Global Market Commentary

What is the most important aspect of the tax bill for investors?

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For Investors, Corporate Taxes Are the Most Important Part of the Tax Bill

The administration is close to notching its first major policy success with the passage of a sprawling tax cut.  We will wait until the legislation is finalized before commenting on its consequences in detail.  However, for many investors, the most significant effects of the tax bill will be on the value of the stocks in their investment portfolios.

That’s another way of saying that despite all the wrangling about the specifics of the tax bill that will affect individual income taxes, the lowering of corporate taxes will have the most dramatic ultimate effects on the economy, on productivity, and on investment returns over the long haul.  Don’t lose sight of the forest for the trees.

Assuming that the tax cut goes through with the statutory rate dropping from 35% to 20%, analysts see a boost to S&P 500 2018 EPS of 10.5% to 12%.  

Naturally, companies will benefit according to their current effective tax rate, but some broad generalizations can be made.  The S&P 500’s median effective rate is 27%; the Russell 2000’s is 32%.  Not surprisingly, across the board, smaller, more domestically focused companies will be greater beneficiaries of the tax cut.  That was apparent to anyone watching the Russell 2000 on the day the Senate passed its version of the tax bill.

There is also a wide variation of median effective tax rates among industries, as illustrated below:

Data Source:  Wall Street Journal

For investors, the immediate question is, are the benefits of the tax cut already priced in?  This question is somewhat complicated, as Deutsche Bank analyst Binky Chadha notes:

“… a rise in earnings 10% above normalized levels is associated with a decline in the multiple of about 1 point as the market looks through cyclically elevated earnings.  So a 12% rise above normalized levels would take off 1.2 multiple points.  Relative to our previous baseline this implies a 6% lower multiple (from 19.5x to 18.3x).”

Translation: not all of the earnings boost translates into stock price appreciation — by Chadha’s analysis, after the multiple discount, about 6% remains for stock prices.  The bottom line is that at best, only some of that has been priced in; perhaps a third by his account.  Of course that’s hard to discern given the normal levels of market noise.  The bottom line is that investors should not assume that tax cuts are already priced in.

          The Longer-Term Effects of Corporate Tax Reform

Also, all of this is only considering first-order effects, and here’s where investors should be putting their long-term attention.  We have written often about how one of the chief culprits behind the sluggish economic recovery since the Great Recession has been depressed productivity growth.  That has come largely from a lack of companies’ investments in plant and equipment as they faced high taxes and a constricting regulatory environment.  Now, at last, we are beginning to see capital investment turn up.  Productivity growth will follow, job growth and economic growth will follow that, and corporate profit growth will be the ultimate fruit.  With a more benign regulatory environment, and funds that would have gone to the taxman turned into investments in plant and equipment, a virtuous cycle will be set in motion which will ultimately have a profoundly beneficial effect on profits.

If you’re a taxpayer who may be negatively affected by aspects of the changes to personal income taxes, take some comfort in the likelihood that the ultimate effects of the reform will help your portfolio.

Investment implications:  The tax cut’s direct effects on corporate profits is probably only partially priced in by the stock market.  The biggest beneficiaries will be high-tax-paying companies: on average, firms with domestic revenue, small firms, and firms in industries with high effective tax rates.  The second-order effects will be much more significant, as companies deploy more capital towards plant and equipment and boost productivity growth in a benign regulatory environment.  From that latter, deeper perspective, the tax cut has probably not been very much priced in.