The broader effects on the economic and financial markets should be felt soon because the changes passed in December are not phased in. The Trump administration considered phasing in the corporate tax cut but in the end, wisely made the changes apply to 2018.
While it still takes time for businesses to rev up their activities, separate from other impacts (such as bad trade policies), one could reasonably expect real GDP growth in the U.S. to accelerate to 3% or more from the 2% level that persisted from the end of the Great Recession. Much of that growth will come from more rapid business formation (also in part due to the reduction in the burden of regulations), continued hiring and accelerated fixed investment with foreign profit repatriation and 100% tax expensing. Even if inflation rises modestly, our research suggests the overall U.S. economy might see nominal GDP growth accelerate by 1 to 1.5 percentage points from the 2% real GDP, 2% inflation levels of the prior eight years. This is a rough aggregate measure of the rise in the growth rate of corporate domestic revenues that, even with rising discount rates, could still see p/e ratios rise with faster S&P 500 earnings growth over the next three to five years.
S&P 500 earnings could see a one-time upward shift due to the reduction in statutory and effective tax rates on domestic earnings. While the lightening of the burden of taxation raises after-tax margins, the potential increase will be somewhat reduced as companies "invest" some of the tax savings to stay competitive. In our view, S&P 500 normal earning power should be boosted by 7% to 10% along with another 7% to 10% in normalized p/e ratios due to the tax rate changes.
With the near 22% rise in the S&P 500 in 2017, has all of that "good news" already been discounted? Probably not. The prospects for tax reform didn't gain traction until the end of last summer. It would, however, be reasonable to believe that much of the S&P's gains in the fourth quarter and in January (the combined amount of which equated to nearly a 13% rate of return) were a result of the new optimism about profits and valuation. So, perhaps half of the upward adjustment has occurred.
Naturally there will be relative winners and losers from the tax changes, and the further caveat is that the negative impact of trade wars could sink those steel boats even while the tide would otherwise be rising. By our estimates, midteens returns on stocks could be achieved over the next five years if trade disputes are resolved, whereas mid-single-digit returns or less would be more likely if the U.S. stirs up a serious trade battle that would destroy many incentives to invest in the U.S.