The New Catalysts
How Tax Cuts, Inflation Risk and Intangibles are Changing the Stock-Picking Calculus.
After a decade of central bankers acting as masters of the universe, deploying extraordinary monetary stimulus in the form of ultra-low interest rates and unprecedented asset purchases, investors now face a new set of forces driving growth and corporate earnings. All of that easy liquidity and low cost of capital was meant to spur spending in a painfully slow global economic recovery. In the event, it drove equity prices higher and seemed to reassure investors that the “Yellen collar” would provide both a floor and a ceiling to markets for as long as the recovery remained fragile. But with strengthening global growth, the Fed is firmly on its policy normalization path and other major central banks are likewise beginning to tighten policy.
Clearly a new set of catalysts is taking precedence for corporate performance, as central bankers hand off the baton to fiscal stimulus. Deputy Global CIO Lori Heinel discusses the most significant of these new levers in the form of historic US tax cuts, the return of inflation and protectionist risks, as well as the inexorable rise of intangible-driven companies. Each of these will affect corporate winners and losers and create opportunities for skilled stock pickers. Joining Lori in the discussion are State Street Global Advisors Senior Economist Simona Mocuta, Harvard University’s Mihir Desai and Jonathan Haskell of Imperial College, London.
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Are investors right to be worried about inflation risk?
Heinel. Let me start with you, Simona: as expected, we saw investor concern around inflation risk drive yields higher in early February after a strong US wage report. After a year of historically low market volatility, investors finally shed their complacency and we saw a 10% correction in the S&P 500. Are investors right to be worried about inflation risk?
Mocuta. Investors are certainly right to watch inflation more closely, given the closure of the output gap and incoming fiscal stimulus in the US, but I think the market overreacted to one single data point. We need to recognize the volatility in the data. In fact, that same overall average hourly earnings index that hit a cyclical high in January had touched a two-year low just two months prior. There are multiple measures of wage inflation and they are all accelerating, as they should be, given the length of the recovery and the decline in the US unemployment rate to 4.1%. However, investors should remember that generating persistent wage inflation is a long process, and I don’t see a spike in wage inflation as an imminent risk in 2018.
Heinel. If you do not see an immediate upside risk to price inflation from rising wages, why has the yield on the US 10-year risen so far in such a short amount of time?
Mocuta. I think it is important to remember where the bond market was with negative term premia. There is a case to be made that bond investors were already retreating from an extreme and unsustainable situation and that the wage data was just a further catalyst in that process. This is not to say that the move had nothing to do with inflation. A number of stimulative policies (the tax cut, increase in spending, etc.) will provide a demand boost; directionally, this is inflationary. But the question is about magnitude and timing. It takes time for these forces to play out. The wage story gets you there, but it is a slow-moving process. We’re not set to see a huge bump this year. We likely will see an uptick thanks to an increase in onetime bonuses following the tax cuts, but those will be limited. At the same time, the quit ratio in the US is still low, suggesting continued worker reluctance to change jobs or demand higher wages. Unless you get persistent wage inflation, you’re unlikely to get spiraling inflation.
My view is that the upside risk to inflation this year won’t come from wage inflation but rather from a policy mistake around, say, protectionism, which would be inflationary. Or there could be a supply shock to commodities that the Fed is not expecting. As global growth has improved, we have seen strong demand globally for commodities, so disruptions to supply would translate much more quickly into significant price changes.
Heinel. If either of those scenarios played out, you would see a differentiated effect across equity sectors. In the case of protectionism, small-cap companies less dependent on global trade would likely fare better. Similarly, a rapid rise in the price of oil would be felt most directly by energy-intensive industries.
Heinel. What about the effect of the US corporate tax cuts? Mihir, you have made global tax policy the center of your career. How should we be thinking about the effects of the US tax changes, not only for US multinationals, but for companies around the world? Is it a net positive?
Desai. On the whole I would say the changes represent a moderate positive, but the devil is in the details. As corporate CFOs delve into what is some mind-boggling complexity, it is becoming clear that the rules will affect different companies and sectors in different and, in some cases, unexpected ways. This is what happens when you try to rush through major tax reform in three weeks in December. For some companies, the effects are not as positive as originally hoped. Most importantly, the new international taxes mean that rather than move to territoriality, we have effectively kept a worldwide system and repealed deferral. Finally, this is a fairly unstable system because it violates a number of international norms and rules and because it is fiscally pretty unsound. Like the tax reform of 1981, I expect there will be years of clean-ups and lobbying to change certain aspects of the rules. This creates a climate of uncertainty, and in the case of other countries, I expect we will see retaliatory cuts in their corporate tax rates, since the effective rate for many US multinational companies now undercuts what prevails outside the US.
Heinel. What about the macroeconomic implications of the new rules?
Desai. From a macro perspective, the better investment incentives for investing in the US will be moderated by the fiscal consequences of the bill and the attendant rise in rates. Moreover, the administration’s estimate that these cuts will cost the government USD 1.5 trillion underestimates the true number. Many expiring cuts will be made permanent and the lower pass-through tax rates will stimulate much avoidance activity. So fiscally, we are still faced with the hard truth that there is a significant gap between what the government spends and what it takes in from tax receipts. At the moment the US spends 21% of its GDP versus 17% in GDP in tax revenue — and that can last only so long.
Heinel. You have spoken about the unintended consequences of the new tax code. What do you mean by that?
