Courtesy Everett Collection
Today’s good news could be bad news tomorrow.
The recently passed tax-reform package was seen as one of the most significant pieces of legislation for the U.S. stock market in years, resulting in an immediate boost to corporate profitability and providing another tailwind for equity prices.
All those positives, however, may just be short-term in nature, and the bill may have simply set markets up for a fall from a greater height.
“Fiscal expansion is near-term growth supportive, but it risks increasing pro-cyclical behavior. The benefits may be ‘in the price’ and investors must account for greater potential market downside at end of cycle,” Morgan Stanley wrote in a note to clients.
On Tuesday, the International Monetary Fund lifted its estimate for U.S. economic growth in both 2018 and 2019, citing the tax bill as a major factor behind the move. The IMF lifted its U.S. growth estimate for 2018 to 2.9% and its 2019 estimate to 2.7%, both increases of 2/10 of a percentage point. Beyond that, the IMF suggested economic momentum would begin to slow in 2020.
Morgan Stanley also conceded the bill “brought some near-term GDP uplift,” estimating an additional 0.3% of economic expansion in 2018, but added that “beyond that, positives become less reliable.”
The investment bank wrote, “While this policy supports growth in the near term, it may worsen the next downturn while limiting the fiscal reaction to it. Even if those concerns are unfounded, we think much of fiscal stimulus’ ‘good news’ is already in the price of key markets.”
Much of that good news for investors involved corporate profits. According to FactSet, earnings for companies in the S&P 500 are expected to grow 17.3% in the first quarter, their fastest pace of growth since 2011. Much of that growth is due to the tax bill; before the bill being passed in December, analysts were expecting a growth rate of 11.4%. The bill sharply cut corporate taxes, giving an immediate lift to profits.
While the spike in profitability has supported markets, it also poses risks of its own. Last week, the Wells Fargo Investment Institute suggested that earnings growth “may have peaked” in the quarter, and that the “high bar” of earnings growth that was being set “will be difficult to exceed” in the future. Goldman Sachs suggested the high expectations, fueled by the tax bill, would make the downside risk of any earnings disappointments “more substantial,” while there was limited upside in merely meeting these forecasts.
Morgan Stanley suggested margins and earnings growth may peak later this year or in early 2019, and suggested valuations had already peaked.
“While there’s a fair amount of debate about how much this fiscal expansion extended the economic cycle, for markets our analysis suggests we’re closer to the end of the day than the beginning,” it wrote. “Hence, there’s less reason to behave like it’s ‘morning in America’ than ‘happy hour in America’.”
The tax bill also featured a plan to repatriate the untaxed profits of U.S. firms held overseas. While proponents of the bill argued that this money would be used for investments and hiring, companies have instead tilted the use of that money to scale up their stock buyback programs and boosting their dividends to record-high payouts. According to TrimTabs Investment Research, U.S. companies announced $305 billion in both cash mergers and acquisitions and stock repurchases during the first quarter, more than double the $137 billion announced in the fourth quarter. This acceleration was fueled by the tax bill.
Buyback programs can support equity prices, as they have the byproduct of lifting earnings per share by reducing the number of shares outstanding. However, the use of buyback programs may peak in the same way earnings are seen to have, which could be a risk for markets, as companies are the biggest source of demand for stock, and slowing buybacks could make deeper losses more likely.
“Corporate behavioral incentives created by the tax reform favor deleveraging later rather than sooner, and hence could worsen the next downturn,” Morgan Stanley wrote. “Hence, markets will have to price in a few factors: a higher probability that the next recession may be more than just ‘shallow and short’; more fiscal and economic ’cliffs’ in the coming years; and the possibility that all investors can rely on in return is a temporary boost to growth.”