It was a solid week for the global equity markets. The French election results provided the spark on Monday and solid earnings reports underpinned the gains. For the week both the S&P and Russell 2000 were up +1.5%. The NASDAQ jumped +2.3% to close solidly above the 6,000 level for the first time ever. Amazon and Google earnings impressed investors.
While the big tech behemoths garner a lot of attention, earnings in general have been pretty good. So far first quarter earnings are up +10.4%, the fastest rate in six years. As you can see below, 78% of companies have beat earnings estimates (black line) while 67% have beat sales estimates (blue line). The sales beat rate is at its best level since the second quarter of 2011.
European stocks performed well again this week. France was up +4.1%, Germany +3.2%. Certainly, the French election helped, but earnings in Europe are also solid. First quarter earnings in the region are up +13%, 67% of companies have beat earnings estimates, and 79% have beat sales. These are some impressive stats.
The French Vote Against Frexit
The week got off to a solid start after the election news in France. Emmanuel Macron and Marine Le Pen came in first and second during the first round of the French election. A late surge by the far-left candidate proved too little too late. At first blush Le Pen’s performance might be disturbing, but she stands a slim chance in the second round, at least at the moment. Recent polls (see below) have Macron winning by over 20 points.
Of course, anything can happen between now and May 7th, but a Macron win will most certainly dampen down the political uncertainty that was pervasive at the beginning of the year.
The market reaction to the verdict was swift. The spread between French and German bonds narrowed quickly. As you can see below, French bond spreads had soared from just 20bps to almost 90bps prior to the election. This was favored hedge fund trade – short French bonds while buying German. However, immediately after the election the spread plunged to 50bps.
Global equity markets also shot higher. European financial stocks were particularly well bid, with the European bank index gaining over 7% on Monday alone.
The French news comes only a week after U.K. Prime Minister Theresa May called for a fresh election. May’s announcement was designed to expand the Conservative Party’s majority, thus neutralizing the ability of a few hardline Tories to scuttle a Brexit deal. Populist forces have also failed to gain ground in both the Austrian the Dutch elections.
In the U.S. President Trump also seems to have caved on his most combative campaign pledges. He agreed to drop his request that Congress pay for the boarder wall with Mexico and defund planned parenthood. This probably averts and government shutdown in the coming weeks. He also said he will neither scrap NAFTA nor label China a currency manipulator.
If political risk was the biggest uncertainty coming into 2017, this risk has diminished significantly the last couple weeks.
GDP Whiffs – The Fed Probably Doesn’t Care
This week’s rally came despite a poor GDP report on Friday. In the first of three estimates, real GDP increased by +0.7% in the first quarter, somewhat below consensus expectations for a +1.0% gain. Key points from the report:
- Inventory accumulation reduced headline growth by 0.9%.
- Domestic final sales (GDP excluding both inventories and net trade) increased by 1.5%, as net exports added 0.1% to growth.
- Consumer spending increased by just 0.3%, the lowest in quite some time (see chart below). Auto sales were weak (-16.1%), but more surprising, services slowed to +0.4% after +2.4% last quarter.
- Government spending was also softer than expected, dropping by 1.7%.
For some reason this report follows a string of weak first quarter growth numbers the last few years. As you can see below, ever since 2013 first quarter growth has been subpar (red circles).
Probably the lesson of the last few years is that to get a true picture on growth you probably should average both the first and second quarter growth numbers. Expectations are for growth of 2.7% in Q2.
Nothing in the GDP report should change the Fed’s plans. They probably won’t hike next week, but the odds of a June hike are reasonably high. As you can see below, the market places a roughly 60% chance of a hike at the June meeting. Maybe surprisingly this didn’t move at all after the GDP number.
Housing – Tight Inventory Drives Prices
Bucking the weak first quarter growth number were home prices. The S&P/Case-Shiller index of home prices in 20 major US cities climbed 5.9% year-over-year in February. Depending on the measure, prices are close to exceeding the 2007 high (chart below).
The report highlights the fact that the supply of existing homes remains tight. As you can see below, the existing home inventory is bouncing around the lowest levels seen since 2001.
