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Copyright © 2017 Edge Capital Partners, LLC.
All rights reserved. Confidential.
Preparing For A Trump Presidency
January 18, 2017
The last time Republicans controlled more power in government was 1928. Trump’s administration stands out for having the lowest average government experience since Reagan but by far the most business experience of any administration in recent history. Trump, himself, stands out as a deal-maker. In short, this is a precedent-setting moment where Trump has the infrastructure beneath him to potentially accomplish significant policy changes.
Trump’s pro-growth policies represent a shift from monetary policy and increased regulation to fiscal policy and de-regulation. Policies includes tax reform, healthcare reform, trade, and energy infrastructure. His objective is to generate more jobs for Americans and spur economic growth.
The stage is set for reflation and the capital markets have reacted accordingly. Interest rates have spiked with the U.S. 10YR Treasury climbing 0.60% since election day. Optimism for economic growth drove U.S. equity prices to all-time highs, strengthened the dollar, and generated a spark in cyclical commodity prices.
Trump’s deal-maker character is also a major shift in how government policy is pursued…which is why we caution that uncertainty remains on when and how these policies will impact the economy and asset returns. Will Trump utilize his power to push through divisive policies? Or if Trump wants to be popular (so the GOP can maintain control and he can get re-elected in 2020), will he follow a more inclusive course? Importantly, when will the administration’s policies be passed and implemented? Tax and healthcare reform is complex and time consuming. The impact to trade policy is complex and difficult to predict. Between tweeting and spectacle press events, the next four years will be entertaining yet volatile for the financial markets…
PREPARING FOR A TRUMP PRESIDENCY
2
Change in number of Democrats since 2008
Source: Washington Post
U.S. 10 Year Treasury Yield
Source: Strategas
President-elect Trump is not one thing or another. He is not an ideological Republican or Democrat. What we
do know is that he will be difficult to forecast and it will be a quick changing environment…
WE DON’T KNOW WHAT IS GOING ON!
3
Wall Street Journal, January 17, 2017
Washington Post, January 15, 2017
Forbes, January 16, 2017
“One of the key
problems today is
that politics is such a
disgrace. Good
people don’t go into
government.”
“My Twitter has become
so powerful that I can
actually make my
enemies tell the truth.”
Trump’s administration stands out as having
the lowest average government experience
since Reagan but by far the most business
experience of any administration in recent
history.
Trump has also leaned heavily on
appointees with military experience to
compensate for his lack of foreign policy
experience.
BUSINESS EXPERIENCE OF TRUMP ADMINISTRATION
4Source: NPR
Types of Experience on Cabinet Members’ Resumes
Affordable Care Act
Repeal requires just 51 votes
Repeal of the 3.8% tax on capital gains/dividends and Cadillac tax ($64B estimated stimulus)
Could take 3 years to implement
De-regulation
Obamacare – could be instant
Energy projects (estimated at $48B) – could be instant
Emissions
Financial services
Labor
Trade
Withdrawal from the TPP
Renegotiations of NAFTA
Border tax proposal in conjunction with tax reform (see pages 12-13)
Cabinet Secretaries
51 votes required
Supreme Court Pick
60 votes required
Tax Reform
See pages 6-13
2017 CONGRESSIONAL AGENDA
5
Corporate Tax Reform
Current rate is 35% but effective average tax rate is approximately 25%.
Trump proposal is 15% while also closing loopholes.
House Republicans have proposed 20% while also closing loopholes.
Border-Adjusted Tax could be an innovation in global tax policy – its short term impact to global currencies could be significant.
Special reduced tax rate on business income from flow-through entities like S-corps and LLCs.
Repatriation tax holiday of foreign profits for infrastructure spending ($100B).
A completed tax reform will likely happen until late 2017 – so no meaningful impact on 2017 GDP. With that said, there is historic precedent for retroactive changes.
Personal Tax Reform
Affordable Care Act repeal of 3.8% tax on investment income is likely.
Leading proposals call for a reduction in the number of tax brackets from seven to three (10%/25%/33%). Currently, the top marginal tax rate is 39.6%.
All deductions are up for elimination except mortgage interest and charitable deductions – a compromise could be a dollar cap on the total allowable deduction amount per return.
Modifying capital gains, dividend, and estate taxes.
Special reduced tax rate on business income on select pass-through entities like S-corps and LLCs. 90% of businesses in the US are pass-through entities whose income is reported on the individual’s tax return and subject to personal tax rates – could this rate end up being lower for some pass-through entities than income taxed as wages? It is possible.
TAX REFORM – RANGE OF OUTCOMES WILL BE LARGE
6
While corporate tax reform is dominating the recent tax related headlines, namely for its connectivity to the
boarder adjustment proposal, any change to the treatment of pass-through entities could have a
profound impact on the small business owners across America. Combined, these entities earn
approximately 50% of all business related income and employ the majority of the private sector workforce.
