After 107 days of the Trump Presidency, we believe that this administration is determined to be the wildest reality TV show of all time. People say, "War is God's way of teaching us geography." Perhaps Donald Trump is God's way of teaching us about the Federal Government?
The purpose of this commentary is to explain the challenges of making radical decisions about the US tax code and economy without creating counter-productive secondary effects. We will also project how these decisions affect specific sectors and industry groups. We'll do our best to write about Trump while leaving partisan feelings to the side.
As we often tell our clients, emotions and news nuggets dominate day by day fluctuations in the US stock market. Over longer time frames - quarters, years, decades - only revenues, earnings and interest rates matter. Ultimately, we invest in the cash flow generated by US corporations, discounted by expectations of current and future interest rates. Rising revenues and expanding earnings support the market; rising interest rates harm the market. With this framework in mind, let's review everything we know about the Trump presidency so far.
Spending on healthcare represents 17.1% of the US economy, yet our health outcomes (obesity, child mortality, addiction rates and chronic disease) trail "socialist" countries that spend much less including Sweden (11.9%), France (11.5%), Canada, (10.4%) and Japan (10.2%). These countries regarding health care spending as an investment in productive workers the way a manufacturer regards maintenance dollars spent on factory robots as an investment.
Americans don't regard healthcare spending as an investment, but as a cost. Uniquely among major industrialized nations, the provision of healthcare in the US is attached to employment, which left 50 million Americans uninsured prior to the passage of the Affordable Care Act in 2010. The ACA, with all its flaws, enabled 22 million to receive insurance, whether through purchasing policies through the exchanges, Medicaid expansion, or as young adults staying on their parents plan. We have HNW clients who are enrolled in Obamacare because it's the most affordable option in their communities.
Conservatives hate the cost of the Affordable Care Act that is covered by a 0.9% increase in Medicare Tax for earned income in excess of $250K for a couple, $200K for an individual and a 3.8% surtax on the unearned income (interest, dividends, passive business income). These taxes apply primarily to the top 2% of US earners and generate about $30 billion annually in tax revenues.
Given that Congress voted over 60 times to repeal the ACA between 2011-2016, observers assumed that repealing Obamacare would be the first act of the new administration. Indeed the S&P 500 Health Care index, sold off through the summer of 2016, rallied just before the election anticipating a Clinton win, sank in the days after the election.
To the astonishment of all, the first attempt to rollback the ACA under the new administration foundered March 24th when Paul Ryan, Speaker of the House, could not corral enough Republican votes to obtain a majority (Democrats across the board refused to support the bill.) Of the Republican dissenters, half felt that the repeal was incomplete, while the other half worried about the damage repeal would do to their own constituents. Apparently, their constituents aren't willing to die so that the richest 2% of Americans could receive tax cuts averaging $33K/family.
Just this past week on the third attempt Congress voted 217-213 to enact the cynically named American Health Care Act, which eliminates the Obamacare taxes, cuts $900 billion from Medicaid expansion over ten years, curtails many popular healthcare initiatives including a 95% budget cut to the office that fights opiate addiction. Congress held no committee hearings, provided no Congressional Budget office score and many congressman admitted that they had not actually read the bill. The legislative process now shifts to the Senate, where the House bill is generally considered "dead on arrival."
For the time being, the greatest beneficiaries of the current regime are insurance providers, but medical device makers and pharmaceuticals should do well. Actual doctors will continue to suffer the squeeze between rising costs and limited insurance reimbursements.
The Budget Process
Conservatives salivated at the idea of obtaining a $1.34 trillion reduction in spending over a decade by eliminating the ACA. Under the 2011 Budget Control Act, Congress can't raise spending or cut taxes without demonstrating that the changes won't increase the deficit. The Congressional Budget Office estimates the effect of changes over a ten year time frame through a process of "Dynamic Scoring." The limitation can be relieved by a super-majority vote of 60 in the Senate, but Republicans only control 52 seats. How are budgeting, tax breaks and tax reform all tied together?
