Fourth Quarter 2017

The past year has been one of the strongest in the eight year bull market run which began in March, 2009. During 2017, the S&P 500 delivered a 20% return (in U.S. dollar terms), far outperforming the Canadian market, which advanced only 9%. The strength of the Canadian dollar versus its U.S. counterpart did have an effect, as the S&P 500 return, on a Canadian dollar basis, was 14%.

U.S. equity market performance was largely boosted in the fourth quarter by an expectation that the proposed corporate and personal income tax reform legislation had a good chance of passing. Indeed, this legislation was passed just before year-end, providing the U.S. with a tax cut that it probably does not need. With robust economic growth, at almost full employment levels, and gently rising interest rates, this is an economy that requires no assistance.

The income tax cut in the U.S. may cause that economy to grow too quickly, spurring inflation and a resultant increase in interest rates beyond what is currently forecast. In addition, it will widen the U.S. deficit, which is not a good idea in an expanding economy. Finally, it will further widen the gap between the wealthy and lower income earners in that economy, which is questionable social policy.

Having said that, this will be a boon to U.S. based corporations. The corporate income tax rate will be cut from 35% to 21%. Massive amounts of corporate cash parked “offshore” will now be incented to return. For corporate America, this represents a major boost in after tax cash flow. The question is: how will these companies deploy this excess cash flow?

As we have written in the past, corporations with the benefit of having true “free” cash flow will have choices as to how to deploy this largesse. The fear is that this extra cash flow will simply be deployed to accelerate share buy backs and dividend increases. However, well managed companies with strong governance from their board of directors will surely consider their options. In addition to share buy backs and dividends, they could decide to further invest in their company’s operations, increase R&D spending, pay down debt, or pursue acquisitions. Any one, or a combination of these options, should make sense to the company concerned and the industry it operates in order to pay off. We do not expect, however, that these tax cuts will provide a significant boost to U.S. economic growth, which has been the cornerstone of Republican rationale for these moves.

As the current bull market continues, there is an increasing fear that it will come to a halt in the near future. We remain positive. A strong growing economy and increasing corporate cash flow (and earnings) will continue to propel this trend. While the North American economy has been growing for quite some time, this is not true for the rest of the world. It is only in the last two years that Western Europe and the emerging economies have turned the corner and are growing again. We have only had synchronous global economic growth for a little more than a year. This current economic growth cycle may yet have a long way to go.

With economic and corporate fundamentals remaining intact, we believe that this will lend further strength to the equity markets. That is not to say that we will avoid any corrections, as they often happen during a long market upswing.

Finally, we have seen some signs of mania and speculation creeping into the financial markets. In the past few months, crypto currencies have been all the rage internationally, while the emerging recreational marijuana suppliers in Canada have caused some local excitement. Every bull market has such phenomenon. For our part, we will continue to focus on sound long term growth companies with proven managements and sound board governance.


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