1st Quarter Outlook, 2018
In our letter to you last January we outlined our 2017 target return for the S&P 500: between +6% and +16%. The S&P 500 returned +19.4% last year, surpassing the high end of our target range and beating the vast majority of Wall Street analysts’ predictions by a wide margin. So, after a positive year like 2017, it is normal for investors to ask: “Can this continue?”
We believe further economic growth and market gains do lie ahead. In fact, we see growth accelerating, due largely to Congress passing the Tax Cuts and Jobs Act of 2017. While some see an “aging” bull market as a reason for concern, we disagree and offer the following graph from December 2014 to November 2016 as evidence to the contrary:
Tax Reform: Meaningful Effects & Opportunities
The U.S. corporate tax rate is now 40% lower than before passage of the tax reform act (21% now vs. 35% prior). This makes our corporate tax structure very competitive with the rest of the world – with our rate dropping from the highest among developed countries, to mid-range. While it is true that not all American corporations paid the highest rate of 35%, there are many companies that did pay the highest rate, or an effective rate even higher (when calculating additional state taxes). Consequently, we see a significant opportunity for upward re-valuation of stock prices as many companies realize the benefit of lower domestic corporate taxes and accelerating economic growth.
Using our institutional-quality database of market information, we are searching for what appear to be the biggest beneficiaries of the lower corporate tax rate. Lower taxes are not enough however. Companies that are ultimately added to our portfolios must fit our “30,000 foot view” of the world – our list of prominent investment themes, given current macro-economic trends.
One such theme is: Internet retailing and consumers benefiting from additional discretionary income from the recent tax cut.
Thus, FEDEX Corporation is one company that fits our model. Below is the Datagraph for FEDEX which illustrates what we are looking for: (1) a strong earnings growth forecast, (2) a substantially lower new tax rate, resulting in (3) an out-year earnings estimate meaningfully higher than Wall Street estimates. Taken together, this produces substantial potential for share price appreciation over the next 24 months.
Of course, there is no guarantee that FEDEX will reach our price target within the next 24 months. We suspect our clients would be pleased with half of the appreciation potential we see at the high end of our target price range. However, FEDEX clearly illustrates the primary factors that are driving our fundamental research during the first quarter of 2018.
On Top of “The Wall of Worries”: The Fed and Rising Interest Rates
There is constant chatter about what the Federal Reserve will do with interest rates this year. Will they raise the Fed Funds rate twice, three times, four times?
We believe it makes little difference whether the Fed raises two, three or even four times this year, so long as they do not raise the rate above nominal GDP (real GDP plus inflation). We expect nominal GDP growth at approximately 4.5% or higher in 2018. Consequently, four interest rate hikes bringing the Fed Funds rate to 2.5% would leave plenty of room for comfort.
A well-telegraphed and slowly-orchestrated rate climb can be a positive thing, as it often accompanies solid economic growth. You can see in the chart below that the Fed Funds rate was much higher in the 1990s than it is today, yet the market did quite well during that time.
We believe that the pundits who are talking about the stock market declining due to rising interest rates will be proven wrong again. Actually, stronger economic growth causes higher interest rates. Higher rates can be a good thing. With repatriated dollars, fewer regulations and lower corporate taxes, we expect businesses to pursue opportunities more aggressively. This in turn will provide more jobs, higher wages and yes, higher interest rates. Fortunately, in that kind of environment, stocks and interest rates can rise in tandem.
With this scenario on the horizon, it makes sense for the U.S. Treasury to consider locking in current low rates to finance our long-term debt. Federal debt has grown over the past ten years to nearly $21 trillion. Rising debt service cost is a concern, but fortunately due to very low rates, the cost relative to GDP and tax revenue is still near its 50 year low. Mexico just issued a 100-year Treasury bond at less than 4%. The United States is at least as good a credit as Mexico – we should be able to issue a 100-year T-Bond near 3%!
We believe there is further good news: in our view, the Tax Cuts and Jobs Act of 2017 should cost nothing, or next to nothing. Consider that repatriation of domestic assets held offshore should bring in at least $650 billion in tax revenue. When you take the approximate $2.5 trillion that is expected to come back, and 10-year corporate savings of approximately $1.3 trillion, you arrive at a minimum of $800 billion in revenue to the U.S. Treasury. We expect an excess of $800 billion, due to dynamic economic gains and the multiplier effect, but if those dollars were to only flow thru to investors via stock buybacks and dividends and taxed at an average of 20%, it would result in $800 billion. Add in the $650 billion from repatriation and the $1.5 trillion estimated price tag of the Tax Cuts and Jobs Act of 2017 is nearly covered.
Isn’t the low savings rate a problem too?
Some analysts have been calling attention to a drop in the personal savings rate to 2.6% in 4Q’17, which is the lowest level since 2005. That got us to do some digging into how the rate is calculated and whether we should be concerned. The pessimists’ theory is that if the personal savings rate is so low, consumers must be in over their heads again – so watch out below!
However, we found that this view on the savings rate leaves out some very important points.
