Trump Tax Plan’s Effect on Inflation and Interest Rates
As everyone now knows, President Trump got his corporate tax reduction bill passed in late December, lowering the tax rate on domestic business from 35% to 21%. Thus far, most investors and pundits have focused on how the lower corporate rate is a boon to big companies nationwide. Obviously, lower taxes should lead to higher profits, all else remaining equal. However, what has received a bit less attention is the effect that the tax plan will have on future interest rates and inflation. According to the Congressional Budget Office, the tax plan will add an additional $1.4 trillion (yes, that’s $14 followed by 11 zeros – or, if one prefers, 1,400 stacks of $1,000,000,000 each) to the federal debt over the next decade. Clearly, with the economy already strong and with debt levels already high, the tax bill should almost certainly result in higher levels of future inflation and, hence, higher future interest rates.
Indeed, it took only a month and a half after the tax plan’s passage for investors to feel the first jolts from higher inflation, as CNN reported on February 6th:
Be careful what you wish for.
Wall Street partied hard while President Trump pushed for huge business tax cuts that the economy didn’t really need. Tax cut euphoria carried the Dow a breathtaking 8,000 points to levels never seen before.
Now comes the hangover. Investors are remembering that giving lots of medicine to an already healthy economy can have side effects, namely inflation.
Those inflation fears are suddenly rocking Wall Street. They sent the Dow plummeting 1,800 points in just two trading days. The losses wiped out a quarter of the gains since Trump’s election.
For months, investors basically ignored the threat that the tax cuts might backfire, causing bond yields to spike and raising the likelihood that the Federal Reserve will have to raise interest rates faster to fight inflation.
“We have an infinite capacity for self-delusion as investors,” said Bruce McCain, chief investment strategist at Key Private Bank. “When we feel good, we don’t want to be bothered by reality.”
How Inflation Swindles the Equity Investor
So, what does all this mean for shareholders? Back in May 1977, Warren Buffett wrote an article for Fortune magazine (full article linked here) entitled “How Inflation Swindles the Equity Investor”. Given that we now appear to be heading into an era of higher inflation, it pays to take a look back at Buffett’s thoughts on the subject from nearly 41 years ago. How does Buffett describe the relationship between inflation and equities in the Fortune article? First, he refutes the previously accepted view that equities act as an effective hedge against inflation:
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out. It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
Basically, Buffett takes the view that equities are disguised bonds that pay around 12% on par value (i.e., book value, or shareholders’ equity). Thus, stocks are hurt just as much as bonds when inflation rises because the price-to-book ratio (and, consequently, price-to-earnings and price-to-sales ratios) for stocks must necessarily decrease just as a bond’s price decreases in inflationary times. Conversely, the lower the relative level of inflation, the higher bond prices rise and the more P/B, P/E, and P/S multiples for stock expand (all other things being equal).
Buffett goes on to identify a key additional characteristic of low inflationary environments: they favor companies that reinvest their earnings (versus paying them out via dividends). Why? Because when stocks are trading at 3.4X book value, as they are today, every $1 of cash from operations that gets reinvested in said book value should translate into an incremental $3.40 in market value for the shareholder (versus worth just $1 when paid out as a dividend, or even less after payment of taxes thereon). Buffett explains further:
This characteristic of stocks – the reinvestment of part of the coupon – can be good or bad news, depending on the relative attractiveness of that 12%. The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value. Note that investors could not just invest their own money and get that 12% return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can’t pay far above par for a 12% bond and earn 12% for yourself.
But on their retained earnings, investors could earn 12%. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.
It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12% rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960s, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to re-invest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.
We note here that the 30-year Treasury bond yield has jumped up recently, appreciating about 45 bps over the past six months to the ~3.20% level (source):
Granted, we are not even remotely close today to the ~15% level of the early 1980s, however, for equity investors, we currently appear to be moving in the “wrong” direction, at least if one buys into Buffett’s thesis. Indeed, looking at the very long view, it appears that the ~35-year bond bull market may finally be ending (source):
Now, we know why investors have been in love with so-called “growth” companies (especially big tech companies) during the recent moderate growth, low interest rate, and low inflation environment. These tend not to pay dividends but rather reinvest all their cash flows into existing or new operating businesses. Consider Amazon (AMZN) for a moment. All operating cash flow is plowed back by Jeff Bezos either into the existing retail business or in newer businesses such as Amazon Web Services. Unfortunately, the higher interest rates rise, the lower the relative benefit of the reinvested dollar for shareholders, and the less attractive “growth” stocks look compared to stodgy dividend payers like AT&T (T) or General Motors (GM) (again, other things being equal).
