Thursday, November 17, 2016

"Every dollar released from taxation that is spent or invested will help create a new job and a new salary."

While doing research for this blog on the 2016 U.S. presidential election, I ran across some interesting quotes. I thought the one above was really interesting, so I did some additional research. Consider this is a quiz – can you guess which individual is responsible for the following quotes? Here is the first one: “Lower rates of taxation will stimulate economic activity and so raise the levels of personal and corporate income as to yield within a few years an increased – not reduced – flow of revenues to the federal government.

Another interesting quote I found is, “In today’s economy, fiscal prudence and responsibility call for tax reduction even if it temporarily enlarges the federal deficit – why reducing taxing is the best way open to us to increase revenues.

One more: “It is no contradiction – the most important single thing that we can do to stimulate investment in today’s economy is to raise consumption by major reduction of individual income tax rates.

Okay, last one: “The largest single barrier to full employment of our manpower and resources and to a higher rate of economic growth is the unrealistically heavy drag of federal income taxes on private purchasing power, initiative and incentive.

After reading all of the quotes listed above, it became fairly clear to me why the U.S. stock market is rallying on the prospects of President-elect Trump’s proposed changes to the federal income taxing system. By now, I am sure you are thinking that that all of the above quotes must have been made by a very conservative Republican, designed to benefit the wealthy and not the poor. However, it could not be further from the truth. Each and every quote above was made by President John F. Kennedy during his short presidential time from 1961-1963. Even in those years, JFK, a Democrat, saw the economic benefits of lower tax rates. Unlike the last eight years where we have constantly faced higher taxes and larger government spending, Kennedy, saw the benefit of lower taxes, an increased economy, higher GDP and more jobs.

I can vividly remember the night that Ronald Reagan was elected President of the United States in 1980. Much like President-elect Donald Trump promises, Ronald Reagan, the former actor, believed that cutting taxes would clearly stimulate the economy and tightening of financial interest rates would slow inflation. The combination of the two would lead to unprecedented growth in the U.S. economy, and in subsequent years would benefit all of us with a better way of life.

If you go back and reflect on the record, you will see that is exactly what happened. During the 1980s, with lower taxes, the economy expanded and through the George H. W. Bush years and Bill Clinton years, the economy expanded with lower taxes, employment was full and the federal budget was balanced. In fact, for the 20 years from 1980-2000, the S&P 500 index averaged 17.88% per year for the 20 years – wow! To me, it does not look like you would need any more proof that lower income tax rates stimulate the economy and the evidence is readily available from the example mentioned above.

I will be one of the first to admit that I incorrectly called the outcome of the election, along with 99% of the polls on the subject. Believe me, it was quite a roller coaster ride the night of the election. As I sat in front of my TV watching the results come in, I kept my iPad open watching the futures on the stock market react. At one point, around the time of the Pennsylvania returns, the futures were down well over 800 points for the evening. Around midnight, some of the circuit breakers kicked in and reduced the losses. And when I got up the next morning after only a few hours of sleep, the futures were down 375. As we approached the opening of the market, I felt a little better but it was still down 250 points. Interestingly, the very first tick on the Dow Jones Industrial Average was actually up and not down. In fact, the markets over the course of the evening moved from roughly 17,500 to 18,700, up over 1,200 points. Over the course of 7-8 hours, we watched the stock market perform a 1,200-point swing.

It would be impossible for me to evaluate the social and economic actions of the President-elect as clearly none of us have any idea of what he will actually do once in office. People must keep in mind that it will be 90 days before he takes office and likely years before any significant legislation is passed. However, I find his economic proposals certainly encouraging for a higher economy and correspondingly a higher stock market, just as John Kennedy recognized in 1960 and Ronald Reagan in 1980. He is basically proposing that if we have lower tax rates and provide less regulation, we will subsequently have a higher GDP, a better economy and full employment. You may think that is wishful thinking, however, that is exactly what happened in both President Kennedy and President Reagan’s cases. As demonstrated in the last eight years, we now know that higher taxes and more regulation do not lead to higher GDP nor reduced deficits.

I find many of the proposals so obvious that it amazes me that they were not done years ago. Currently, all major U.S. corporations that have international operations do not pay taxes on those operations until they bring the money back to the United States. With the United States having the highest corporate tax rate in the world, it is no wonder that few of these corporations will bring their money back to the U.S. at the current 35% tax rate. One of the proposals under the Trump administration would be to tax this money coming back at a one-time 10% rate. It is believed by many experts that roughly $1 trillion would reenter the United States creating a windfall tax of $100 billion in only one year. In addition, this money would be used to improve U.S. facilities, pay dividends and compensation - all of which would create additional income tax to help the economy. This situation has been going on for years, but the government did not react to it, costing the United States plenty of lost revenues. This law will surely pass.

Balcony of the Speaker of the House - 1995

Ava and Josh - 2016

When you go back and reflect on the fact that the lower tax rates under the Reagan administration led to a balanced budget in the 1990s for the Clinton administration, you see the blueprint of the proposal that Trump is promoting. In reducing the federal tax rate for both individuals and corporations, there will be more money for taxpayers to spend to improve the economy and expand GDP. As President John Kennedy points out above, even though the rates are lower, the absolute dollars to the treasury would be greater.

