- Factors other than tax reform, low interest rates, rising earnings, and the global economic recovery have been driving stocks higher.
- If enacted, tax reform could provide benefits for corporate profits, particularly cyclical sectors, small caps, and US-centric firms like financials.
- On the bond front, the reform proposals could be negative for high-yield bonds and could limit the issuance of certain municipal bonds.
The stock market has continued to rally as the tax reform debate unfolds in Washington. Of course, the tax proposal is far from final, and it could change a great deal, or never happen. What's more, markets have historically been driven far more by the business cycle than by any one policy from Washington. But if tax reform legislation passes, it could have an impact on corporate earnings, bond issuance, and sector performance.
Viewpoints caught up with 4 Fidelity experts, who shared their insights on what the various tax proposals could mean for investors, if enacted.
Markets driven by business cycle—not just tax reform
Jurrien Timmer, Director of Global Macro
Many investors have been wondering about how tax reform could impact the markets if it does in fact happen. I think it is important to note that despite the intense focus on Washington's fiscal policy, the recent run-up in the market has been driven more by low interest rates, rising earnings, and the global economic recovery.
What's more, I think that the overall impact of the cuts may be smaller than previous efforts at fiscal stimulus. Normally, tax cuts come at the end of recessions while the Fed is lowering rates. But this time, the stimulus would hit 8 years into an expansion while rates are headed up, and while the US unemployment rate is near 4%. That could limit the relative economic impact of this effort.
For much of the past year, the prospect of tax reform did not have much impact on the S&P 500. Since August, that has changed. Normally, as time passes, future earnings estimates come down. But since August, first quarter 2018 earnings estimates have actually risen, as analysts started to price in tax cuts. Of course, tax cuts may not impact earnings in 2018, but ultimately, if tax reform lowers corporate taxes it could improve earnings for US companies, particularly for some domestically oriented sectors, and for small-cap stocks, which pay higher taxes today relative to large multinationals.
If tax reform doesn't pass, I think investors should remember that there is a lot more driving the recent rally than Washington policy. Those fundamentals will ultimately help to drive market performance.
Cyclical sectors and small caps could benefit
Denise Chisholm, Sector Strategist
History suggests that if tax reform passes it would raise the likelihood that cyclicals will continue to outperform into 2018. Since 1962, there have been 5 corporate tax cuts, and in those years, an equal-weighted portfolio of the cyclical sectors—consumer discretionary, energy, financials, industrials, materials, real estate, and technology—has outperformed defensive sectors, on average (see chart).
Historically, tax cuts have helped smaller-cap stocks relative to large caps, in terms of stock performance, on average (see chart). Therefore, should tax reform come to fruition, targeted sector exposure that includes small- and mid-caps as part of a diversified portfolio is something I suggest investors may want to consider, so long as it fits into their goals, circumstances, and time horizon for their portfolio strategy.
Keep an eye on financials
Chris Lee, Manager of Fidelity Select Financial Services Portfolio
The biggest beneficiaries of the pending tax reform proposals look to be high-tax-paying, US-centric businesses. Financials tend to have among the highest proportions of pure-play US businesses of any sector. Within financials, regional banks, which have almost no international exposure, as well as US-based wealth managers and consumer finance companies, seem likely to benefit immediately, if corporate taxes are, in fact, lowered.
However, you have to look beyond any one policy change to determine what type of companies may be better positioned to retain the long-term upside benefit from lower tax rates. Banking is ultimately a commodity type of business. As a result, I think regional banks could see the near-term benefit of lower tax rates competed away over time.
By contrast, financial exchange, data processing, and technology companies may not gain as much initially from US tax reform because of the sizable international exposure in their respective businesses. But I believe many of these financial companies may have a better chance of retaining any upside from tax reform farther into the future—particularly those that have high market share and less commodity-like business models.
In addition, I think US-centric businesses that also have a proprietary component may have the most to gain from tax reform. From this standpoint, the parent company of the Chicago Board Options Exchange (CBOE), is well-positioned because it's both very US-centric and it has a lot of proprietary products. On the data processing and technology side, card processors Visa (V) and Mastercard (MA) are global brands that are effectively duopolies. That means that competitive pressures would most likely not compel them to pass the savings from lower tax rates on to their customers.
Risks and buying opportunities in bonds
Tom DeMarco, Market Strategist, Fidelity
Both the House and Senate tax reform bills have provisions that could impact bond investors.
The House bill and the Senate bill would each have implications for the corporate and municipal bond markets. On the corporate side, both tax policy proposals would permanently lower the corporate tax rate to 20% and allow for immediate expensing of capital expenditures. If enacted, lower corporate taxes would more than likely increase corporate earnings, increase cash flow, and make debt more expensive—since debt is tax deductible. This has the potential to notably lower leverage in the corporate debt market, particularly in the investment-grade corporate market. That could support higher prices in that part of the market, as it would improve the creditworthiness of those companies over time.
Both the House and the currently proposed Senate bills (note that the Senate bill has not been voted on at the time of this interview) also have provisions that limit the deductibility of interest for corporations.
My team in Fidelity Capital Markets, a division of Fidelity Institutional, evaluated the potential implications of both the House and Senate plan for debt issuers, and we didn't find many investment-grade issuers that would be affected by the House plan. We did conclude, however, that the House's provisions would have a negative impact on issuers rated between B and CCC. The Senate version is more onerous: Our analysis indicates it would affect a small portion of the investment-grade market, but would have a greater impact than the House version on the high-yield market. Relative to the investment-grade market, prices for high-yield bonds have fallen in recent weeks, and I think that's at least partly explained by the market's reactions to these 2 bills.
Both the House and Senate bills left in place the tax exemption for municipal bonds. There are 2 important overall factors to consider when analyzing the impact of the tax-exemption for municipal bonds: First, banks and insurance companies held 28% of the municipal bonds on the market as of second quarter 2017. If corporate tax rates are cut to 20%, those companies may have less incentive to own munis. Second, the tax bill may do away with 2 specific types of municipal bond issues: advance refundings, which are bonds issued to pay off existing municipal debt, and private activity bonds, in which a municipality issues debt to provide financing for a private enterprise. (The House version gets rid of both, while the Senate bill only does away with advance refundings.) As a result, we could see very heavy issuance through year-end as municipal issuers try to squeeze in advance refundings or private activity bonds. If issuance did move from 2018 and into late 2017, my team believes that this could put pricing pressure on the muni market.
If this were to unfold, then I would view that scenario as a potential buying opportunity in the municipal bond market. Advance refundings and private activity bonds are around 30% of the muni market, so a big reduction in their appeal (from an elimination or reduction in their tax-exempt status) would likely cause a big decline in overall muni issuance next year. So, we could see a glut of issuance causing prices to fall late this year, but lower supply next year could act as a positive technical factor for the municipal market.
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