Our managers see positive impacts from the tax bill -- but with some sectors, companies and individuals reaping greater benefits than others. However, that disparity could well create opportunity for active managers.
- The $1.5 trillion tax package will help the U.S. become more competitive with the rest of the world. Importantly, tax reform gives corporate managers the clarity needed to make long-term decisions about operations; many had held off investments in the hope of being able to fully expense them in 2018.
- As such, we expect a percentage pickup into the high single digits for capital spending. The most recent December ISM Manufacturing New Order Index, with a reading of 69.4, confirms that this is the case. This is a very strong number: any reading above 50 is expansionary.
- Never before in U.S. tax history has 100% expensing of capital expenditures been combined with a repatriation. This combination should fuel a boost of activity, with a potential pickup in productivity as a byproduct -- helping to boost U.S. GDP in upcoming years.
- Late-cycle capex increases are a typical market phenomenon, as the bite from high wage growth begins to eat into corporate margins. Investment in capex has historically been a way to help maintain those margins. Accordingly, companies that provide productivity-enhancing services should have a tailwind for the next couple of years.
- Forced repatriation will allow companies to bring back overseas capital to the U.S.: many consider the amount could be close to $1 trillion in liquid assets. That money could be used for capex, or for shareholder-friendly activities like M&A, share buybacks and dividend increases.
- Two sectors that could see an outsized boost from these operations are health care and information technology. One leading consultancy (Strategas) estimates the S&P 500 health care sector has approximately 20% of its market value as unremitted foreign earnings, while information technology garners 18% -- percentages much higher than most other sectors in the index.
- The tax reform package should be a positive for U.S. growth, but the magnitude of that impact is hard to determine. The bill has significant potential to impact four sectors where we invest:
- Investment Grade Credit: The cut in the corporate tax rate to 21% is unequivocally a positive development for the investment grade rated US Credit market. IG Credit is also insulated from the cap in interest expense deduction, as only a handful of IG-rated credits have interest expense greater than 30% of pre-tax income.
- High Yield Credit: The impact of the tax reform bill on below-investment grade rated (“high yield”) issuers is harder to determine. On one hand, the majority of high yield issuers are profitable and the reduction of the corporate tax rate to 21% is an obvious positive for those companies. This positive is tempered by the loss of the ability to deduct interest expense beyond 30% of pre-tax income. Due to this dynamic, the impact of the bill will be company specific and will require focused, bottom up analysis to determine the impact on each credit.
- Housing: Over 90% of homes in the U.S. have mortgages below the $750,000 threshold to qualify for the interest rate deduction. Additionally, the $10,000 limit on SALT and property tax deduction affects approximately 5% of the population in states with higher home prices like New York, California and Florida. We also hold the view that homeowners typically buy for reasons other than the tax reduction (i.e. schools, neighborhoods, etc.). While it is possible the bill could be a headwind to housing market, we remain constructive on the U.S. consumer and housing fundamentals overall.
- Municipals: While the top marginal tax rate for households has been reduced by a small amount – 2% - the substantial restriction of state and local tax deductions to $10,000 should increase overall demand for municipal debt by individual purchasers. Another positive technical for municipal markets is decreased supply of tax-exempt bonds due to the banning of the pre-refunded structure. These positive effects are tempered by reduced demand from corporations which will be driven by the reduction in the corporate tax rate to 21%.
- The new tax reforms favor the commercial real estate asset class and all property sectors. No changes were made to the existing FIRPTA (Foreign Investment in Real Property Tax Act), 1031 revenue reinvestment laws, LIHTC (Low Income Housing Tax Credit) or carried interest rules, which means commercial real estate continues to remain attractive to both domestic and international investors.
- The change to the mortgage interest rate and property, and state and local sales taxes may deliver benefits to commercial real estate investors, particularly multi-family property investors in high-cost metro regions such as New York, Boston, Los Angeles, DC and the Bay area, as workers shift from homeownership in the suburbs to renting closer to their jobs. In addition, renters may have more disposable income available to pay the higher rents required in high-cost markets - which is good news for landlords.
- REIT investors will benefit from the tax breaks that “pass through” businesses will receive as investors will be now allowed deduct 20% of their REIT dividend income.
- The retail sector, while still volatile, will potentially benefit as retail companies realize much lower corporate tax rates (as retailers often have fewer intellectual property and other tax write-offs that lead many companies to already pay a lower-than-21% tax rate). In addition, as consumers feel they have more disposable income, they may spend more of it in brick and mortar storefronts as indicated by better-than-expected holiday sales.
- Companies, realizing the benefits of lower tax rates and $3 trillion in overseas revenues being brought back into the U.S., will spend some of that money expanding their footprint and investing in newer, more flexible and technologically capable office spaces.
- Lastly, higher consumption will drive more distribution demand which supports continued investment and growth in the already strong industrial sector.
Royce & Associates
- We think the reduced corporate rate is a real positive for small-cap stocks.
- Having said that, we think investors need to understand a few key points. First, the positive effect becomes lasting only to the degree that it encourages productive capital investment and allocation—in our view, that’s the key to creating additional growth beyond the reduced rate.
- We also think that the excitement over tax reform has kept many investors from seeing what looks to us like the more significant development—the acceleration of the global economy.
- The effects of this can already be seen by looking more closely at recent returns for the Russell 2000 Index, which advanced 15.6% in 2017. Companies in the small-cap index with no foreign sales were up 12% while those with foreign sales of 30% or greater advanced 19%.