Once the stock market realized that President-elect Donald Trump might actually win, they realized that a higher GDP would be better for corporate profits, and therefore a positive for the stock market. Almost simultaneously, there was a significant increase in interest rates and a rotation from bonds into stocks has already begun. With interest rates moving up above 2.2% on the 10-year Treasury, it is the highest rate so far in 2016. A higher GDP growth is most assuredly going to lead to higher inflation in the coming years and correspondingly higher interest rates. These higher interest rates should be great for the savers in CDs and money market accounts, but not for those investors holding bonds. Do we know this will actually happen? Of course not!

So, the most important part to watch during this new administration will be what exactly they are able to get through Congress and make effective over the short term. One of the benefits that Trump will have that has not been available since 2008 is a Congress comprised of only his own party. Now that the Republicans control the House, Senate and the White House, while still difficult, there is a high likelihood that many of the proposals that he made during the campaign will become law. Almost unquestionably, there will be a reduction in income tax rates for both individuals and corporations.

Using history as our guide, lower income tax rates will lead to higher GDP and profits, which will benefit equities. In addition, the President-elect has indicated he would be tougher on interest rates so we will likely see interest rates go up in the coming years. As interest rates increase, bonds move lower and the money escaping from bonds most likely will find its way to equities, giving them an added boost. We should also expect to see higher inflation in the coming years, which will benefit people holding real assets. Real assets include real estate, gold and other things you can drop on the floor that could hurt your feet. Higher inflation necessitates higher interest rates and again all of these are detrimental to bond investors.

The President-elect has also proposed massive infrastructure projects. These include building roads, highways, airports, etc. But just as President Obama found out in 2009, this is a lot simpler to propose than to implement. As we now know, these shovel-ready projects took years to implement and had little or no effect on the economy. As Gary Shilling said, “They haven’t even made the shovels yet, and they no doubt would be made in China!” It will take years.

The effect of all of these acts will almost assuredly increase Federal deficits, which will be a drag on future generations, but lower tax rates will be enough to offset the lack of revenue to the government with more people paying tax even at a lower rate. So, there is much to be seen as it affects the U.S. economy. Already, the effects overseas have been noted. The emerging market funds have lost roughly 6% only in the three trading days since Donald Trump was elected. Mexico, particularly, has been hit hard with the peso down 9% and the indexes representing Mexican companies now down 12% since the election. Of course, Asia, which was a perceived enemy of the President-elect, is also down dramatically, but the economics of the Asian economy will probably be more influential than the actions of any president. Currently, the Asian markets are 15% lower than their traditional averages and their earnings are higher. The emerging market companies are the cheapest index in the world, but are currently being pounded by the rhetoric of a president who has not even taken office.

I am not surprised that the equity markets have gone up since the election that was predicted by almost no one. If you believe that a new president can get his proposed legislation through, then it would be the natural assumption that equities must move higher along with GDP and correspondingly inflation. All of these are factors that lead to higher stock prices. Given the totally unexpected victory of President-elect Donald Trump, you would expect to see traders try to exploit areas of the market that they think would benefit from future legislation.

As always, traders tend to trade first and think second. Whatever happens in the legislation will be a slow process, even with the majority of Congress being controlled by the same party. Any income tax decreases are likely not to be effective until later years, certainly unlikely in 2017. As we know, shovel-ready projects tend to drag out for months if not years. Therefore, all of the changes that are being proposed are likely to not be as dramatic or as rapid as we might believe, and your temptation to trade on these possibilities will likely be time-challenged.

It is, therefore, my opinion that the best approach to investing, even with our new President-elect, is to be diversified along a broad range of investments that give you exposure to various asset classes. I fully expect that the international markets will recover shortly since they are too important to us to continue to drift down. Frankly I would be shocked if the President-elect is successful in proposing tariffs to foreign countries to import into the United States. While he has promised to improve the job possibilities in the United States by bringing manufacturing back from overseas, it will be a slow process and certainly not something that will happen over the short-term. Further, while it benefits all citizens to create more jobs in the United States by transferring manufacturing back here, it is a detriment to consumers who currently buy products built overseas but sold in the U.S. at a lower price.

Therefore, there is financial hope that we will enjoy a higher GDP going forward, but at this point, it is just a hope. A higher GDP will create a lot more jobs than tariffs that interfere with worldwide commerce. I think we will see a dramatic difference between the candidate Trump and the President Trump. Once he is in office and finds the obstacles of implementing legislation that is being proposed, a good deal of the current assumptions will be tempered by negotiation and time. Given the unknowns and the time necessary to implement proposed actions, I do not recommend any significant changes in any portfolios based upon these facts at this time.

We invest in companies and mutual funds that we believe have great long-term prospects. Nothing that happens over the next 30, 60 or even 120 days will have a dramatic long-term effect on these companies. Clearly, short-term traders try to benefit from these changes in economic circumstances and political change, but remember they are traders, not investors. As investors, the best course of action is to be consistent, diversified and conscientious of what is happening around you. Nothing I know today or have read in the hundreds of articles on the subject indicate anything other than to stay the course with your investment philosophy, but yet be aware of what is actually happening and hope that we all benefit from whatever actions are taken.

If our own history is a guide, the era of the 1980s-1990s is a good example. While deficits soared under Reagan’s reduced income tax rates, they led to much higher GDP, higher growth and in the end, higher revenues to the government. President Clinton was the benefactor of that increase in revenues to the government. By actions taken by him in Congress, we actually had surplus revenues during the 1990s. As compared to the last eight years of increasing taxes, I am optimistic that trying something different might be the answer to the deficit issue. Higher taxes have not even come close to reducing the deficit – so far.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins