Notes on the Week AheadContributor Dr. David Kelly
Political Lions and Corporate Cattle
In the last scene of Sydney Pollack’s beautiful movie “Out of Africa”, two lions gather on the hero’s grave and look out at the cattle on the plain below. It is a princely scene – an assumption that the animals below are somehow the property of the lions, to consume whenever they feel hungry.
For some reason, I was reminded of this scene this week, as politicians from both parties decried what they saw as corporate bad behavior and proposed measures to fix it.
The S&P500 has now risen in seven of the last eight weeks and is up 10.7% year-to-date. In the week ahead, investors will be considering prospects for further gains, given both economic and political trends.
On the economy, data due out on Thursday should support the idea that economic growth is slowing but not stalling. In particular, the delayed Durable Goods report for December should show solid gains, even outside of the volatile aircraft category, making up for some of the weakness seen in last week’s retail sales report. In more timely data, Unemployment Claims should have fallen in the latest week while the Philly Fed index could post a modest gain.
Information from the Federal Reserve this week should also be market positive, with the release of the minutes from the January FOMC meeting on Wednesday and speeches by a number of Fed officials on Friday. Some commentators have downplayed the change in messaging from the Fed at their January meeting. However, Fed communications this week will likely reaffirm the importance of this change, helping convince many that the next Fed move is as likely to be a cut in rates as an increase.
The earnings season is winding down with 49 S&P500 companies set to report in the week ahead. A strong rebound in markets in recent weeks may have overshadowed actual earnings numbers which have, objectively, been pretty weak. So far, with 85% of market cap reporting, the year-over-year gain in operating EPS appears to have fallen from 32% in the third quarter to 14% in the fourth. It is worth noting that effective tax rates fell sharply in the fourth quarter of 2017, so the pre-tax slide in year-over-year profit growth from 3Q2018 to 4Q2018 was somewhat milder.
However, entering 2019, the pressure on profits is increasing. The last of the tax cut effect will fall out of the year-over-year earnings gains in the first quarter. In addition, companies will face multiple headwinds including weaker global growth, a stronger dollar and lower oil prices than a year ago, faster growth in wages and higher corporate bond yields. All of this could cut year-over-year growth in operating EPS to near zero in the first quarter, with the rest of the year averaging low to middle-single-digit growth.
In 2020, profit gains should stabilize, as the global economy picks up steam and the U.S. dollar drifts down. However, a new threat to equities is emerging in the form of attacks on corporate behavior from politicians on both the right and the left.
In particular, in the last week both Republican and Democratic senators have proposed limiting the use of stock buybacks, either by taxing them as implicit dividends or by prohibiting buybacks unless a company meets a number of criteria such as a $15 minimum wage and ‘decent pensions and more reliable health benefits’. In both cases, the senators argue that stock buybacks should be limited to encourage companies to invest in their own enterprises. However, investors have good reason to be nervous about the rationale as well as the politics behind these proposals.
It is true that buybacks have a tax advantage over dividends. $1 million paid out in qualified dividends will all be subject to tax (in taxable accounts). Only part of $1 million paid out in stock buybacks will be subject to tax since only the capital gain and not the whole price of the stock is taxed. Moving to a model of taxing buybacks as implicit dividends would reverse this since stock buybacks would trigger a dividend tax for all shareholders (in taxable accounts) as well as capital gains tax for those who sold.
However, companies today actually have an incentive to hoard cash relative to distributing it and this incentive would only increase if stock buybacks were discouraged. If a dollar retained in a company was ultimately as productive as it would be in the hands of shareholders, it would make sense for the company to hold onto it and defer any payment of tax for years to come. Shareholders could then realize capital gains when it suited them and might avoid capital gains altogether if they passed it onto their heirs.
Of course, the problem is that companies often don’t know what to do with their excess cash. They had a great idea, generated huge profits and currently run an efficient business but ultimately they don’t have a winning growth plan. In this case, it is far more efficient to let companies distribute the cash rather than encourage them to invest in areas that seem less profitable. Moreover, while achieving higher wages, decent pensions and more reliable health benefits are noble social goals, they could probably be better achieved by direct government action or regulation rather than by forcing certain companies to supply them in order to gain permission to allocate profits efficiently.
As for the politics, it is unnerving to see politicians from the left and right once again attack corporate greed as the source of all the nation’s problems. The people who work at all levels in American corporations are no better or worse than the rest of us – in fact, to a very large extent, they are us. Having finally achieved a federal corporate tax rate in line with the OECD average, the danger is that the next populist wave will see corporate profits as just too juicy a target.
In the grasslands of American politics, corporate profits may look like a tempting meal. But voters who are also shareholders should remember that while the lions make a persuasive case, they also have a strong interest in the health of the cattle.