07/14/17 04:02:37 PM
Corporate Tax Cut Scenarios
The Trump administration is signaling its commitment to getting tax reform completed sooner rather than later, with Treasury Secretary Steven Mnuchin, legislative affairs chief Marc Short, and Chief Economic Advisor Gary Cohen all recently saying that the White House aims to deliver a plan for overhauling the U.S. tax code to Congress within two months.
Yet corporate America isn't confident that tax relief is around the corner. Among one group, tax professionals, only 26% expect the legislation to be enacted this year, according to a report from the Tax Council and Ernst & Young.
Many political analysts say there is an increasing likelihood that tax cuts will be Congress's answer to tax reform, as contentious issues will make a comprehensive reform bill beyond reach.
Corporate management teams are reluctant to include any of Trump's stimulative policy measures infrastructure spending, deregulation, tax reform or repatriation into their earnings guidance, given the lack of clarity.
This has been reflected in S&P 500 consensus earnings estimates. The growth estimate for 2017 has been reduced by about 200 basis points to 10.4% from the January 1 expectation.
S&P 500 earnings growth in 2018 is currently pegged at 12.0%, which CFRA views as reasonable given domestic economic growth expectations, an improving global environment, and business and consumer confidence.
If a corporate tax cut alone were implemented, earnings growth expectations would increase significantly (see table).
Approximately 40% of the S&P 500 has an effective tax rate of 30% or higher, and more than 50% of the index has an effective tax rate of 25% or higher.
President Trump announced plans for a corporate tax rate of 15% when he outlined his tax plan in April. But there is speculation that the corporate tax rate may end up more like a House of Representatives tax reform bill known as the "Blueprint," in which a 20% corporate tax rate is proposed.
If a tax cut to 20% is implemented by early 2018, CFRA estimates that earnings growth could improve to 20.4% from the current 12.0% estimate. Growth would be better if Trump's 15% rate were agreed upon. If the corporate tax rate is only reduced to 30%, growth would still improve, albeit by much less.
Importantly the market price-to-earnings (P/E) multiple would be reduced to 16.4X in a 30% tax rate scenario, which is in line with the historic average. Perhaps a small tax cut is what the market is pricing in, given the return to the historic multiple. If so, anything more aggressive should be well received by the market and likely drive market upside.
Meanwhile, CEO optimism is on the rise, which is typically a good thing for spending. The Business Roundtable's CEO Economic Outlook index reached its highest level in three years in the second quarter of 2017. The CEOs surveyed say they plan to continue increasing capital spending over the next six months.
Turning back to tax reform, the sectors that have the largest exposure to higher tax brackets are consumer discretionary, industrials, and financials. Industrials and financials are among the sectors that led the market higher in the wake of the election of Trump. Since the start of the year, however, those sectors have performed about in line with the market, while other sectors took the lead.
Industrials and financials still trade at a premium to their historical averages, but would be immediate beneficiaries from any change to the tax code. Consumer discretionary may be more interesting to investors looking for tax reform beneficiaries as the group trades at less of an historical premium and has a wider discount on a relative basis to the S&P 500.
Another cyclical sector that could benefit from a reemergence of the reflation trade (resulting from tax reform and capital spending policies) is information technology. To be sure, the sector is positioned to have the second-best earnings growth in 2017 (after energy) at 13.2% and doesn't need Trump's policies to flourish. But economic stimulus would most likely result in higher growth.
CFRA has a number of strong buy and buy recommendations among S&P 500 technology constituents, and we view the sector's 1.6% decline since June 8 as a buying opportunity, even as the sector remains the best performing one in the S&P 500 index.
Among key industry groups, we continue to favor semiconductors given its discounted valuation, favorable industry trends, and end market drivers.
Consumer Discretionary Select Sector SPDR (XLY 90 Overweight), Industrial Select Sector SPDR (XLI 69 Overweight), and Materials Select Sector SPDR (XLB 55 Overweight) offer exposure to some of the S&P 500 sectors highlighted above. These ETFs rank favorably based on holdings and costs. Another to consider is VanEck Vectors Semiconductor (SMH 87 Overweight), which offers exposure to global semiconductor companies.
Lindsey Bell, CFRA Investment Strategist