The Republican Party’s proposals for the most radical overhaul of the US corporate taxation regime in a generation could have significant implications for equity and bond markets.
In recent times the word uncertain has become something of a cliché when used to describe the outlook for financial markets, with its use typically spiking alongside bouts of volatility. After all, isn’t the future always hard to divine?
Nevertheless, with the election of Donald Trump and a Republican Congress, the outlook for global financial markets is hazier than it has been for many years. One of the most important questions exercising investors’ minds right now is: what form will American corporation tax reforms take? The potential impact is hard to overestimate.
In June 2016, House of Representatives Speaker Paul Ryan presented a blueprint entitled a ‘A Better Way’, in which the Republican Party outlined a plan to address what it perceives to be the biggest challenges facing the country.1 Among the proposals is what is widely regarded as the most radical overhaul of US taxation policy in at least 30 years.
Included is a call for the US corporate tax rate to be slashed to 20 per cent from 35 per cent – Trump wants to go further still cutting the rate to 15 per cent – and more controversially, to introduce a ‘border-adjusted’ tax. Among other significant proposed changes, companies would no longer be able to deduct net interest expenses from their pre-tax profits, whereas the cost of capital investment would be fully deductible immediately.
Bring it on home to me
Additionally, Trump has separately vowed to temporarily slash the tax rate on retained profits that are repatriated to just ten per cent. His plan is to encourage companies such as Apple, Google and Microsoft to bring home a hoard of cash – which credit rating agency Moody’s estimated in November was set to grow to $1.3 trillion by the end of 2016 2 – as a means of boosting domestic investment.
“Taken together, these tax reforms arguably pose as big a question for a stock-market investor as the threat of a euro zone break-up did five years ago,” says Giles Parkinson, Global Equity Fund Manager at Aviva Investors.
However, while working out the first-order impact of the tax changes on individual companies is relatively straightforward, assessing the second-order impacts is an altogether trickier task. Furthermore, it is hard to attach a probability to any of the individual measures coming into force in the first place.
Although leading Republican lawmakers recently vowed at their annual retreat in Philadelphia to get the tax cuts enacted by August, there are doubts as to whether they will be able to meet this goal. If such aggressive tax cuts are enacted, Trump's promise to expand health care coverage and spend more on defence and the nation's ailing infrastructure will be hard to reconcile with the Grand Old Party’s competing commitments to balance the budget and reduce the nation's debt burden.
Nevertheless, Parkinson believes that since the potential impact of reforms to the corporate tax regime could be so big, it would be prudent for any investor to assess how the various proposals would affect their portfolio in the event they were to come into force.
“In isolation, the magnitude of the cut in the corporate tax rate being proposed could make the US stock market the cheapest it has been in four years, even allowing for the recent rally,” he says.
For every $100 of pre-tax income, a US company focused purely on its home market currently earns $65 net profit. Cutting the tax rate to 15 per cent would boost net profit to $85 – a 31-per-cent increase – and provide a similar uplift to equity prices, he explains.
With his fund having for some time been tilted towards companies with exposure to the US economy, Parkinson says the question foremost in his mind is whether or not to increase this bias further.
“This could be achieved through switching away from geographically-diversified multinationals such as Colgate and Unilever in favour of more US-centric businesses such as Clorox or PepsiCo. For now, we are thumb-sucking, but we will act if it looks as if the proposals will not be diluted by Congress,” he says.
Fixed-income portfolio manager Joubeen Hurren says the tax changes could have “massive” implications for bond investors too.
“We’re building this into our scenario analysis. We had fundamental reasons to like US credit already. Although, in and of themselves, the proposed tax changes are not enough to force us into trades right now due to the level of uncertainty as to their introduction, they offer quite significant upside potential to this asset class,” he says.
Hurren says the proposed cut in the corporate tax rate, would be likely to depress bond spreads by encouraging companies to employ less leverage as it will effectively increase the after-tax cost of issuing debt.
At present companies can deduct debt interest payments from pre-tax profits in order to determine their tax bill. That means that with a 35 per cent corporate tax rate, for every $100 of debt interest costs a company incurs, the net cost is actually $65, since it pays $35 less tax. With a 15 per cent corporate tax rate the net cost of the same $100 of debt interest rises to $85.
