By Justin Pawl, CFA, CAIA, CFP®
Last Week Today. The Bank of Canada announced it would soon begin tapering asset purchases, making it the first G-7 country to try to end Quantitative Easing. | The WSJ reported there are 1.5 million licensed realtors in the U.S., but only 1.0 million homes and apartments for sale, highlighting the extreme undersupply in residential real estate. | February’s Durable Goods Orders unexpectedly declined by 1.1%. The overall level remains strong, and some of the weakness can be attributed to extreme weather in the mid-west. However, supply constraints also played a role as the world grapples with a shortage of semiconductor chips used in phones, computers, automobiles, and appliances. | Federal Reserve data indicates households’ saving deposits rose $1.43 trillion over the eleven months ending January 2021. The new round of stimulus is expected to push savings close to $2 trillion. As the economy re-opens consumers will have an astronomical 10% of annual GDP burning a hole in their pockets, as they look to make-up for a tough pandemic year of limited spending on products, services, and experiences.
Global equities added to March’s gains on the back of U.S. stock performance. Outside of the U.S., developed international and emerging market indices declined between -0.5% and -2.2%. However, a +1.6% rise in the S&P 500 was enough to push the MSCI All Country World Index (which is comprised of ~55% U.S. stocks) up +0.3% for the week. It’s worth noting the Nasdaq Index didn’t participate in the rally (-0.6%), as investors grapple with high valuations in speculative shares and is now down for the month (-0.4% vs. +4.4% for the S&P 500). Meanwhile, bond yields declined (as we suggested might occur in last week’s Huddle), halting a seven-week run of consecutively higher rates that saw the yield on the 10-year UST rise from 1.06% to 1.72%. The amplitude and alacrity of the yield increase was one of the largest moves in the last 20 years, and thus we expect it will be weeks before rate volatility declines. For detailed asset class performance, click on the table below.
Taxes and Corporate Earnings. President Biden ran for office with an agenda of raising taxes. With this week’s coming announcement of a multi-trillion infrastructure plan, investors are beginning to handicap the impact on corporate taxes. The infrastructure plan is part of Biden’s original promise to deliver two large stimulus programs, the American Rescue Plan and the American Recovery Plan. The former was a nearly $1.9 trillion direct relief package that included $1,400 checks to qualifying individuals across the country. While the ink is barely dry on those checks, the next stimulus package is expected to be even larger. Current estimates place the American Recovery Plan’s spending between $2 trillion (if limited to infrastructure spending) and up to $4 trillion (if the plan also addresses health care, education, and childcare initiatives).
Politicians are spending money like it grows on trees, but they’re not entirely irresponsible (just ask them). Indeed, they plan to raise taxes to pay for some of the expenditures, even if their math is based on long-range forecasts with a host of dubious assumptions. As a mentor once told me, “If you torture the data hard enough, it will tell you anything you want.” Aside from brewing discussions about raising taxes on the “rich,” corporations are a favored target to source new tax revenue. After all, President Biden campaigned on raising the corporate tax rate from the current 21% to 28%.
Biden’s plan, as currently contemplated, would also institute a minimum corporate tax rate and increase the Global Intangible Low-Taxed Income rate from 10.5% to 21%. The “GILTI” tax is assessed on income generated overseas by domestic companies and was first instituted in the 2017 Tax Cut and Jobs Act (TCJA). Essentially, the GILTI tax disincentivizes corporations from establishing subsidiaries overseas in lower-tax rate domiciles by forcing U.S. corporations to pay taxes on profits from foreign subsidiaries in the year its earned. That’s a simplified explanation, but you can learn more about the GILTI tax here.
If the corporate tax policy Biden espoused on the campaign trail is fully implemented, Goldman Sachs estimates S&P 500 Earnings will decline by about 9% in 2022. However, campaign promises are rarely fully kept. Goldman’s baseline estimate includes a corporate tax rate hike of 25% and no change to the GILTI tax rate. The table below provides a nice illustration comparing a fully implemented Biden tax policy (S&P 2022 EPS of $185) with what Goldman’s analysts believe will come to fruition, representing only a 3% drag on corporate profits ($197 EPS).
The following table details a higher resolution view of Biden’s tax plan’s earnings impact across the various sectors of the S&P 500. Increasing the statutory corporate tax rate to 28% would hit businesses with a high proportion of domestic revenues the hardest. This includes companies in the Financials, Industrials, and Consumer sectors that benefitted the most from the 2017 TCJA tax cuts.
In contrast, increasing the GILTI tax would impact those companies with significant offshore profits. These companies tend to be in the higher growth Communication Services, Information Technology, and Health Care sectors. Slower growth, defensive and cyclical sectors would be less impacted by the GILTI tax as these companies tend to be more domestically focused.
Higher tax rates are coming, but the devil is in the details, as is often the case. From an investment perspective, a higher statutory tax rate will hurt earnings for all companies, but particularly those with high U.S. sourced profits. A higher GILTI tax will put additional earnings pressure on sectors (Communication Services and Info Tech) where some speculative stocks already look to be in bubble territory. Thus far, markets do not appear to be pricing in tax hikes, or they are pricing in something more akin to Goldman’s baseline increase that would have only a marginal impact on earnings. If later this year Biden’s administration can pass legislation more in line with the tax policy he campaigned on, the market will need to adjust quickly.