November 2017

yellow sign reading

“This is too difficult for a mathematician. It takes a philosopher.”

Albert Einstein on filing tax returns

The House and Senate have delivered their respective tax plans with edits occurring in real time. Their paths may differ but their goals of progrowth economic stimulus are aligned. In this edition of Market Monthly we remain hopeful as we focus on potential investment implications from eventual tax reform. Taxpayers must wait for final details in the coming weeks as the House and Senate resolve the differences between their respective bills. Motivated by upcoming 2018 midterm elections and driven to extend the economic recovery, we think Congress ultimately crosses the finish line by combining features of both plans.

Summary:

Potential Effects on the Economy: The thrust behind tax reform remains economic growth and each of these preliminary bills delivers it in its own way. These bills require folks to view them through two lenses: that of a taxpayer who wants to pay less and that of an investor who wants to earn more. We will focus on the latter. These bills are largely investor friendly.

Potential Effects on Equity Markets: The impact and timing of the corporate tax cuts, interest expense deductibility, conceptually eliminating double taxing corporations on paid dividends, a repatriation tax holiday and a territorial tax system will each have winners and losers. Put simply, each of these items is relevant to corporate earnings and stock prices so we remain cautiously optimistic.

Potential Effects on Bond Markets: Bond markets remain more sensitive to Fed policy than to tax policy. Limitations on corporate interest expense deductibility and changes to tax-exempt status on select segments of the municipal market highlight changes in the tax bills that bear watching.

Setting the stage: We frame the tax reform discussion with some basic facts. The chart below provides factual context and background to illustrate the magnitude of the task at hand for law makers. Those writing the tax laws are quite aware of the story it tells.

  • The left reflects the percent of total individual income tax returns filed and taxes paid.
  • The bottom reflects the adjusted gross income (AGI) ranges that apply to the respective number of returns filed and taxes paid.
  • As an example, filers with under $50,000 in AGI comprised 61.4 percent of all returns filed and 6.4 percent of taxes paid.

bbt-perspectives-market-monthly-november-2017-2015-tax-return

Fast facts:

Of the 150,494,271 tax returns filed for the 2015 tax year:

  • 23.7 percent were filed at the 0-percent tax rate
  • Those with AGI under $100,000 represented 83.2 percent of the returns filed and 21.8 percent of taxes paid (80/20 rule)
  • Those with AGI over $100,000 represented 16.8 percent of the returns filed and 78.2 percent of taxes paid (80/20 rule)
  • For relevance, estate taxes raised $17.2 billion representing just .56 percent of total IRS revenue for 2015 (Estate tax revenue was the equivalent of the market cap for Best Buy Co. Inc.)

Timelines: The House passed their bill on Thursday afternoon, Nov. 16, largely along party lines with a vote of 227 for and 205 against. The Senate Finance Committee also approved their version and the full vote is likely to occur by Nov. 30th. Next, the House-Senate conference committee could convene as soon as the week of Dec. 4th to write a final compromise bill. This occurs simultaneously with a Dec. 8th budget deadline to avoid a government shutdown and a Dec. 12th special election for the Alabama Senate seat, which creates a delicate vote balance in an already fragile Republican majority. An early 2018 passage remains the best case, but getting tax reform done as an early Christmas present is not out of the question. Either way, we think it will succeed.

Potential Effects on the Economy:

What is progrowth about tax reform? The thrust behind tax reform all along has been to generate economic growth.

  • Those drafting the bill expect a broader base of tax payers willing to spend their tax savings.
  • Corporate filers are expected to allocate their tax savings to growing their businesses and create high-paying jobs.

The chart below illustrates expected GDP growth from tax reform and compares it to the 2003 Tax Reform Act (in blue). The House bill (red) is front-end loaded with immediate tax savings and economic growth with forecasted results similar to 2003. The Senate bill phases in taxes and is expected to have less short-term economic growth.

bbt-perspectives-market-monthly-november-2017-net-fiscal-stimulus-chart

Incremental economic growth of 1 percent could help the U.S. out of its prolonged slow-growth slump, but we acknowledge there other factors at play here such as tighter Fed policy with an increasingly hawkish board. Balance is key.

Timing is Everything: The House and Senate have proposed cutting top corporate tax rates from 35 percent to 20 percent but vary in the timing of their implementation. The House wants to cut taxes immediately in 2018 whereas the Senate wants to phase in tax cuts by beginning in 2019. Phase-in tax cuts risks could delay the growth to the economy as the previous chart illustrated. This could be a market negative.

