While the permanent 21% corporate tax rate in the new Tax Cuts and Jobs Act is boosting earnings forecasts for 2018, investors should curb their enthusiasm about what that means for stock prices in the long run, according to David Kelly, chief global strategist for JPMorgan Funds.
Kelly laid out in his Tuesday commentary five reasons for investors to not get their hopes up about the new corporate tax rate’s long-term impact on stock prices.
He also sees the “beta” play in stocks over the past year, with stocks soaring in anticipation of tax reform and then rising further once it passed, now turning into an “alpha” play post tax reform, and he cautions that 2018 will not be “as positive for stocks in general as many believe.”
Under the new tax law, “every company is impacted differently depending on their previous tax rate, their asset holdings overseas, their capital spending plans, their interest costs, their R&D budget, their tax-loss and tax-liability carry-forwards and a host of provisions of the tax act,” Kelly explained.
Because tax reform “has shuffled the deck and given each company a new hand,” Kelly told ThinkAdvisor in separate comments, “this is a great opportunity for fundamental investing.”
The alpha opportunity exists, he said, “for those investors and fund managers who can most accurately and quickly assess the value of these new hands.”
Forecasts of 2018 earnings “now stand at $150.57 for the full year compared to $145.80 just three weeks ago and $144.71 at the end of September 2017,” Kelly said.
The “sharp upgrade” in earnings forecasts is “almost entirely” due to passage of the new tax law. However, as Kelly explains, the following factors about the new tax law should dull investors’ enthusiasm:
1. The scale of the corporate tax cut, in total, is actually modest.
The net cost to the federal government of the corporate tax cut, once the repatriation tax is included, is $329 billion over 10 years or $33 billion per year. This is less than 2% of the roughly $1.8 trillion that U.S. corporations are expected to make after taxes in 2018.
2. Earnings in 2018 are being bolstered by one-time charges to the fourth quarter of 2017.
Accounting rules require companies to recognize their new liability for taxes on overseas assets in the period in which the law was enacted, i.e. the fourth quarter of 2017. Consequently, all the benefits of the tax law show up in 2018 and beyond while corporate balance sheets take a hit at the end of last year. It is notable that just since the start of the year, analyst estimates of 4Q2017 “as reported” S&P500 EPS have fallen by $4.67 – almost exactly offsetting the upgrade to 2018 earnings over the same period.
3. The benefits of the tax cut fade over time.
While the corporate tax rate has been cut permanently from 35% to 21%, a number of other provisions get less generous within a few years. In particular:
- 100% expensing of capital spending is phased out after 2022
- Companies are forced to capitalize rather than expense research and experimentation from 2022 on,
- The threshold for deductibility of interest expense gets much lower after 2021, and,
- From a cash-flow perspective, only 40% of the repatriation tax needs to be paid in the first five years but the other 60% has to be paid over the following three.
The net result of all of this is that 92% of the 10-year cash-flow benefits of the tax cut show up in just the next four years.
4. The overheating caused by fiscal stimulus could squeeze margins.
Seventy-seven percent of the benefits of tax reform accrue to individuals and, as is the case on the corporate side, the tax cuts are front-loaded. In an economy which already is seeing solid growth, this fiscal stimulus could cut the unemployment rate to a 49-year low of 3.5% by the end of this year. However, if it does so, it should finally put some upward pressure on wage growth — good news for American workers but it would likely hurt corporate profits, both directly through higher unit labor costs, and indirectly as it could cause the Fed to raise rates faster, perhaps four times this year rather than the three they currently projected, thus contributing to higher corporate interest expense.
5. Today’s tax cut could mean future tax hikes.
The tax cut will result in significant increases in federal budget deficits over the next few years. No serious economist believes that it can pay for itself. Because of this, some future federal government will have to levy taxes to pay for the cost of this tax cut and no one should assume that corporations will be spared from contributing to this.
— Check out 10 Data Points Investors Should Be Watching Now: JPMorgan’s Kelly on ThinkAdvisor.