When President Trump took office in early 2017, he clearly wanted to deliver sweeping tax reform intended to reduce the tax burden and facilitate further growth in the real economy. Below, we run through a Q & A with both our Head of Outcome-Based Strategies in the US, Marta Norton, as well as our UK-based Associate Director in Manager Selection, Dan Vaughan, to look at how the changes, especially those for corporations, might impact the attractiveness of US equities.
Marta, what has changed?
Following an extensive period of political negotiation, the tax reform bill was passed on December 22, 2017 and signed into law effective from January for the 2018 tax year. Although media coverage has focused on the expected decrease to personal taxes, it seems the bill could have a greater effect on corporations. On December 6, Mark Sanford, a Republican from South Carolina, told The Washington Post the bill was “fundamentally a corporate tax reduction and restructuring bill, period".
In our opinion, the key changes for corporate taxation were:
- Lowering the corporate tax rate to 21%. The fall in the effective tax rate would be much less dramatic. Eliminating deductions helps explain the lesser impact on the effective rate
- Capping the interest expense deduction. Effects appear to be limited to certain sectors of corporate debt issuers
- Eliminating double-taxation on foreign profits
- Allowing for a one-time tax on the repatriation of cash and non-cash assets
- Full expensing of capital expenditures in the year of purchase. The benefit would last five years, followed by a five-year phase-out
- Lowering the tax-loss carry-forward deduction, and elimination of the carry-back deduction. This would likely limit the future tax benefits of major corporate losses
Dan, at a global level, what has been the reaction to the tax reform bill?
US policy changes have a habit of impacting global investor sentiment, although in this case, it is difficult to interpret whether the tax reform bill has altered the outlook or not. Many of the global fund managers we talk to see the developments as mildly constructive, with a positive near-term impact on the US economy, corporate profitability and cash flow.
The bill is viewed as generally beneficial for large-cap US companies, but not in equal measure, so they are not using the approval of the package as justification to blindly purchase baskets of stocks. Stock picking remains key and most continue to find more attractively valued stocks outside of the US.
Marta, how might the changes affect the US real economy?
GDP could increase 0.8% on average each year over a decade relative to the baseline forecast, according to a November 2017 projection by the nonpartisan Joint Committee on Taxation. Our own analysis of the effect of previous tax cuts on corporate earnings shows mixed results.
After-tax earnings should increase in the near-term, but given the tax bill’s emphasis on near-term incentives, the possibility of repeal, and the textbook corporate finance argument that any benefit would be competed away, it’s harder to handicap the potential long-term effects. The future is always less certain the further you go out, and here we just don’t see much evidence to support a significant impact on long-term earnings.
Dan, do you think the tax reform could result in a change of direction by active fund managers?
We would warn against such extrapolations. While it is possible to draw inferences, especially as they relate to Trump’s pro-business and pro-US policies, we would suggest this is considered under the framing bias. The funds management industry, much like the global economy, is the sum of many moving parts. It is therefore unlikely to materially impact the average fund manager.
Our highest conviction active managers run differentiated strategies, typically with a longer-time horizon than the average manager and have demonstrated the ability to look through market noise. In developed markets, such as the US, we have a preference for equity managers with a philosophy aligned to our own, so any changes to portfolios would likely be driven by fundamental bottom-up stock selection.
Marta, is the run up in US stock prices sustainable?
US stocks have climbed steadily since the tax reform passed. In our opinion, the fact that the House and Senate versions of the law had long been public suggests that whatever benefit corporations might expect from the reforms may be predominantly priced into the broad US market.
Dan, do you think the tax reform bill has any implications at a portfolio level? Why?
It is important to apply some perspective here. As valuation-driven investors, we are intently focused on finding fundamentally sound investments where the price is below the underlying fair value. While one could argue that the tax reform has very modestly increased prices, or at least coincided with an increase in prices, the real question is whether the fair value or “quality” of the investment has changed.
Our take, given the information at hand, is that the fair value of most investments will remain largely unchanged. Therefore, when determining position sizing and constructing portfolios, our philosophy remains unchanged. We seek a margin of safety between the price and valuation for an asset class and are acutely aware that the further price moves away from intrinsic value the greater the likelihood of a drawdown.
Marta, does this change our views on the attractiveness of US equities generally?
From an investment perspective, potential benefits from the reform — at least at a broad level — are uncertain. We expect near-term after-tax earnings to improve, particularly for financials and consumer staples, but long-term effects are less certain, and there are a variety of reasons we may see no improvement to long-term earnings. For example, over time companies could pass along any marginal gains to consumers.
With limited improvement to fundamentals, we remain convinced that the prevailing bull market, which stretches back more than eight years, pushes US stock prices well beyond our estimates of fair value. As a result, we remain broadly underweight US stocks across our portfolios.
