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Markets Are Already Enthusiastic Ahead of Proposed Changes to the Tax Code

The U.S. stock market is getting another boost from the proposed tax reform framework that was recently released by President Donald Trump and Republican congressional leaders.

Prospects of a potential interest rate increase in December by the Federal Reserve has also buoyed recent surges in U.S. benchmark stock indexes, an indication that the so-called “reflation trade” that lifted markets in the weeks following the November 2016 presidential election may have resumed.

Signs of the reflation trade have emerged since early September when President Trump and Democratic congressional leaders agreed a deal to extend government funding and suspend the nation’s debt limit until mid-December. Partly reflecting inflation expectations, the yield on the 10-year Treasury note has climbed to about 2.33% through October 4, up from about 2.05% when the debt-limit agreement was rolled into an aid package for Hurricane Harvey victims.

In turn, rising bond yields have provided further fuel for gains in small-cap stocks, as the reflation trade sparks interest in rotating out of bonds to stocks. During the past month, the S&P 500 has gained 2.9% through October 4. The S&P SmallCap 600 is up by 8.9%, and the Russell 2000, a broader measure of small cap stock performance, has risen by 7.5%.[1]

Throw in the prospect of lower corporate tax rates, which aid small companies with a majority of their business done domestically, and a one-time, lower tax rate for foreign earnings accumulated overseas, a boon for large-cap stocks with cash overseas, and the overall market has largely benefited.

The proposed tax framework, (a breakdown here) among other things, reduces the corporate tax rate to 20% from 35%. According to figures from S&P Dow Jones Indices cited here, the telecom (33.4%), consumer staples (29.1%) and consumer discretionary (28.5%) sectors of the S&P 500 paid the highest tax rates last year. There were 99 companies in 2016 that paid more in taxes than the 35% rate, while 115 companies paid less than 15% – 42 of those receiving money back from the government.

The one-time treatment of accumulated foreign earnings as repatriated, could potentially be a boon for shareholders of cash-rich companies. In the past, tax breaks on repatriation of assets has generally led to dividends, share buybacks and increased capital used for acquisitions. It’s estimated that the amount of cash held overseas by U.S. non-financial companies amounted to $1.3 trillion at the end of 2016, according to Moody’s Investors Service.

Apple Inc., Microsoft Corp., Google parent Alphabet Inc., Cisco Systems Inc. and Oracle Corp. collectively had about $594 billion of cash overseas at year-end 2016. A smaller, yet substantial portion of cash is also held overseas by U.S. pharmaceutical companies, among other multinationals.

Banks are another sector that could potentially benefit from a lower tax rate. While details of how the proposed tax cuts would be paid for, any unfunded taxes could potentially ignite inflation and lead to higher interest rates from the Federal Reserve. That would benefit banks’ margins, or the spread on what a bank pays on its deposits and what it charges to lend to borrowers.

Small and regional banks with little in the way of international operations would also benefit should bond yields move higher and the yield curve steepen on the heels of a more “hawkish” Federal Reserve. The Fed last raised rates on June 14, the fourth time in the current interest-rate tightening cycle.

Similar to the broader market, regional banking stocks have also performed well since the debt-ceiling announcement and in the period following release of the proposed tax framework. The Dow Jones U.S. Select Regional Banks Index, for example, is up 8.6% in the past month through October 4.[2]

Among the potential pitfalls for companies within the framework is the proposal to partially limit the deduction for interest expenses that corporations are able to declare on their debt. The proposal doesn’t make clear what the partial limit would be.

The issuance of debt has become a key component in companies’ capital structures as opposed to the issuance of equity. This report estimates that it is worth up to 11% of the value of corporate assets. Debt issuance also benefits the underwriting and capital market operations of banks, while private-equity buyouts are primarily paid for through debt and leveraged financing. Moody’s notes that the loss of interest deductibility would be a burden for speculative-grade companies because of their debt service expenses.

 

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Citations.

[1] http://bigcharts.marketwatch.com/historical/default.asp?symb=SPX&closeDate=9%2F06%2F17&x=34&y=25

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPX&closeDate=10%2F04%2F17&x=23&y=20

http://bigcharts.marketwatch.com/historical/default.asp?symb=SP600&closeDate=09%2F06%2F17&x=23&y=21

http://bigcharts.marketwatch.com/historical/default.asp?symb=SP600&closeDate=10%2F04%2F17&x=30&y=21

http://bigcharts.marketwatch.com/historical/default.asp?symb=rut&closeDate=09%2F06%2F17&x=35&y=20

http://bigcharts.marketwatch.com/historical/default.asp?symb=rut&closeDate=10%2F04%2F17&x=43&y=21

[2] http://bigcharts.marketwatch.com/historical/default.asp?symb=djsrbk&closeDate=09%2F06%2F17&x=18&y=24

http://bigcharts.marketwatch.com/historical/default.asp?symb=djsrbk&closeDate=10%2F04%2F17&x=34&y=21

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