I don’t know if we could pass a Mother’s Day Resolution right now.
– Representative Matt Gaetz as quoted in the Wall Street Journal March 25th, 2017
Easier Said than Done
Since the election of Donald Trump to the office of the President of the United States, the US stock market has been on a steady upward climb. From October 11th, a few weeks prior to the election, till March 21st the S&P 500 did not experience a greater than 1% drop on any given day – the longest such streak since 1995. It is always speculation to attribute market movements to a single factor but the relative calm and optimism of the market appears, at least in part, to be due to President Trump’s plan to grow the economy. However, during the week of March 20th the realities of implementing legislative agendas began to set in as the Repeal and Replace bill for the Affordable Care Act (ACA) was to come to a vote.
Repeal and Replace, as it is commonly called, has been on the minds of Republicans for several years. It seems most – if not all – Republican candidates running for election since the passing of the ACA ran on a platform that included its repeal. During the Obama administration, the Republican controlled Congress sent several Repeal bills to the President knowing his veto was a certainty. One would think after so many years of campaigning for the Repeal of the ACA and after passing several bills at the congressional level to Repeal the ACA that the Republican Party would have a readymade, passable bill. However, now that the vote was for a bill that would become law building consensus became more difficult. The Republican Party fractured and the bill failed.
The Repeal and Replace bill was the first in a set of legislative dominoes to affect change in the US economy. The tax savings achieved through Repeal and Replace would make room for greater adjustments to the tax code which would in turn guide infrastructure spending. These items were intended to stimulate the corporate and economic growth the market has been banking on. The failure to Repeal and Replace the ACA does not spell certain doom for the other items on the legislative agenda. As Republican Rep. Matt Gaetz’s quote indicates it does demonstrate the difficulty in building consensus in a ruling party.
Building consensus will not get easier as the President and the House move on to the next item in their agenda, tax reform. One of the major pieces of the GOP proposed tax plan (http://abetterway.speaker.gov) is to add a Border Adjustment Tax (BAT…an unfortunate acronym but we’ll go with it). To keep things moving along here we won’t go into the inner workings of a BAT. We’ll just say the intended consequence is to reward US based companies for exporting goods and penalize them for importing goods. Sounds great, right? Well, if a BAT is implemented you will find your next trip to COSTCO quite a bit more expensive. Retail items are largely imported. If importing goods suddenly costs companies more money that extra cost will get passed on to you.
The proponents of a BAT argue this increase in cost to the consumer (you) will eventually be quickly because it will cause the dollar to strengthen in value relative to other global currencies thus making goods from other countries cheaper we are not convinced the cause and effect connection is fully there. There are far too many variables impacting the value of the dollar relative to other world currencies to rely on one factor to account for a massive shift in currency valuations. We are not alone in our skepticism no fewer than 19 Republican Senators have expressed concern over adding a BAT and several of those are strongly opposed. Even the White House, and President Trump specifically, have expressed concerns regarding implementing a BAT. When you have Senate majority by two seats and vice presidential tie breaker you only have two votes to give up…there is not a lot of wiggle room there to lose votes. As the administration proceeds with its agenda to overhaul the tax code and implement the other changes the market seems to be banking on it finds itself looking up at another set up hurdles while still lying on ground from the last hurdle it just failed to clear.
Though any tax reform bill is at least 7 months away we remain mindful of the impact tax codes changes can have on financial markets. One such instance, the Tax Reform Act of 1986, caused massive shifts in the real estate market. While the current proposed tax plan does not appear to make any changes that would so directly affect one specific asset class there are a few provisions that will impact markets. The BAT tax discussed above will have drastic impacts on certain market sectors: retail, auto and aviation to name a few.
There are other provisions of the proposed tax code which have the potential of causing major shifts in the markets as well. One provision will allow US based companies to repatriate dollars held overseas at a tax rate of 8.75%. Another provision removes company’s ability to deduct interest expense on money it borrows. While seemingly unrelated the combination of these two provisions would fundamentally change the math behind corporate finance and could cause large shifts in the bond market. Given these potential impacts we will closely monitor the tax bill as it works its way through the legislative process.
Oil Markets Settle into a Range
For years, the
oil market has been run by a cartel…the OPEC nations. The price of the commodity
shifted based on their production levels. However, their influence over the
price of oil appears to be waning. New technology developed over the last
decade or two has allowed for oil to be extracted from shale fields
which resulted in a large
increase in United
production. The Saudis’ recent experiment to slow this growth of US oil production by over-supplying the markets has resulted in a consolidation of the US oil market but not a lessening of capacity. If indeed this was the Saudis’ intent they underestimated the ingenuity of American oil producers. As we stated in our 2016 Q1 Commentary US oil companies have been making money in oil for 150 years in many different environments. Given time they would adjust to the new normal and that’s what has happened. Over the last few years the break-even point for US oil producers operating in shale fields has dropped through technology and innovation.
What this likely means for the oil market going forward is a pricing system more defined by market forces and less by a cartel. OPEC will continue to have influence on oil markets…they’re still the 900 lbs. gorilla. But limiting demand to drive up oil prices, as they have done in the past, will now be met with greater production from US producers. This very scenario has played out over the last year. As oil prices returned to the $40-$50/barrel range US producers picked up production.
The 2015 – 2016 turmoil in the oil markets provided us with some opportunities to over-weight our energy portfolio with assets at reasonable values. In our opinion, the market forces described above would keep the price of oil in the $40 – $60 range for some time limiting the near-term upside potential in the price of oil. In response, we unwound or reduced some of those positions in January 2017 and shifted our energy portfolio to be more sensitive to oil production levels (which we believe will continue to increase regardless of price) and less sensitive to the price of oil. While this will limit our upside if the price of oil unexpectedly goes up it should also limit our downside should the price return to the low levels we saw in 2015.
The US market is not alone in its relative calm. European and Emerging Market economic data is being read as overwhelmingly positive (there is some good, bad and ugly in emerging markets) and global markets are responding with steady upward climbs. Events that once shook the market – fed interest rate increases, talk of a wind-down of Federal Reserve assets, geopolitical uncertainties – no longer seem to carry the weight they once did. It is during these times of calm when our awareness of risk needs to be at its greatest. Not because risk is inheritably greater in times of calm but because the calm can cause a dangerous sense of ease. We will continue to look for opportunities to invest capital at an acceptable level of risk.
Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.