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We would not seek to position portfolios specifically for tax reform as markets have already priced in some improvement in earnings from tax cuts, and the winners and losers from the proposed tax changes will not be clear until more details are provided. Global cyclical and value stocks offer better risk/reward prospects as they should benefit if tax reforms are passed, but are not reliant on such an outcome.
As President Trump’s agenda has been slow to materialize and the Republican majority has proven to be splintered, markets that had priced in expectations for US tax reform after the US presidential election had gone round trip by late summer. In recent weeks, the tax reform trade has resurfaced, following the release of a tax reform proposal in late September by members of the Trump administration and top Republican house and senate leaders, the so-called Big Six.
The details of the tax proposal matter, but have not yet been sufficiently laid out. For example, questions surround the treatment of taxation of intellectual property, which could disproportionately penalize technology and pharmaceutical companies.
Perhaps the biggest question for US multinationals is the tax treatment of foreign revenue. The proposal indicates that the United States will transition to a territorial tax system. In theory, this is favorable, as today corporations are required to pay higher US tax rates on global earnings than most foreign competitors.
Under territorial tax systems, corporations’ foreign profits are typically not taxed. However, the proposal indicates that it would seek to protect erosion of the US tax base by taxing foreign profits of US corporations at a reduced tax rate to prevent companies from shifting profits to tax havens. Further, the new proposal would close the tax loophole of deferring taxes on earnings that are not repatriated. Today, an estimated $2.6 trillion in untaxed earnings remains outside the United States at subsidiaries. Foreign earnings that have remained outside the United States would be subject to a low one-time tax that would be payable over a multi-year horizon. The inability to defer taxes indefinitely and the taxation of all future earnings would potentially increase the tax rate of many US multinational companies relative to current tax bills.
What we do know is that, under the proposal, companies that pay higher taxes today would benefit over those paying lower taxes, particularly as special deductions are reduced or eliminated to pay for a decrease in the corporate tax rate. Smaller companies (at least those with positive net income) tend to pay higher taxes, while large companies, particularly technology companies, have benefited from lower tax rates overseas provided they don’t repatriate earnings. The median effective corporate tax rate for US small-cap companies was 33% in 2016, materially above the 29% paid by large caps.
The market has largely priced in the relative benefit of lower corporate tax rates for small-cap stocks. The performance of US small-cap stocks relative to mid- to large-cap stocks started to rebound following the failure of the Senate to repeal the Affordable Care Act, which signaled a shift in focus from health care to tax reform. Since the low in relative performance in late August, small caps outperformed large caps by about 6 percentage points through early October. About one-third of the outperformance was gained on the back of the release of the tax reform proposal in the last few days of September, although some of these gains have reversed in recent days.
In addition, the expectation that the tax proposal will include some deficit financing has pressured up US Treasury yields (along with anticipated Fed moves) and given a lift to the US dollar, which rallied about 2% from its early September lows after previously suffering a loss of about 10% this year. Similarly, value stocks, which benefit in a rising rate and stronger growth environment, have seen a tentative reversal of similar magnitude since their early September lows relative to growth stocks.
Some of the prospective improvement in earnings has been priced in, but should actual reform or sharper tax cuts pass, US equities, particularly small-cap, cyclical, and value stocks; the US dollar; and US rates would likely continue their ascent. Given that US small-cap stocks are at peak valuations and have already priced in a sizeable degree of relative benefit, global value and cyclical stocks offer a better risk/reward proposition. Globally, value stocks are cheap relative to growth stocks, they have priced in less improvement in earnings growth, and they should be expected to benefit from accelerating global growth irrespective of developments in the US tax proposal.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.
Originally published on October 24, 2017
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