One of the biggest questions for investors now is how much expected corporate tax cuts are already priced into the market. Both the S&P 500 index and Dow Jones industrial average have gained more than 20% over the past year and are trading near record highs, which have been set multiple times this year.
Many strategists attribute a good part of those gains to expectations for tax cuts, especially corporate tax cuts. Is there room for more gains once those cuts become official?
Congress is expected to pass a tax bill within the coming weeks, slashing the corporate tax rate from 35% to 20%, give or take a few percentage points. That’s a tax cut of almost 50%, though many U.S. companies don’t pay the current top rate. The effective corporate tax rate overall ranges from 22% to 28%, according to several U.S. Treasury reports.
“Tax reform will play a significant role in equity markets but changes to the economic forecast will not be as big,” says Omar Aguilar, chief investment officer, equities, at Charles Schwab Investment Management. “Financials and small-caps will benefit the most from the tax bill.”
Financial companies and small-cap companies are thought to be big beneficiaries of tax cuts because many tend to pay higher effective corporate tax rates than other companies, and small-caps tend to have greater exposure to domestic markets than do large-cap multinationals.
Much of the impact of tax cuts on stock prices will depend on whether a company will actually be paying lower taxes and then what it does with the extra money, primarily how much is distributed to shareholders.
Using the extra funds to buy back stocks, for example, would benefit stock prices more than investing in equipment, which positions companies for longer-term benefits.
“If a bank used the benefits of tax reform [a 20% corporate rate] to raise wages and benefits by 5% and technology spending by 10%, KBW estimates that the rewards … to earnings per share will decline by 35% to 40%,” writes KBW analyst Frederick Cannon. “It is hard to know how much of the benefits of tax reform will go to shareholders and for how long.”
Many strategists expect corporate tax cuts will increase EPS among S&P 500 stocks, which in turn will support prices, and they have raised their earnings expectations for 2018 from roughly $140 per share to somewhere between $150 and $160.
“Corporate profits should get a bump of about 8% largely due to the fall in the corporate tax rate and the repatriation of overseas cash,” write UBS strategists in a recent report. “Assuming that valuation multiples remain unchanged, tax reform could drive a further 3-5% gain in the S&P 500.”
UBS strategists expect that the biggest winners from tax reform will be small-cap and mid-cap stocks and within large-caps, consumer discretionary, financials, industrials and telecom — all having large exposures to domestic markets.
They also expect that mega-cap tech companies with large cash reserves overseas will also be big beneficiaries of the final tax legislation because they will be able to repatriate those profits at lower-than-current rates. It’s estimated that those companies hold about $2.8 trillion in profits abroad and would save approximately $570 billion in taxes if they brought them back to the U.S.
Still, what they would do with the money is unknown. Companies like Apple can already invest domestically because they have lots of cash here and can borrow at low rates, notes Gary Shilling, president of A. Gary Shilling & Co., an investment and research firm.
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