Post-Election Earnings and Possible Tax Reform

Investment Strategy

Post-Election Earnings and Possible Tax Reform

Michael Gibbs, Managing Director of Equity Portfolio & Technical Strategy, and Joey Madere, Senior Portfolio Analyst, Equity Portfolio & Technical Strategy, discuss earnings before and after the U.S. presidential election.

April 3, 2017

Earnings are the driver of the equity markets over the long term. Over the past couple of years, stagnant earnings growth played a major role in the equity market’s failure to advance. Subsequently, positive earnings growth in the third quarter of 2016 played a role in the uptrend in stock prices.

Current Earnings Estimates

Post-election, stocks rallied, fueled by investor enthu­siasm that earnings will surge even higher in the coming years due to fiscal stimulus. Although our estimates are below cur­rent consensus forecasts, we still see healthy growth in the years ahead, especially if fiscal reform transpires.

Prior to the election, we were comfortable with the consensus estimate for sales growth in 2017 of 5%; however we used more conservative margin assumptions due to our expectations of rising interest rates and wages. The result was a base case earnings estimate of $128 in 2017 (8% growth from 2016)**. This was also in line with the downward trend in consensus earnings revisions that has taken place in recent years, which would likely bring the consensus earnings estimate of $131 closer to our more conservative assumptions.

Post-election, our conviction that these estimates will be met has increased, as the odds of earnings growth picking up have improved on the heels of anticipated fiscal stimulus. However, until these policies come closer to being passed, we are holding our $128 earnings estimate steady.

Tax Reform Considerations

We feel that cutting the U.S. corporate tax rate to 20% has the potential to boost S&P 500 earnings by an additional 6% to 7%. Please note that although the statutory U.S. corporate tax rate is currently 35%, the S&P 500’s effective tax rate is roughly 27% as tax-savvy companies have used accounting rules to their advantage. A tax reduction to 20% may not be possible given the negative impact such a large reduction could have on the deficit and debt levels. If the tax rate declines to 25%, the ben­efit is approximately 3%.

Also, a favorable repatriation tax (assumed 10%) would likely result in a large amount of the estimated $2.4 trillion in over­seas cash coming back to the U.S. While that cash can be used on capital expenditures and reducing debt, it is also likely that a portion would be spent in the near future on mergers and acquisitions, stock buybacks, dividend increases and other shareholder-friendly actions. In our estimate, we see that potential increases in share buybacks from the repatriated cash could improve earnings by an additional 1% to 2.5%. The limitations of our calculations regarding lower tax rates and repatriated cash should not be minimized given the many unknowns. Other possible changes, such as interest deduct­ibility and depreciation, could alter our estimates substantially. With tax reform being the more likely outcome, as opposed to easy-to-implement tax cuts, the process may take some time.

Infrastructure and Other Unknowns

Increased infrastructure spending, another potential boost to the economy under the Trump administration, is often a slow pro­cess as well. Therefore, the increase to earnings will likely not be fully felt until 2018. It is also important to note that a stronger U.S. dollar would be a headwind to earnings, as would tighter trade policies; so there remain downside concerns as well.

A Look Ahead at Earnings

For 2018, the consensus estimate for earnings is $146 (11.5% growth), however we conservatively estimate 2018 earnings in the mid to upper $130 area. Similar to our 2017 earnings estimates, our 2018 estimates are also held back (relative to consensus) due to elevated profit margins, the likelihood of rising interest rates and wages, and the tendency for forward estimates to be revised lower over time. If tax reform does occur, earnings could reach the $140 to $146 area in 2018. In this scenario, applying a P/E of 19x (vs. 20x currently) would result in the S&P 500 reaching a level in the upper 2,600s to mid 2,700s (or 10% to 15% above current levels over the next two years). Because of this, (and due to lofty valuations) the timing and size of actual fiscal policies will be a key influence on earnings growth and market movements in the coming years.

Read the full April 2017 Investment Strategy Quarterly
Read the full April 2017 Investment Strategy Quarterly

* Compound Annual Growth Rate
** The earnings estimate of $128 is the earnings per share of all of the companies represented by one share of the index.

Investing involves risk including the possible loss of capital. Past performance may not be indicative of future results. The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made directly in this index. The performance noted does not include fees or charges, which would reduce an investor's returns.

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