What if Tax Reform Doesn’t Pass?
By David Nelson, CFA
Markets are beginning to price in the potential for tax reform and in particular some level of repatriation of corporate cash held offshore. Therein lies the opportunity and of course the danger. Stocks are discounting system and in today’s machine trading, fast paced algo driven markets, stocks will likely hit targets quickly as confidence builds and rhetoric morphs into reality.
Storyline B is a very quick reversion to the mean giving back any gains made along the way with a likely overshoot to the downside if once again Republicans are left standing at the altar.
After two failures on healthcare, Tax Reform seems a stretch especially as we head toward January and the unofficial start of the election cycle. Never the less the President and his team headed up by Gary Cohn and Secretary of Treasury Steve Mnuchin are putting on a full court press to shepherd the it through the process.
Politically both sides of the aisle can point to parts of the package they support and in some cases hate. In this forum I’m not going to debate the merits of tax reform or do a line by line explanation of the proposals but focus more on what it will mean for stocks if and when we actually get meaningful legislation.
The centerpiece of the package revolves around a potential 15% cut in the corporate rate from 35% to 20%. Many will point to the effective rate as being lower and even comparable to European counterparts. While there is some truth to that statement it ignores the fact that close to 5000 U.S. companies have left the United States seeking a lower tax status likely skewing the numbers. Some have left through inversion, others just left and still more let themselves be acquired by foreign entities. There’s certainly room for debate but in the end capital goes to where it is treated the best.
Estimates vary but a number of strategists believe we could get a $15 bump in S&P 500 earnings if the package goes through as we understand it today. I’m not sure I’m on board with the estimate but it’s safe to say earnings per share could rise and was likely the single biggest factor driving equity performance as we closed out the month and quarter. As September closed the reflation trade was in full swing as details of the plan started to leak. Energy followed by industrials, financials and materials took the lead with defensive sectors bringing up the rear. The rotation held back technology in particular some of the mega-caps like Facebook (FB) Apple (AAPL) and Amazon (AMZN).
The rotation had many of the same characteristics as last year’s post-election Trump bump just without the same velocity. Treasuries were the tell as 10 year yields climbed off the bottom finishing above 2.3% and the dollar jumped off the canvas.
A big part of the package and maybe the most influential to 2018 returns is potential repatriation of corporate cash held hostage offshore. Estimates vary widely but the median is about $2.5 Trillion. The $15 bump in earnings seems a stretch especially considering funds would return to the states over time. More important is to have a tax structure that changes what the President refers to as an offshoring model.
All of this begs the question, just what will CEOs do with the money when they bring it home. Past history points to buybacks and special dividends. For CEOs it’s the low hanging fruit and the quickest way to boost EPS and stock price. I’m not that cynical. While I’m certain much of the funds will be used to that end I believe U.S. corporations are gearing up to re-invest with a renewed focus on revenue growth not just earnings. Buybacks can do wonders for the bottom line but absolutely nothing for the top.
Even if I’m wrong and management turns to the gimmicks of old it’s still money coming back into the economy and a contribution to tax revenues.
The battle between growth and value also seemed to take its cue from Washington. Here again September largely echoed post-election trading as many of the high flyers i.e. Facebook (FB), Amazon (AMZN) and others treaded water. I don’t think anyone is going to shed any tears for tech still the leading sector year to date and well positioned to succeed. If repatriation becomes a reality tech should be one of the biggest beneficiaries. Apple (AAPL) with an offshore cash hoard well over $200 billion is just one example of mega cap tech companies with a substantial percentage of their balance sheet waiting to be unleashed.
Given an election cycle just around the corner tax reform is anything but a lock. Any kumbaya moment between Democrats and Republicans on bi-partisan legislation will get tougher to realize as 2018 wears on.
Look, the following bears repeating. Tax reform is a lot more than just cutting taxes and bringing home the cash. We have a 77,000 page tax code that has spawned a generation of lobbyists and tax attorneys each with their own agenda. You can bet they aren’t going down without a fight.