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The Chief Investment Office takes a look at the economy nine months after the Tax Cuts and Jobs Act was signed into law
Head of CIO Portfolio Strategy
CFA®, Vice President,Investment Strategist
It has been nine months since the Tax Cuts and Jobs Act (the “Act”) was signed into law. Since that point, tax paying citizens, investors and companies alike have done their best to navigate the legislation and some results have begun to take shape. Observers are keenly poring over the data flow to gain a better understanding of how tax reform is affecting the macroeconomic landscape and capital markets. After all, comprehensive tax reform has been a battleground issue in the political arena for decades, with many stakeholders offering alternative viewpoints on what the implications would be. Now that the legislation is in the books the time to keep score has come.
In particular, seven observations stand out to us as they pertain to the ultimate efficacy of tax reform. These range from the impact felt by consumers, to businesses, to the international community, and to various layers of the government. In the sections to follow, we will detail these early inferences and preliminary impacts. While the implications for this tax
legislation are by no means set in stone, and the results over nine months may not be prudently extrapolated over a longer timeframe, we find it a useful exercise to examine the early feedback. The capital markets have reacted to this legislation in many forms, and it is reasonable to expect further market movement as expectations continue to be recalibrated. As such, we remain attentive.
One of the more immediate and noticeable effects of tax reform has been to make many U.S. businesses more competitive on the global stage. Corporate tax rates for other major economies around the world had been trending lower over the past two decades, leaving the U.S. as a clear outlier and placing its companies at a competitive disadvantage. The Act realigned the U.S. with other major global economies, by lowering the corporate tax rate from 35% to 21%. Under the current administration, tax reform, in conjunction with other pro-business fiscal and regulatory policies, has helped to spur investment in the U.S. to drive profits, hiring and economic growth. For instance, a prominent technology company announced plans in January to increase investment in its U.S. operations, including over $30 billion in capital expenditures over the next five years and over 20,000 new jobs. We expect this trend to continue as companies take advantage of a more business-friendly environment here in the U.S.
What’s more, as economic growth in the U.S. picks up relative to its global peers, other governments have been compelled to implement more pro-growth fiscal policy. A key example that we see today is China, which amid its economic slowdown and concerns over global trade tension has reportedly announced individual income tax cuts of 510 billion yuan ($75 billion), according to Evercore ISI. The government is following the U.S.’s lead on a more pro-growth fiscal policy, increasing export tax rebates amid the global trade tension as well and helping support Chinese banks that lend to small businesses.
The 2017 narrative of synchronized global growth has shifted into a U.S.-led economic expansion driven by pro-growth fiscal policy. Tax reform has provided a boost to the U.S. economy, making it more competitive and resilient in the face of global trade tensions; reflected in strong economic data as well as strong relative performance of U.S. equities versus the rest of the world.
The cornerstone of the strength in U.S. equities recently has been the pickup in corporate earnings growth, especially following the passage of tax reform last December. After a solid year of 11% growth in 2017, earnings are expected to surge 23% in 2018, according to FactSet. Not all of the growth has been from a lower tax rate, however, as sales growth was about 10% for Q2, with corporations benefitting from robust consumer spending, higher commodity prices and demand for capital goods and equipment.
Tax reform led to a surge in the three-month S&P 500 earnings estimate revision ratio at the beginning of 2018, which has moderated slightly since but currently remains strong at 1.27 and indicates more earnings estimate upgrades than downgrades across most sectors. A strong economic backdrop aided by pro-growth fiscal policy has contributed to rising earnings expectations for 2018 for the U.S. in contrast with declines elsewhere such as Europe and Emerging Markets, indicating that U.S. equity relative outperformance has the potential to continue, in our view.
Amid strong nominal growth in gross domestic product (GDP) aided by tax reform in the U.S., modest growth in wages and unit labor costs, and a cautious approach to raising rates by the Federal Reserve, we expect solid earnings growth over the next year to continue to support U.S. equity performance.
The Act has induced a flood of previously undistributed and untaxed corporate profits into the U.S. tax system through a process known as deemed repatriation. This one-time mandatory toll placed an effective tax levy of 15.5% on overseas cash held by U.S. corporations and, in our opinion, should prove enduring as the American tax regime transitioned towards a territorial system in concert with the overwhelming majority of the international community. The forced nature of this exercise paired with the comprehensive overhaul of the tax system represents a stark departure from the last episode of repatriation, which came in the form of a 5.25% optional tax holiday offered to companies across 2005-2006. According to the Tax Foundation, roughly $312 billion of deferred income was brought stateside during that period.
Corporate caches of unremitted foreign profits have become substantial, reaching an estimated $2.6 trillion prior to tax reform, according to Strategas Research Partners. Approximately 65% of this is cash that is thought to be available for repatriation. The results of new policy have been swift and significant, with the Bureau of Economic Analysis calculating $464 billion of repatriated earnings during the first half of 2018. Quite simply, companies are bringing cash back stateside at a very impressive clip.
