New Tax Law Likely to Boost Corporate Earnings

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law. This bill represents the largest change to taxation in the US in the last 30 years, permanently lowering the corporate tax rate to 21% (from 35%) and putting in place a temporary tax break for individuals. Proponents of the new tax law argue that the lower corporate tax rate will make the US more competitive and will encourage businesses to hire more workers and raise wages.

Detractors of the new law argue that it does not go far enough in providing immediate, direct relief to middle- and lower-class citizens and that the projected increase in the deficit could hamper future GDP growth.

The short-term benefit of the new tax law to corporations is immediately clear: a substantially lower tax rate. This change is almost immediately accretive to corporate bottom lines and will cause earnings to be higher than they would have otherwise been with a higher tax rate. In this regard:

  • UBS’s head of US equity strategy predicts that corporate earnings will be 7% higher in 2018 than they would have been under the old regime, resulting in S&P 500 earnings per share of $141.35.
  • KKR estimates that 2018 aggregate earnings per share for the S&P 500 will be $153.90, a 16.5% increase from estimated 2017 S&P 500 earnings per share of $132.10. KKR attributes $13.80 of its estimated $153.90/share to the increased corporate tax rate (9%).
  • Factset reports that analysts increased their 2018 S&P 500 EPS estimates from December 11, 2017, to January 11, 2018, by the largest amount over that period since Factset began tracking this data in 1996. President Trump signed the tax bill during that interval.

While this higher earnings outlook should provide a significant tailwind to US equity prices in the short- to medium-term and likely improves the risk/return profile for domestic equities, market optimism is tempered by the following factors:

  • Relatively high current valuations; Factset estimates that the forward S&P 500 P/E ratio is 18.4, above the 10-year average of 14.2.
  • Operating margins may peak due to higher labor and input costs.
  • The domestic economy is likely running at or near full employment, which may lead to wage inflation pressure and higher long-term yields (although wage inflation has been largely absent since the 2009 global financial crisis).
  • Potentially unsustainable levels of low volatility in public equity and bond markets.

With an estimated 2018 S&P 500 earnings per share range of approximately $140-$155, the implied value of the S&P 500 at its current forward P/E ratio (18.4) is 2,576-2,852; as of January 16, 2018, the S&P 500 Index value was 2,770, above that range’s midpoint of 2,714, but below the high end.

We therefore revise our outlook on both large- and small-cap US equities from neutral/underweight to neutral as corporate earnings growth is likely to support peak valuations in the current low interest rate environment. Due to elevated valuations, we will likely not recommend a neutral/overweight or overweight posture until valuations appear more reasonable. Furthermore, we carry a bias for quality and value, as certain segments of the equity market appear to be overvalued and ripe for dislocation. For example, as illustrated below, the relative valuation premium for the Russell 1000 Growth Index over the Russell 1000 Value Index is at its largest since the “dot com” bubble burst in the early 2000s.

Screen Shot 2018-01-22 at 1.41.48 PM.png

For individuals, the tax bill reduces the top tax rate from 39.6% to 37%, doubles the standard deduction, caps state and local tax (“SALT”) deductions at $10,000 (as opposed to the previous rules which allowed all SALT to be deductible), and limits mortgage interest deductions to mortgages up to $750K, down from $1M. Important to high net worth families, the bill increases the exemption amount subject to the estate tax to $11.2M from $5.6M. While Delegate cannot provide tax advice, this piece from Keiter summarizing the changes may be helpful, and we strongly recommend discussing the new tax regime with your tax advisor in order to properly prepare and account for 2018 and beyond.

While the short-term implications of the new tax regime benefits corporations and many individuals as noted above, the long-term implications are unknown. On the one hand, the reduction in the corporate tax rate may lead to job, wage and, ultimately, higher GDP growth. On the other hand, the increase in the budget deficit caused by the reduction in national revenue may not be offset by expected increased GDP growth, serving as a headwind to the domestic economy in the decades to come.