Is the Tax Plan a Game Changer for Market Leadership?
Equities have been caught in a fierce three-day (11/27-29/17) rotation as the tax bill advances through Congress. Television screens at trading desks across the country are hailing “a great rotation out of growth stocks” and welcoming a new era of higher interest rates.

Investors can be excused for having a sense of déjà vu.

It was only a little over one year ago when the prospects of a Trump presidency and GOP control of Congress set off a sharp rally in U.S. value stocks and a selloff in U.S. Treasuries. The trade worked for seven weeks. By inauguration day, the realities of governing had already set in. Politics aside, in my view, nothing had meaningfully changed:

  • Fiscal stimulus was non-existent while monetary policy was tighter.
  • Hopes of higher sustainable trend growth in the U.S. disappeared.
  • The yield curve flattened.
  • Investors bid up growth stocks in what continued to be a slow growth environment.

The growth trade worked until three days ago. Value stocks, which were flat for the month heading into Thanksgiving and underperforming growth stocks by nearly 300 basis points in November (and 1,600 basis points year-to-date), are now outperforming month-to-date.1 What a difference three days make.

Before we go out and dump all our growth stocks, let’s first consider the merits of the proposed tax bill and its potential impact on the economy. Foremost, the tax bill is a boon for corporate earnings. Simply put, businesses will get to keep more of what they gross. However, the benefits will not be spread equally across sectors. Many of the accounting tricks multinational companies have used will be disallowed under the proposed tax regime. A move to a territorial tax system will increase taxes on earnings booked abroad. The technology sector will be most negatively affected, in my view.

I believe companies in more domestically focused sectors such as telecommunications and financials will be least impacted and stand to see their earnings benefit the most. It should be no surprise then that over the last three days, the financial sector is up 5.5%, the telecommunications sector has gained 4.4%, while the technology sector is off 2.4%.2

Inflection Point for Value-Stock Leadership?

For this to be the inflection point to new value-stock leadership and rising interest rates, the tax bill would need to produce a sustained increase in economic activity. I’m skeptical for the following reasons:

  1. Companies are already profitable and flush with cash. Corporations’ liquid assets as a share of short-term liabilities are close to 50%, nearly as high as they have been in over a half century.3
  2. The job market is already tight. Remember the U6 “real” unemployment rate, the one that includes part-time workers and those marginally attached to the labor force? It is now as low as it was before the 2008 financial crisis.4 Businesses that intended to hire have generally already done so.
  3. The business investment cycle has already turned higher. Capital expenditures as a percentage of GDP are already climbing.5

Finally, my biggest concern is that any near-term boost to U.S. economic activity could prove to be nothing more than a “sugar rush,” bringing forward monetary policy tightening, flattening the yield curve, and paradoxically shortening the cycle.

This is not to say that value stocks won’t have anything more than a three-day run. It may last for a while. But at some point it will become clear that the growth trajectory is not changing meaningfully. And without the catalyst of higher sustained growth, value stocks will once again underperform.

Investors may wish to consider favoring growth wherever they can find it, including in U.S. growth stocks and in parts of the world where growth is accelerating, such as the emerging markets.

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  1. ^Source: Russell Growth Index and Russell 1000 Value Index, 11/1-29/17. Past performance does not guarantee future results. 
  2. ^Sources: S&P 500 Financials, S&P 500 Telecommunications Services, and S&P 500 Information Technology sector indices, 11/27-29/17. 
  3. ^Source: U.S. Federal Reserve, 10/31/17. 
  4. ^Source: U.S. Dept. of Labor, Bureau of Labor Statistics, 10/31/17. 
  5. ^Source: U.S. Bureau of Economic Analysis, 10/31/17.