Desai. Reducing the headline corporate rate and moving to a territorial system where companies are taxed only once on the revenue they earn outside the US were important and long overdue changes. Those alone would have been hugely important, much more so than what was last done in the 80s, because the changes are structural. They would have brought us in line with other countries’ practices and reduced the “self-help” approaches that led to the wave of mergers and offshoring we saw, particularly with tech and pharmaceutical companies, as US multinationals sought to evade the higher headline corporate rate. But the additional international taxes (a minimum tax, an export-contingent patent box and a base-erosion tax) and the pass-through rules offset much of the good from the core changes. At the very least, they add tremendous complexity to rules that companies are still trying to figure out.
Heinel. Who are the winners and losers when it comes to equity sectors?
Desai. Truly domestic companies in the US will be clear beneficiaries of the new lower corporate tax rate, so for example, construction companies. For US multinationals, it is a much more mixed picture. For example, it is not at all clear whether the new rules will end the practice of offshoring intellectual property. Some of the clear losers are those companies who benefited from the previous “self-help” regime of shopping for lower rates abroad. The minimum rates of 10% or 13.125% for revenue earned abroad could actually be higher than what they had been paying. So I think we need additional clarity about how these overlapping rules will net out for companies, particularly those intangible-driven companies in the tech and pharmaceutical sectors.
Heinel. Do we think US companies will use the opportunity presented by immediate expensing to increase capital investments?
Mocuta. We should see more capital expenditure because of where we are in the cycle. The previous tax rules incented companies to invest overseas. Now you have a lower corporate rate as well as immediate expensing for five years. Capacity utilization is high, demand is very strong, labor is tight. And now you have the new policy incentives to invest. If not now, then when? Another important effect of those capital expenditures in this full employment environment is that they will directly improve productivity growth, which should create a certain cap on inflation. That is another reason I do not see an immediate upside risk to inflation. The tax cuts and potential fiscal stimulus from infrastructure spending provide a demand boost, but immediate expensing and the shift to a territorial system, if it in fact reduces offshoring incentives, are conducive to a matching supply response.
Heinel. Jonathan, I think Mihir’s points about the difficulties of understanding how the new US tax rules will affect the offshoring behavior of intangible-driven companies in, for example, the tech and healthcare sectors points to the larger issues that are at the center of your latest book, Capitalism Without Capital, The Rise of the Intangible Economy. This shift to intangibles has caused quite a bit of soulsearching among policymakers. You essentially argue that we need to completely rethink how we tax, regulate and value these companies, whose growth is driven by intangible assets like the intellectual property (IP) around software and drug patents or branding. Is this the biggest catalyst of all in terms of disrupting traditional methods of analyzing and valuing the growth prospects of companies?
Haskel. I think the first point to make is that this shift to the intangible economy is already well underway. In the US and UK, intangible assets account for more investment than traditional tangible assets (see Figures 1 and 2).
That shift has important implications for how investors think about the valuations and growth prospects of these new kinds of companies. They also present policy challenges around areas like taxation and regulation. It is much easier for a company to relocate IP around the world than it is with physical property.
Analysts need to think differently about these companies’ growth prospects because the scalability of their growth model is very different from a traditional type of company. For example, if you’re running a taxi cab company and you want to carry more passengers, you have to order more taxi cabs. If you are running a platform-based company like Uber and you want to carry more passengers, you can basically use the same software, so there is no extra cost. So with very little incremental investment, these new kinds of companies can scale up very quickly and dramatically.
For traditional companies, investment analysts have thought of growth prospects in terms of taking on more staff and building additional physical plant and equipment. Again, taxi cab companies would have to acquire more taxis and Walmart would have to open more stores, all of which is very tangible. By contrast, in the new intangible economy, companies will expand and contract more quickly as many more firms vie to be the winner in the race to create and monetize intangible assets. And the cost of entry is much lower, so new sectors could have many more firms for investors to consider at early stages than in previous generations.
Heinel. I agree that these companies present new challenges around valuing intangibles. Because we are still in the early stages of understanding how to account for them, I think there are significant opportunities for active managers to identify mispricings.
Our equity investors are already adjusting the way they value tech and healthcare companies, precisely because of the role of intangible assets. They have created a new, proprietary research and development (R&D) factor for their valuation models to account for the IP inherent in software or drug development in a more nuanced way. For example, in the case of pharmaceutical or biotech companies, the long-term nature of drug development means that the value of the IP varies according to what stage of development the compound is in. It is a much more complex analysis than the traditional depreciation models of physical assets.
Desai. I also think the rise of these intangible-driven companies is going to lead to far-reaching changes in global tax policies. Tech companies like Google and Facebook are already coming under pressure from European countries who are pushing back on their protestations that they earn no revenue in their countries. It’s a big problem, and one that I think will drive the shift toward a destination-driven taxation system, because consumption is the one variable that you can’t easily move somewhere else.
Globally the trend is to make all the tax regimes destination-based, so tax consumption rather than income. In a digital economy it is unclear where income is being generated so the system is unstable.
As intangibles grow, we’ll move toward a destination-based system in which consumption is taxed. I imagine that the US will have some form of consumption taxation in the next 10 years.
Heinel. In the meantime, however, it sounds as if we are likely to have an unstable global tax system with a range of uncertain outcomes. This might be another promising area for skilled managers to understand the intricacies of the interim system and, more importantly, discern how that will affect capital allocation decisions for companies across sectors and regions as well as their ability to generate strong, long-term earnings for their investors.