Three reasons why investors need to be careful about the Trump tax plan

Stock markets are bubbling up again, with America’s NASDAQ, the UK’s FTSE 250 and Germany’s DAX all setting new record highs this week. Hopes for some details this week on President Trump’s long-awaited tax cuts are one reason why.

Russ Mould, investment director at AJ Bell, comments:

“Bearing in mind Warren Buffett’s comment that “A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept between its teeth,” markets may well welcome plans to reduce corporation tax in America, but investors will need to be wary of the hype and focus on the facts for three reasons:

  • First, it is unclear whether any of the President’s proposals will pass through Congress unmolested, especially as the November 2015 Bipartisan Budget Act, which suspended America’s debt ceiling, lapsed on 15 March. America’s federal debt stands at nearly $20 trillion, a record high, or 105% of GDP. The Republican Party fought all five of the increases to the debt ceiling pushed through by the Obama administration, which took the limit from $11.3 trillion to the since-surpassed $18.1 trillion.

Source: FRED, St. Louis Federal Reserve database

  • Second, this makes it clear that Trump has a lot less room for manoeuvre than Ronald Reagan, to whom he is regularly compared for his tax-cutting and deregulating zeal. Whereas when Reagan took office in 1981, inflation and interest rates were falling, federal debt was low and US stocks were cheap after a vicious bear market, Trump is taking control at a time when interest rates and inflation look to be rising (albeit slowly), federal debt stands at record levels and US stocks look expensive relative to their history after an eight-year bull run, using the Shiller CAPE ratio (although market-cap-to-GDP multiples also look stretched):

 

Reagan, January 1981

Trump, April 2017

Fed Funds rate

18.0%

1.00%

US 10-Year Treasury yield

15.0%

2.3%

US 30-year mortgage rate

16.0%

4.1%

Federal US debt to GDP

32%

105%

Total US debt to GDP*

96%

215%

US inflation

8.0%

2.7%

Shiller CAPE

9.0 x

29.4 x

Source: FRED, St. Louis Federal Reserve database, Federal Reserve Bank of New York, www.econ.yale.edu/shiller/data/ie_data.xls

*Excludes pension obligations.

  • Finally, US corporations are already paying historically low amounts of tax. According to Federal Reserve data, American companies’ tax bills represented just 7.5% of pre-tax profit and 3.4% of sales in 2016.

Source: FRED, St. Louis Federal Reserve database

A 43% cut in the US corporate tax rate to 15% from 35% (assuming this is proposed and then delivered) is therefore likely to add 1.5 percentage points to corporate profit margins, using that 3.4% tax paid-to-sales ratio as the starting point.

On a total company sales base of $15.6 trillion, that is the equivalent to around $225 billion, or 13% of the aggregate post-tax profits made by corporate America in 2016.

This is the profit uplift that the Wall Street lemmings are clearly seeking, but the S&P 500 is already up 11% since Trump’s election, while it remains to be seen whether such a windfall is landed, given likely opposition in Washington and how American corporations’ tax affairs already seem to be run very efficiently.”