By Raymond Chan

Our Chief Economist Michael Knox, and our Strategy Team, came up with an excellent piece of research on Trump's speech. Latte with Ray thinks it will be beneficial to share this with our Switzer readers. 

Donald Trump delivers his first speech to Congress

The content of yesterday's speech will be pored over by financial journalists in the coming days, and is an important marker in the context of the S&P500's record run. We thought it was timely to circulate Michael Knox's views on Trump's agenda and the enthusiasm already built into US equities, arguably with flow on effects to Australian shares.

Our strategist Michael Knox's view in a nutshell

The outlook for the US economy is good and the outlook for US earnings is even better. However, the US equities market is now pricing itself very fully on the prospect of better earnings in the future. Part of the reason for that optimism is the prospect of much lower corporate tax rates. We think that these tax reforms are guaranteed to have a noisy passage through the US Senate and that this could easily give inflated equity markets a scare.

Michael's views in more detail: "Too much good news"

Since the US presidential election in November, the US stock market has been rising strongly. This rise has been followed by a similar rise in Australian equities. This partly reflects better fundamentals, but much more of this rise simply reflects better sentiment. 

A stronger US economy 

In 2016, the US economy was relatively soft. GDP grew at only 1.6% for the full year. The reason for the weakness was a slowdown in non-residential construction. Very low oil prices in the beginning of 2016 meant a much lower level of investment in oil drilling, gas drilling, and energy infrastructure such as gas pipelines. Improving energy prices in the second half of 2016 caused the beginning of a recovery in the same non-residential construction. In 2017, the US economy should accelerate to 2.3%. In 2018, growth should pick up further to 2.7%. This improving economic outlook has generated a remarkable scenario for operating earnings per share of US corporations. 

However, US stocks look to have overshot our model of the S&P500 

With stronger growth and the prospect of much better earnings, it's not surprising that the US stock market has risen. The question is, has it risen too much? We model the S&P500 based on the level of operating earnings per share and US 10-year bond yields. This gives us a pretty good model explaining more than 80% of monthly variations. 

S&P 500 Operating Earnings

The problem is what the model now tells us. Based on the current level of earnings per share and bond yields, our fair value for the S&P500 in February 2017 is only 1916 points. At the time of writing, the market was way above that, at 2351 points. In the future, earnings will justify such a level of the S&P500, at a level of bond yields around where they are now. The problem is how far in the future it will be before earnings provides that justification. 

Our model tells us that, even with the much better earnings expected in the future, fair value of the S&P500 does not reach a fair value of 2338 until the third quarter of 2018 and 2394 until the fourth quarter of 2018. That means that the S&P500 is currently trading at fair value based on earnings that do not arrive until the third and the fourth quarter of 2018. 

Rotation from debt to equity has been driving equity prices

Why is this happening? We think that the US market is receiving a flood of liquidity from the US corporate debt market. The difference between US corporate yields and US sovereign yields has fallen dramatically since February 2016. Where previously investors might have bought corporate debt, the decline in the yield on that debt is now leading investors to switch from corporate debt to corporate equity. The money from the corporate debt market is flooding into equity prices and driving equities to a level that the market does not yet justify.

And, of course, euphoria around promised tax rate cuts

In addition to liquidity, the market is being supported by sentiment. Much of this sentiment is driven by the prospect that the new Republican administration will cut corporate tax rates. We have written before about the proposal to cut US corporate tax rates from 35% to 20% and maybe even to 15%. These corporate tax cuts are possible through the elimination of most of the corporate tax deductions that currently exist in the tax code. In addition, revenue is raised through a border adjustment tax. The elimination of tax deductions for corporate imports provides an effective revenue tariff of 20%, assuming a corporate tax rate of 20%. 

The problem is that even though those proposals have the support of the House of Representatives and the American President, they have yet to gain the support of the American Senate. US elections are much more open to the operation of lobbyists than is the case in Australia. This is primarily because of the very large cost of running elections in the US. This, in turn, is due partly to the high cost of advertising to very large populations.

There is no doubt that some Republican donors currently feel that the businesses that they are engaged in will lose out through the introduction of the Border Adjustment Tax. Our understanding is that this has resulted in heavy lobbying against the Border Adjustment Tax in the US Senate.

The problem is that without the Border Adjustment Tax, there is not enough revenue to support a cut in the corporate tax rate. Without the Border Adjustment Tax, a cut in the corporate tax rate will result in a large budget deficit. 

The stock market is banking on a cut in the corporate tax rate. Unfortunately, the passage of the corporate tax cut through the US senate is likely to be achieved only after much public argument. As the market sees those corporate tax cuts at risk, it is possible that its reaction could be both volatile and negative.