Market Strategy Radar Screen Weekly January 02, 2018

The Only Certainties in Life are Death and Taxes

We were reminded of this adage after the President signed Tax Reform into Law

The tax reform act signed by the President on December 22nd, laden with detail and the result of last minute negotiations over particulars contained in the respective Senate and the House versions of the reform act, will provide accountants and tax attorneys plenty of work and opportunity to serve in determining just how much their clients’ respective tax burdens have been lessened (or in some cases actually increased) as well as projecting the varied effects of the whole process over the course of the next eight years.

For corporations the tax reform package appears broadly favorable (reducing their tax rate to 21% from 35%) but as with individuals the degree of favor is not evenly spread among the diverse constituencies the new tax regime rules over.

As market strategists we have already received a number of requests to comment as to which sectors will be favored more and which may be put at a disadvantage by the changes in the new tax law. Before providing an opinion we always remind our readers that we are not tax accountants nor tax attorneys but rather professional investors, market and asset class strategists.

Our first suggestion to investors pondering what action to take within their portfolios in response to the recent changes in the tax law is to not jump to conclusions or project reactively to the changes. Fortunately the tax reform appears not to be retroactive but rather begins with the New Year. So, there should be some time to gather more information than what is currently available and determine what and whether any changes need to be made in positioning portfolios.

While Wall Street analysts have already begun to increase their profit forecasts for 2018 the reality of what effect the Tax Reform package will actually have will take some time to assess and even more time to realize. Theory and projection can differ substantially from the result once “the rubber meets the road.”

Our experience from over three decades in the markets reminds us that economic growth, revenue growth, and earnings growth are factors most important to stock price direction. The effects of tax hikes and tax cuts in previous cycles on the economy and corporate results have tended to fall short of that expected by the reformers who drove the changes. There are so many more factors (both cyclical and secular) other than tax considerations that drive private and public investment including need, innovation, demographics and social trends along with technology and globalization.

That said we would expect that the changes in the new tax law could well have some effect on how corporations will position or reposition themselves to maneuver the new landscape. Restrictions on the deductibility of interest payments (up to 30% of those expenses) on debt could drive a significant increase in funding of corporate spending via equity issuance instead of from debt financing. M&A (Merger & Acquisition) activity could get a boost from corporate restructurings including spin-offs of non-core assets as well as from tactical bolt-on acquisitions. Most importantly we believe that opportunity to do business (perceived or otherwise) will remain a key factor in determining how corporations function in the new tax environment.

As to the uneven hand of the reform package which appears to create distinct winners and losers in the reshuffling of the US tax regime, an historical view reminds us that taxes were significantly higher for individuals and corporations during banner years for the markets in the post-World War II decades of the 1950s and 1960s as well as in the 1980s.

As for the economy and the expected stimulus effect? It will take some time to learn whether or not the latest tax reform works as a significant source of stimulus for the economy. With the consumer accounting for around 69% of US economic activity, the dollar amount of tax relief for shoppers and prospective purchasers of all kinds of things will be a key factor.

For example a reduction of the deductibility of mortgage interest and state and city taxes in some of the highest taxed states in the country (including New York, New Jersey, Connecticut and California) could negatively affect home prices in those states and even produce a negative knock-on effect on adjacent regional economies. On the other hand, the opportunities, amenities and charms of these high tax states and the regional economies they influence could well overcome the disadvantage of reduced tax deductibility.

It had been suggested by some observers that while most individuals will benefit early on from the tax reform, they will lose those benefits over the course of the plan as indexing for tax purposes is eliminated over the life of the tax reform as it applies to individuals (tax cut for individuals will slowly decrease over time and expire in 2025).

For corporates the tax reform is said to be permanent. However, while many corporations should benefit early on others will suffer at first from the expense of evaluating and making adjustments for the process of the tax reform. Already a number of large banks have noted that they expect to take charges against costs and taxes related to tax reform including from the effects of taxation of earnings repatriation. However, over the long term, banks are expected to be among the biggest beneficiaries of tax reform. Other sectors with member companies expected to take hits to earnings from the process of the new tax regime early on before experiencing the advantages include companies in information technology and pharmaceutical companies within healthcare that have significant global exposure.

Preliminary analysis widely shared in the media and among the analytical community provides us with a preview of how a number of sectors and industries are expected to be affected. Here are some examples which we provide at this juncture to provide our first take on how tax reform may initially affect equity market sectors.

Consumer discretionary sector:

• retailers—expected to benefit from their domestic exposure;
• Restaurants/hotels/food services—similar to above; though those with international operations less so initially;
• Construction—to benefit from domestic exposure;
• Transportation—railroads and airlines to benefit from domestic exposure.

Consumer Staples—a sector widely expected to benefit from tax reform via its domestic exposure.

Financials—expected to be a key beneficiary of the lowering of the corporate tax rate from 35% to 21%. Large banks, regional banks, insurers, broker dealers, money managers and hedge funds expected to benefit.

Information Technology—Likely to benefit from effects of repatriation but less so from corporate tax rate being cut from 35% to 21% as sector previously enjoyed an effective low tax rate.

Industrials—domestic exposure a benefit

• Manufacturers to benefit from change in expensing of capex.

Materials

• Chemical manufacturers—expected beneficiary;
• Miners—expected beneficiary;
• Agriculture—domestic role and as exporter expected to benefit.

Health care

• Hospitals—domestic beneficiary;
• Pharmaceuticals—domestic exposure positive with initial global exposure a possible negative impact on earnings.

Real estate

• Hospitals—domestic beneficiary;
• Pharmaceuticals—domestic exposure positive with initial global exposure a possible negative impact on earnings.

• Commercial real estate—a beneficiary from a domestic perspective as well as development/construction perspective;
• Residential—potential negative impact from reduced mortgage interest deductibility regime and limits on deductibility of property taxes particularly in high tax states.

Energy sector

• Refiners’ domestic exposure an expected beneficiary of tax reform;
• Integrated oil companies to benefit from domestic exposure while experiencing negative impact of taxes on foreign earnings repatriation;
• Exploration and Production—domestic exposure and export benefits.

Telecommunications:

• Carriers—domestic earnings beneficiary;
• Towers—domestic earnings beneficiary.

Utilities:

• Electric utilities’ domestic exposure a benefit, but
  the sector likely not a major beneficiary from tax
  reform and likely to experience negative impact on
  debt financing from limits on interest deductibility.

Again we remind our readers that the actual effects of tax reform on all sectors could differ substantially from what is expected at this time, as economic, cyclical, and secular factors carry the greatest impact on corporate entities.

At this time we reiterate our call for the S&P 500 to cross $3000 in 2018 based on our projections for earnings to grow to $146 per share this year.

We also maintain our various sector ratings while we give the market, investors and the analytical community time to digest the new tax reform.

For the complete report, please contact your Oppenheimer Financial Advisor.

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