In 2016, the US spent $3.9 trillion including 23.3% to Social Security, 15.0% to Medicare, 8.4% to Medicaid, 14.4% to unemployment benefits, federal retirement benefits and the earned income tax credit, 15.0% to Defense, and 6.2% to interest on the National Debt - 84.6% of spending is non-discretionary. The remaining 15.4% of discretionary spending includes the Departments of Health and Human Services, Education, Veterans' Affairs, State, Homeland Security, Intelligence, Housing & Urban Development, Energy, Agriculture, Justice, Transportation, NASA, Treasury, Labor, Social Security (administration,) Interior, Commerce, and the EPA.
On March 16th, President Trump released a budget proposal which cut discretionary spending 9.5% by $54 billion, while increasing Defense spending by a like amount. That proposal was largely ignored by Congress. Turns out, millions of constituents derive considerable benefit from discretionary spending - Republican Congress members got quite an earful during the Spring recess.
Congress avoided another government shut down on April 28th by passing a continuation resolution to fund the government through May 5th, which was then extended through September on May 5th. President Trump still wants $20 billion for the Mexican wall and new income tax rates. Congress is set on protecting programs that benefit their constituents. It will be a long summer in Washington.
In general, diverting dollars from discretionary spending (government agencies that support the functioning of the economy) to Defense would lower growth rates of the economy and by extension corporate revenues (except for defense companies.)
The IRS collected $3.27 trillion in taxes in 2016. The IRS could have collected an additional $1.5 trillion in 2016; money that is instead diverted to tax breaks such as the deductibility of employer health care expenses, lower tax rates on capital and gains and dividends, deductions for mortgage expenses, state and local taxes, charitable contributions, deductions for contributions to 401K pans and defined benefit plans. Corporations benefit from tax deferral of foreign profits and the deductibility of interest payments.
Specific industries benefit from a host of tax breaks, on average paying taxes at a rate of only 10.4%. Real estate developers pay an average income tax of 2.0%. Given Donald Trump's history of real estate bankruptcies (the losses of which can be applied against income without limitation,) it's likely that he has not paid income tax in 20 years. To be fair, his properties HAVE generated a substantial amount of real estate and payroll taxes over the last 35 years.
Congress or the President could lower income rates in general by partially or completely removing tax breaks. However, the pain of removing a tax break is felt acutely by a powerful constituency; the benefit to the general population is diffuse.
Conventional wisdom dictates that tax cuts promote economic growth, but the evidence of the last 25 years suggests otherwise.
Under President Clinton, top rate on income was 39.6%, 21.2% on capital gains. The budge deficit turned into a surplus, the economy grew by 56.2%, and the S&P 500 gained 264.7%. Under President George W. Bush, the top rate on income was lowered to 35%, top capital gains rate to 15.74%, the economy grew 39.0% but the S&P 500 lost 30.0% over 8 years and the national debt increased 77%. US wars in Iraq and Afghanistan cost $4 trillion. No taxes were raised to pay for those adventures; the cost was "financed" by expanding the national debt.
Under President Obama, income rates rose to 39.6%, capital gains to 25%, the economy grew 29.7% and the stock market gained 221.1%. The national debt grew 81.1% to a record $18.150 trillion from $10.024 trillion at the end of the Bush Administration. About $5 trillion of the increase was due to deficit spending to bail out the banking industry and stimulate demand after the 2008-9 financial crisis. Considering that Bush cratered a booming economy, while Obama rescued an economy on the verge of a second Great Depression, hard to argue that Obama was a worse steward of the economy compared to Bush.
The budget deficit soared to $1.4 trillion (9.8% of GDP) in 2009, shrank steadily down to $438 billion (2.4% of GDP) in 2015, began rising again in 2016 ($587 billion) after Congress made permanent a host of tax breaks.
At present the ratio between national debt and nation income is 106.7%. Generally once this ratio exceed 120%, the burden of interest payments overwhelms a country's ability to pay for anything else. Greece (158%), Italy (127.0%) and Portugal (123.0%) belong in this category. Japan (237.9%) remains in recession since 1991.
The last time the tax code was substantially reformed was under Reagan in 1986. Since then, many exceptions and exclusions have worked their way into the tax code. An army of lobbyists prepares to defend these exceptions.
In general, any legislation that makes the tax code simpler and more fair should benefit the economy and American businesses. Unfortunately, the Trump administration has shown no aptitude for the painstaking process of negotiating with Congress over the details. The "Trump Rally" faltered in March as investors realized that tax reform in 2017 was not assured.
