Trump must deliver on tax reform to validate equity markets’ rise

The Organization for Economic Cooperation and Development (OECD) this week said publicly what many are wondering privately — have U.S. equity markets risen above and beyond levels that could be justified by underlying economic growth?

If so, could this realization lead to a reversal that would threaten the ongoing economic expansion?

{mosads}The OECD, in our view, raises a valid question and one that is reflected in the relatively stark difference at present between “soft data” like surveys of business and consumer confidence, and “hard data” on actual household spending and business investment.

Since the presidential election last November, much of the soft data has moved sharply higher. For example, the NFIB Small Business Optimism Index has risen to levels not seen since 2003-05, with many small business owners saying they plan to increase employment and capital outlays. By a two-to-one margin, small business says now is a good time to expand. Consumer sentiment has improved, albeit to less of a degree.

The Institute for Supply Management’s index on manufacturing, which is a highly watched indicator of the state of the manufacturing sector, has rebounded to levels last seen in mid-2014 before the appreciation of the U.S. dollar sent the sector reeling. Two important subcomponents on new orders and production stand near recovery-level highs.

That said, the hard data on spending and investment have not been as robust. The economy grew at an annualized pace of 1.9 percent, and our tracking estimate of growth in the first quarter is running a bit below 2.0 percent. Labor markets remain robust and consumer spending has been fairly healthy as of late, and there is a wide variety of data that points to stabilization in the industrial side of the U.S. economy.

But there is a difference between stabilization and acceleration. It’s still early, but there is little evidence that business investment is mirroring the upturn in business sentiment. For now, it seems business is content to wait until it sees what policy changes are coming.

Financial markets have shrugged off the hard data and followed sentiment, as the S&P 500, DJIA, and NASDAQ are up 14 percent, 17 percent, and 16 percent, respectively, since early November. Much of this improvement likely reflects expectations of corporate tax reform that is mechanically translated into higher earnings and valuations.

MSCI World Index hit a fresh record. World equities have gained about $6tn since Trump election, equals to combined GDP of Germany and UK. pic.twitter.com/hz4deDLWE9

— Holger Zschaepitz (@Schuldensuehner) March 2, 2017

Tax cuts do not necessarily get factored in as easily into prices of other assets such as bonds or currencies, but reduced corporate taxation has a direct effect on after-tax earnings (by definition). The timing of the buoyancy in markets — immediately after the presidential election — points to policy expectations as the primary catalyst.

The problem, as some see it, is that equity valuations have gone too far against an economy that continues to expand at a moderate pace. One standard measure of richness is the price-earnings ratio — how much investors are willing to pay in terms of share price for $1 of earnings. That ratio currently stands at 21 for the S&P500. The last time this level was reached (outside of the recent recession, when earnings plunged) was in 2003 during the “dotcom boom”.

Those urging caution on current valuations have a point. Equity markets may be pricing in an overly optimistic view of what kind corporate tax reform passes and when and to what degree any tax policy changes induce more in the way of business investment.

The risk is that by doing immigration and health care policy first, the Trump administration and Republican-controlled Congress end up delaying tax policy. Treasury Secretary Mnuchin already points to the August recess as the earliest expectation for a plan on tax reform. But that could easily slip until 2018, given how difficult tax reform has proven historically.

It has been 31 years since the last comprehensive tax reform, for a reason; tax reform is hard to move forward and faces stiff resistance from entrenched interests.

To reflect this, we have adjusted our view that fiscal stimulus will take effect in early 2018, as opposed to late 2017, as we previously assumed. We do not believe this minor adjustment is enough to cause a reversal in the optimism that has taken hold of equity markets just yet. The market can handle a one- to two-quarter delay as long as it still believes good things are coming.

However, it is not unreasonable to think that further policy delays could cause a reversal in sentiment and, in turn, equity valuations. We do not think we are there now, but the point is that tax policy has to come at some point to affirm current valuations. Otherwise, valuations unsupported by fundamentals cannot be sustained indefinitely. 

Michael Gapen is the managing director and chief U.S. economist for Barclays Investment Bank.

The views expressed by contributors are their own and not the views of The Hill.