With Donald Trump sworn in as the 45th president of the United States, it’s worth noting that while a lot can change with any new administration, a lot continues to chug along. The housing market continues to improve, the labor market continues to heal, and the Federal Reserve (Fed) continues to normalize monetary policy. Keeping that theme of continuity in mind, investors should stay focused on the long term and go about daily life. Most changes coming out of Washington D.C. tend to be rather slow moving and long lasting in their implications. With an eye on the near- and long-term landscape, here are thoughts on how two key parts of President Trump’s agenda—trade and tax reform—could take shape in D.C. and affect the markets.
The art of the possible
President Trump’s inaugural address hinted at what policies he might push for: altering free trade agreements, corporate tax reform, infrastructure spending, and health insurance reform. The late 19th century German Chancellor Otto von Bismarck said, “Politics is the art of the possible.” President Trump wrote a book about the art of the deal. Realistically, any deal around these policy priorities will require compromise to make it through the legislative process. This means getting programs in place that are paid for and getting things through a Congress that isn’t as skeptical of current trade agreements as President Trump. This “art of the possible” will be an important driving force behind policies that will likely emerge over the next few months and even years.
Emerging market stocks and currencies were both hit hard by President Trump’s election, as investors perceived he would throw out existing trade agreements, renegotiate them, and not likely approve future agreements. Since the election, Trump has clarified that he simply wants better trade deals. Officials from major trading partners, like Mexico, seem to agree that existing trade deals could be improved. As long as the perception exists of the U.S. getting better agreements, there is no need to throw out existing ones.
We’ll see a lot of political pushback to closing U.S. borders to trade. Large businesses (500 or more employees) are responsible for 76.3% of all exports and 73.2% of all imports. Small businesses (less than 50 employees) tend to import twice as much as they export, while large businesses import 1.5 times what they export. Whether large or small, businesses will be sensitive to disruptions in trading relationships.
If the Trump administration alters trade relationships adversely, consumers will likely be sensitive to price changes; furniture, clothing, and food have a high import content. This is especially true with food, as climate conditions and crop seasonality have led the U.S. to import more over the years.
Trade negotiations are never purely one-sided, but always the product of give-and-take. Altering import rules would almost certainly alter what and where the U.S. exports. And exports are important: aircrafts, automobiles, and agricultural goods are only a few examples. The U.S. also exports many services, from financial services to education. Any attempt at changing import rules will likely result in rule changes tied to export markets.
Corporate tax reform
While individual income tax reform may be too big of a problem to tackle quickly, corporate tax reform could be low-hanging fruit. Corporate income taxes make up approximately 10% of federal revenues. From a budget-impact perspective, it is easier to change corporate taxes than individual taxes. One proposal that seemed likely to pass was the Republican border adjustment tax plan. Lately, though, President Trump has described the border adjustment tax as too complicated. The winners and losers under a border adjustment plan—which effectively subsidizes exports and taxes imports—depends on companies’ supply chains. Broadly, retailers and east coast oil refiners would pay higher taxes, while U.S. corporate farms that produce for foreign consumption would be big beneficiaries.
With any change, there are winners and losers. Profitable companies stand to benefit the most. Firms with tax loss carryforwards will lose the value of those carryforwards. Moving up the capitalization spectrum, there is a larger proportion of profitable firms, but they tend to have lower effective tax rates. The middle may be the sweet spot.
|Market capitalization||% of firms that had taxable profits||Median effective tax rate|
|Top 500 companies||85%||27.57%|
Past performance is no guarantee of future results.
By sector, telecommunication, industrials, and financials tend to have higher effective corporate income tax rates compared to REITs, information technology (IT), and health care. However, even by sector there is a big difference across company size when it comes to taxes. IT has the biggest divergence between large and small companies. In the third quarter of 2016, 90% of large-cap IT firms had positive effective corporate tax rates, while only 55% of small-cap IT firms had positive effective corporate tax rates. The effective tax rates were also wildly different with large-cap IT companies with a median effective corporate tax rate of 18.87%, compared to 30.82% for small-cap IT companies.
Any corporate tax reform will likely benefit small- and mid-cap companies more than large-cap companies. It will also likely benefit telecommunication, industrials, and financials more than those sectors with lower effective tax rates.
Other possibilities for tax reform
Another reform that is being discussed entails not allowing companies to deduct interest expenses, which would increase the cost of raising capital through debt. Even if this proposal doesn’t fly, lowering the corporate tax rate would reduce the marginal benefit of issuing debt rather than equity. This could mean less supply of corporate debt relative to what happens under the current tax code. Less supply tends to mean higher prices, and with bonds, lower interest rates. Corporate tax reform could result in interest rates being lower than they otherwise would be without reform.
Tax reform can also encourage companies to put foreign cash holdings to work in the U.S. In 2004, policymakers held a repatriation tax holiday that resulted in cash coming back, but used mainly to pay dividends or for share buybacks. Permanent changes are a better approach than a holiday, because they can alter the incentives of whether and where to invest. A permanent change could incentivize firms to invest in expanding the productive capacity of the economy, potentially leading to higher productivity growth and stronger real wage growth over the long term.
Expanding the economy’s productive capacity can also alleviate inflationary pressures, meaning the Fed can likely take a “low and slow” approach to monetary policy normalization. However, it could also raise what the Fed views as the “neutral rate” for its target rate over the long term. Right now, the Fed estimates a 3% target for the federal funds rate, which it expects to reach by the end of 2019. If productivity growth picks up, that neutral rate could easily rise to 3.5% to 4%.
Now the rubber hits the road. The proof is in the pudding. Insert whatever other cliché you want. When I look at the intersection of what the president has promised and what Congress might tolerate, the most likely scenario is one where we see quick action on corporate tax reform. Other things might take a while to hash out in committees and deliberations. The outlook for 2017 isn’t affected significantly by what comes out of D.C., but the longer-term outlook is a work in progress–just as it’s always been and always will be.