With the passage of the Tax Cuts and Jobs Act of 2017, Congress took the reins from the U.S. Federal Reserve and became the new driver of economic stimulus. This shift from monetary to fiscal policy nine years into an already record-setting bull market will likely result in a new macro regime characterized by higher levels of interest rates, inflation, and volatility. Equity managers in our network also expect to see market rotation in 2018, as the beneficiaries of tax reform become clearer.
Some sectors stand to benefit more than others
Among the new tax law’s most important changes for corporations is the replacement of the graduated corporate tax rate—which had a top statutory rate of 35%—with a single corporate rate of 21%. However, the actual tax rates paid by companies before the new tax law varied widely as a result of tax breaks and other loopholes that applied to specific companies or sectors. For example, real estate companies paid an effective tax rate (income tax expenses divided by income earned before taxes) of around 6% in 2017, while financials paid close to 30%. As a result, the biggest beneficiaries of the new tax law from an earnings standpoint are those companies that had the highest effective corporate tax rates prior to the new law.
Certain sectors have already seen meaningful upgrades to their 2018 earnings estimates, as analysts consider the potential effect of the tax code on go-forward earnings. Just two weeks into the new year, for example, financials have seen earnings estimates rise by an average of 51%. Financials are also benefiting from the new law’s 20% deduction for income from pass-through companies—roughly one third of all community banks are organized as pass-throughs.1 Our asset management network already favored financials due to their relatively lower valuations and accelerating earnings growth. The new tax law has given companies in the sector an added boost.
The potential dispersion of earnings in the year ahead could create another favorable backdrop for stock pickers broadly. As portfolio management teams do the work of finding tax-reform’s relative winners and losers across equity markets, many expect to find opportunities outside of the mega FAANG stocks that have come to dominate the performance of market-cap weighted indices. Identifying companies and sectors that paid the most in taxes prior to the new law is a good place to look.