30 Sep Quarterly Letter to Clients – Sept 2017
U.S. media provided overwhelming coverage in September of three major hurricanes; the war of words between Trump and North Korea’s Kim Jong Un; and the political battles in Washington surrounding healthcare legislation. Largely drowned out by this reporting was coverage of a surprisingly strong U.S. economy – a development which no doubt contributed to rising stock prices.
Real gross domestic product, which in the first quarter had been up only 1.2% at an annual rate, jumped to 3.1% in the second quarter, the highest level in three years. Strong consumer spending was the primary contributor. Other economic measures have also been impressive. Unemployment is currently only 4.3% and inflation less than 2%. Manufacturing, which accounts for about 70% of total economic activity, has been supportive of good growth and seems likely to continue to do so for the balance of 2017. Plans for both output and hiring in this sector appear solid and inventories low.
Even with the background of a healthy and growing economy, stock prices are not at bargain basement levels. The Standard & Poor’s 500 Index at the close of the third quarter represented a multiple of estimated current year earnings in the low twenties, above historic averages in the mid- to upper-teens. Applying most estimates of earnings for 2018 brings the multiple down to the high teens, a more reasonable level, particularly if strength in the economy continues beyond next year, carrying earnings even higher.
This year, another major factor could come into play – the action Congress might take to enact new tax legislation. The Administration is seeking, among other things, a reduction in the corporate tax rate from 35% to 20%, a change which by itself would increase net corporate income after taxes substantially. The final tax package, if enacted, would no doubt include other provisions which would lessen the increase, but the final net impact could still be a significant increase in net corporate earnings. This would lower projected price/earnings ratios more than the impact of rising economic activity alone. The Administration proposals are likely to face opposition from many Republicans as well as Democrats, so passage is far from certain. However, since Republicans thus far have not been successful at seeing their other major initiatives become law, they are likely to press forcefully for tax reform.
Carl Tannenbaum, a Northern Trust economist, aptly used the German phrase Sturm und Drang (literally storm and stress) in his September “Outlook” letter to describe the immediate past and near future for the U.S. economy. Third quarter economic statistics should provide evidence of that when they are released. The negative impact of storms and flooding in Florida and Texas, in addition to causing considerable human hardship and loss of life, probably brought overall third quarter economic growth in the U.S. down to 1.5%, although a rebound to a 3% or higher rate should occur in the fourth quarter. Rebuilding from the storms should also add to overall economic activity into next year as well.
We face some significant risks both here and abroad. Fortunately, except for the near-term hit from the hurricanes, the economy is strong and growing. Stock prices have been reflecting this and seem poised for even more gains in the months ahead.