On December 20 the House of Representatives passed the Tax Cuts and Jobs Act (referred to as “Tax Reform”) which, following Senate passage a day earlier, was then promptly signed into law by President Donald Trump. This legislation was highly partisan in nature, as the final votes in both the House and Senate were strictly along party lines, and the debate throughout the process showed virtually no signs of compromise across the two sides of the aisle.
With implementation planned for early 2018, we believe it’s important to look beyond the intense political disagreements surrounding Tax Reform, the first widespread federal tax reform in more than 30 years, to gauge its potential impact on the markets.
The major changes
The headline features for individuals include seven new tax brackets, all lower than the ones currently in place, with the top bracket for the highest income earners dropping from 39.6% to 37%. The standard deduction for joint filers doubled from $12,000 to $24,000, and perhaps the biggest adjustment is the $10,000 cap on the federal deductibility of state and local taxes (SALT). The increase in the standard deduction will likely reduce the number of individual filers who itemize their tax returns, and the dramatic reduction in SALT deductibility will have differing impacts to individuals depending on their state of residence.
Much of the bill was crafted to help provide fiscal stimulus for the economy, and here we would like to point out two very important elements. The first is a reduction in the marginal corporate tax rate from 35% to 21%. In making this comparison, it is helpful to recognize that the average effective corporate tax rate is currently estimated to be about 29%. Even when taking this into account, taxes paid by corporations will be materially reduced looking forward.
The second is the repatriation of cash derived by corporations from foreign profits presently being held overseas. This amount is estimated to be quite large at more than $2.5 trillion. The new Tax Reform legislation will allow these funds to come back to American shores at a discounted tax rate of about 16%. Upon paying this lower rate, companies can deploy this capital however they see fit. How these funds are applied by corporations and whether they wind up being widely circulated throughout the economy is a subject of speculation and debate at this point.
Potential impacts to the markets
We view this new Tax Reform as having a potentially favorable effect on the overall U.S. economy. It is coming at a time when economic growth is experiencing renewed momentum, as evidenced by two consecutive quarters of 3%-plus gross domestic product (GDP) growth – 3.1% in 2Q17 and 3.2% in 3Q17 – and encouraging trends in retail sales and consumer spending. We think Tax Reform could be additive to those trends as a large majority of U.S. citizens will be paying less taxes, corporate profits should increase, and the repatriated cash will be regenerated into the economy in one form or another.
Tax Reform is also coming at a time when the U.S. labor market has tightened considerably, as seen in the recent November jobs report where unemployment fell to 4.1%, its lowest level in more than 16 years. Combining this increasing demand for workers with potentially higher levels of corporate profitability and excess cash could help spur long-awaited wage growth, which if achieved could provide further economic momentum.
The reduction in the corporate tax rate is likely to have a favorable and immediate effect on stock earnings. While estimates currently vary, we believe this lower rate could add approximately $8 – $10 to S&P 500® underlying company earnings in 2018 (presently at about $146 representing approximately 11% growth from 2017). This upside to earnings is meaningful in our opinion and, in isolation and all else being equal, we feel increases the probability of higher stock prices in the year ahead.
While more challenging to quantify, we also believe the potential repatriation of more than $2.5 trillion in overseas corporate cash could also be beneficial for stocks. Admittedly, it is not known with any certainty as to how companies may ultimately use this cash, and there seems to be a consensus the majority will not be applying it toward hiring, capital expenditures, or other high-velocity activities within the economy.
However, this does not mean it will not prove beneficial for stocks. In fact we believe it will. Even if used on an individual company basis for objectives such as debt reduction, stock buybacks, or internal infrastructure improvement, we believe this could still result in stronger balance sheets, better earnings leverage, and higher profitability for a large number of companies. Again, all else being equal, this could lift stock prices.
Bond markets
As we believe Tax Reform could be a tailwind to the overall economy, it will likely contribute further to a rising interest rate environment. Since late November, when it first become apparent that Tax Reform had a strong chance of passage by year end, the 10-year Treasury yield has increased 0.18%, and now at 2.50% stands at its highest level since mid-March. Moreover, to the extent Tax Reform is stimulative to the economy, as we believe it should be, this current 10-year Treasury yield and its spread to the 2-year bond yield (currently 0.65%) probably stand to rise further.
We also believe corporate bonds will benefit from this legislation, as the lower tax rate and potentially improving balance sheets from repatriation could enhance credit quality at many companies. Repatriation might also help reduce supply, as some corporations previously using the bond markets to raise cash for stock buybacks may no longer need to do so.
In regard to the municipal bond market, the reduction of SALT deductibility at the federal level ($10,000 cap) should increase demand for tax-exempt bonds in those higher-taxed states. While municipal bond issuance increased considerably during November and December in anticipation of Tax Reform and revised tax-exempt status for certain issue types, we would expect that, post signage, longer term supply should begin to decline which, of course, should prove favorable for bondholders.
Conclusion
In summary, while the passage of Tax Reform proved to be politically partisan and at times highlighted hostilities between the two parties, we believe on balance it will likely create additional economic momentum and further strengthen the equity and fixed-income markets.
About the author
Tom Ward is responsible for overseeing the investment and mutual fund product development functions and sub-adviser selection process. He also actively publicizes Transamerica’s investment thought leadership and products to advisors, clients, and the media. Tom has more than 25 years of investment experience and has managed large mutual funds and sub-advised separate account portfolios. Tom holds a bachelor’s degree in political science from Tulane University and an MBA in finance from the Wharton School at the University of Pennsylvania. He has earned the right to use the Chartered Financial Analyst (CFA®) designation.
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