In a new quarterly letter to Grantham Mayo Van Otterloo’s institutional clients, chief investment strategist Jeremy Grantham predicts corporate margins — and hence (probably) the market in 2017 — will likely move up this year.
“Unless there are some substantial unexpected negatives, U.S. corporate margins will be up this year, making for the likelihood, in my opinion, of an up year in the market at least until late in the year,” Grantham writes. “This does seem to make the odds of a major decline in the near future quite low (famous last words?). Next year, though, is a different proposition.”
Grantham says there are three factors moving in favor of U.S. profit margins this year.
First, he says, oil and resource prices appeared to have bottomed out last year and “seem likely to have favorable comparisons for a few quarters.”
According to Grantham, rising oil prices have a short-term effect of about one year of boosting profits and vice versa because oil company profits quickly respond and the much more thinly spread benefits cause profits to move in the opposite direction, but much more slowly.
The second factor moving in favor of U.S. profit margins is related to President Donald Trump’s tax agenda.
According to Grantham, Trump is likely to settle for a “moderate reduction” in corporate tax rates this year after bouncing off the “infinitely complex task of a full redo of the tax code.”
“In a theoretical world, corporate taxes are a pass-through to consumers, but in the current, stickier, more monopolistic, more profit-fixated world, a corporate tax reduction will raise corporate profits for quite a while from where they otherwise would have been,” Grantham writes.
The third factor involves Trump’s order to reduce regulations.
At the end of January, Trump signed an executive order to require federal agencies to propose deleting two regulations for each new one they issue, and also said his administration plans to do a “big number” on the Dodd-Frank Wall Street Reform and Consumer Protection Act.
“Removing regulations here and there will … lower corporate costs in the short term,” Grantham writes.
According to Grantham, steadily increasing corporate power over the last 40 years has been the defining feature of the U.S. government and politics in general — and has been good for corporate profit margins.
The gains have been skewed toward the “larger and more politically savvy” corporations, according to Grantham.
“As new regulations proliferated, they tended to protect the large, established companies and hinder new entrants,” Grantham writes.
This caused a steady drop of net new entrants into the U.S. business world — or as Grantham writes, “they have plummeted since 1970!”
As Grantham explains it, increased regulations cost all corporations money, but the very large can better afford to deal with them.
“Thus regulations, however necessary to the well-being of ordinary people, are in aggregate anticompetitive,” he writes. “They form a protective moat for large, established firms.”
This is why Grantham says the “current ripping out of regulations willy-nilly will of course reduce short-term corporate costs and increase profits” in the near future.
However, for the longer run, Grantham says that “the corporate establishment’s enthusiasm for less regulation is misguided: Stripping out regulations is working to fill in its protective moat.”
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