’s either from existing floating rate borrowings or when fixed coupon bonds mature and have to be refinanced.
Remember how I said before that it would take just a 1.5% increase in expenses for the benefits of the corporate tax cuts to evaporate? Wage (and other) inflation pressures and higher borrowing costs have the potential to achieve that.
But surely companies would also raise prices? Well, maybe. But, all things being equal, if the corporate tax cuts raise post-tax profits by 15%, on average, then the companies’ return on capital will also jump.
Is America still a capitalist country? I certainly hope so.
In which case, higher returns on capital will bring in new competition. Or existing competitors will drop prices to gain or maintain market share, knowing they can still make a decent return.
Either way, there will be price competition (apart from for certain oligopolists and quasi-monopolists). Remember: it only takes a 1.3% fall in top line sales, relative to costs, to wipe out the benefit of the corporate tax cuts.
The combination of price, cost and interest rate pressures could quickly do away with the tax benefits for a great many companies, and perhaps most of them.
That leaves elevated stock prices resting on the potential for big, one-off stock buybacks from repatriated cash (and always remembering that cash could be used in other ways). But buybacks are no panacea either.
It’s important to make a distinction here, between ongoing buybacks funded from annual earnings, and “special”, one-off buybacks from historically stockpiled cash.
Ongoing buybacks are like dividends in terms of returns to the investor, although the tax treatment is usually different. Ongoing buybacks reduce the share count in a relatively predictable way, thus driving up the EPS each year.
Since the stock price reflects expected future EPS growth, those regular payments are reflected in the price – substituting a higher potential dividend yield for incremental capital gains. The same amount of dividend dollars spent by the company would have the same (pre-tax) effect on returns, except investors get income instead of capital gains.
However, one-off buybacks are different beasts. Say a company has a market capitalisation of $100 billion and is sitting on $20 billion of excess cash. If it uses $20 billion to buy 20% of the shares, then future EPS will go up by 25%. It retains 100% of the same earnings power, but split between 80% as many shares.
However, the market capitalisation of the company – which includes the value of the excess cash – should also fall by $20 billion, to $80 billion. Put another way, the stock has gone “ex-buyback”.
No ongoing boost to annual EPS growth is caused by this one-off situation. Once the cash has left the company – paid to ex-shareholders – there’s less value to divide between the lower number of remaining shares. Hence, the stock price should be completely unaffected.
Overall, investors in US stocks are hugely optimistic. But there are clearly major risks to their rosy view of the world.
To me, this looks like irrational complacency. I continue to believe that it’s best to take a cautious stance (see here).
(This is why I’m so rigorous about screening stocks when making recommendations for OfWealth Stock Investor. When stocks are already cheap, the risks are much lower.)
Stay tuned OfWealthers,