Goldman Puts A Number On It: Here’s How Much The S&P Rises If Tax Reform Gets Done

Ok, look: we’re as sick of writing about a tax reform plan that has no chance in hell of passing in its current incarnation as you probably are of reading about it.

But alas, this plan that isn’t really a “plan” is serving as the impetus for a pretty epic rotation in equities and more than that, it’s helped to supercharge a move in rates and the dollar that was initially predicated upon a more hawkish Fed. So unfortunately, everyone has to keep pretending like tax reform is imminent at least until Trump tweets something about the wrong lawmaker and/or fires Gary Cohn in the middle of the night thereby putting everyone back to square one.

Appropriately given the bank’s representation in Trump’s inner circle, Goldman has released a bevy of notes over the past couple of days exploring pretty much all aspects of the tax plan. We’re going to spare you the bits about how difficult this is going to be to actually implement and skip to some analysis about what tax reform is likely to mean for equities because at least that’s some semblance of interesting.

Ok, so here are the broad strokes because that’s all anyone is prepared to listen to … cue Archer…

every time I read sellside note on tax reform reminds me of Archer: "Who am I Kissinger?! Broad strokes."https://t.co/A6IudPirkE

— Heisenberg Report (@heisenbergrpt) October 3, 2017

Via Goldman:

Although many details remain unclear, the White House plan as proposed could boost 2018 S&P 500 adjusted earnings by 12% from our current top-down estimate of $139 to $156. A major impediment to the adoption of this plan is that the potential deficit increase may be above what the Senate and House are willing to accept.

An alternative scenario that would bring the plan closer to the allowance in the Senate budget resolution could lift 2018 EPS by 7% to $148. Assuming no change to our current forecast 2019 EPS growth of 5% and forward P/E multiple of 17.1x, these earnings would suggest an S&P 500 index level of roughly 2650 by the end of next year (5% above the current level).

So there’s the direct impact. Then if we extrapolate a little further we can kinda, sorta come up with a back-of-the-envelope calculation for the second order effects. Here’s Goldman with that “math”:

In addition to the direct earnings benefit, the combination of corporate and personal tax reform could spur faster economic growth. We estimate that each incremental percentage point (“pp”) of US GDP growth is worth about 3 pp (or $4) of S&P 500 EPS. Our economists’ estimates that tax reform could stimulate US economic activity by roughly 0.2 pp in the first year would accordingly likely be worth an additional boost of less than 1 pp of S&P 500 EPS (less than $1/share). However, by accelerating economic growth late in the cycle, fiscal stimulus could also boost inflation and therefore the path of Fed tightening, potentially adding downside risk to equity valuations.

That’s kind of weird in the sense that it starts out positive and then takes a demonstrable turn for the bearish right at the end (bolded passage).

Anyway, Goldman goes on to illustrate the effect all the tax talk has had in terms of restoring faith in the “Trump trade” or, more accurately, in ushering in the rotations we’ve been talking about for days. Here’s a set of visuals – the one in the right pane is actually pretty useful:

And then Goldman goes on to give you a bit more color on the Russell rally that’s been the story of the financial world for the past couple of sessions:

The Russell 2000 represents a popular index-level tool for investors to capture fiscal stimulus and tax reform, and its performance has closely matched that of other “Trump trades.” Small-caps are more domestic-facing than large-caps (80% of sales derived from the US compared with 71% for the S&P 500), and therefore highly levered to both US economic growth and domestic tax rates. The median tax-paying Russell 2000 company bears an effective tax rate of 33% compared with 27% for the median S&P 500 company.

However, the index is an imperfect tool. 31% of Russell 2000 companies have zero or negative pre-tax income, diminishing the potential benefits from tax reform. An alternative tool is our equity analysts’ basket of stocks with the highest exposure to small and medium businesses (“SMB”). Although these stocks performed similarly to the Russell 2000 immediately post-election, the basket has outperformed the small-cap index by 16 pp YTD (27% vs. 11%) on the strength of SMB activity and should benefit if tax reform and deregulation stimulate a further acceleration in that part of the economy. The NFIB Small Business Optimism Survey rose sharply post-election and remains near the highest levels since 2004.

Again, there is absolutely no telling how this is going to turn out and the indeterminacy surrounding it means that most of this amounts to little more than a thought experiment.

That said, there’s some utility in this exercise. For one thing, the market is already pricing in some of this, so to the extent you think the chances of something getting done are slim, you know where to look for opportunities to fade the recent moves. On the flip side, if for some reason you think there’s a good chance the current “plan” passes (which, you’ll recall, BofAML’s David Woo thinks is a patently absurd proposition), you now have a sneak peek at what’s likely to run further.

The bottom line, from Goldman, is this: “These estimates contain considerable uncertainty.”

Indeed.