Employment and Immigration
Though President Trump lost the general election by 2.9 million votes, he won enough blue collar voters in Wisconsin, Michigan and Ohio to capture the Electoral College. Those voters cared only about one thing - jobs! The greatest threat they see to those jobs is competition from immigrants. Our observation: if someone left a South America jungle with a third grade education and no English, walked across Mexico, crawled through the desert, hitchhiked the Interstate to your town and took your job, you're not very good at your job! You need to put down your video game controller, cancel your fantasy football subscription and get yourself back to technical school. Can you imagine Trump saying that at a rally? No. Much easier to blame "the illegals."
Fun fact: a record 29.8% of players in Major League Baseball are foreign born; but no sports fan or player ever complains about unfair foreign competition in baseball.
Here's the critical issue of the next 50 years. The world of work can be divided into intellectual (lawyer, doctor, architect) and physical (nurse, contractor, truck driver, oil rig worker.) Within these divisions are both routine and non-routine work. Any work that is routine can be automated. For example, toll booth collectors were replaced by EZ-Pass and overhead cameras. Bookkeepers were replaced by Quicken. Retail salespeople are being replaced by direct delivery from Amazon. Truck and taxi drivers could be replaced by driverless vehicles within ten years.
White collar workers are not immune from this trend - law associates can be replaced by e-discovery and wealth advisors can be replaced by robo fund selection. Every time a computer or robot replaces an employee, a business gains (robots can be depreciated, need no overtime pay, vacation or sick leave, won't unionize.) The workers in demand will be those who can program the computers or build the robots. The rest are left competing for minimum wage jobs ($13,926/year after deductions for Social Security and Medicare.)
Half these workers are 16-24, just starting up the career ladder. Half are older workers, many of whom held higher paying jobs previously that allowed them to buy a home and support a family. Many have chosen to drop out of the workforce permanently. The number of Americans receiving Social Security Disability benefits climbed from 5.042 million in 2000 to 8.909 million in 2015 - an increase of 65%. Coincidently, the rate of death from opioid overdoses (legal prescriptions and illegal heroin) increased 200% from 2000-2014.
The labor force participation rate peaked at 67.2% in 1999, currently hovers around 63%. There are about 205 million working age Americans in 2017, so approximately 8.6 million Americans have voluntarily or involuntarily left the work force. The non-workers don't spend much, so don't support the economy, which is currently running about 1.6% below potential. With each passing year, their skills atrophy and the workers become ever less employable.
At present 13.3% (42.4 million) of residents in the United States are immigrants, of which about 11.1 million are considered "illegal." In 2014 two-thirds of illegal immigrants arrived on non-work visa and simply overstayed. The number of undocumented aliens coming over the Mexican border is down by 90% since 2005, currently about 170,000/year. Illegal workers are represented heavily in housekeeping services, taxi driving, food processing and construction, though Americans still account for the majority of workers in these industries. Native born Americans hold 25% of agricultural jobs, 21% are legal immigrants on H-2A agricultural visa and 53% are illegal immigrants.
Legal immigrants are generally highly skilled workers who arrive for up to six years on an H-1B visa - 85,000 are issued annually. Melania Trump modelled "illegally" in the US under a B1/B2 tourist visa for 7 weeks in 1996, obtained an H-1B visa in October of that year. An additional 66,000 H-2B visa are issued for "seasonal" workers - the people who staff ski and beach resorts. There are also a limited number of visas designated E1- E5, for researchers, managers, especially skilled workers, performers, professionals such as lawyers, and finally investors and entrepreneurs. This category of visa can put an immigrant on track for a green card. At present, about 150,000 green cards are issued annually, with about 4.5 million applications waiting to be processed.
Studies show that white collar workers face little competition and indeed benefit from the low cost and productivity of immigrants. The Americans most harmed in competition with illegal workers are white males 30 or younger with no education past high school. In 2000 66% of Americans with this profile were employed; by 2015 the employment rate dropped to 53%. However, if all illegal immigrants disappeared tomorrow, it is unlikely that less educated American would have a much easier time. Between 2000 and 2010, 5 million manufacturing jobs disappeared, of which 13% were exported to China, Mexico and elsewhere, while 87% were lost to automation.