Possible solutions we’ve seen from research partners include:

  • Cut the tax rate to 23 percent instead of 20 percent but make it immediate
  • Phase in corporate tax cuts incrementally over two-three years

The chart below illustrates the results of the 2001 and 2003 tax cuts. In 2001, tax cuts were passed in July but were set to phase in over several years. Economic growth sputtered. The tax cuts in 2003 recognized this flaw and corrected it by accelerating the 2001 tax cuts to make them immediate rather than phased in. Two things happened.

  1. Economic growth responded quickly and stayed sustainably strong.
  2. Actual economic growth exceeded expected economic.

bbt-perspectives-market-monthly-november-2017-GDP

The final bill should make tax cuts as front end loaded as possible to allow taxpayers to benefit from tax savings as soon as possible.

Final Point on the Economy: The U.S. and the rest of the world remain in a robust economic recovery despite what happens with tax reform. But tax reform would certainly help.

Potential Effects on Equity Markets:

Economic growth drives earnings growth and earnings growth drives stock prices. Stocks have generated double-digit returns so far in 2017. U.S. stocks have seen a two-part market recovery. The first part of the recovery was driven by a PE expansion during an earnings recession. It is now driven by solid earnings growth for the first time in several years. That begs the questions: What’s next?

Tax reform is not a cure-all, but it is expected to add 8 percent to S&P 500 earnings in 2018. Below are some themes in the tax bills that identify potential leading and lagging sectors among the 11 that comprise the S&P 500. Some sectors that are winners from one tax law may be losers from another tax law. For purposes of this discussion, we are isolating themes solely based on impact from proposed tax reform knowing there are many other factors at play in making an investment decision.

Lower U.S. Corporate Tax Rates: The primary impact to earnings from tax reform would come from tax savings associated with lower corporate tax rates. Companies with higher relative tax rates benefit the most.

  • Winners: Consumer Discretionary, Telecom, Industrials
  • Losers: Utilities, Real Estate, Materials

Repatriation of Foreign Profits:  U.S. multinational companies who do significant business abroad have kept almost $3 trillion of these profits overseas to avoid high U.S. taxes. A Repatriation Tax Holiday will allow those companies to bring cash back to the U.S. at reduced rates. Combined with lower tax rates, firms will be incented to bring the money home and keep the money home at reduced rates.

  • Winners: Technology, Health Care, Consumer Staples
  • Losers: Telecom, Utilities, Real Estate

Deductibility of Interest Expense: House and Senate bills both propose limiting the ability of firms to deduct the interest expense on their corporate debt. Firms whose capital structure is heavily debt financed or financed at high interest rates will be disadvantaged.

  • Winners: Utilities, REITs (excluded from the bill)
  • Losers: Energy, Consumer Discretionary

As a side note, Senator Orrin Hatch of the Senate Finance Committee proposes the elimination of the double-taxation of dividends by allowing companies to deduct dividend payments.

Many of these themes have not yet been priced into the market. U.S. stocks are in “seeing-is-believing” mode. Unless and until a tax bill is finalized U.S. stocks are not yet pricing in tax reform in a meaningful way. Stay tuned as this could change.

bbt-perspectives-market-monthly-november-2017-stock-index

The orange bars in the chart above reflect YTD returns for various equity asset classes thorugh Oct. 31st. Once again, international equities have led the way.

U.S. stock valuations continue to carry premium valuations. YTD returns have impressed and successful passage of tax reform would be a big plus. While we remain broadly optimistic we are also realistic.

The Fed’s unwinding of nine years of extraordinary monetary policy can be expected to have a surprise or two along the way. We continue to think policy missteps between the Fed and Washington remain one of the largest market risks. Tax reform failure remains the largest near term risk. Volatility remains at an all-time low and we are in the second longest stretch in history without a 5-percent drawdown. For now the economy and earnings growth support our view of cautious optimism, but we expect increasing risks for renewed volatility. Execution is everything.

Potential Effects on Bond Markets:          

Bond markets remain more sensitive to Fed policy than tax policy. Two of the more impactful areas of the tax bill that affect bonds are:

Limitations on Corporate Interest Deductibility: The limitations on interest-expense deductibility negatively impacts firms who depend heavily on debt in their corporate structures and those who have higher interest obligations because of lower credit quality. Utilities have been excluded from this section of the bill. Roughly 40 percent of high-yield bond issuers (and their investment bankers) could be impacted by this. Investment-grade issuers are largely unaffected.