Buffett notes that a “reversal” phenomenon took hold in the mid-to-late 1960s just after major institutional investors had stampeded into growth stocks at nosebleed valuations:
This heaven-on-earth situation [regarding the superiority of growth stocks in low interest rate environments] finally was “discovered” in the mid-1960s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10% area), both the equity return of 12% and the reinvestment “privilege” began to look different.
Are we on the precipice of a new downward revaluation of stocks, given looming inflation? Today, stocks trade around 3.4X book value, compared to 2.0X book value in 2009 and just 1X book value in 1980. Let’s take an extreme scenario where interest rates are rising significantly and investors are only willing to pay book value for the S&P 500 again, as they did at the conclusion of the last bond bear market. Obviously, a growth company that trades today at 10X book value pays no dividends and earns 15% return on equity has much more potential downside than a dividend payer trading at 1.5X book value also earning 15% return on equity, since, even if the former were to trade at a consistent 3X the market multiple of book value (as it does now), it would still lose 70% of its value in the adverse scenario (i.e., its valuation would be reduced from 10X book to 3X book). In comparison, the dividend payer now trading at 1.5X book value might trade down to 1X book in the adverse scenario, meaning it would only have 33% downside, or less than half that of the growth stock.
Wither Tech Stocks Post-Trump Tax Reform?
We find that Amazon trades at 26X, Tesla trades at 14X, and Netflix trades at 34X book, or an average for the three of about 25X book value. This represents a multiple of over 7X the overall market’s (already historically high) P/B ratio. Moreover, none of these companies pays a dividend, so they receive maximum credit from investors for the fact that all cash (including cash sourced from incremental debt) gets reinvested in the underlying business at book value. As interest rates have relentlessly fallen during the current 9-year bull market, investors have logically marked up the equity valuations of these three to higher and higher multiples of book value. If Buffett is correct, however, these will be the very companies whose valuations contract the most when inflation and interest rates rise, as should occur in an era of higher and higher government spending and deficits.
Moreover, the likes of Amazon, Tesla, and Netflix are also the type of companies helped the least by the Trump tax cuts. For one thing, they are either unprofitable or marginally profitable, so cutting their tax rate yields minimal to no gain for them in terms of immediate earnings and cash flow. Second, the value of any deferred tax assets on their balance sheets is lower, since going forward, the amount of taxes they will be able to offset with their DTAs will be lower under a 21% tax regime than a 35% tax regime (for example, Tesla had $2.4 billion in DTAs on its balance sheet as of the end of 2017). Finally, the current market valuation for all three companies is largely based on investors’ expectations of massive profits many years down the line (under typical sell-side analyst DCF analyses, near-term profits for these companies remains subdued to nonexistent and then explodes to the upside in the out years, similar to a hockey stick effect). Yet if the tax cuts lead to higher interest rates, the present value of these out-year profits will necessarily be less, as the discount factor applied to them will be higher. Thus, we find that the Trump tax cut has a triple negative effect on companies such as Amazon, Tesla, and Netflix.
Indeed, media outlets noted the initial negative tech investor reaction to the tax bill:
Of course, certain highly profitable large-cap tech players such as Apple (AAPL), Google (GOOG) (NASDAQ:GOOGL), and Microsoft (MSFT) should benefit from the Trump tax plan, as their cash taxes should decrease significantly going forward. In addition, they will be able to repatriate billions of overseas profits at favorable rates. Thus, not all tech companies should be put into the same boat.
The passage of the Trump tax plan looks to be a major negative for companies like Amazon, Tesla, and Netflix. Not only do they fail to benefit immediately from the lower corporate tax rate (since they generate minimal to no profits), the present value of their future profits is less if higher government deficits lead to higher long-term interest rates (a process which seems to be already well underway). Not only that, but if Warren Buffett’s analysis is to be believed, higher rates will necessarily cause price-to-book multiples to contract market-wide from the current (historically high) 3.4X level. As a group Amazon, Tesla, and Netflix trade at a massive 7X the overall market’s P/B ratio, indicating that the downside risk from such a contraction could be significant. To be sure, the valuation of any individual company depends on many variables, including the quality of management and products, revenue versus expense growth, market share dynamics, etc. However, the truly scary thing for Amazon, Tesla, and Netflix shareholders about the Trump tax bill is that the negative knock-on effects for these companies, as outlined in this article, are completely outside their and their company managements’ collective control.
Disclosure: I am/we are long GM, AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are also short TSLA and NFLX.