Asset Class Implications from the new US Tax Bill
By Doug Cohen, Managing Director, Portfolio Management
The broadest tax overhaul in thirty years is now advancing toward being signed into law. This bill is significant for financial markets, as it lowers tax rates for both households and businesses and is likely to provide a boost to the US economy and corporate earnings. However, not all asset classes will react equally to the impending changes. Here’s what we expect the implications of the new tax bill to be on the markets over the course of the next year.
Most Wall Street strategists expect the corporate tax cut to increase S&P 500 earnings anywhere from 5% to 9% in 2018, on top of the 8% to 10% earnings growth that was already embedded in consensus forecasts. Of course, equity prices are influenced by so many variables that there is no way to definitively determine how much of the boost to earnings from tax reform has already been factored into stock prices. That said, many investors did not expect the GOP-led Congress to successfully implement their tax agenda after they failed to overhaul the Affordable Care Act in late September. The S&P 500 has rallied by 8% since then, with stocks of companies that stand to benefit the most from the new tax bill dramatically outperforming those with more limited benefits. So the old market adage, “buy the rumor, sell the news”—at least in relation to tax reform—may apply.
From a broader equity perspective, we believe there are some clear benefits from the new tax bill. Most notably, US corporations will now be on a far more level tax-related playing field on a global basis. Industries with a decidedly US orientation, such as telecom, retail, and financials, also stand to benefit from the lower corporate rate. Conversely, it is important to note that this is an unusual time for a major tax cut in that we are currently in the midst of a strong synchronous global expansion with historically low US unemployment levels. Most independent analyses indicate that passage of the bill will have a deleterious impact on the US debt, with the impact becoming more acute three to five years in the future.
Market bulls will plausibly argue that the tax cuts will help to sustain the animal spirits that appear to have taken root in some parts of the domestic and global economy. We would certainly acknowledge that possibility, but also warn that sustained 3% or more domestic economic growth could lead the Federal Reserve to expedite its tightening process at a time when valuations are near historical highs on most conventional metrics and several global central banks appear poised to join the US in starting to withdraw the unprecedented liquidity injected into the global economy since the financial crisis. It is not our base case, but the combination of significantly higher inflation due to stronger economic growth and higher interest rates would almost undoubtedly pose a major risk to the ongoing bull-run.
Unlike equities,credit markets have been relatively indifferent to the tax bill. Limitations on interest deductibility will be a net negative for lower credit quality companies, though this will be partly offset by lower corporate taxes and the ability to fully deduct capital expenditures. Given the benign credit environment, companies are more likely to distribute proceeds from the tax bill to shareholders through dividends and share buybacks rather than reduce leverage. The debt of retail companies, which has been a negative outlier in 2017, is likely to gain support from the tax bill as those companies are expected to receive a substantial tax cut.
The reduced deductibility of state and local property taxes, in our opinion, is a clear potential blow to high tax states (in particular, California, Connecticut, Illinois, Massachusetts, New Jersey, and New York), many of which were already losing ground on an economic basis to lower tax states such as Texas and Florida. The impact could include reduced tax receipts, lower real estate prices, and an exodus of some businesses and wealthy families to lower tax states. It could also pressure those states to reduce their tax rates, at least over time, in order to become more competitive with other states.
From a municipal bond perspective, the aforementioned elements could result in diminished creditworthiness for higher tax states, some of which already face fiscal challenges. The reduction in the mortgage interest deduction could reduce housing demand and eventually flow through to lower property tax collections, which would be negative for local general obligation bonds. Also, the reduction in the corporate tax rate may reduce demand from corporations, banks, and insurers (about 30% of cumulative municipal bond demand), although this should not prove overly material as much of the demand is driven by asset-liability matching and regulations surrounding capital requirements.
On balance, however, municipal bonds should retain the vast majority of their prior appeal despite the modest reduction in the top federal marginal tax rate (historically there is only a very small correlation between municipal bond performance and changes in the top tax rate). Given the new state and local tax (SALT) limits, we believe municipal bonds exempt from state and local taxes in high tax states will be increasingly attractive to potential buyers. Early speculation regarding the imposition of limitations on municipal bond interest exemptions proved unfounded. Nor were there any changes toward the treatment of private activity bonds. Municipal bonds that are currently subject to the Alternative Minimum Tax (AMT) will have additional appeal to investors when they are no longer required to pay AMT.
We believe the tax bill has several favorable elements for private equity and also some clear negatives. The reduction in the corporate tax rate is a clear positive—more than offsetting the more limited interest deductibility for companies with low to moderate debt levels. Moreover, the shift to a territorial system will result in lower taxes on repatriated funds from overseas—with a greater potential for share buybacks and dividends over time. Finally, the immediate expensing on many capital expenditures will help earnings and encourage growth.
The notable potential negative for private equity, in our opinion, is that the limitations on the deductibility of interest expense will likely put additional pressure on more heavily indebted companies, especially during a cyclical downturn. As such, we expect private equity firms are likely to pull back a bit on new investments in more cyclically-oriented industries. More broadly, all else equal, private equity would face additional pressure in refinancing these companies if interest rates move significantly higher.
In terms of real estate investments, we believe, office real estate should benefit from generally lower tax rates. Residential real estate will be hurt by the reduction in mortgage interest expense deductibility from $1 million to $750,000, particularly in higher tax states where the $10,000 SALT provision will have a more pronounced impact. At the margin, this should favor renters over owners. Industrial real estate, already benefiting from e-commerce related tailwinds, should benefit further from the more favorable capital expenditure expensing provisions. Finally, the recently beleaguered “brick and mortar” retailers should have an outsized benefit as they currently pay taxes at very close to the peak 35% corporate rate. Note that while REITs pay very little of their income at the corporate rate, they will likely benefit meaningfully from the lower pass-through provisions.
In our opinion, most energy companies should benefit from the combination of the lower US corporate rate and enhanced capital expense deductions, partially offset by the more limited interest deduction. The impact is likely to be more mixed for a Master Limited Partnership (MLP). Some MLP’s should benefit from a lower pass-through rate at the individual level from a cash flow perspective. However, that advantage may be offset from an equity market trading standpoint as the gap between traditional MLP tax structures and more conventional C-corps has narrowed. Some MLP’s may find the more simplified corporate structure to be more advantageous. Indeed, several prominent MLP’s have converted to a corporate structure even prior to tax reform.
Athena Capital Advisors LLC (“Athena”) does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on, for tax, legal or accounting advice. Clients should consult their personal tax, legal and accounting advisors for advice before engaging in any transaction.