Changes for Municipal Bonds: The repeal of the AMT would be welcome for many muni bond buyers although some folks previously subject to the AMT could be shifted into new higher tax brackets. The good news is municipal bonds retain their tax-exempt status for traditional public purpose bonds. Both bills target removing the tax-exempt status for advanced refund bonds issued by municipalities to retire older debt at more favorable terms. Since this represents up to 20 percent of all new municipal bond issuance, this actually could lend price support to municipals due to a shrinking supply of available bonds.

A final point for municipal bonds is the interaction with the proposed repeal of the State and Local Tax (SALT) deduction for individual taxpayers. Due to the loss of the SALT deduction some investors, especially from high tax states like California and New York, will have even greater demand for in-state municipal bonds whose interest is exempt from state income tax.

Below, we’ve seen a performance shift in recent months in the global bond segment where returns have turned negative. As the U.S. dollar has recently gained strength, international bond returns for U.S. investors have suffered. Municipal bonds and high yield bonds have continued their strong performance.

bbt-perspectives-market-monthly-november-2017-bond-index

Closing Thoughts:

Tax reform tends to lead most recent conversations we are having with our clients. That explains our focus on tax reform for this month’s issue. We have a global economy and invest in global markets with many moving parts beyond just taxes.

  • Global economies continue to perform above trend.
  • We expect another rate hike at the Dec. 12-13 Fed meeting.
  • The controversial special Senate election in Alabama on Dec. 12 could reduce the already fragile Republican majority.
  • If tax reform passes, which we think it will, investable subthemes may present themselves as opportunities.
  • We are in a late cycle economy with a late cycle bull market that has staying power into 2018.
  • Downturns should be bought and market timing should be avoided.
  • The 2018 voting Fed is undergoing rapid change and will continue to normalize monetary policy while the economy performs above trend.
  • Midterm elections are around the corner and will motivate policy makers.

The finish line to tax reform is getting closer, and we think it will get done. Stay tuned.

November 2017

yellow sign reading

“This is too difficult for a mathematician. It takes a philosopher.”

Albert Einstein on filing tax returns

The House and Senate have delivered their respective tax plans with edits occurring in real time. Their paths may differ but their goals of progrowth economic stimulus are aligned. In this edition of Market Monthly we remain hopeful as we focus on potential investment implications from eventual tax reform. Taxpayers must wait for final details in the coming weeks as the House and Senate resolve the differences between their respective bills. Motivated by upcoming 2018 midterm elections and driven to extend the economic recovery, we think Congress ultimately crosses the finish line by combining features of both plans.

Summary:

Potential Effects on the Economy: The thrust behind tax reform remains economic growth and each of these preliminary bills delivers it in its own way. These bills require folks to view them through two lenses: that of a taxpayer who wants to pay less and that of an investor who wants to earn more. We will focus on the latter. These bills are largely investor friendly.

Potential Effects on Equity Markets: The impact and timing of the corporate tax cuts, interest expense deductibility, conceptually eliminating double taxing corporations on paid dividends, a repatriation tax holiday and a territorial tax system will each have winners and losers. Put simply, each of these items is relevant to corporate earnings and stock prices so we remain cautiously optimistic.

Potential Effects on Bond Markets: Bond markets remain more sensitive to Fed policy than to tax policy. Limitations on corporate interest expense deductibility and changes to tax-exempt status on select segments of the municipal market highlight changes in the tax bills that bear watching.

Setting the stage: We frame the tax reform discussion with some basic facts. The chart below provides factual context and background to illustrate the magnitude of the task at hand for law makers. Those writing the tax laws are quite aware of the story it tells.

  • The left reflects the percent of total individual income tax returns filed and taxes paid.
  • The bottom reflects the adjusted gross income (AGI) ranges that apply to the respective number of returns filed and taxes paid.
  • As an example, filers with under $50,000 in AGI comprised 61.4 percent of all returns filed and 6.4 percent of taxes paid.

bbt-perspectives-market-monthly-november-2017-2015-tax-return

Fast facts:

Of the 150,494,271 tax returns filed for the 2015 tax year:

  • 23.7 percent were filed at the 0-percent tax rate
  • Those with AGI under $100,000 represented 83.2 percent of the returns filed and 21.8 percent of taxes paid (80/20 rule)
  • Those with AGI over $100,000 represented 16.8 percent of the returns filed and 78.2 percent of taxes paid (80/20 rule)
  • For relevance, estate taxes raised $17.2 billion representing just .56 percent of total IRS revenue for 2015 (Estate tax revenue was the equivalent of the market cap for Best Buy Co. Inc.)