Another way to look at this is below. The blue line is the year-over-year change in inventory levels – they are down -6.6% over the last year. Furthermore, there are only 3.8 months worth of supply on the market today. This is the lowest level since 2005
Nationwide the housing backdrop looks solid. You are starting to scratch your head at some of the bay area values though!!!
More Like Tax Cuts Than Tax Reform
The other major political news for the week was President Trumps opening salvo in the tax debate. The plan is almost identical to the final plan Trump released on the campaign trail. Basic points are:
- Reduce the number of tax brackets from seven to 3 ((10%, 25%, and 35%).
- Increase the standard deduction to $24,000 for couples.
- Abolish every itemized deduction except for the mortgage interest and charitable deductions. Notably, this includes getting rid of deductions for state and local taxes (it is estimated that this would raise $800 million over 10-years).
As an aside, the WSJ had the chart below showing which states get hit the most by all the deduction changes. As you might expect they are the high tax democratic states like New York and California. For example, getting rid of all deductions with the noted exceptions would cost the average Californian roughly $3,200 assuming no other changes (like lower marginal rates and elimination of AMT).
- Trump is now fully exempting income that companies earn overseas from tax, adopting a “territorial” approach to corporate taxation.
- Cutting the corporate tax rate by more than half, from 35% to 15%.
- Letting “pass-through” companies pay the lower 15% corporate rate rather than the top individual rate of 35%.
- Eliminating Obamacare’s 3.8% surtax on investment income.
- Abolishing the Alternative Minimum Tax.
- Abolishing the estate and gift tax.
Goldman Sachs estimates that all the proposals, if enacted, would cost just under $5 trillion over 10-years. So how will it be paid for?
Let’s quote Goldman here:
“Our preliminary expectation is that the White House will assume that the majority of the fiscal effect of the tax cut would be offset through a projection of faster GDP growth. For example, if the White House assumes a 3% growth rate over the next ten years, rather than the 1.8% average rate that CBO assumes, this would increase revenues by roughly $3.7 trillion over the ten- year period.”
This is what is called dynamic scoring. Arthur Laffer must be smiling to himself!! However, Congress must use growth projections from the Congressional Budget Office, they can’t just pencil in a number they like.
Can the Republicans structure this so they can pass it based solely on a party vote? Goldman again:
“Rules regarding the “reconciliation” process make it more difficult to pass a tax cut than to pass revenue-neutral tax reform, but we expect lawmakers to get around these obstacles. Republican leaders have made clear their intent to use the reconciliation process to pass tax legislation, since this allows the Republican majority to circumvent likely Democratic opposition in the Senate. However, the “Byrd Rule” in the Senate prohibits reconciliation legislation from increasing the deficit after the period covered by the budget resolution that governs the process, which traditionally lasts for ten years. The most obvious way that congressional Republicans might get around this constraint is simply to allow the tax cuts to expire after ten years (i.e., by 2027). This was done in 2001 when the Bush Administration passed a large individual tax cut.”
Of course, the question is how many House Republican’s from New York and California will balk at the state tax changes. But we have a long way to go. The next steps are:
#1 – President’s Budget
This should be submitted to Congress in mid-May. This should have some more details on the tax plan, especially forecasts for revenue and expenses under the new proposal.
#2 – Health Care Bill
It looks like the Republicans will take another stab at passing the American Heath Care Act. At some point Republican leaders will need to decide if they have the votes or whether they should move on to tax legislation. Open question – do some Republicans need the savings from Healthcare to justify they stance on tax cuts? Time will tell.
#3 – Draft tax legislation
Here the devil is in the details. Regan’s first tax reform proposal ran to 500 pages. Trump trimmed it down to one page. Needless to say, some meat needs to be put on the bones. It is tough to say when the process of actually drafting the legislation will take place. We are seeing estimates of June or July, but there have been calls for hearings before then to explore issues such as the boarder tax. This means any type of voting looks unlikely before August. We should assume that passage of whatever comes out of the sausage machine is a fourth quarter issue at the earliest.
Have a good weekend.
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