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Difficulty: Moderate
1) US corporate tax rates were lowered from 35% to 21% in 2018.
The median S&P 500 company saw its effective tax rate being reduced from 27% to 19% under the new tax regime. This boosted S&P 500 earnings per share by 10% in 2018.
2) A US corporate tax hike may be unavoidable
Biden is proposing to increase the US corporate tax rate from 21% to 28%. As of last week, betting markets have been pricing him as the favourite to win the US Presidential Race.
3) We highlight the sectors and stocks most at risk from a tax hike
Energy, Financials and Consumer Discretionary sectors performed best during the 2018 corporate tax rate cut. The opposite may be true now. We will also share the list of 37 potentially most impacted S&P 500 stocks, as highlighted by Goldman Sachs.
The InvestQuest’s view on highlighted list: Some of the names that caught my eye in the list of 37 stocks include: Netflix, Boeing, salesforce.com, Visa, NVIDIA. In particular, Netflix (+29.7%) and NVIDIA (+51.8%) have done very well year-to-date. Given this list, I would watch these stocks carefully especially as the US Presidential Election nears.
The InvestQuest’s view on geographical allocation: With material risks of a US Corporate Tax hike, we do see this as an opportunity to trim some US stock exposure in favour of Asian stocks, where valuations are less expensive in absolute terms as well as on a time-series basis.
Recap of the US Tax Cuts and Jobs Act (TCJA)
President Trump signed the Tax Cuts and Jobs Act (TCJA) into law on Dec. 22, 2017, bringing sweeping changes to the US tax code.
One of the biggest changes was a massive reduction in the US corporate tax rate from 35% to 21% that would apply from 1 January 2018 onwards. Given that US corporate tax rates were one of the highest globally at 35% in 2017, this rate cut increased the attractiveness of the US as a business destination.
Do note that tax rates shown above do not include provincial/municipal taxes.
The median S&P 500 company saw its effective tax rate reduced from 27% to 19% under the new tax regime (chart below). According to Goldman Sachs, S&P 500 earnings per share was boosted by 10% in 2018 as a result.
The sweeping changes to US Tax law didn’t come cheap. According to the US Congressional Budget Office, this tax overhaul was projected to increase the US national deficit over the 2018–2028 period by about $1.9 trillion.
Why discuss corporate tax rate hikes now?
As of last week, betting markets have been pricing Joe Biden as the favourite to win the US Presidential Race. The probability of Biden or Trump being elected as President is now at 50% vs 43% on Smarkets and 53% vs 46% on PredictIt respectively.
This news is significant because Biden is proposing increasing the corporate income tax rate from 21% to 28%, risking more downside to already struggling corporate earnings. If Biden’s tax plan is enacted, Goldman Sachs estimates that S&P 500 earnings per share for 2021 would decline by $20 (almost 12%), from their base case forecast of $170 to $150. The Tax Foundation offers a good summary of Biden’s tax proposal.
Tax hikes might still be inevitable, regardless of who wins the US Presidency. While Biden’s growing chances of election success is bringing the discussion of corporate tax hikes into the spotlight sooner, we concede that tax hikes might be inevitable even if Trump is reelected. The US government is going to see lower tax receipts this year from soaring unemployment and corporate earnings declines, while having to dole out handouts to prop up the economy. This funding will have to come from somewhere, be it increasing national debt or raising taxes. We reiterate views from Ray Dalio (Co-CIO and Founder of Bridgewater) and Larry Fink (CEO of Goldman Sachs), which we had published earlier in IQ Weekly Takeaways on 10th May.
Sectors and stocks most at risk from a corporate tax hike
Quoting from Goldman Sachs US Weekly Kickstart (published 5 June 2020) on the 2018 Tax Cuts and Jobs Act (TCJA):
“Firms that had the highest effective tax rates benefited most from the TCJA, and many of these companies would be particularly vulnerable to a rate hike.”
Nearing the period TCJA approval, Energy, Financials and Consumer Discretionary sectors posted the best returns, even though the reduction in effective tax rate for these sectors wasn’t the highest. The discrepancy between the extent of tax rate reduction and stock price returns could be due to how the market views these sectors as being particularly cyclical. These sectors might be most at risk if corporate tax rates are to increase.
Goldman Sachs published a list of 37 stocks which had experienced comparatively larger reductions in tax rates and had outperformed relative to peers following the TCJA passage. As a result of the US corporate tax rate cut in 2018:
- The median of these 37 stocks managed to lower its effective tax rate by 14 percentage points (from 35% to 21%), compared to just 8% percentage points (from 28% to 20%) for the median S&P 500 company.
- In terms of stock price performance, the median of the 37 stocks outperformed the median S&P 500 company by 20% (24% return vs 4% return) in the 6-month period around the TCJA passage.
If we do see a US corporate tax rate hike, these might be the stocks most at risk of a pull back. We note that year-to-date, the median return for this list of 37 stocks has generated +1.1% total return, outperforming the median S&P 500 company which has generated -5.0% total return.
The InvestQuest’s View: Some of the names that caught my eye in the list above include: Netflix, Boeing, salesforce.com, Visa, NVIDIA. In particular, Netflix (+29.7%) and NVIDIA (+51.8%) have done very well year-to-date. Given this list, I would watch these stocks carefully especially as the US Presidential Election nears.
Conclusion
The InvestQuest’s View: With material risks of a US Corporate Tax hike, we do see this as an opportunity to trim some US stock exposure in favour of Asian stocks, where valuations are less expensive in absolute terms as well as on a time-series basis.
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