Timelines: The House passed their bill on Thursday afternoon, Nov. 16, largely along party lines with a vote of 227 for and 205 against. The Senate Finance Committee also approved their version and the full vote is likely to occur by Nov. 30th. Next, the House-Senate conference committee could convene as soon as the week of Dec. 4th to write a final compromise bill. This occurs simultaneously with a Dec. 8th budget deadline to avoid a government shutdown and a Dec. 12th special election for the Alabama Senate seat, which creates a delicate vote balance in an already fragile Republican majority. An early 2018 passage remains the best case, but getting tax reform done as an early Christmas present is not out of the question. Either way, we think it will succeed.

Potential Effects on the Economy:
What is progrowth about tax reform? The thrust behind tax reform all along has been to generate economic growth.

  • Those drafting the bill expect a broader base of tax payers willing to spend their tax savings.
  • Corporate filers are expected to allocate their tax savings to growing their businesses and create high-paying jobs.

The chart below illustrates expected GDP growth from tax reform and compares it to the 2003 Tax Reform Act (in blue). The House bill (red) is front-end loaded with immediate tax savings and economic growth with forecasted results similar to 2003. The Senate bill phases in taxes and is expected to have less short-term economic growth.

bbt-perspectives-market-monthly-november-2017-net-fiscal-stimulus-chart

Incremental economic growth of 1 percent could help the U.S. out of its prolonged slow-growth slump, but we acknowledge there other factors at play here such as tighter Fed policy with an increasingly hawkish board. Balance is key.

Timing is Everything: The House and Senate have proposed cutting top corporate tax rates from 35 percent to 20 percent but vary in the timing of their implementation. The House wants to cut taxes immediately in 2018 whereas the Senate wants to phase in tax cuts by beginning in 2019. Phase-in tax cuts risks could delay the growth to the economy as the previous chart illustrated. This could be a market negative.

Possible solutions we’ve seen from research partners include:

  • Cut the tax rate to 23 percent instead of 20 percent but make it immediate
  • Phase in corporate tax cuts incrementally over two-three years

The chart below illustrates the results of the 2001 and 2003 tax cuts. In 2001, tax cuts were passed in July but were set to phase in over several years. Economic growth sputtered. The tax cuts in 2003 recognized this flaw and corrected it by accelerating the 2001 tax cuts to make them immediate rather than phased in. Two things happened.

  1. Economic growth responded quickly and stayed sustainably strong.
  2. Actual economic growth exceeded expected economic.

bbt-perspectives-market-monthly-november-2017-GDP

The final bill should make tax cuts as front end loaded as possible to allow taxpayers to benefit from tax savings as soon as possible.

Final Point on the Economy: The U.S. and the rest of the world remain in a robust economic recovery despite what happens with tax reform. But tax reform would certainly help.

Potential Effects on Equity Markets:
Economic growth drives earnings growth and earnings growth drives stock prices. Stocks have generated double-digit returns so far in 2017. U.S. stocks have seen a two-part market recovery. The first part of the recovery was driven by a PE expansion during an earnings recession. It is now driven by solid earnings growth for the first time in several years. That begs the questions: What’s next?

Tax reform is not a cure-all, but it is expected to add 8 percent to S&P 500 earnings in 2018. Below are some themes in the tax bills that identify potential leading and lagging sectors among the 11 that comprise the S&P 500. Some sectors that are winners from one tax law may be losers from another tax law. For purposes of this discussion, we are isolating themes solely based on impact from proposed tax reform knowing there are many other factors at play in making an investment decision.

Lower U.S. Corporate Tax Rates: The primary impact to earnings from tax reform would come from tax savings associated with lower corporate tax rates. Companies with higher relative tax rates benefit the most.