First, consumers don’t solely derive purchasing power from their income; they also get it from the value of their assets. Asset values soared in 2017. The market cap of the S&P 500 rose $3.7 trillion, while owner-occupied real estate increased approximately $1.5 trillion. This could be a problem if the stock market or real estate was wildly overvalued. Considering corporate tax cuts and potential for rising earnings, one can make a strong case that the stock market is still undervalued. Further, the price-to-rent ratio for residential real estate is near its long-term average, so it looks reasonably valued.
Second, the tax cut for individuals will raise after-tax income. According to the Congressional Budget Office, the tax cut for individuals should reduce tax payments from individuals by $189 billion in 2019. Thus, consumers will be able to save more in the next few years, even if we don’t include the extra income that should be generated by economic growth.
Third, the personal savings rate doesn’t include withdrawals from 401(k)s and IRAs, many of which are swollen with capital gains. Assume a worker contributed $5,000 of her income into a 401(k) thirty years ago and kept that money in the S&P 500. Today she can withdraw more than $100,000 and spend it. When calculating the savings rate, the government counts every penny of that spending while not counting any of it as income (although they tax it as income). If $4,000 is withdrawn and spent, yet the account grows to $107,000, there is no savings calculated, but $4,000 of spending is measured. As the population ages and spends down wealth they’ve already made, the savings rate will tell us less about the saving habits of today’s workers. With aging baby-boomers, a more accurate method of calculating the savings rate needs to be found.
We expect American corporations will repatriate approximately $2.5 trillion of overseas capital over the next several years. This capital will fund new investment in plant & equipment and produce new jobs. Apple announced that they will bring home nearly all of their $250 billion in overseas cash, using it to build a new campus, new data centers and other capital projects. Their five-year plan also includes creating 20,000 new jobs in the U.S. Fiat/Chrysler announced a $5 billion investment in Detroit to move the Dodge Ram truck production home from Mexico. There are many others who have announced similar investment plans. This bodes well for those who build plants and sell equipment, and for those wanting a job or looking for a better opportunity. We are searching now for fundamentally sound companies that will benefit from this wave of capital spending. We’re also looking for companies who will benefit from low and middle-income earners having more after-tax pay from higher wages and bonuses.
Hopefully, our dysfunctional Congress can come together on an infrastructure plan. The country certainly needs the fix. If they can, this too will lead to many investment opportunities.
Since these projects take from months to years for completion, we can expect the economy to click along for some time to come – almost certainly for another year or two, barring an unforeseen shock.
Europe, India and Asia are growing, so we also expect additional investment opportunities around the globe. The European Central Bank (ECB) is expected to wind down their Quantitative Easing (QE) this year. As they do, we expect the Euro to strengthen against the U.S. Dollar. When the U.S began QE, the Euro was approximately $1.45, having been near $1.60 at its peak. As the U.S. ended QE and Europe began theirs, the Euro dropped to $1.05. While the ECB has been tapering down their QE, the Euro has risen to $1.22 today. Although we do not invest in currencies, we do pay attention to them. We expect that the Euro will rise to previous levels, into the $1.40 to $1.50 range (+15% or more from current trading). Further, as we find fundamentally attractive European companies for investment, we expect the stronger Euro will provide a tailwind. For example, if we were to invest in a European company that appreciates 10%, while the Euro rises 10% – it would produce a 20% return for us. Consequently, as global GDP grows, so does the universe of good investment opportunities.
We are truly excited about investment prospects in 2018, and into 2019. Of course, there is always the day-to-day management of risk & volatility, and not all investments perform as well as we expect. But stepping back, we see many companies poised to do very well. In fact, we consider many of them to be conservative investments. They might make the machinery or products that will build new infrastructure, or they might deliver packages bought online. Some might make the cardboard boxes that all those goods are packaged in. There are companies providing products and services to re-build devastated hurricane and fire zones. There are companies making exciting medical breakthroughs, and then there are those who provide entertainment or travel to the millions of households who have extra money every month due to lower taxes. The list goes on, but the point is the same – we believe this is a very good time to be invested.
The Beck Capital Management Team
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Investment advisory services offered through Beck Capital Management LLC, a registered investment adviser.This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results. Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor. Beck Capital Management explicitly disclaims any fiduciary responsibility or any responsibility for product suitability or suitability determinations related to individual investors, as may relate to the information contained herein.
Disclosure: Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor. Frank Beck & Beck Capital Management explicitly disclaims any responsibility for product suitability or suitability determinations related to individual investors. The investment products discussed herein are considered complex investment products. Such products contain unique risks, terms, conditions and fees specific to each offering. Depending upon the particular product, risks include, but are not limited to, issuer credit risk, liquidity risk, market risk, the performance of an underlying derivative financial instrument, formula or strategy. Return of principal is not guaranteed above FDIC insurance limits and is subject to the creditworthiness of the issuer. You should not purchase an investment product or make an investment recommendation to a customer until you have read the specific offering documentation and understand the specific investment terms and risks of such investment.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.