US tax reform: shifting the investment goalposts
We discuss how investors might benefit from the sweeping tax reform agenda that has emerged as the new administration’s policy priority
The highs that markets saw following the election of President Trump had, in our reasoning, very little to do with the accent of the man himself. Instead the political harmony of a Republican-controlled White House working alongside a Republican-controlled Congress clears the way for the implementation of an economic agenda that investors can have some confidence in positioning themselves for.
In this Talking Point series, Fares Benouari – Equities Advisor – considers four key investment themes arising from the policy priorities of the new administration, and offers his insight into how to exploit them in portfolios.
In this first part of the series, we discuss how investors might benefit from the sweeping tax reform agenda that has emerged as the new administration’s policy priority.
Corporate tax cuts
At a headline rate of 35%, US corporation tax is among the highest in the developed world. Ever since Donald Trump pledged to slash this tax on corporate profits to 15%, markets have salivated at the impact this might have on US company earnings. The proposed blueprint of reforms – which includes this and other proposals affecting imports, capital expenditure and overseas earnings – would add USD 8 to the S&P500’s earnings per share (EPS).
But the US tax system is a political and administrative chink in the armoury of the world’s largest economy, and we doubt that the proposals will make it through the adoption process unscathed. Instead, we are poised for a more modest reduction to approximately 20%. Either way, it is worth remembering that every 1% reduction in corporate tax would generate approximately USD 0.30 additional earnings for US companies1, making this a meaningful theme for investors to consider exploiting in portfolios.
With corporate tax currently equal to 2% of US GDP2, the proposed cut would reduce government revenue by about 1% of GDP, thus shifting capital away from government back into the corporate sector. The potential increase in investment as the corporate sector seeks to put these earnings to work could boost economic growth – lowering government revenue losses – and ultimately supporting equities.
One of the most controversial areas of the Blueprint is the border adjustment tax (BAT), which proposes a levy of up to 20% on goods depending on where they are consumed rather than where they are produced – i.e. taxing imports and exempting exports.
These proposals will undoubtedly deter US businesses from fleeing overseas, while eliminating the advantage that the current system gives to foreign companies selling into the US or competing with US rivals abroad. Should such an import duty be implemented, it will boost the global competitiveness of US-made products and services. Given the potential for these changes to transform the competitive landscape for corporates, both in the US and overseas, the market was surprised by President Trump’s failure to reference the BAT in his maiden speech to Congress on 28 February 2017.
The process of reforming the US’ notoriously complex tax system will be laced with political challenges, and the tax regime that emerges will have uneven consequences across the investment spectrum.
But from what we know of the proposals so far, it is possible to begin picking through the market to identify which sectors are likely to benefit the most.
Given the protectionist undertones of the Blueprint, it seems clear that the most domestically exposed companies will be the main beneficiaries of the reforms. Similarly, companies with limited imports, stronger margins and less debt will also benefit. By contrast, corporates that are reliant on imports – particularly those with lower margins – are likely to fair less well.
From an investment style perspective, high-tax rate, domestically focused corporates, with relatively low levels of debt, should see the bulk of the EPS gains. It also follows that small and mid-cap names may enjoy some advantages relative to larger caps, which tend to be more globally oriented.
Looking at the sector-specific impact, we see financials – particularly regional and retail banks, as well as consumer finance – as one of the sectors likely to see the strongest EPS gains. On the contrary, areas of the consumer and automobile sectors may be hurt by the BAT levy on imports. As far as the imports-heavy oil and gas sector is concerned, we may see these companies pass higher costs onto households and end-users, generating potential headwinds for consumer spending. But, it isn’t all bad news for households. Government plans to simplify the tax code for individuals could boost disposable incomes and potentially generate an opposing tailwind for companies exposed to the US consumer.
Active management: the most-efficient tool against an unpredictable president
While the Blueprint gives a good indication of the general direction of the upcoming reform agenda, it is worth stressing that the proposals are unlikely to be passed in their current form. Even with a Republican majority in the Congress, President Trump will have to make some concessions. The timing of the reforms is also highly uncertain. While the first decisions should start to impact some industries first (the defense budget, healthcare and financials reforms), tax reforms and additional infrastructure spending could be announced later this year.
We, therefore, strongly believe that active management strategies are the most effective means of navigating these uncertainties and adapting to unforeseen outcomes. This is particularly the case when the eventual content of the proposals will be dominated by the will of a president that is widely considered unpredictable.
1 Source: Goldman Sachs estimates
2 Source: World Bank, 2015
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