The implications of these inflows are vast as they pertain to fiscal budgets, deployment of corporate cash and capital market dynamics. In fact, the conversion of foreign-denominated profits back into dollars to be repatriated has most likely influenced the dollar’s strength in the first half of 2018. While it will be difficult to sustain the surging flow of remittance from abroad, the markets and macroeconomic landscape may continue to benefit from what remains of foreign-held earnings and what is to come from new profits earned abroad.
The weight of evidence suggests that corporate coffers are stuffed. A triumvirate of earnings from those retained, those repatriated, and those newly created have sourced bulging cash positions with companies seeking out efficient means for deployment of this capital. According to S&P Global, U.S. companies held a record $2.1 trillion of cash in June, although approximately half of that amount is held by the top 1% of companies. The popular narrative has focused on share buybacks commandeering the lion’s share of the cash stockpile, but the reality is more varied. Companies are also engaging in significant levels of debt repayment, pension funding and mergers & acquisition (M&A) activity.
A savvy curator of financial media would be well aware of the simmering war of words between proponents and opponents of share repurchases. The post-tax reform debate has been supercharged as approximately 79% of cash repatriated following the Homeland Investment Act of 2004 was earmarked for buybacks1 and critics expect a similar experience this time around. Buyback antagonists espouse concern that corporations are enriching the executive and shareholder class at the expense of workers, prudent expansion and the greater economy. Proponents counter that buybacks have not precluded companies from productive investment, as cheap capital has been plentiful in case internal rate of return (IRR)-positive opportunities present themselves, while retiring shares represents a tax-efficient means for returning value to shareholders. While first half buybacks are higher by 50% year-over-year at $379.7 billion, led by Technology, Financials and Health Care,2 U.S. corporations are also increasingly looking to fund growth through M&A.
Nominal deal value has ratcheted back up to levels last seen in 2000 and 2007, giving pause to some market observers who cite this occurrence as leading evidence for market excess or an eventual pullback. Year-to-date, over $1.1 trillion and 7,500 deals have been completed or are pending within the U.S.3 However, while the total value of M&A activity rivals previous market peaks, the value as a percent of S&P 500 market cap remains much more modest, with completed and pending deal value standing at around 4.5%. There is a belief within some circles that corporate action may be backlogged as companies await regulatory signals from recent high-profile deals filtering through the federal approval process. Further clarity on the regulatory front could unleash more M&A activity.
Finally, U.S. companies are using their cash windfall to shore up their balance sheets. After nearly a decade of cheap capital the window is beginning to close and the costs associated with borrowing are rising. As a result, many companies are taking this opportunity to trim their liabilities by paying down debt. Aside from the cash influx prompted by tax reform, certain provisions within the legislation also shift tax incentives and are helping to direct cash flows. The deduction of interest expense has been limited, thereby reducing the economic benefit of carrying a certain level of debt. Better cash flows also mean that corporations are less reliant on debt capital markets, as year-to-date bond issuance by non-financial corporations is down 28% year-over-year, according to the Federal Reserve.
Furthermore, while the corporate tax rate has been reduced from 35% to 21%, companies were allowed to deduct their pension contributions at the higher rate of 35% till September 15th, incentivizing them to accelerate pension contributions before this date. According to Wolfe Research, Russell 3000 companies could contribute $90 billion to pension plans this year before the deadline, up from $81 billion last year. It is noteworthy that the aggregate funded status of pension liabilities has dramatically improved in recent years as S&P 500 obligations are now funded at 90% after dipping below 76% in 2016.4
A host of factors such as solid global growth, higher commodity prices, rising capacity utilization and strong consumer spending led to a pickup in business spending that began towards the end of 2016. The Act added additional fuel to the fire by allowing firms to expense their investment in qualified property, and by stimulating final demand across a number of end markets by lowering corporate taxes and marginal personal tax rates.
For S&P 500 companies, the recovery in capital investment is in full swing, with second quarter capital expenditures (“capex”) up by 24% (the fastest since 2011, led by technology and energy companies), following first quarter growth of 21%.5 This pickup is consistent with rising capital expenditures across the broader economy, as manufacturers’ shipments of core capital goods (non-defense capital goods excluding aircraft) have been growing by around 7% year-over-year over the past 12 months.
As economic growth has picked up and firms benefit from the pro-growth policies of the current administration, business sentiment has continued to strengthen. Throughout the early stages of the current cycle, business sentiment remained in recession-type territory as the relatively weak nature of the economic recovery following the Great Recession meant companies lacked optimism that the economy was going to improve and were thus reluctant to invest money in capital equipment. This changed after the 2016 election, which led to a surge in business confidence as companies anticipated that pro-business fiscal policy from a Republican administration and Congress would lead to a surge in economic growth.
