As we enter this last week of November and are about to end 2017, it is crucial for us to recognize that the financial markets are now rotating around what I like to call the “Big Three”. As noted in the title of this post, the Big Three are taxes, stock buybacks, and interest rates. While this have always been important to the markets, especially in the case of rate hikes, to the best of my knowledge we have never before seen a situation in the markets where taxes and stock buybacks were comparably as important as interest rates. This is yet another reason why I believe that the current market environment is vastly different than those before it, and more importantly I am convinced that the only serious sources of volatility we are likely to see going forward through 2018 will be the Big Three. But why is this?
With respect to taxes and buybacks, we are on the cusp of the first major corporate tax reform since the 1980s. While there are have been many laws passed which have had tremendous impacts on the US financial markets since then, we did not have a significant change in the corporate tax rate. US companies have stashed away trillions of dollars in offshore accounts, and until now they have had little reason to be expected to repatriate those funds. This of course is strongly due to the higher corporate rate they would have to pay in the United States as opposed to those of tax havens abroad. Although those funds are often placed into the US markets through foreign affiliates (essentially shell companies) in the form of investments in US stocks or government treasuries, such funds are still considered to be “foreign” and therefore the companies can avoid paying the US corporate rate. Most importantly, these foreign funds cannot be used to purchase company stock. But if a corporate rate cut is passed and a repatriation initiative goes with that cut, then companies are likely to keep more funds in the US as well as repatriate more funds currently parked offshore. Much of those funds will inevitably be used for more buybacks, which would serve to sustain and advance equity prices.
With respect to interest rates, we are now seeing some indications that the FOMC might decide to slow down the pace of normalization. Part of this is due to a feared slowing inflation, which is a very big area of focus by the Fed. Current FOMC chair Janet Yellen has made it clear that she sees any slowing of inflation as a major concern and would halt any future hikes until inflation was up to par. Add to this the current uncertainty as to the success of the GOP tax bill, and the risk posed by the changing of FOMC chairs in February, and we have a situation where increasing interest rates might stall in 2018. This would likely provide a boost to the markets in the short term, but it would also prolong the life of the current debt-fueled bubble in US equities that we are now seeing.
In the end, I expect that 2018 will be dominated by trends in the Big Three. I will only speculate at this point that rate hikes are likely to continue provided that the GOP tax bill is passed in a form similar to the current wording, at least in terms of the corporate rate. However, if that effort fails, then I expect the markets to decline significantly as buybacks will stall along with any boost in corporate profits. We will get our first glimpse of what is to come with the Senate decides to vote on the tax bill, presumably by early December.