After the election of President Trump in November 2016, earnings estimates for U.S. corporations began to steadily creep up for 2017 and 2018 in anticipation of a corporate tax cut that would bring rates to as low as 15% from the current 35%. The S&P 500 is now expected to show yearly earnings growth of 10% and revenue growth of 6% — the highest numbers seen since 2011 (see “Earnings optimism,” below).
Nearly all of the companies in the S&P 500 would benefit from the proposed tax reform, although some more than others. A reduction in the corporate tax rate particularly helps multinational companies, which a majority of S&P 500 companies consist of. Nearly 50% of revenues from those corporations come from overseas.
Currently, these companies must pay a tax on all profits, regardless of where they are earned. This has been somewhat detrimental in the last couple of years as the U.S. dollar has been particularly strong, and repatriating those international sales back to the dollar has undercut profits. The Trump administration’s proposal would move to a territorial system for businesses, requiring companies to only pay taxes on those profits earned in the United States. It is also promising to allow corporations to repatriate profits held overseas at a one-time low rate.
Arguably, large financial institutions will be the biggest beneficiaries of tax reform. Late last year, Morgan Stanley (MS) analysts estimated that reducing the corporate tax rate to 20% could result in double-digit profit growth for big U.S. banks, with the exception of Citigroup (C) which would likely only see a single-digit increase due to deferred tax assets on their balance sheet. As far as regulation is concerned, many bank executives have been very vocal about their desire for relief from tough capital and liquidity standards under current regulations.
Consumer discretionary names will not only benefit from corporate tax reform, but the income tax reform that has been proposed. If consumers have more money in their pockets, the hope is they will put that back into the economy by buying both large ticket items such as cars and appliances, and even spending at retailers.
One thing consumers may not be spending on, however, is housing. The current proposal would maintain the home mortgage interest deduction, yet doubling the standard deduction and limiting itemized deductions are disincentives to buying or improving homes. This would hit both homebuilders such as Lennar (LEN), DR Horton (DHR) and PulteGroup (PHM), as well as the home improvement retailers that have been doing so well lately such as Home Depot (HD) and Lowe’s (LOW). The heightened housing prices that we’ve seen over the last few years are directly correlated with homeowners investing more heavily in their properties. A lack of demand for homes could diminish this trend.
Several other pockets of the economy would benefit from tax reform, but how long should investors wait? If tax reform policies aren’t set in motion this year, or aren’t to investor’s liking, there is the chance the markets will see a considerable pullback, as much of this optimism is already priced-in. Tax reform has already been taken into account in corporate profit guidance for the later half of the year and 2018. The more prolonged the wait for tax reform, the more investors are going to expect from the eventual plan, and the more the market will be disappointed if Congress doesn’t deliver.