Industrial production in the United States is at an all-time record high - up 80.5% in 2000-2016. Automobile production peaked in 1999 at 13.0 million, fell as low as 5.7 million in 2009, regained to 12.105 million by 2015. In general, goods produced in the US today tend towards high value products like aircraft and MRI machines. Employment in low value industries like apparel declined 68.1% between 2000-2015.
What is the takeaway? The only way to address continued under-employment among US born workers is to increase STEM spending in high schools and increase spending for technical and vocational skills post high-school. Spending $22 billion on the Mexican border wall will not solve this problem. Spending $22 billion on 220 technical colleges ($100 million each) would be an excellent use of funds.
During the campaign, the President relentlessly bashed the North American Free Trade Association (NAFTA), the Trans-Pacific Partnership (TPP) and China ("currency manipulators".)
The TPP was a free trade agreement creating multi-lateral relationships between Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States and Vietnam, but notably excluded China. The agreement removed trade tariffs between signatories, established minimum standards for environmental, financial and labor regulations, blocked both human and wildlife trafficking. US exports were expected to gain $305 billion by 2025, increase the income of American workers by $77 billion.
So what's not to like? In the US, the benefits of the TPP accrue primarily to white collar workers while the pain of increased imports of low value goods falls on blue collar workers. By one estimate, wages for blue collar workers fell 17% between 1990-2000. As wages fell, traditional manufacturing communities in the South and Midwest hollowed out.
On Day 4 of the new administration, Trump signed an executive formally withdrawing from the TPP. The remaining 11 nations may complete the TPP without the US, scaling back environmental, financial and labor protection. China may well move into the vacuum left by the US, which is not good news for US in the long run - we lose the opportunity to shape Pacific Rim government relationships for the next 50 years.
NAFTA dates back to the 1994 and the Clinton Administration. During the campaign, President Trump labeled NAFTA "one of the worst deals ever" for American workers. As noted above, blue collar American workers derived more harm than gain. After 25 years, the three economies are tightly integrated. US exports to Mexico grew 245.6% to $235 billion. Imports grew faster - 353.8% to $295 billion for a current deficit of $60 billion. Offsetting the goods deficit, the US runs a surplus in services of $9.2 billion.
The US also gains from increased stability south of the border. As we noted above, illegal immigration from Mexico declined 90% because good jobs were created in Mexico.
What the President plans to do about NAFTA is unclear, other than signing an executive order on January 23rd to renegotiate the treaty. On April 26th, Trump announced that he would withdraw the US from NAFTA. Withdrawal from the treaty would be a net loss for US corporations from supply chain disruption. The economies of Texas, Arizona, California and the Northeast states of Ohio, Illinois, Indiana, New York, Pennsylvania, Tennessee are the highly dependent on exports to Mexico and Canada. On April 27th, facing push-back from Congress and his own Cabinet, President Trump announced that instead "he would renegotiate NAFTA."
Our president's plan to apply a 45% excise tax on Chinese imports appears to be on hold - apparently he revised his opinion about China after dinner with Chinese President Xi Jinping. President Trump hopes, probably in vain, that China will apply economic pressure to North Korea to back down from their nuclear program.
Fading from the mix is discussion of Paul Ryan's "border adjustment tax." In theory, the US could promote domestic production by changing how corporate taxable income is calculated. Companies could no longer deduct the cost of goods sold that were sourced abroad, which increases net income and therefore net tax. Simultaneously the tax on income from goods sold abroad would be eliminated.
Theoretically this tax would be neutral on net corporate tax. However the effects vary wildly by industry. Retailers who import low value goods from overseas would be crushed - there is no manufacturing base left to produce these goods. Energy prices could shoot up as well, causing soaring inflation for average Americans. However major exporters like Boeing, Caterpillar, Pfizer and General Electric could benefit. In theory the higher cost of imported goods would be offset by an increase in the value of the dollar (but then exporters lose their advantage.)
Bottom line, we believe that world wide supply chains are so finely calibrated that the disruption caused by adjusting to the new tax regime would drive the US economy into recession.
Corporations love to complain about regulation. Banks hate the strictures of Graham-Dodd. Coal mines hate when the EPA requires protection of waterways. It's reasonable to ask that regulations be simplified, perhaps even to include "sunset" clauses so that regulations have to be reauthorized every ten years. Industries can use regulations to create artificial markets, even monopolies. For example, for many years sofa manufacturers were required to apply flame retardant chemicals to fabric, with obvious benefit to the manufacturers of such chemicals. Unfortunately, these chemicals can accumulate in the tissues of children and pets, causing health problems and increasing cancer rates.
