What Do US Tax Cuts Mean for Global Investors?
Recent tax reform in the US will have far-reaching consequences for both US and foreign companies. Which sectors will benefit — and which will lose out?
The tax reform recently enacted in the US has been billed as the most comprehensive since the 1980s, with far-reaching consequences for US companies and their foreign counterparts. As companies can no longer rely on central banks to provide liquidity in an age of gradual policy normalization, catalysts such as changes in global tax regimes will exert a stronger influence on corporate performance. Given the complexities and uncertainties of the new system (discussed in our investment roundtable), an assessment of the impact of these reforms can be only preliminary. Nonetheless, our researchers found that some sectors will derive significant long-term benefits, others will lose out and the overall economic impact could be modest.
There should, however, be substantial rewards for those companies that were previously highly taxed and that have strong balance sheets and large amounts of offshore cash to repatriate. In our view, the impact of the tax changes on these companies and the likely pick-up in M&A and share buybacks are underestimated by the market, creating the potential for outperformance.
More Competitive Tax Rate but Modest Economic Impact
The US has long had one of the highest corporate tax rates in the world despite a number of overhauls. Figure 1 shows how the US corporate tax rate has changed over time compared to the rest of the world.
While the tax reforms have made the US more competitive versus global peers, its corporate tax rate still exceeds the global average rate. However, its marginal effective tax rate (METR),1 previously among the highest in the world, should now moderate in line with a global downward trend in corporation tax since the financial crisis (Figure 2). At lower taxation levels, companies are more likely to make investments at the margin that would have been dismissed under the previous regime.
The overall economic impact, however, is likely to be modest. A 2016 paper by Ljunqvist and Smolyansky found little evidence that corporate tax cuts between 1970 and 2010 led to more jobs or higher incomes, except during deep recessions.2 Conversely, it found that tax increases had led to significant decreases in employment and income levels. Recent estimates by the Tax Foundation and broker research suggest US GDP growth will be 0.3% to 0.4% higher a year, post the tax reforms. The January 2018 World Economic Outlook of the International Monetary Fund (IMF) is more optimistic, expecting a higher annual projected increase in US GDP growth of 1.2% by 2020.
Increase in Share Buybacks and M&A
One of the most anticipated effects of the tax reforms is that US multinationals will no longer suffer from the "lockout effect" — holding cash within foreign affiliates to avoid paying taxes when offshore profits are remitted to the US.3 US companies now hold USD 2 trillion of profits offshore; eight technology companies alone, including Microsoft, Apple and Google, hold over USD 400 billion. However, it is unclear how much will actually be repatriated. US companies are not generally short of cash and the tax reforms do not address all the inefficiencies of the current system, so there may be fewer immediate effects on investment or employment than expected. Consensus estimates for capital expenditure are up 3% since the changes were announced.4 But, in our view, it is too early to make realistic estimates as to how any incremental cash from the reforms might be allocated as we are likely to see a mix of uses.
According to a report by Dharmapala, Foley and Forbes (2011), however, repatriation can increase the likelihood of share repurchases, which are more common in the US than elsewhere. Some commentators are predicting buybacks could top $1 trillion in 2018,5 while the S&P 500 Buyback Index has outperformed the main S&P 500 this year.6
We could also see a pick-up in M&A. Following tax reform in Japan, for example, there was a 32% increase in M&A transactions. Moreover, many US companies held back on M&A in 2017, articularly in pharmaceuticals, waiting for greater clarity on tax reform. They may now revive those plans. Other sectors, such as technology, that did not pause in 2017 may see activity accelerate and potentially larger transactions in 2018.
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In our view, it is too early to make realistic estimates as to how any incremental cash from the reforms might be allocated as we are likely to see a mix of uses.
While complex tax reforms often have unforeseen consequences and will affect individual companies differently, we believe there are likely to be winners and losers in the equity market. Our active quantitative equity (AQE) team has designed a model to assess the impact of the changes on different sectors. It gives each company in the Russell 3000 a tax score,7 groups them into industries and takes the median score for the set. It also gives each company an alpha score8 — an estimate of how it will perform in the near future — and plots that against the tax score (Figure 3).
The AQE team believes that industries such as retail in the top right quadrant of this figure, with high tax and high alpha scores, should benefit most from the new tax regime. In particular, the highest tax-paying consumer-focused industries, given their quality balance sheets and cheaper valuations, are likely to be winners in a lower tax regime, alongside transport and professional services. On the flip side, industries that screen poorly on the team’s alpha model, like biotechnology and energy, and pay the lowest taxes, stand to gain little and are likely to underperform going forward.
In addition, the ability to expense capital expenditure immediately should benefit capital intensive industries such as railroads, airlines and manufacturing of heavy machinery and electrical equipment. Meanwhile, the lowering of mortgage interest deductions and the cap on state and local taxes, particularly in high tax states such as California and New York, could adversely influence the real estate sector.
