Covenant Weekly Market Synopsis for November 9, 2018

November 12, 2018

“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” – Winston Churchill

Last Week Today. The results of the midterm elections, while exciting in certain local races, concluded as expected at the national level with a divided Congress (Democrats control the House and the Republicans the Senate). Correspondingly, prospects for a second round of tax cuts are likely dead in the water, while the chances of a government shutdown over budget negotiations increased. | The Federal Reserve met last week and surprised no one by leaving interest rates unchanged. The only noteworthy change in their subsequent statement was an acknowledgment of slower business investment in the third quarter. Nevertheless, strong economic growth and a tight job market make a December rate hike a near certainty as the Fed reiterated in their meeting notes their intent for “further gradual increases in the target range for the federal funds rate.”

U.S. equity markets rallied smartly following the midterm elections as domestic political uncertainty was put temporarily to rest. Although domestic markets gave back some of the gains on Friday, they closed the week solidly in the black as the S&P 500 gained +2.2%. International developed equity markets (as measured by the EAFE Index) rallied in sympathy, but to a lesser degree at +1.1%. Although yields on long-dated US Treasury bonds declined modestly on the week, mortgage rates continued to rise topping 4.8%, which is the highest level since 2011. To investors, higher mortgage rates translate into lower home affordability, and homebuilder stocks have been summarily throttled – the iShares US Home Construction ETF is down -33% since January.

Crude oil declined for ten consecutive days and is officially in a bear market, falling -21.2% from $76.41 per barrel in early October to $60.19 on Friday. The price decline is blamed on oversupply as the Saudis and Russians increased production to compensate for an expected US sanction-induced decline in Iran’s exports, which never came to fruition.

For detailed weekly, month-to-date and year-to-date asset class performance, please click here.

Q3 Earnings Update. Through last week, roughly 90% of S&P 500 companies reported Q3 earnings and results were strong. Earnings per share rose by 27%, and revenue growth was 12%. Management teams took full advantage of the new tax laws, exceeding analyst estimates as the effective corporate tax rate fell to 19%(!) in Q3 vs. analyst consensus expectations of 21%. Importantly, companies were able to grow efficiently as pretax earnings rose 14% year-over-year, two percentage points more than revenue growth… in other words, lower taxes were not the only driver of higher profits.

No Country For Taxed Men (or Women). Through the first nine months of 2018, states with a lower tax burden created new jobs at nearly twice the pace of high-tax states. This trend began in the first quarter of 2018 following changes to the Federal Tax code, which, amongst other actions, eliminated the State and Local Tax (SALT) deduction. According to the Bureau of Labor Statistics, low-tax states (such as Texas, Arizona, Nevada, and Florida) created 2.15% new private sector jobs, while high-tax states (e.g., California, New York, and Illinois) only experienced job growth of 1.18% over the first nine months of the year. Said differently, job growth in low-tax states was 87% faster than in high-tax states.

By comparison, in the 18 months before the tax cuts, the job growth variance between low- and high-tax states was only 30% in favor of low-tax states. The tax reform package incentivized a transfer of investment capital from high-tax states to low-tax jurisdictions where businesses can earn higher after-tax profits and laborers pay less to local governments. Not coincidentally, states with high tax burdens are seeing residents migrate to low-tax states.


Source: Professor Steve Hanke (Johns Hopkins University)

The population exodus presents a problem for high-tax states as fewer residents result in a smaller tax base. Lower tax revenue exacerbates thorny budget issues, which is the reason the states implemented higher taxes in the first place (see Churchill’s quote above on the sagacity of this approach). It’s a complex, positive feedback loop that will be difficult for high-tax states to reverse. However, the situation presents a competitive advantage for low-tax states – a steady flow of new workers at a time when labor markets are incredibly tight.

Bullish? Historically, the S&P 500’s performance improves following mid-term elections. The gray area in the chart below depicts the performance range leading up to and following the 11 mid-term elections since 1974; the blue dotted line represents the median performance.


While a decline in the S&P 500 over the next seven months would not be without precedent, history favors the bulls. Of course, if history were always a perfect guide to the future, the SEC would not require investment managers to plaster the phrase “Past performance is no guarantee of future results” across all of their marketing materials.

Be well,