Wall Street investors look warily at gathering tax ‘storm’

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US equities investors are attempting to gauge the strength of a “storm” on the horizon as President Joe Biden lobbies for tax rises that would partially reverse a historic windfall doled out to corporate America by his predecessor.

Stocks this week sailed to new peaks as fund managers shrug off risks ranging from rising borrowing costs, to elevated valuations and a new wave of coronavirus sweeping parts of America and other leading global economies.

But Biden’s proposal to raise the corporate tax rate from 21 per cent to 28 per cent and enact a global minimum tax represents a fresh threat that some analysts warn could derail the steady rise in US stocks.

“Everybody is kind of at a picnic right now and you can see the potential for a storm coming in,” said Ann Miletti, head of active equity at Wells Fargo Asset Management. “But you’re trying to time the direction of the storm and whether or not it’s going to hit you in 2021 or 2022, or if it might miss you all together.”

Tobias Levkovich, chief US equity strategist at Citigroup, added the “investment community is too upbeat” and failing to show “any concern for plausible tax increases being proposed by the Biden administration”.

The Trump administration’s tax cuts, passed by Congress in the waning days of 2017, provided a powerful boost to corporate bottom lines by reducing the headline statutory federal tax rate from 35 per cent.

The tax rate paid by average US companies, which encompasses federal, state and local levies, fell to 27 per cent in 2018 and has held at that level since then from 40 per cent previously, according to accountancy KPMG.

America’s corporate titans, which are included in the S&P 500 index of large-cap stocks, pay even lower taxes on average because many have sprawling international operations that allow them to take advantage of more favourable tax regimes abroad.

The S&P 500 tax rate stood at 17.5 per cent in the third quarter of 2020, while that of the tech sector, which has a particularly amorphous tax base because of its relatively small physical operations, was just 14.8 per cent, according to Howard Silverblatt at S&P Dow Jones Indices.

The tax reductions passed in 2017 lifted earnings per share of S&P 500 companies by 10 per cent the following year, according to analysis in June 2020 by Goldman Sachs. “Since 1990, declining effective tax rates have accounted for 2 percentage points of the 4 percentage point increase in net profit margins and 24 per cent of total S&P 500 earnings growth,” the New York bank noted at the time.

Now, investment banks are providing clients with reams of research on the potential implications of a new tax regime.

Line chart of S&P 500 reported quarterly earnings per share ($) showing Lower taxes helped lift US corporate profits

Goldman estimates if Biden’s tax plan is passed in its current form, it could shave up to 9 per cent from S&P 500 earnings per share next year. An increase in the corporate tax rate of just 4 percentage points — compared with 7 pitched by Biden — could knock S&P 500 EPS by 3 per cent compared with what analysts have already pencilled in for the index this year, Citi’s Levkovich said.

“We do see higher taxes as one of the largest risks that loom in the back half of the year and into 2022,” said Emily Roland co-chief investment strategist at John Hancock Investment Management.

She added the impact could be substantive enough also to curb companies’ rehiring plans. “The risk is that as tax rates go up, companies may not fully restaff based on the impact on margins,” she said.

Bar chart of % showing Tax rates have fallen for most S&P 500 sectors since 2017 cuts

So far, any effect on stock prices has been muted, with the S&P 500 having hit multiple record highs in the past week alone. Analysts say this is because Wall Street is in a wait-and-see mode over how much of a rise Biden ultimately can wrangle through with a razor-thin Senate majority.

One Senate Democrat, Joe Manchin, already rejected a 28 per cent corporate tax rate, calling instead for a 25 per cent cap.

Despite these potential headwinds, the sheer strength of the economic rebound, coupled with the enormous fiscal and monetary support provided by policymakers, has muffled any alarm bells about the equity market’s record-run. Earnings of S&P 500 companies for the first quarter, which will start being announced in coming weeks, are expected to have soared by almost a quarter compared with the same time last year, FactSet data show.

That has bred a complacency that Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, warned could eventually prove hazardous.

Expected volatility in US equities — as measured by the Vix index — has fallen sharply, with Wall Street’s fear gauge now hovering below its long-run average of 20. In the midst of the coronavirus-induced market turmoil last March, it spiked as high as 85.

“When the green light is flashing all clear to invest and when unexpected bad news comes along, the market can’t withstand it,” said Slimmon. “The biggest risk is that investors seem to think the coast is clear.”

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