Eye on the Markets - 2017

Trump Tax Plans and Potential Outcomes

By Ketu Desai

In April, President Trump announced an outline of his tax plan. It was a short document, however, it contained a general framework of his vision. In this article, we will review recent market activity, provide an overview of the proposed plan, and its potential impact on markets and various asset classes.

In recent weeks, the bond market and the equity market have been telling different stories.

The bond market has expressed caution as Treasury yields have come in, and got below 2.2% at one point during April, before widening recently. There was also a bid for safe havens like gold during recent weeks. Bond investors are cautious due to the recent economic data, geopolitical events, and policy uncertainty. At the same time, global equity markets rallied, particularly during the end of April.

Equity investors are bullish due to corporate earnings, higher expected growth rates, and the potential for pro-growth policy changes. Among the key disputes between the two asset classes is the ability for the President to implement pro-growth policies, chief among them is the tax reform.

One of the clear goals of the tax plan is to improve economic growth. The Treasury Secretary has stated in numerous interviews that the goal is 3% or higher economic growth. This would be a significant improvement if achieved, considering we have been stuck around 2% annual growth in recent years. While a 1% increase may not sound like much, however, when you consider the US economy is approximately $19 trillion, a 1% increase is a significant amount of extra dollar growth that is created. The idea is to make business more competitive in the United States, which will foster investment and growth. At the same time, allow Americans to keep more of their earnings to spend, which also fosters growth.

In summary, the tax plan cuts the corporate tax rate from 35% to 15%. It further cuts the top pass-through rate from 39.6% to 15%. Both of these are aimed at businesses, large and small. The pass-through rate helps small businesses, many structured as LLCs. The plan also lowers taxation on profits earned by companies overseas, and incentivizes them to bring profits back to the United States. This is critical for large companies such as Apple, GE, and Microsoft that have billions deposited abroad. These companies can bring this cash back and reinvest in the US or simply return the capital to shareholders.

On the personal side, the idea is simplification. Trump's proposal would reduce the current seven tax brackets to three with rates of 10 percent, 25 percent and 35 percent. He also plans to reduce the amount of itemized deductions and increase the standard deduction.

Let's assume, all else equal, the tax reform has its desired impact in increased economic growth. What is the impact on various asset classes? The impact on equities would largely be positive. Higher economic growth generally means a better revenue opportunity. Further, a lower tax rate generally means higher earnings per share. Earnings per share are an important driver for equity returns. The policy could have north of a 10% increase in S&P earnings per share. This would be a significant amount, and change the forward-looking return expectations for equity markets.

For the bond market, it will depend on the type of security. For a Treasury bond, this could be negative. Theoretically, higher economic growth would lead to higher inflation. Higher inflation would mean higher interest rates. For bonds, price and yield (or interest rates) move inversely. Perhaps a simpler way to think about it is if there is inflation, each fixed payment a bond makes is worth less, because it has less purchasing power. However, for other types of bonds such as inflation-protected or floating rate bonds, this type of environment might not be so bad, and you will actually be able to make money on them.

Gold could see an increase in demand due to higher inflation, as gold historically has been an inflation hedge. However, gold will ultimately move inversely with real interest rates. Real interest rates are the interest rate, after you factor in inflation. Thus, the movement in gold will depend on the magnitude of inflation we get from the policy, and the movement it creates in interest rates. That said, gold would certainly provide a level of protection in this environment.

What are the risks? The first is purely political, does the plan go through, and what version. If the plan does go through, it does risk over-heating our economy. We are in the eighth year of our economic recovery, the unemployment rate is low, such a policy might create more inflation than desired. Perhaps the risk that will be most discussed is that what it will do the Federal deficit. While many in the administration say that economic growth will pay for the plan, many outsiders remain skeptical. If the plan doesn't pay for itself, it risks increasing the $559 billion deficit, and the $14.8 trillion of debt outstanding. Severe increases to either or both, hampers long-term growth for the country. The tax plan specifics are yet to be determined.