Everyone’s talking taxes
Tax Reform was a focus for Washington and Wall Street during the fourth quarter. By repeatedly reaching new all-time highs, the markets celebrated the December passage of the most significant tax changes in 30 years. Under the new tax regime, undoubtedly some sectors of the economy will fare better than others.
Some companies have publically indicated they expect to deploy the forecasted increase in earnings by raising employee pay, providing bonuses, and investing in technology and infrastructure. The question is whether these actions will be broad or sustainable enough to drive up inflation. We believe the effects will include continued growth with moderate pressure toward higher inflation.
Retail, industrial and financial corporations will benefit from the corporate tax rate dropping from 35 percent to 21 percent. Financials will also likely benefit from regulatory relief, which should increase profitability. Retail companies will get a lift from continued economic growth. These sectors could step in as market leaders in 2018.
Technology, which led equity market gains in 2017, may not get as much help from the new law. The effective tax rate for most technology companies is already well below the statutory rates due to the nature of the business. The bill’s repatriation provisions give U.S. companies incentives to bring money kept overseas back into the country. While technology companies may not have a strong enough incentive to participate, other companies may return money now kept overseas, a potential economic stimulus.
Housing, which drives a large part of the economy, may feel some negative effects from new limits on mortgage interest and property tax deductibility, along with the increase in the standard deduction. We foresee a real trade-off between owning and renting, especially for younger millennials. On the plus side, the economy is already approaching full employment, and additional economic growth could help push up average hourly wages. That in turn could help workers afford more expensive homes and apartments, giving real estate a boost. Commercial real estate may see some of the biggest benefits go to real estate developers and operators, thanks to accelerated depreciation. Tax reform is expected to lead to higher corporate earnings and increased hiring, which could increase demand for commercial real estate.
We expect the tax law’s limits on deducting interest expenses will help investment grade corporate bonds and may hurt lower quality (high yield) issues. Companies will need to rely less on debt, which could help strengthen balance sheets.