Tax Reform Special: What the bill means for investors

12-20-2017

Now that the tax bill has passed both houses of Congress and awaits President Trump’s signature, what can investors expect? We asked Federated strategists for insight.

Bonds: Macro view & munis

We expect the tax bill to offer moderate economic stimulus—various estimates suggest it could add 0.3 to 0.4 points to real GDP growth annually—primarily through increased corporate investment in response to the higher after-tax return on investment resulting from the lower 21% corporate tax rate. This could have some positive impact on job creation, although large portions of the capital investment could flow to labor-saving technology, muting the positive job impact.

Individual tax cuts seem likely to goose consumption, although the largest beneficiaries of the tax cuts—higher-income earners—may be less likely to spend those savings. Regional differences resulting from the new cap on state and local tax deductions also may mute the bill’s overall consumption effect.

Positive economic feedback effects from a somewhat faster growing economy seem likely to shrink the tax bill’s deficit impact relative to the “static scoring” estimate of about $1.5 trillion. That said, the tax cuts still are likely to add to the deficit, causing greater issuance of Treasury securities in coming years. 

In short, tax reform should exert some upward pressure on Treasury yields in the short to medium term as a result of somewhat faster growth and a bigger deficit. Obviously, many factors—monetary policy, inflation, international forces, among others—affect U.S. yields, not just U.S. growth and deficits.

Municipal bond market performance should benefit somewhat from the final tax bill. The bill maintains the muni bond tax exemption and should reduce gross muni issuance through the elimination of tax exempt advance refunding issuance.  Demand from individuals should remain steady given modest changes in top marginal tax rates and the cap on state and local tax deductions, while demand from banks and insurance companies should decline given the lower corporate tax rates.

– R.J. Gallo, senior portfolio manager, head of Muncipal Bond Investment Group

Bonds: Credit sector

While the market is interpreting the tax plan as a steepener for the Treasury curve, fundamentally, it should be positive for the credit securities because of the anticipated higher after-tax earnings and supply constraints due to a reduced incentive to leverage. That said, we will need to be on the lookout for increased merger & acquisition activity and other equity-enhancing moves such as dividend increases (i.e., what will corporations do with the tax-cut savings?).

Another aspect to watch: does strong equity-market performance combined with rising rates (bond price declines) create outflows to bond funds? If so, managers will sell what they own—and many are overweight corporate debt securities. This and tight spreads—the gap between corporate bond yields and that of comparable-maturity Treasuries—might mitigate any positive impact from the tax package.

Finally, markets tend to move on quickly to the next item, so what’s next? A possible government shutdown? A battle over entitlements? In other words, might this be a “buy the rumor, sell the news’’ moment now that tax reform is done?

– Robert Ostrowski, chief investment officer for the Global Fixed Income Group

Equities

The longer-term impact on stocks should be positive, as the bill will reduce the federal corporate tax rate from 35% (statutory rate at 39%) to 21%. This makes the U.S. more competitive with the rest of the world, which has a global corporate average rate of 24%.

As a result, we have raised our 2018 S&P 500 earnings-per-share estimate from $140 to $150 (versus $130 in 2017), with a target P/E multiple of 20 due to relatively low Treasury yields (around 2.40%) and benign core PCE inflation (1.4%). This yields our target price of 3,000 for the S&P, up 12% from current levels, by the end of 2018.

On the broader economy, Federated’s Macro Economic Policy Committee recently nudged up its forecast for real 2018 GDP growth a tick to 3.0%, in part on the anticipated stimulative effects from tax reform, including increased business and consumer spending.

– Phil Orlando, chief equity market strategist

Money markets

Although Janet Yellen, in her final press conference as Fed chair, last week said most members of the policy-setting Federal Open Market Committee had taken into account the tax deal’s fiscal stimulus when making their dot-plot projections, its passage reinforces the Fed’s path toward higher short-term rates in 2018.

Deemed repatriation will be a focus of the front end and has the potential for some spread widening in 2018, depending on the timing and magnitude of tax payments from repatriated overseas profits. The so-called BEAT tax—technically the “base erosion and anti-abuse’’ tax designed to discourage multinationals from moving profits and jobs offshore—could potentially have an impact on our counterparties for repurchase agreements, although the picture is somewhat murky at this point.

The bill’s passage also potentially complicates Treasury issuance relative to the debt ceiling, as lower tax receipts under the new tax plan could cause Treasury to run out of extraordinary measures earlier than originally thought. Next up for Congress is the need to reach an agreement on spending before the continuing resolution (CR) expires on Dec. 22, forcing the federal government to shut down. We expect another short-term CR to be passed to fund the government into the New Year.

– Sue Hill, senior portfolio manager, head of Government Money Market Group