PASS-THROUGH ENTITY TAX REFORM RELEVANCE
7Source: Tax Foundation, IRS
Recent Growth In Pass-Through Entities over C-Corps Pass-Through Businesses Net Income now exceeds C-Corps
US CORPORATE TAX RATE COMPETITIVENESS
8Source: Strategas, Tax Foundation, and Organization for Economic Cooperation and Development
Statutory Corporate Tax RatesCombined Federal + Subnational Tax Rates
OECD International Tax CompetitivenessCorporate Tax Score
US tax rates are relatively high and uncompetitive compared to the rest of the world…
The effective US corporate tax rate is ~25%.
Looking at the S&P 500 sectors by their effective tax
rates, more sectors than not benefit from the GOP tax
rate proposal.
HIGHER TAX RATE SECTORS
9Source: Strategas, Tax Foundation, and RBC Capital Markets
Top US Corporate Income Tax Rate &
Effective US Corporate Tax Rate
S&P 500 Sector Effective Tax Rate
Companies with high tax rates are outperforming since the election.
Companies with domestic-only sales exposure are outperforming (particularly small caps).
MARKET REACTION TO TAX POLICY SINCE ELECTION
10Source: Strategas
S&P 500 Companies with High Tax Rates vs.
S&P 500 Companies with Low Tax Rates
S&P 500 Companies with 100% US Revenue Exposure
Relative to the S&P 500
Presidential Election
President-elect Trump’s Treasury Secretary nominee explicitly said that income tax rates could
be lowered with no additional benefit for the wealthy as they would lose significant deductions.
This could also include taxing municipal bond interest which is currently exempt from
federal income tax.
Municipals have been hit hard since the election for several reasons:
Interest rates are moving higher
Real possibility of federal income tax rate cuts that make munis less attractive all else being
equal
Potential for increased supply from new highway spending – including public/private
partnership funding sources
The threat to the municipal bond interest exemption from income
TAX REFORM MAY CONTINUE TO PRESSURE MUNICIPALS
11
12/13/2015 12/13/2016
Index YTW YTW
Barclays Agg 2.60% 2.60%
Barclays Municipal 2.20% 2.70%
0.50% change in spread
Unusual for Taxable Yields
> Tax Exempt Yields
Source: Bloomberg
Unusual for Taxable Yields to
be less than Tax Exempt
Yields
Congress is proposing tax reform, not tax cuts.
The goal is for “deficit neutral” tax reform that lowers tax rates while removing tax deductions and credits.
The Border Adjusted Tax system is a destination cash flow tax proposal and includes:
Capital expenditures receive an immediate write-off – no depreciation.
No more deductions of net interest expense (although financial services would get treated differently).
Eliminates the tax deduction for expenses incurred overseas while excluding revenues generated overseas.
Theoretically, it incentivizes businesses to reduce debt and encourages more equity in the capital structure. It
also incentivizes companies to increase capital expenditures in the US and move manufacturing operations or
other profitable divisions out of lower tax jurisdictions overseas.
Example of impact on a US retailer that sells imported goods in the US:
Taxes would be paid on the full sale price of imported goods rather than the profit of the transaction.
It should also reduce the trade deficit (estimates are $1.2T) and theoretically strengthen the dollar.
If the tax package increases the deficit over the 10-year window, the provisions are temporary and defeats the
purpose of reforming the tax code.
BORDER ADJUSTED TAX PROPOSAL
12
The Border Adjusted Tax system eliminates the tax deduction of expenses incurred by importing
goods…
Taxes would be paid on the full sale price of imported goods rather than the profit of the transaction.
SAMPLE BORDER ADJUSTED TAX IMPACT ON RETAILERS
13
Current Corporate Tax Border-Adjusted (All Imported Goods) Border-Adjusted (All Domestic Goods)
Net Income Margin = 20% Net Income Margin = 12% Net Income Margin = 24%
Source: RBC Capital Markets
Fiscal policies should lead to higher inflation in the US…
US bond yields spiked substantially more than Germany and Japan.
Federal Reserve is projecting for ~200bps increase in the Fed Funds Rate over the next 3 years.
POLICY SHIFT IS REFLATIONARY
14Source: Federal Reserve and RBC
Change in 10YR Government Bonds Since June Lows
A US Phenomenon
Federal Funds Rate
Federal Reserve Projections (December 2016)
Wages are due to accelerate…
US is currently long in the economic cycle.
US unemployment rate is low.
REFLATION – WAGE INFLATION
15
Unemployment Rate (RHS) vs. Wage Increase (LHS)
Closing the Gap
Yearly Wage Increases
Creeping Towards > 2%
Source: RBC
US Inflation expectations have spiked…
REFLATION - INFLATION
16Source: Federal Reserve and Statista
Projected Annual Inflation Rate Personal Consumption Expenditure Inflation Rate
Under the Border Tax Proposal, companies relying on imports would see higher
taxes and lower net incomes – resulting in higher prices for those goods…
REFLATION – HIGHER RETAIL PRICES
17Source: Wall Street Journal
Non-defense discretionary spending by the US government has fallen to historic lows – at the expense
of public infrastructure…
REFLATION – GROWTH IN INFRASTRUCTURE
18Source: Center on Budget and Policy Priorities
Non-Defense Discretionary Spending
(spending as a % of GDP)
Public Infrastructure Has Been Neglected
(infrastructure needs, funded and unfunded, 2013-2020)
The last repatriation tax holiday of 2004
resulted in $300B or roughly half of foreign
earnings repatriated back to the US.