Still, however, under the previous tax regime companies had continued to report that one of their primary concerns was the level of taxes they pay. Following the passage of tax reform, focus has shifted to the quality of labor as they face increased labor shortages, with job openings in the U.S. reaching 6.9 million in July, the highest level on record. Companies are shifting their attention to optimizing the productivity and efficiency of their workforce, which we believe would support continued demand for capital equipment.
One of the concerns among market commentators and political pundits has been that the effects of tax reform would be short-lived and that the pickup in capex would quickly dissipate. On the contrary, economic data remain consistent with solid investment growth going forward. For example, in the August Small Business Economic Trends survey from the National Federation of Independent Business (NFIB), the percent of companies planning to make capital expenditures over the next 3-6 months was at its highest level in over a decade. Further evidence came from the Institute for Supply Management’s Semiannual Economic Forecast in May, which noted manufacturing survey respondents expected 10.1% growth in capital expenditures for 2018, up from 2.7% in December of last year.
Continued strength in capital spending resulting from tax reform should support a pickup in productivity growth, helping to restrain unit labor costs and potentially extending the current economic cycle.
Corporations were not the only beneficiaries of the Act, as a reduction in marginal tax rates on personal income as well as higher child tax credits has helped to support consumer confidence and spending. Estimates from Strategas indicate that taxes were cut for 90%-95% of the population, totaling $120 billion, similar to giving almost every worker in the U.S. a 3% raise.
The data suggest that this cash windfall is being put to work, as real personal consumption expenditures rose by 3.8% in the second quarter, contributing 2.6 percentage points of the 4.2% rise in real gross domestic product (“GDP”). Amid healthy balance sheets in the household sector (with the financial obligations ratio close to a record low) and strong consumer confidence, the tax savings for consumers should continue to provide in less or equal than that projected by the Congressional Budget Office in its August 2003 report. Higher than expected growth and revenues were credited for the difference.
Frequent adjustment of estimations are neither new nor are they surprising. The CBO itself has laudably acknowledged the difficulty and variability of its projections. For example, in 2012 the nonpartisan group published a report examining how and why its baseline projections for 2001 showed a cumulative surplus of $5.6 trillion for the 2002-2011 period, however a cumulative deficit accrued over that period totaling $6.1 trillion, a staggering variance of nearly $12 trillion from initial estimates. Clearly, projecting policy and economics far into dynamic times is incredibly difficult and path-dependent. As feedback data from the most recent tax legislation continues to flow it should be expected that the forecasting agencies will also alter their estimates, perhaps substantially.
To that end, some positive feedback has already begun to filter through and prompt revisions to the recent Act. In April, the CBO revised its baseline revenue estimates, which now reflect $42 trillion in tax revenues collected over the next 10 years, a shortfall of “just” $1 trillion, due in part to the effects of tax reform. Individual tax receipts have shown promise, registering a 4% year-over-year increase ($105 billion) for the first 11 months of fiscal year 2018. Therefore, while the loss of tax revenues is significant, it is noteworthy that the forecasted amount of this decline in revenue has already been blunted by approximately $440 billion. Greater than expected flows of repatriated capital, increased capital gains revenue,6 or more taxable transactional activity7 can pair with stronger growth to contribute more tax revenue than expected to federal, state and municipal coffers.
Furthermore, current real and nominal GDP growth assumptions for the next decade stand at 1.9% and 4.0%, respectively. We believe both figures could be short of realized growth this year and may be upgraded going forward. In fact, the CBO has recently revised upwards nearly $6 trillion of nominal GDP growth across the preceding decade, owing to an average boost of 0.7% each year. While it is painful to justify any expansion of an already bloated federal budget, the real cost of tax reform may be less onerous than once expected, especially if the economy continues to expand at an impressive clip.
Surprise! The early effects of tax reform fall short of the loftiest projections but far exceed the most pessimistic estimations. The tax legislation has yet to pay for itself and productivity growth has not solved all of our economic challenges. However, we have seen encouraging corporate and consumer behavior that has bolstered the current expansion and may extend the cycle beyond consensus expectations. As we progress into the later portion of the year and move into 2019 and beyond, the fiscal effects from tax reform should continue to provide a stimulant to growth, in our view.
1Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes: “Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act”, NBER, 2009
2Yardeni Research, “Stock Market Indicators.” September 25, 2018.
3Bloomberg. September 21, 2018.
4Aon Pension Risk Tracker. September 21, 2018
5BofA Merrill Lynch Global Research “Earnings Season Update.” August 6, 2018. Preliminary as of 406 S&P 500 companies reporting.
6Greater macroeconomic growth and company-specific earnings potential often contributes to rising share prices. In addition, a decrease in tax-policy uncertainty may induce investors to implement taxable market events that they otherwise were delaying during periods of policy flux. The combined result of taxable events being brought forward with greater gains would enhance tax revenues.
7A more accommodative policy backdrop in addition to more certainty can spur taxable corporate action such as dividends, mergers, and acquisitions.
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