Our AQE team looks at three main factors when assessing which stocks to include in its portfolio: quality, value and sentiment. The team finds a positive relationship between companies’ profitability and their effective tax rates, and that less leveraged companies, which do not benefit from tax shields, pay higher rates. Given such companies typically have better balance sheets and are more profitable, the team concludes that tax reform should favor the quality factor. Additionally, they find a positive relationship between the value factor and tax rates, as the higher taxed companies are, on average, more attractively priced than those paying less tax. As regards sentiment, using a proxy of forecasted earnings trends across companies with different tax rates, the team finds little evidence of any meaningful relationship, suggesting that the market has yet to fully digest these reforms and factor them into eparnings upgrades or downgrades. Such mispricing offers the potential for excess returns.
The highest tax-paying consumer-focused industries, given their quality balance sheets and cheaper valuations, are likely to be winners in a lower tax regime, alongside transport and professional services.
Sovereigns. The US Congressional Budget Office (CBO) estimates that the tax reforms will increase the deficit by roughly USD 1.5 trillion over the next 10 years. In concert with the Federal Reserve’s (Fed's) ongoing balance sheet reduction, this could lead to a big expansion in Treasury supply and cause further rises in longer-term US government bond yields such as the 10-year rate,9 pushing up the cost of borrowing for companies. The overall fiscal stimulus could lead to higher tax receipts over the long term, though, as we have seen above, tax cuts alone do not appear to drive economic growth.
Investment Grade. Despite the potential for higher government bond yields, a lower tax rate should be moderately positive for investment grade bonds and we expect to see spreads over Treasuries narrow. As with equities, so with bonds; different companies will win or lose depending on their situations. However, using Internal Revenue Service (IRS) data, Longstaff and Strebulaev (2014)10 found a direct relationship between changes in corporate leverage and changes in corporate tax rates for all except the smallest firms, and that an increase in corporate leverage over time influences corporate capital structure.
Higher after-tax profitability should enable companies to reduce their debt levels, better service their existing commitments and avoid taking on new debt to fund growth. However, we expect the impact on overall financial leverage to be limited. Our fixed income team estimates that, assuming 25% of tax-reform-related incremental cash (excluding repatriation flows) is used to pay down debt, corporate bond spreads over Treasuries will narrow by slightly more than two basis points by the end of 2018 for the industrial component of the Bloomberg Barclays US Credit Index.
Repatriated cash, however, may be net negative for credit if the money is used for share repurchases or M&A and cash cushions are reduced.11 Also, more M&A could lead to greater supply of bonds, alongside cash, to finance deals. The new interest expense deductibility limits are not a material negative factor for investment grade companies in the near term, in our view, and will only have a mild impact on bond supply over the long term.
Financials are likely to be among the winners in the credit space. They tend to pay higher effective tax rates than their industrial counterparts, due to a lack of tax-based incentives and depreciating assets that may be used to reduce tax. So the tax rate reduction should flow directly to the bottom line, making additional funds available for investment in operations or distribution to shareholders; regulations make it unlikely to be used to reduce debt. They will have to write off deferred tax assets, which will hurt short-term profits, but this should be offset by other changes over the long term.
Utilities are likely to be significant losers, because they generally pass through the corporate tax rate to customers, while paying little tax themselves. This difference, which is accounted for as deferred taxes, is a material benefit to utilities’ cash-flow measures and will now decrease with the lower rate. In our view, some utilities will have sufficient levers to manage this transition, while others could see their credit rating downgraded.
Municipal Bonds. Municipal bonds should gain from the tax changes in aggregate. The tax-free nature of muni coupons means retail demand for them is likely to increase in high-tax states where local taxation is now capped at USD 10,000 per annum and more people will be looking for ways to reduce their taxable income. Institutional demand on balance is likely to be negative, as demand from banks and insurers will decrease due to the lower corporate tax rate. However, this could be partially offset if Congress designates munis as High-Quality Liquid Assets (HQLA) later this year. If designated as HQLA, munis would become more valuable to banks in their liquidity calculation requirements for regulators.
We expect the muni supply to decrease by approximately 15% as the bonds can no longer be "advance refunded." This means municipal issuers will now only be able to refinance their bonds after their call dates, as opposed to at any time after they had issued them, which had previously been the case. Historically, call dates have been set for 10 years after a bond was issued. We expect the elimination of advance refunding to cause issuers to gradually alter bond structures to include shorter call dates, shorter maturities and lower coupons or instead to issue taxable "advance refunding" bonds.12
In our increasingly technology-driven and globalized world, the US tax changes are likely to make the country a more competitive place to do business. However, the complexity of the reforms and their failure to tackle more of the inefficiencies of the previous tax code means the long-term economic impact may be limited, especially at this point in the business cycle. Management teams will have more choices when it comes to allocating capital and trying to balance credit-friendly actions with shareholder awards, so security selection is likely to become more important to equity and bondholders alike. Certain sectors will benefit more than others, and until the market prices in the full impact of the reforms, including secondary effects around the world, this should create harvestable value for investors.
With contributions from State Street Active Quantitative Equity and Credit Strategies teams