Today there is over $2T of foreign earnings
that could come back to the US.
If enforced, another repatriation tax holiday
could be earmarked for activities like hiring
workers or capital expenditures in the US…
REFLATION – FOREIGN EARNINGS REPATRIATION
19Source: Strategas
De-regulation should be a tailwind for the economy, particularly in certain sectors…
Energy
Financial Services
Healthcare
REFLATION – DE-REGULATION
20Source: JP Morgan
Increase in Government Regulation
Thousands of pages in the Code of Federal Regulation
Cumulative number of economically significant regulations
published during equivalent periods in office
Small business optimism rocketed to tis highest level since 2004…small businesses make up
approximately half of U.S. private-sector employment and output…
REFLATION – SMALL BUSINESS CONFIDENCE BOOMING
21Source: National Federation of Independent Business
Small Business Optimism Index
(indexed to 100)
Small Business Single Most Important Problem
(Regulation continues to dominate small business issues)
S&P 500 revenues and earnings are still less than where they were two years ago. Unemployment is
already low and the administration’s policies should lead to more jobs, greater capex, infrastructure spend,
wage growth, and consumption. It is estimated that for each 0.10% incremental gain in GDP should lead
to a 0.50% pick up in S&P earnings.
REFLATION – EARNINGS GROWTH
22Source: Standard & Poors and RBC
S&P 500 Sales & Earnings Growth Since Q3-14
(indexed to 100)
Potential EPS Growth From Change In GDP
(EPS increase per each 0.10% incremental gain in GDP)
0.70
0.80
0.90
1.00
1.10
1.20Quarterly EARNINGS
Quarterly EARNINGS - Estimated
Quarterly SALES
US budget deficit could continue to increase with lower revenues, higher spending, and increasing
interest rates…
TRUMP AGENDA SHOULD LEAD TO MORE TREASURIES
23Source: Strategas
MAJOR DEBT BURDENS FOR TRUMP
24Source: Strategas
LOOKING FORWARD THROUGH A HISTORICAL LENS
25Source: Strategas
LOOKING FORWARD THROUGH A HISTORICAL LENS
26Source: Strategas
U.S. 10 Year Yield
The potential changes in tax and spending policies can ignite animal spirits such that consumers spend more and businesses
increase investments. The degree to which improving sentiment will flow through to actual behavior along with the
timing and magnitude of actual policy execution are the big questions. The early days of the Trump Administration will
likely determine how successful they will be.
ANIMAL SPIRITS ARE HIGH…BUT TRUMP CONFIDENCE IS LOW…
27
U.S. Economic Confidence
Source: GALLUP
Americans’ Spending – Monthly Averages
Americans’ Approval of Congress
Pre-Inauguration Favorable Ratings
DISCLOSURES
This material is being provided to demonstrate the general thought process and methodology used by Edge when constructing a portfolio for an individual client. This material should not be
interpreted as a representative sample of the portfolio performance achieved by all Edge clients and there can be no assurance that any client is likely to achieve the results shown.
Since each portfolio will be tailored to the specific client’s unique investment objectives and tolerance for risk, a client's actual portfolio and investment objective(s) for accounts managed by
Edge Advisors, LLC may look significantly different from this or other models, as appropriate. Investors are strongly urged to consult with their own advisors regarding any potential strategy or
investment.
This material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. Past
performance is no guarantee of future results.
Index information reflects the reinvestment of dividends and is included merely to show the general trend in the equity markets for the periods indicated. You cannot invest directly in an index.
The opinions expressed herein are those of Edge Capital Partners (“Edge”) and the report is not meant as legal, tax or financial advice. You should consult your own professional advisors as
to the legal, tax, or other matters relevant to the suitability of potential investments.
The external data presented in this report have been obtained from independent sources (as noted) and are believed to be accurate, but no independent verification has been made and
accuracy is not guaranteed.
The information contained in this report is not intended to address the needs of any particular investor. This presentation is solely for the recipient. By accepting this report, the recipient
acknowledges that distribution to any other person is unauthorized, and any reproduction of this report, in whole or in part, without the prior consent of Edge Capital Partners is strictly
prohibited.
This communication is not to be construed as an offer to sell or the solicitation of an offer to buy any security such as an offer can only be made through receipt of an offering memorandum
which will explain all risks.
All figures are estimated and unaudited. The case studies shown are meant to demonstrate Edge’s investment process and are not meant as an indication of investment performance. Past
performance is not necessarily indicative of future results.
Copyright © 2017 Edge Capital.
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