- We also think small-cap investors should be aware that more domestically focused small-caps will derive more of a benefit from the reduction if they are both profitable and have low debt. About a third of the companies in the Russell 2000 have no income while many others have so much debt that the limits on interest deductibility may actually harm them. This creates a potential advantage for profitable companies that generate most of their earnings—and pay the bulk of their taxes—here in the U.S. as well as for those that have little debt and thus won’t be harmed by deductibility limits.
- Passage of US tax cuts has been our #1 key issue in terms of macro & economics for much of the last 12 months. As analysts & forecasters incorporate the lower tax rates, they are driving up company earnings forecasts and boosting 2018 US GDP from the mid 2% to 3% level -- (stronger consumption & investment). Just in the last few days Merrill Lynch has increased its S&P 500 EPS forecast by 10%, largely due to the lowering of the corporate tax rate from 35% to 21%.
- Stocks that benefit from this package have further to go up. Inflation and bond yields have been well behaved during 2017, in the United States and around the world.
- However, the US is already operating at full capacity – so we’ll be watching wages growth closely for signs of overheating (the output gap has already closed, and the US is the main country that has evidence of firming inflation).
- The largest beneficiaries in the universe of stocks we follow are the US rail companies. Utilities have a neutral-to-slightly-negative impact.
- Deleveraging will be a key factor in determining whether the tax bill will be accretive to U.S. corporate credit. The impact should be very positive for shareholders and generally positive for corporate debtholders if the “tax savings” is used to deleverage.
- Cash generated in foreign subsidiaries may now be repatriated at much lower tax rates. Again, it could be a credit positive if those extra proceeds are used to deleverage.
- The lower tax rates on corporate earnings provides a smaller tax shield for using debt. This can be viewed as a positive credit event if companies use the opportunity to deleverage and reinvest in the business.
- The corporate interest deduction cap will be a negative for very highly levered/stressed companies in junk bond market.
- In equities, there are negative aspects of the tax bill such as interest rate deductibility, but even companies that will be affected by the change in interest expenses will also benefit from the legislation. Therefore, we are talking about degrees of positivity from the tax bill and not winners and losers in absolute terms. Of course, negative scenarios exist but it is hard to come up with a clear negative scenario in the short-to-medium term
- The cuts benefit some companies more than others, including airlines and banks. The reported tax rates for airlines should fall dramatically—and these stocks are already cheap to begin with. While the industry as a whole is paying far less in cash taxes than booked taxes, future cash tax payments should fall meaningfully from expected levels. For banks, we believe the benefit from lower taxes will not be competed away as depositors focus more on paid interest rates which are tied to the Federal Reserve, and return on equity (ROE) levels at the big banks are still below historical norms. Thus, there are not excess margins to compete away. Banks with a larger domestic client base stand to benefit more than competitors with broader international exposure.
- On a macro level, the risk here, if there is one, is that faster growth is accompanied by a faster-than-expected increase in inflation that leads the Fed to tighten monetary policy too quickly.
- We don’t expect a huge impact from tax reform on the overall economy. It may add incremental growth -- but if it does create faster growth than expected, this would likely lead the US Federal Reserve to raise interest rates faster and, in turn, dampen growth and potential inflation.
- On the corporate side, tax reform could bring capex forward but we don’t expect a dramatic increase in capex; if capex were particularly attractive at this point we would have already seen it increase, as corporate earnings have been strong. However, some sectors might benefit from qualified capex being able to be immediately expensed versus being depreciated over time. Beneficiaries could include capex-intensive sectors such as Telecom, Utilities, Industrials and Energy.
- In terms of corporate earnings, we expect some repatriation of capital which would likely result in an increase in share buybacks and/or dividends, which will support stock prices.
- It is less clear how tax reform may affect buying behavior of consumers, given differing impacts. People in states like New York and New Jersey with high state and local income tax rates -- and/or with high real estate taxes and mortgages -- may not benefit much from tax reform (as they won’t be able to deduct those taxes from their federal returns). Others, in lower State and Local income states, may benefit. Beneficiaries may spend more stimulating the economy but the short-term nature of individual tax decreases that dissipate over the next 10 years may lead consumers to save more of any benefit rather than spend it. It will be important to monitor consumer behavior to determine the impact at the individual level.
- One under-appreciated aspect of the Tax Cut & Jobs Act is the nearly immediate benefit to most individual tax payers. The tax cuts are likely bigger for individuals and small businesses in 2018 than they are for corporations. Workers may see higher take home pay as soon as February. This will be a big positive for consumption and disposable income.
- Corporate tax cuts are a long-term positive as well. They are expected to lead to increased earnings growth for most companies in 2018. Another likely benefit of the tax bill becoming official is that it may unleash corporate “animal spirits” and lead to increased capital expenditures to invest in growth projects and potentially increased merger activity. Repatriated earnings held overseas can be used to fund both in addition to increased stock buyback activity that is likely to result.
- Q1 earnings announcements will be noisy as many companies will be forced to take charges on deferred tax assets and pay taxes on cash held overseas. This will create opportunities for active stock pickers.
- GDP growth could see a sharp increase over the next couple of quarters. If that is followed with higher wages and inflation, interest rates may increase above current market expectations and the Federal Reserve may be forced to hike interest rates more than investors expect. This is one potential source of volatility.
- It’s logical to ask who loses if corporations repatriate cash back to the US. These companies typically do not simply leave cash in the bank: they will presumably want to maximise investment income. Their asset allocation would almost definitely be focused on investment grade securities, and it is highly likely to be in low investment taxation jurisdictions, such as the Netherlands, Ireland, Bermuda, Hong Kong, etc.
- As such, it is hard to envision an Emerging Markets country in which we invest where the repatriation of profits to the U.S. would be a problem.
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