Hurren points to a recent piece of research by Barclays in which their analysts estimated leverage among US corporate some bond issuers could decline by as much as 25 per cent as a result of the corporate tax rate being cut to 20 per cent. 3
Barclays reckons that could in turn lead to the spread on the wider US corporate bond market tightening by almost 25 basis points and on the industrial sector by as much as 40 basis points.
“The effect would likely be even more dramatic in high yield, where we estimate that spreads could tighten about 90 basis points,” the Barclays analysts added.
Somewhat counterintuitively, the proposal to end companies’ ability to deduct interest costs from pre-tax profits when working out their tax bill could reinforce the attraction of high-yield bonds. That is because although the measure would hit companies’ profits, it may boost bond prices thanks to shrinking supply. Since high-yield issuers tend to be the most heavily indebted, they would have the biggest incentive to reduce leverage on their balance sheets.
“Obviously by deleveraging, these issuers’ credit quality would improve. And of course net issuance (of debt) would be vastly reduced at the same time,” Hurren says.
But he cautions that this depends on legislators implementing the changes very gradually, allowing high-yield borrowers plenty of time to restructure their balance sheets.
“Failing to do this would cause these companies major problems as they’re not going to be able to get debt down overnight,” Hurren warns.
He adds that even then, the change is likely to present an existential threat to some, particularly heavily indebted companies in the energy sector, as they will struggle to pay down debt swiftly enough.
On the borderline
For Parkinson, the so-called border tax – which he describes as a form of “crypto-tariff” – could have similarly big implications for the equity market.
Under the proposal, US companies would be allowed to exclude receipts from exports in calculating their taxable income. At the same time, they would not be permitted to deduct payments to foreign suppliers or affiliates.
“It would be a massive boost for exporters. If you’re Brown-Forman, suddenly you’re not paying any tax on the profit you made on that case of Jack Daniels you sent overseas,” says Parkinson.
“For others it could be catastrophic. You’re effectively saying to retailers: ‘don’t import all that stuff from China; buy it from domestic companies instead’. For instance, according to research by RBC Capital Markets, Wal-Mart could go from earning four dollars a share to potentially losing three without taking mitigating action,” he adds. 4
Although a border tax has profound implications for almost every company, once again Parkinson says working out the precise impact is impossible. “Wal-Mart’s not going to go bust. It’s going to change its suppliers and put up prices, and it will probably be helped by a stronger dollar.”
Nonetheless, he believes it is sensible for equity investors to assess the exposure of their investments to the various elements of the proposed tax reforms. “If risk is equal to severity times likelihood, my observation is that little has been priced in to markets,” he says.
Low margin retailers like Wal-Mart, which import their merchandise, look particularly vulnerable. By contrast, manufacturers with pricing power which source domestically and export overseas – such as Church & Dwight or 3M – could be beneficiaries.
Analysts say while there is no guarantee any of the proposed tax changes will come into force, the prospects for a border tax look especially uncertain.
One of the main attractions of a proposal, that by taxing imports more and exports less ought to produce income for a country with a trade deficit, is that it should help to fund some of the other corporate tax giveaways. That is important because it seems likely that in order to get its tax proposals through Congress, the Republican Party will need to show that as a whole they are revenue neutral.
It is perhaps no surprise then that House Ways and Means Committee Chairman Kevin Brady says it is an essential part of his party’s plan to overhaul the tax code. As an additional benefit, he argues the tax – which he says is not much different to the value-added taxes common in other countries – would be consistent with Trump’s vow to get more Made in America stamps on goods, thereby creating US jobs.
Not in this house?
However, it is far from clear the White House shares his enthusiasm. In a January 16 interview with the Wall Street Journal, 5 Trump described the tax as "too complicated", although just two days later he appeared to backtrack somewhat, reportedly saying the idea was "certainly something that is going to be discussed". 6
In any case, says Mary Rosenbaum, managing director at New-York based macroeconomic policy think tank Observatory Group, even were Trump to be persuaded of its merits it is far from clear Brady and Ryan would be able to secure congressional support, particularly in the Senate.
