Major United States tax code overhauls are rare events, as they tend to occur only once every two or three decades. The recently enacted $1.5 trillion bill, with its substantial business tax cuts and moderate reductions in individuals’ tax burdens, is the most sweeping since the Reagan era. From our vantage point, the changes will be positive for the U.S. economy and equity market.
Key benefits for equity investors include:
- U.S. GDP should rise roughly half a percentage point more than it would have for at least the next two years, according to our economists. For example, instead of GDP growing by 2.5%, it could grow by 3.0% annually.
- The S&P 500 and other major indexes should see a meaningful boost in earnings growth.
- Industries with a large share of domestic revenues and high capital spending levels should capture the greatest incremental increases in free cash flow.
- Small-capitalization public companies and small private firms should see the biggest declines in tax rates as they previously paid the highest effective rates.
- The provision that allows companies to immediately deduct 100% of certain business expenses seems underappreciated. This can provide a big boost to cash flow.
- Momentum for business capital spending — a key component of GDP — should improve due to immediate deductibility.
- U.S.-based multinational firms that had high tax rates will be able to compete more effectively with low-taxed foreign rivals.
- Many companies will likely use the extra cash flow to initiate or increase stock buybacks, hike dividends, embark on acquisitions, and/or grow their businesses by other means — all of which can be positive for shareholders.
Market gets a head start
Some of this good news is likely priced into the stock market. It is well known for incorporating positive developments ahead of time, especially when they are well telegraphed, and this is no exception.
For example, as it became clearer the tax package could become a reality, the S&P 500 surged 5.0% from mid-November through the latter part of December just before the bill passed both chambers of Congress. Additionally, the market’s jump immediately following the 2016 presidential election was partly due to optimism about tax cuts and the Trump administration’s other pro-growth initiatives.
Yearning for higher earnings
Even though the tax cut bill has already helped push the U.S. equity market higher, its full effect may not be completely factored in.
The positive corporate profits and cash flow impacts — the meat on the bones of the tax cut package — won’t become fully visible until companies begin to incorporate the tax code changes into their 2018 earnings estimates. These upward earnings adjustments are not yet completely embedded into the consensus forecast, in our view, and therefore the positive impact on profits may not be totally discounted by the market.
Instead of the S&P 500 growing earnings at our 7.5% y/y estimated rate without tax cuts, we anticipate profits could expand 14%–18% or more with tax cuts in 2018. This higher growth range would represent $149–$155 per share in earnings, above the current $147 consensus forecast compiled by Thomson Reuters I/B/E/S. But the consensus forecast could end up rising even higher — potentially up to $160 per share, according to our national research correspondent.
S&P 500 annual earnings per share and estimates in USD
Source - Thomson Reuters I/B/E/S, RBC Wealth Management; 2017 and 2018 light gray data represent current consensus estimates
Earnings growth could jump meaningfully in 2018 because the corporate tax rate has been slashed substantially to 21% from 35%. This takes the U.S. from nearly the highest statutory rate in the world (only a handful of tiny economies have higher rates) to a rate well below the G7 and G20 averages, slightly below the European Union, and just a tad above the Asia average, according to the Tax Foundation.
If higher earnings growth pans out as we anticipate or is even stronger, it could push the market’s valuation down to a more reasonable level (see table below). In any of these scenarios, the market’s valuation would have room to expand in 2018 and potentially beyond, which is supportive of stock prices.
Forward price-to-earnings (P/E) scenarios based on full-year 2018 earnings estimates
Source - RBC Wealth Management, Thomson Reuters I/B/E/S; data based on S&P 500 closing price of 2,673.61 on 12/29/17
Domestically focused industries, small-cap firms, and companies with high capital spending could see their tax rates drop and cash flows increase by the greatest magnitudes.
Among large-cap companies, many are in the retailing, telecommunications, industrials, utilities, and financials industries, and the list goes on.
Effective tax rates of select industry groups (before tax cuts)
Source - National research correspondent, Thomson Financial, FactSet, Standard & Poor’s; data based on 3-year trailing dollar weighted effective tax rate; data through 12/29/17
For example, without tax cuts, bank industry earnings seemed set to rise roughly 9% y/y in 2018. But with tax cuts, RBC Capital Markets believes the average growth rate could jump to 15%–19%.
As companies adjust their 2018 forecasts for tax cut benefits in coming months, investors will have a better picture of the biggest potential winners.
Concerns in the out-years
Even with all of the benefits for companies and equity investors, we would be remiss not to acknowledge the tax cut package is no panacea.
It could end up adding a trillion or so dollars to the national debt over time — a manageable, but still unwelcome amount given the federal debt-to-GDP ratio already ranges from 77% to 104%, depending on how it’s calculated.
The tax cut package probably won’t solve the country’s wage growth or income disparity challenges in one fell swoop. Wages have been drifting moderately higher recently, but our U.S. economist doesn’t expect the corporate tax cuts to drastically change the trajectory.
The tax reforms include some provisions that create uncertainties, or could turn out to be negative, for high-income taxpayers in high-tax states. While the legislation minimized the pain of the alternative minimum tax, at this stage it’s unclear if that will fully or only partially offset the loss of a portion of state, local, and property tax deductions for these taxpayers, or if states can develop “workarounds.”
Some economists are questioning or criticizing the timing of the tax cuts. They argue that fiscal stimulus of this magnitude should come when the economy is struggling or attempting to gain its footing, not when it is at the strongest of the recovery cycle like now. While we are sympathetic of this theoretical argument, we are less bothered by the timing because the GDP growth trajectory of this recovery cycle is much lower than normal and the tax cut stimulus may not even push the economy back to the strong GDP growth rates reached in previous recoveries.
More troubling to us, the benefits of this tax bill could unwind in the out-years. A number of the provisions are temporary so they would need to be reauthorized by a future Congress and president or they will expire. If lawmakers are unwilling, tax cut tailwinds could become tax hike headwinds over time.
Lower taxes, higher expectations
Even with the bill’s shortcomings, we cannot ignore the fact that the most significant tax cut package in 31 years has been enacted into law, a meaningful portion of which should benefit publicly traded companies. The earnings and dividend streams of U.S. companies seem set to rise due to tax cuts and the economy’s underlying strength. The legislation should add to an already improving economic foundation and provide U.S.-based companies with additional flexibility to grow their businesses, compete globally, and prosper — to the benefit of employees and shareholders.
The material contained herein is for informational purposes only and does not constitute tax advice. Given that RBC Wealth Management does not provide tax or legal advice, clients should consult with a qualified tax advisor or attorney with regard to their personal tax situation.