Since the passage of tax reform, we have seen stocks rise on expectations of stronger earnings fueled, in part, by a reduction in the corporate tax rate to 21% from 35%. There is also optimism that the improving economic data of late will rouse the animal spirits and lead to more spending and investing. And finally, it is also worth mentioning that higher commodity prices in recent months – also a function of the strengthening economy – should boost earnings for companies operating in the heretofore underperforming Energy and Materials sectors. These anticipated benefits to aggregate corporate earnings have lifted stock prices into “fully valued” territory. As earnings season approaches, expectations are high and investors will be paying close attention to each company’s earnings outlook, or “guidance” for 2018. It seems like that the next leg up will require an upward reset of earnings growth for 2018 and perhaps beyond. Having said all of that, we believe there will be a couple of offsetting factors to be aware of that could weigh on corporate earnings, and therefore stock prices, in 2018.
First, we think there is some pressure on management teams to “share” some of the tax windfall with employees, if for nothing else than to make it look like the cuts weren’t simply a gift to corporations (which had been putting up record profits and margins prior to the tax cuts). Banks, in particular, seek to get in the administration’s good graces during a period in which the banking regulations are being revised. Indeed, we’ve already seen a number of retailers and banks, in particular, announce bonuses, minimum-wage increases, or the expansion of benefits since the tax cut bill was passed. Wal-Mart was the latest yesterday. These expense increases could be a drag, albeit somewhat minor, on earnings in the year to come.
The second offsetting factor, which is the most “pro-growth” aspect of the tax overhaul but could weigh on near-term earnings, is related to a provision in the tax bill that allows companies to immediately write off, in full, any capital expenditures. While there are separate accounting books for taxes and financial reporting, this provision will likely lead to an acceleration in investment spending, some of which will likely eat into earnings next year and offset the tax windfall.
The takeaway from this is that while the new tax bill has improved the near-term outlook for U.S. companies, one must remember that stock prices have been going up, almost uninterrupted, for a long time. The recent run-up in stock prices increases the possibility that some companies, or sectors, will fall short of high expectations. With this, we expect that the earnings season will show us if stock prices have gotten ahead of themselves. We have noted several times in the past that the market is due for a correction and that still holds true as it has been almost 2 years since the last 10% sell off. With stocks near all-time highs, we remain defensive but fully invested in companies with solid fundamentals.