For sure, we would like financial services to remain tightly regulated - we don't want to see a repeat of the 2008-9 crisis ever again. If you think banks have reformed, just be reminded that Wells Fargo recently paid $185 million to settle allegations of creating 2 million unauthorized accounts to "harvest" $2.6 million in fees from unsuspecting customers. CEO John Stumpf "retired" in October and forfeited $41 million in executive compensation (in other words, the worst "trade" of his career.)
The Department of Labor was scheduled to implement a "Fiduciary Rule" applicable to advise offered to Americans rolling over 401K accounts on April 10th. The DOL had previously estimated that unscrupulous brokers "harvested" $17 billon annually from American retirement savings. As Registered Investment Advisers required to provide fiduciary advice under the regulation provided by the 1940 Advisers Act, we whole-heartedly support this regulation. At present, implementation is delayed until June 9th. Consumers don't have to rely on the DOL rule however. Simply ask any financial advisor whether he or she operates under the fiduciary standard. If the answer is "No," move on!
Some regulations are good; others are ill conceived. Eliminating regulations could benefit companies but harm consumers, not a win for the economy. Building a better process for establishing the cost-benefits of regulations would be a better strategy, we think, than eliminating regulations outright.
Though the US economy cries out for $2 trillion in infrastructure spending (highways, bridges and tunnels, water systems, electrical grids, airports) the money cannot be borrowed given the current size of he national debt.
New construction (a new bridge, a new subway) is always more glamorous that infrastructure maintenance (typically 10% annually of the original cost of construction.) For example a proposed high speed train between Dallas and Houston would cost $21.5 billion and run a deficit of $400 million annually to move 90,000 people a day downtown to downtown in 90 minutes, versus 3 hours 30 minutes driving. However, there are 25 flights a day moving 10,000 people in 70 minutes. If demand was that high for fast travel between Houston and Dallas, far less than $21 billion could be spent to add capacity at existing airports.
Even maintenance projects take time to organize. The Obama administration passed the American Recovery and Reinvestment Act in 2009, authorizing $789 billion for "shovel ready" projects. Even two years later much of the money had not been distributed. At present, China spends $1.4 trillion annually on infrastructure, more than Europe and the United States combined. Some of that expense is wasted, but imagine the competitive advantage!
Until the US figures out how to pay for infrastructure spending, expect growth to remain depressed in heavy machinery and construction materials.
Over the last hundred years, world sea levels rose by one foot. Hardly terrifying, yet we can already see that cities like Miami and Brooklyn are at risk from flooding. At the end of the last Ice Age 19,000 years ago, sea levels were 400 feet lower. If polar ice melted completely, sea levels would be 230 feet higher, swamping all major US coastal cities, and submerging most of the United States from Miami, north to Charleston SC, and west to Houston.
Global warming is apparent in our lifetimes. What's not clear is whether the effect is caused solely by burning fossil fuels, or whether other factors are at work. What is known is that carbon dioxide levels were stable in a range of 180-280 ppm for the last 400,000 years, but have jumped dramatically since 1950 and now exceed 400 ppm. 25-30% of air born carbon dioxide dissolves in sea water, leading to the acidification of the oceans, which subsequently harms reefs and mollusks (acidic water interferes with shell formation.) No reefs and no shellfish mean no fish - bad news as fish account for 17% of world protein consumption for 7.5 billion humans.
In 1974 scientists first observed that chemicals (CFC's) commonly used in spray products and air conditioners caused ozone depletion in the upper atmosphere. Life on Earth is dependent on ozone to absorb cancer causing UV-B light. Skeptics and industry representatives pushed back against the research, but by 1987 world protocols were established to reduce use of CFC's and find replacements, Ozone losses continued through the 1990's (CFC's don't disperse easily) but by the early 2000's, researchers could see that the hole in the Ozone Layer would disappear by 2050. Science and government worked hand in hand to avert danger.
