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2018 Commentary — Part 4 of 4 – Investment Summary and Conclusions

Date Posted: December 8, 2017

The Economy Shows Little Excesses–Economic Growth Should Continue in 2018
Little economic excesses exist that would suggest a slowdown in 2018. This comfortable economic backdrop helps to underlay the current financial market “complacency”. The historically low volatility index—the VIX– provides evidence of this “complacency.” Last week the VIX experienced its lowest intraday reading on record—8.56. As a reminder, despite this favorable economic outlook, market corrections can occur without recessions. Such corrections normally prove to be short in duration.

Will the Fed “Put” Save Investors?
The relatively low market volatility would suggest investors feel confident that the Fed will quickly reverse its current policies at the first signs of an economic slowdown or financial market weakness. If the Fed shocks investors by failing to do so, a new market “tantrum” may result.

Reduced Import of Financial Engineering—Increasing Earnings per Share the Old Fashioned Way
Strategists point out that investors recently tended to reward companies investing capital for growth rather than buying back their own stock. In our view, this represents a very positive change. The last decade’s very accommodative monetary policies afforded corporations the opportunity to borrow cheaply; buyback their stock; and thereby create earnings per share growth greater than their net income. In our view, the Fed’s very accommodative monetary policies bear a share of the blame for the misallocation of capital spending for non-productive purposes. If this increasing capital investment shift grows in force, this may signal a return to building long-term earnings growth the old fashioned way through capital investments. In addition, investors may penalize businesses that grow their free cash flow by holding back on needed capital investments and substitute stock buybacks to spur EPS growth.

Protecting Margins–Also the Old Fashioned Way
With the continuing decline in the unemployment rate, we also expect more businesses to raise prices to offset the wage increases required to attract skilled workers. By doing so, they would either protect operating margins or reduce their erosion. This represents another potential example of businesses returning to their old fashioned way of growing earnings–better business management. Over the next 24 months, if this proves correct, more aggressive pricing could also lead to increasing rates of inflation.

Some Assumptions of Tax Reform Enactment Already Built Into the Equity Markets
Investors cannot easily judge how much equity markets have already priced in the passage of tax reform. Empirically, some price effect already exists. This showed up when investors reacted negatively upon learning the Senate bill postponed corporate tax reductions until 2019. At the same time, the equity market bounced when the Senate budget committee moved the tax bill to the Senate floor.

Where to Look for Higher Earnings from Corporate Tax Rate Reductions?
Obviously, domestic companies will be a prime benefactor from lowered corporate tax rates. At one extreme mid and small cap companies with primarily domestic operations would see higher earnings. At the other extreme, telecoms and other communication service companies would also see their earnings jump.

Big Tech Companies Will Benefit Differently From Tax Reform
Major technology companies earn a substantial amount of their income outside the United States. Therefore, they already enjoy lower effective tax rates. At the same time, the tax bill will make it easier for tech companies to repatriate their huge hoards of cash “stored” overseas. Tech companies will likely use their repatriated cash to increase both capital expenditures and dividends and most important purchase public and private companies. With their stocks at peak current valuations, there seems less likelihood they would use this cash to repurchase stocks.

Capital Equipment Spending Will Be Accelerated From Tax Reform
The new tax bill will permit fully expensing capital equipment investments in the year incurred. Later next year, the resulting increased capital expenditures will add to the earnings of capital equipment suppliers as well as engineering, construction, and production equipment companies. Because this tax bill provision sunsets in five years, businesses will likely move quickly to speed up their long-term capital spending plans. This should benefit near-term economic growth. We expect increased capital spending should finally begin improving the sluggish growth trend of U.S. productivity.

Partial Capping Interest Rate Deductions May Affect High Yield Borrowers
In the past, underperforming businesses took advantage of low-interest rates to finance themselves in the high yield market. In the future, the tax bill’s partial capping of the deductibility of interest expenses may limit that source for these underperformers. Investors should carefully review businesses with questionable cash flows that will need to replace current high yield financing, more than likely at higher rates, to remain in business.

Less Accommodative Monetary Policies Could Cap Stock Multiples Later This Year
Over most of this decade, expanding price/earnings multiples, more so than growing corporate earnings, drove stock prices higher. In our view, the Fed’s very accommodative monetary policies stimulated that multiple expansion. Later in 2018, that could change as the Fed’s reversal of its easy monetary policies could begin capping stock multiples.

Earnings Growth Rather Than Multiple Expansion Key to Future Stock Performance
With the possibility of an earnings multiple cap, future equity market performance will increasingly depend on the outlook for corporate earnings growth. With the greater focus on earnings growth, will investors continue singing the same old market song– buy growth stocks—despite their relatively high current market valuations?

Shift from Long to Short Duration Fixed Income Investments –Add Alternatives
Higher long-term interest rates seem likely later next year when less accommodative Fed policies take hold. With that possibility, investors should consider shifting their exposure from longer duration notes/bonds to shorter-duration fixed income paper. As part of that shift, substituting some alternative investments for traditional long-term fixed income investments also may make sense. One caveat, this outlook also sounds familiar and repeats the same old song calling for higher interest rates. However, unlike the growth stock song, this one never seems to be sung.

Final Thought—For Perspective
An American economist, Hyman Minsky, examined the characteristics of the financial crisis. The following quote comes from his research:

“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”

So prosper from the current markets but keep those words as a reminder.