Of Trump, taxes, and earnings growth

The S&P 500 is up 8.5 per cent this year, outperforming both global and emerging market indices:

With Thompson Reuters reporting earnings are due to be up 24.9 per cent from Q2 2017, following an equally strong Q1, just who should investors be thanking?

Some may point to a resolute US economy. GDP growth touched 4.2 per cent in Q2 according to the Federal Reserve Bank of St Louis. While unemployment hovers around record lows, 3.9 per cent at last count.

Others may mutter about share buybacks. As Brendan and Colby reported a fortnight ago, both Goldman and Bernstein have predicted money spent by companies consuming themselves will total $1tn in 2018.

Yet, according to Zion Research Group, this is only the half the story. The whole other half is Trump's corporate tax reform.

A quick primer before we dive into Zion Research's findings. In sifting through the S&P 500, it has chosen to only include companies with 0-45 per cent tax rates, so as to eliminate bizarre outliers such as pharmaceutical company Eli Lilly, who reported a tax rate of 5,515 per cent last quarter. That leaves 395 companies with quarter ends between April and June.

Over to Zion:

As you know 2Q was a good one (been reading a lot about record profit growth) and you also know that lower taxes helped fuel that. What you might not know is that according to our estimates lower tax rates accounted for 47% of year-over-year earnings growth (2Q18 v 2Q17) in the aggregate for the S&P 500 companies analysed; that’s down a bit from the first quarter (where lower tax rates drove 49% of year-on-year growth).

So just a touch below half of earnings growth are thanks to team Trump. A slight decrease on Q1, which we covered a few months ago.

Across four sectors with accelerating profits — telecoms, consumer staples, consumer discretionary and industrials — lower payments to the IRS accounted for more than half of profit growth. In the first two of those four sectors, earnings would have otherwise shrunk - lower taxes accounted for a staggering 152 per cent of swelling earnings of phone companies.

Even in a sector such as consumer discretionary where there's returning investor enthusiasm tax cuts accounted for 90 per cent of the sector's 14 per cent year-on-year earnings growth. For instance, ubiquitous provider of caffeine Starbucks recorded the biggest decline in its tax rate, a 17.3 percentage point drop from 34.3 per cent to 17 per cent. This change accounted for 110 per cent of its net income growth.

Or, to put it another way, had Starbucks paid the same rate as in the second quarter of 2017, its profits would have been $178m lower than the $853m reported, a decline of 2 per cent year-on-year.

However, as Starbucks note in its 10-Q, while a good portion of the lower taxes are attributable to the reforms — 9.5 percentage points to be exact — it also made non-taxable profits from a gain on purchase of its joint venture in East China, which it completed last year for $1.3bn. So not all of Starbuck's tax reductions are thanks to the Donald.

Away from froth and frappuccinos, other major beneficiaries of lower taxes include energy-drink creator Monster Beverage and Bank of America — both of whom owe 86 per cent of their earnings growth to lower taxes. Although, in Bank of America's case, the comparable is distorted by the $690m of taxes it paid in Q2 2017 related to the sale of its non-US credit card business, according to the company's 10-Q.

Still, maybe investors don't mind. According to a Credit Suisse, the quarter was the best for growth since the first quarter of 2011, even when excluding the effects of tax reform. For the second quarter of 2019 estimates are a lot lower, meanwhile — the consensus of Wall Street's soothsayers expect only 6.8 per cent growth, according to Bloomberg — so perhaps there is a recognition the good times cannot roll on forever.

As JPMorgan Cazenove note this morning, S&P 500 earnings per share are just above their historical trend:

Although a look at the history on that chart might start to tax investor's confidence.

Related Links:
The slow death of public markets - FT Alphaville 
The bull market is running out of brea(d)th — FT Alphaville
Earnings growth: a one-trick tax pony? — FT Alphaville
The great pension plan pivot — FT Alphaville