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Guest post contributed by Marty Kerns and Parker Binion of Kerns Capital Management.

In case you haven’t heard, last week President Trump signed into law an historic overhaul of the US tax code.  Significantly, the new tax code reduces the federal corporate income tax rate from 35% to 20%!

Tax reform the most significant game changer for the American economy in more than 30 years.  It will be the catalyst that drives stock prices higher, perhaps much higher, in 2018.  Here’s why!

High relative corporate tax rates make it difficult for US companies to compete because they have to charge more than their global competitors for the same or similar items to make the same profit.

Until last week, the United States had the highest top corporate tax rate (a combination of federal, state and local taxes) in the world at 38.9%.  Source: Organization for Economic Cooperation and Development (a group of advanced economies). China’s corporate income tax rate is 25%; however, that rate is reduced to 15% for qualified enterprises.  Source: PWC, China.

Assuming companies are able to take every deduction and credit available under their respective tax codes, the US drops to 18.6%.  Mexico, China and South Korea come in at 11.9%, 10% and 4.1%, respectively. Source: Congressional Budget Office.  

 

US companies must therefore charge significantly more than their counterparts to make the same profit on the same item.  For perspective, imagine giving your competitor a 23% (i.e., China) head start in the 100-yard dash.  Did you win? 
Accordingly, to be competitive, US companies must be more efficient in the production and distribution of their products.  Increased efficiency can come in many forms, but most often manifests in the labor force via technology (think robots), wage reduction and outsourcing to other lower-wage countries like Mexico and China.   And when that’s still not enough to make up their opponent’s head start, corporations simply pack-up and move their operations to another more tax-friendly nation.  A lose-lose scenario for America.

 

This all changed last week.  Corporate America is rejoicing in what they see as a long overdue leveling of the playing field, e.g.
  • AT&T said it would give $1,000 bonuses to more than 200,000 employees in the US and promised to invest an additional $1 billion in the US in 2018.
  • Boeing announced it would spend $300 million on “employee-related and charitable investments.” “The reforms enable us to better compete on the world stage and give us a stronger foundation for the investment in innovation, facilities and skills that will support our long-term growth,” said CEO Dennis Mullenburg.
  • Comcast is giving $1,000 bonuses to 100,000 “frontline and non-executive employees.” CEO Brian Roberts also said the company expects to spend “well in excess of” $50 billion on infrastructure investment over the next five years.
  • Fifth Third Bancorp said it would increase its hourly minimum wage to $15 for US employees.
  • Wells Fargo said it would increase its minimum wage for U.S. employees from $13.50 to $15 and spend $400 million on donations to nonprofits and community organizations in 2018.
Scott Wren of Wells Fargo perhaps summed it up best last week when he told CNBC, “These companies have had a lot of cash. They could have done capital spending all along into this recovery, they chose not to. Now we’re expecting them to do more.”  

 

We do too. Much more. 
 

Rising Interest Rates … Bad for Bonds
The Fed plans to continue its policy of “normalization” (i.e. increasing short-term interest rates) in 2018. The market is expecting three interest rate hikes in 2018 … which still leaves us with historically low rates.  Foreign central banks are a good bit behind the Fed in this process. 
 
Over time, raising rates will have a negative impact on stocks, particularly if the Fed goes too fast.  Currently, however, rising rates are:
  1. Positively affecting the stocks … proof of an improving economy; and 
  2. Negatively impacting bonds … money that would have gone into bonds is going into stocks instead.

The Drum Beats On … S&P 3,000 … Dow 25,000!
 Back in our August 2017 newsletter, when the S&P was trading at 2,475, we noted the potential for the market to gain another 20-30% over the next year or so. That range implies the S&P could hit 3,000 to 3,200 in 2018.

 

Currently, the S&P trades at 2696. The consensus on Wall Street predicts that the S&P will reach 2,800-3,000 in 2018.  We remain on the bullish end of that spectrum. That said, we won’t have another calendar year of twelve straight winning months. There will be ups and downs, as volatility makes a return to stock market investing. 

 

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