She notes that the usual route to passing legislation in the upper house is via a so-called cloture vote. The problem is that in order to pass laws in this way 60 per cent of the votes are required. In other words, with Democrats occupying 46 of the Senate’s 100 seats, cutting off debate via a cloture vote would require some sort of deal-making.
There have been suggestions in some quarters that Republicans could look to bulldoze their new tax proposals through the Senate via a fast-track legislative process called reconciliation. This would allow a bill to pass in a limited time period, with the support of a simple majority – in other words 51 senators. The problem is that this would require the tax proposals to be ‘deficit-neutral’; hence the attractions of a border tax.
But Rosenbaum cautions that even then, in order to assess the prospects for a border-tax bill, it is still important to ask where the consensus is among Republicans.
“It’s not enough for someone to say it doesn’t matter what Democrats think because such and such could be passed under the reconciliation mechanism. We have to secondly look to see if there’s consensus or not among Republicans.
“As far as a border-adjustable tax is concerned, I don’t think one has been sought yet, but I’d be surprised if there were one. That’s not to say you couldn’t find a consensus, but it’s not going to be straightforward,” she argues.
Opponents say that aside from the difficulties of administering such a complicated tax, it would unfairly cut profits in some sectors and send US prices higher too.
For instance, the head of Toyota’s North American business, which employs 136,000 people, recently estimated that shifting production to the US from existing Mexican plants to avoid any border tax would push up the cost of a car by a minimum of $1,000. He said the unintended consequence would be less US sales, and cuts in US production and employment. 7
Worse still, some say the result could be trade wars. Former US Treasury Secretary Lawrence Summers, writing in the Financial Times, said the World Trade Organisation (WTO) is “very clear” that income taxes cannot discriminate to favour exports. 8 As such, the proposals will be seen by other countries and the WTO “as a protectionist act that violates US treaty obligations”.
“While the WTO process would grind on, protectionist acts by other nations would be licensed immediately,” he wrote.
As for the other proposed changes, Hurren says Trump’s plan to let companies bring overseas profits into the country at a one-off tax rate of ten per cent has the potential to depress yields appreciably. In this case, the debt issued by major multinationals, notably in the technology and pharmaceutical sector, would be the main beneficiary.
Under present legislation , US companies can hold foreign profits overseas without paying US corporate tax on them, unless and until those profits are repatriated. With the US corporate tax rate comparatively high by international standards, most businesses choose not to.
Largely as a result of this, corporate cash holdings have more than doubled in the last decade, driven by rising cash levels at technology companies. Apple for example recently said it had a record $246.1 billion of cash and investments sitting on its balance sheet, $230.2 billion, or 94 per cent, of which was being held overseas.
Hurren says that partly as a consequence of companies’ reluctance to repatriate this cash there has been a sharp rise in investment-grade bond issuance over the past decade as can be seen in the chart below.
US Investment Grade Net Supply ($bn)
That debt has been used partly to fund acquisitions. But it has also enabled companies to buy back their own stock. Since the earnings yield in the equity market was so much higher than the cost of issuing debt, issuing debt to buy their own shares provided companies an easy way of boosting shareholder returns.
Hurren says if companies such as Apple are now given an incentive to repatriate cash the result could be “a huge shift” in the structure of investment-grade companies’ balance sheets, with big implications for bond markets.
“Suddenly, after a couple of years of record (bond) issuance, it could be about to get more economical for companies to start buying debt rather than selling it,” he says.
For instance he reckons that with a tax ‘amnesty’ Apple, which last year issued $24 billion of debt to fund share buybacks, would not need to issue any debt at all.
Hurren says it is feasible gross issuance of investment grade debt, which has averaged just over $1 trillion in recent years, could fall by as much as 40 per cent in the first year after any amnesty were granted. As a result, he adds, while the spread on US investment-grade bonds already looks tight, it could yet fall further as and when uncertainty surrounding the precise form the tax reforms take begins to lift.
3 Barclays Credit Strategy research note published 13 Jan 2017
4 RBC Capital Markets research note published 6 Dec 2016
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