In matters of government policy, it is often difficult to take a dispassionate view. Some would say the modern discourse is so polarized, the strictly rational, factual view is drowned out. In this brief overview, we are going to attempt to lay out a few of the potential implications of the recently passed U.S. tax legislation. The aim is not to judge the merits of the legislation, or to say that the adjustment of policy is “good” or “bad.” Our role is think through the macroeconomic and market consequences of its enactment and lay out what we believe are the most important and relevant effects on the U.S. economy, the fixed income markets and the equities markets.
The U.S. economy is strong. Most academic and commercial economists agree that the growth rate of the U.S. economy that is considered its long-term “full potential” lies somewhere in the range of 2 percent. Since the middle of 2016, the U.S. economy has been growing at a faster pace than 2 percent. At the beginning of 2017, we forecast that GDP would grow at a 2.3 percent pace and it is highly likely that the year will end with growth at 2.5 percent or better. Similarly, the labor market in the U.S. is strong and has been stronger than we, and most others, had anticipated. Household balance sheets are in much better condition than a decade ago, consumer confidence is high and retail sales reports suggest the Christmas season capped 2017 with very strong consumption. Notably absent amidst the strong growth pattern was inflation, with all measures of inflation undershooting expectations for now.
The tax legislation somewhat reduces statutory tax rates for individuals, and changes some deductions and exemptions for some cohorts of income distribution. It also decreases the statutory tax rate for most mid-sized to large corporations and some “pass-though” corporations. Our estimate of the effect that this will have is a 0.2 percent to 0.4 percent boost to real GDP in 2018 and 2019 through moderate increases in both consumption and capital spending. The implication of this estimate is that we now forecast 2018 GDP will be 2.8 percent. A 2.8 percent growth rate is 40 percent higher than the U.S. trend growth rate at a time when the unemployment rate is at 4 percent. The potential for unemployment to fall further, into the range of 3.8 percent to 3.6 percent, is high. Unemployment rates that low are traditionally associated with periods of strong wage gains, as qualified labor becomes scarce. In the last several months of 2017, inflation trended higher and we believe the core inflation rate has bottomed and will end 2018 above the U.S. Federal Reserve’s “target” of 2 percent.
Fixed income – interest rates
Our view that inflation has bottomed and that the tax legislation can push growth, at the margin, to somewhat lofty heights, has implications for interest rates and therefore fixed income positioning. The Federal Reserve has a median forecast of three additional rate hikes for 2018, but yields in the bond market indicate a lack of belief in the resolve of the Fed to carry through with this. We believe that this position is untenable and given our growth and inflation forecast, continue to advise caution in bond markets as both short and long-term interest rates are set to rise.
Fixed income – credit markets
With growth already strong in 2017, and the tax legislation favoring a pro-growth agenda, credit markets are receiving a boost by virtue of a continuing positive outlook for corporate profits. In an environment where corporate profitability is strong, we see little reason to doubt that the market for corporate bonds can remain stable. This is not to say that we expect corporate credit spreads versus government bonds to continue to narrow, but a stable environment is reason enough to continue to own credit versus government bonds. There are mixed views on M&A activity, but for companies that benefit from a lower marginal tax rate under the new law (not universally the case), the extra cash flow after tax should be positive for both capital expenditure and M&A. Research has shown that somewhere between 60 percent and 70 percent of investment grade-rated companies have effective tax rates above the new statutory rate 21 percent and therefore benefit from the reduction.
For high yield credit markets, the reduction in the corporate tax rate has a smaller effect. Only approximately 40 percent of high yield issuers in the U.S. have an effective tax rate above 21 percent, but of that cohort a large percentage of the BB and B-rated universe will have some benefit through lower rates and the full depreciation provision for capital expenditures that was included in the legislation. In the legislation, there is also a cap on the deductability of interest expense, but this should negatively affect only the most highly levered companies that sit in the “C” ratings tiers.
As we alluded to above, it would appear that equities markets are a clear beneficiary of the reduction in corporate tax through increases in profitability and a better growth outlook. On average, analysts predict an 11 to 13 percent rise in earnings per share for the S&P 500; estimates have risen from a consensus of 9 to 11 percent since November. The average S&P 500 company had an effective corporate tax rate of 26 percent, but this could have ranged from 0 to 35 percent in the previous system. The benefit is, therefore, unequally distributed amongst sectors and individual companies within sectors so it is difficult to generalize that the legislation benefits “everyone.”
One of the sectors that appears to be a big beneficiary of the lower corporate tax is retailers, most of whom would be classed as “consumer discretionary” companies. Wall Street estimates are that U.S.-focused retailers may benefit from as much as a 20 percent lift in earnings per share in 2018, whilst those with more international reach will have a much lower benefit. However, U.S.-based retailers face myriad structural headwinds and we believe equities valuations have fully priced the boost in EPS. This example clearly shows that some industries that may be beneficiaries of policy change still may not be good investment opportunities. Another area that is a clear beneficiary is small and mid-cap companies that derive a majority of their earnings from the U.S. and therefore pay structurally higher effective tax rates than S&P 500 multi-nationals. Buying U.S. mid-cap equities, versus small-cap growth stocks, is one way to own a lower risk position for tax reform within an equities allocation. In short, tax reform is certainly helpful to equities at the margin, but we would fight the temptation to move to an overweight position in the asset class as current valuations based purely on tax policy.
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.