Financial Insights

On the Verge of Greatness, or the Precipice of Disaster?

We are nearing the end of a tumultuous year in U.S. and global politics. The economic news has largely been positive, while the political news has been more worrisome, but mostly a distraction, for markets. As we head towards year end, we are looking for resolution on  tax reform, renegotiation of NAFTA, and avoidance of a government shutdown. The latter is likely to be resolved without drama. The outcomes for tax reform and trade policy, however, may very well alter the course of markets and that of our current economic expansion.  The VIX, or “fear index,” has crept higher in recent weeks as investors attempt to assess the impact of these material sources of uncertainty. At ACM, we are combining tax-harvesting portfolio adjustments with rebalancing to take into account possible shifts in corporate profits, sector performance, and broader economic forces.

The tax bill passed last week by House Republicans features a 20% corporate tax rate, lower personal income tax rates for most Americans, reductions in estate and pass-through taxes, and a host of cuts to deductions to help pay for the package. The net negative effect on federal tax revenues is estimated to push the federal deficit higher by $1.1-$1.7 trillion over the next ten years, but this is viewed as worthwhile if the overhaul reduces harmful distortions embedded in the current tax regime since growth could strengthen as a result. The Senate version, if passed, differs in the details but also promises to lower corporate and personal taxes. The Senate has yet to vote, the two bills must be melded into one, and so the political math needed for success remains challenging.

The direct positive aspects of the legislation are fairly straightforward: lower corporate taxes mean higher earnings and so more valuable companies. If we take a simple example and imagine that the average US effective tax rate for S&P 500 companies were to drop from its current rate of 26% to 20%, stocks would appreciate by nearly 10%, assuming the current market multiple remains unchanged. Alternatively, the S&P 500’s price-to-earnings ratio would drop to roughly 16 from its current level of 18. More likely, some combination of the two would result. While stocks of companies with among the highest effective tax rates surged immediately after the election, they have underperformed since, suggesting that very little of the benefits of a tax cut are priced into shares.

On the corporate side, the combination of a lower tax rate and a provision to encourage the repatriation of cash held abroad could give a boost to capital spending, stock repurchases, and dividends. In addition, corporations would be able to fully deduct capital investments at the time they are made, offsetting the costs and pushing some marginal projects into positive net present value territory. The resulting increase in capital spending would not only boost GDP, but also would raise labor productivity (giving workers better tool boxes, essentially) and this would help wages move higher.

On the other side of the ledger, both the House and Senate packages would raise the federal deficit, and the additional borrowing required by the government would likely drive interest rates higher. This would raise borrowing costs for firms and households alike, putting greater pressure than otherwise on household balance sheets and crowding out some investments by firms. And some of the changes associated with these plans would raise the cost of education and research, which would undermine long-term growth prospects for the U.S.  Finally, a higher deficit because of tax cuts would make it harder for the government to embark on near-term spending programs that would improve private-sector productivity, such as funding upgrades to the country’s infrastructure.

Housing will likely take a hit if the mortgage deduction and state, local and property tax deductions are reduced or eliminated. In large part, this will act like an ex-post tax on current home owners in high-tax states like NJ, NY and California, rather than have a major negative impact on future home building. Home prices are likely to drop in response to a reduction in these deductions, compensating potential home buyers who have the flexibility to shift to a less costly locale.  The shake-out of marginal home buyers, however, could also shift demand towards rental properties, depending on the ultimate tax treatment of real estate businesses. So when looking for investments tied to the inflow of millennials into the housing or rental markets (and out of their parents’ basements), it’s best to look for investments (materials, fixtures, furniture) that work regardless of whether new buildings take the form of apartments or houses.

Corporations and start-ups may rethink longer-term decisions regarding corporate office or headquarters locations, since removal of the state and local income tax deduction will force firms to pay employees more or lose them to competing offers from rival employers located in other states. If any of these three states hopes to lure Amazon’s second HQ, that mission just became a lot more expensive. This isn’t a Brexit-level event like that impacting London’s financial sector, but at the margin, look for economic growth to be lower than what it would’ve been in these states than under the current regime. Municipal bonds will need more careful scrutiny in these states since tax revenues would be likely to decline, and since their budgetary outlooks are already tenuous.

These and additional questions about the implications for tax reforms on specific sectors and firms create further complexity in evaluating investment opportunities.  And while negotiations on NAFTA resumed again on Friday, there remains a great deal of uncertainty as to final changes and how those will affect different sectors of the economy, such as automotive, textiles, and agriculture. Then add to these uncertainties the prospects of another Fed rate hike in December and tapering of the Fed balance sheet, and we have a recipe for increased market risks through year end. We are taking steps to reallocate portfolios in conjunction with tax-loss harvesting to position clients for these and the next waves of economic and market risks as we head into 2018.

 

 

 

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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