Equities Strategy: the Repercussions of the US Tax Reform and the Sector Rotation

The US tax reform saga continues. On 2 December, no doubt spurred by the next mid-term elections scheduled for November 2018, American senators finally succeeded in passing (albeit narrowly) a bill to cut taxes on businesses, and to a lesser extent, individuals. Corporate tax could be slashed from 35% to 20%, tax imposed on foreign earnings could be reduced and certain tax breaks revisited. Total tax cuts over the next ten years are estimated at $1,400 billion. The game is not over because the two chambers (House of Representatives and Senate) must now find a compromise between their respective versions. The final tax brackets have not yet been unveiled. Nonetheless, political observers appear confident in a potential “reconciliation” between the two versions.

In this context, what is the impact on stock markets? The implementation of substantial tax cuts would certainly drive up the profitability of American companies. The policy encouraging the repatriation of foreign earnings coupled with tax cuts imposed on companies domiciled in the US would prompt analysts to revise up their earnings estimates. With higher earnings per share (EPS), a correction in the US valuation would logically occur.

Beyond this general effect on business profitability, who will be the real winners (and losers) of this tax reform?

Even though the reform’s impact on a company will essentially depend on its specific tax situation, there could be differences across sectors. The effective tax rate may vary from one company to the next according to the nature of its business activity. In other words, US companies generating a large slice of their earnings on home soil should enjoy greater benefits. Clearly these will be direct (immediate tax cuts), but also indirect (stronger economic growth, and thus higher demand in the US).

A simple exercise consists in ranking US sectors according to their share of revenues generated in the US. Telecom companies (more than 90% of revenues are home-grown), financials (80%) and utilities (more than 90%) largely depend on domestic demand, whereas technology is the most international sector (45% of domestic revenues and only 15% for its semi-conductors sub-sector).

However, on the US stock market, the first two sectors rebounded after the Senate vote, to the detriment of technology stocks (growth stocks) which were trading at high valuation levels.

The sector rotation, which seems to be favouring “value” stocks, could continue in the coming months. The prospect of a tax reform in the US raises hopes that the economic cycle— already in the late stages—will be extended. US economic growth could reach 3% in 2018, driven by consumption and investment. The unemployment rate might hit a 50-year low, and consequently, inflation would edge up. This reflationary environment therefore offers greater potential for discounted (cyclical) stocks, e.g. financials. Hence it is essential to follow the US economy and the tax debate over the coming weeks to know whether it is relevant to maintain an interest in US “value” stocks.