  • Winners: Consumer Discretionary, Telecom, Industrials
  • Losers: Utilities, Real Estate, Materials

Repatriation of Foreign Profits:  U.S. multinational companies who do significant business abroad have kept almost $3 trillion of these profits overseas to avoid high U.S. taxes. A Repatriation Tax Holiday will allow those companies to bring cash back to the U.S. at reduced rates. Combined with lower tax rates, firms will be incented to bring the money home and keep the money home at reduced rates.

  • Winners: Technology, Health Care, Consumer Staples
  • Losers: Telecom, Utilities, Real Estate

Deductibility of Interest Expense: House and Senate bills both propose limiting the ability of firms to deduct the interest expense on their corporate debt. Firms whose capital structure is heavily debt financed or financed at high interest rates will be disadvantaged.

  • Winners: Utilities, REITs (excluded from the bill)
  • Losers: Energy, Consumer Discretionary

As a side note, Senator Orrin Hatch of the Senate Finance Committee proposes the elimination of the double-taxation of dividends by allowing companies to deduct dividend payments.

Many of these themes have not yet been priced into the market. U.S. stocks are in “seeing-is-believing” mode. Unless and until a tax bill is finalized U.S. stocks are not yet pricing in tax reform in a meaningful way. Stay tuned as this could change.

bbt-perspectives-market-monthly-november-2017-stock-index

The orange bars in the chart above reflect YTD returns for various equity asset classes thorugh Oct. 31st. Once again, international equities have led the way.

U.S. stock valuations continue to carry premium valuations. YTD returns have impressed and successful passage of tax reform would be a big plus. While we remain broadly optimistic we are also realistic.

The Fed’s unwinding of nine years of extraordinary monetary policy can be expected to have a surprise or two along the way. We continue to think policy missteps between the Fed and Washington remain one of the largest market risks. Tax reform failure remains the largest near term risk. Volatility remains at an all-time low and we are in the second longest stretch in history without a 5-percent drawdown. For now the economy and earnings growth support our view of cautious optimism, but we expect increasing risks for renewed volatility. Execution is everything.

Potential Effects on Bond Markets:
Bond markets remain more sensitive to Fed policy than tax policy. Two of the more impactful areas of the tax bill that affect bonds are:

Limitations on Corporate Interest Deductibility: The limitations on interest-expense deductibility negatively impacts firms who depend heavily on debt in their corporate structures and those who have higher interest obligations because of lower credit quality. Utilities have been excluded from this section of the bill. Roughly 40 percent of high-yield bond issuers (and their investment bankers) could be impacted by this. Investment-grade issuers are largely unaffected.

Changes for Municipal Bonds: The repeal of the AMT would be welcome for many muni bond buyers although some folks previously subject to the AMT could be shifted into new higher tax brackets. The good news is municipal bonds retain their tax-exempt status for traditional public purpose bonds. Both bills target removing the tax-exempt status for advanced refund bonds issued by municipalities to retire older debt at more favorable terms. Since this represents up to 20 percent of all new municipal bond issuance, this actually could lend price support to municipals due to a shrinking supply of available bonds.

A final point for municipal bonds is the interaction with the proposed repeal of the State and Local Tax (SALT) deduction for individual taxpayers. Due to the loss of the SALT deduction some investors, especially from high tax states like California and New York, will have even greater demand for in-state municipal bonds whose interest is exempt from state income tax.

Below, we’ve seen a performance shift in recent months in the global bond segment where returns have turned negative. As the U.S. dollar has recently gained strength, international bond returns for U.S. investors have suffered. Municipal bonds and high yield bonds have continued their strong performance.

bbt-perspectives-market-monthly-november-2017-bond-index

Closing Thoughts:
Tax reform tends to lead most recent conversations we are having with our clients. That explains our focus on tax reform for this month’s issue. We have a global economy and invest in global markets with many moving parts beyond just taxes.

  • Global economies continue to perform above trend.
  • We expect another rate hike at the Dec. 12-13 Fed meeting.
  • The controversial special Senate election in Alabama on Dec. 12 could reduce the already fragile Republican majority.
  • If tax reform passes, which we think it will, investable subthemes may present themselves as opportunities.
  • We are in a late cycle economy with a late cycle bull market that has staying power into 2018.
  • Downturns should be bought and market timing should be avoided.
  • The 2018 voting Fed is undergoing rapid change and will continue to normalize monetary policy while the economy performs above trend.
  • Midterm elections are around the corner and will motivate policy makers.

The finish line to tax reform is getting closer, and we think it will get done. Stay tuned.

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, www.irs.gov

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.