President Trump believes that most scientific research is "fake," famously tweeting "The concept of global warming was created by and for the Chinese in order to make U.S. manufacturing non-competitive." Within days of taking office, reports and data on climate changed disappeared from federally administered websites. In the short term, we don't notice global warming. At current rates of sea rise, however, 13.1 million Americans will be displaced from coastal cities by 2100, and hundreds of trillions of dollars in real estate and business will be destroyed. Not an issue for the stock market in the short run, but in the long run?
Credibility: Can Trump Last Four Years?
Our final comments address the President's credibility. We wrote our clients last fall "If our president worked in your company, school or church, how quickly would you fire him out of self preservation?" 75% of Trump's statements are lies or falsehoods. Politicians lie all the time (think Clinton and her email server) but Trump's lies can be refuted in real time with Google on an iPhone - this psychosis is unique in American political history. (Definition of psychosis: a severe mental disorder in which thought and emotions are so impaired that contact is lost with external reality.) For the time being Congressional leadership (McConnell, Ryan) are willing to cravenly ignore President Trump's bizarre behavior to further their own agendas, but for how long?
The President wastes no time with conventional presidential ethics. He remains tightly involved with his businesses through sons Eric and Donald, Jr. His daughter and son-in-law occupy prominent positions in the White House. Foreign leaders stay in a Trump hotel in Washington, violating the previously obscure Article 1 of the US constitution, the "Emoluments Clause," which prohibits the President from receiving anything of value from a foreign government.
The current president's Achilles heel may be the "Russian Connection." By 2000, President Trump was persona non-grata among American bankers. Fortunately for the President, Russian oligarchs were delighted to lend him money in exchange for the opportunity to launder money through real estate purchases, many at Trump developments in the US. Relationships developed through the 2000's and into 2016. A number of Trump campaign operatives, including Paul Manafort, Corey Lewandowski, Carter Page and Michael Flynn are uncomfortably close to Kremlin officials; Flynn was forced to resign after just three weeks as National Security Advisor for "lying to Vice-President Pence about his conversations with the Russian ambassador" after the November election.
On March 4th, Trump tweeted that the Obama administration had wire-tapped Trump Tower. As President, Mr. Trump has unlimited access to top-secret intelligence, so if the assertion was true, he could simply order the NSA or CIA to produce the evidence. No such evidence was shown. On March 21st, House intelligence chairman Devin Nunes suddenly rushed to the White House "to meet with a source in a secure location." The following day he announced that FISA surveillance of Russian foreign nationals had picked up conversations with US nationals including members of the Trump transition team. The FISA law provides that if an American falls under surveillance, their identity must be masked. However, it seems likely that names were leaked to the White House and to Nunes. Nunes stepped down as chairman April 6th following an ethics complaint lodged against his handling of the matter. Though the matter has fallen from the headlines, House, Senate committees AND the FBI continue to investigate.
We don't know yet what this all means. We do know that Russian hackers leaked details of the Democratic National Committee campaign strategy to WikiLeaks, which posted details at inopportune moments in the final days of the presidential election. We insist that if Congress was willing to spend thousands of hours and millions of dollars investigating Benghazi, Clinton's email server and Monica Lewinsky's dress, Congress should be willing to spend millions more understanding the ties between President Trump and Russia.
Of the 13 presidents for which we have data, only the President started his administration with a lower approval rate (41.3%) than disapproval rate (52.4%), a deficit of 11.1%. Trump says he doesn't care (or that the polls are fake.) At a certain point, other Republicans have to wonder about the cost of remaining attached to Trump. We doubt he would resign, but impeachment is not out of the question. Betting at PredictIt, the political futures site gives Mr. Trump an 85% chance of remaining President through 2017 and a 70% chance through 2018.
A drawn out impeachment process is NOT good news for markets. As the Watergate scandal unfolded between February 1973 and Nixon's resignation in 1974, the S&P 500 fell 45%.
Overall conclusions for investors
An interesting time! For decades our research revolved around earnings reports and industry conferences. Now we have to read Trump's Twitter feed and monitor Fox News. At current levels, US stocks are slightly overvalued by the Morningstar Valuation Model. The rally which started November 9th leveled out in mid-March. Our expectation is that stocks trade sideways for the next two quarters, rally in the 4th quarter as earnings catch up to valuations. BUT! Uncertainty around the current administration is at unprecedented levels. Stay tuned!