Wall Street Sizes Up Tax Reform Possibilities

Wall Street experts predict that tax reform will pass Congress and will be signed into law by President Donald Trump sooner rather than later.

The House tax bill released last week drops the number of tax brackets from seven to four and reduces the corporate tax rate from 35 to 20 percent.

It also doubles the standard deduction, increases the child tax credit, eliminates estate and alternative minimum taxes and caps the tax rate for small and family-owned businesses.

Wall Street certainly took notice of the business-friendly tax package, which represents the biggest changes to the tax code in 30 years.

“For much of this year we have been espousing what has felt like a minority view—that Republicans would reach some sort of tax agreement in early 2018,” said Burt White, chief investment officer at LPL Financial, in a recent research note. “The plan is geared toward securing votes from the most conservative wing of the Republican Party and appears to have achieved its objective.”

Presuming all that goes as planned, what would the impact of a revised tax structure be on the U.S. stock market?

White, who co-wrote the LPL research report with Jeffrey Buchbinder, a market strategist at the company, said the following investment sectors would likely benefit if and when tax cuts are enacted into law:

Small-cap stocks. Like high-tax stocks, small caps tend to be more domestic, pay higher taxes, and therefore, tend to be bigger beneficiaries of tax reform.
Financials sector. Pro-growth policy tends to put upward pressure on interest rates and steepen the yield curve, while financials are more domestic and pay higher taxes.
Value style. Financials benefit from pro-growth policy and higher interest rates, favoring the value style.
Interest rates. More growth and more inflation tend to push interest rates higher.
U.S. dollar. The Trump administration’s U.S.- focused trade policy and potential upward pressure on interest rates are generally bullish for the U.S. dollar.

'Lower Tax Rate is a Boon'

LPL isn’t alone in that assessment.

“A lower tax rate is a boon for highly-taxed corporations,” said Jason Pride, director of investment strategy at Glenmede. “The cornerstone of the latest tax reform proposal is a decrease in the corporate tax rate to 20 percent.

“Corporations with relatively high effective tax rates will likely enjoy materially lower tax bills should the cuts pass, so look to publicly-traded equities within this class as a barometer for the probability of passage.”

So far, a growing number of high-profile U.S. companies are increasingly buzzing over potential tax relief.

“The S&P 500 and Dow Jones Industrials Average both hit all-time high values during mid-October,” said John Butters, senior earnings analyst at FactSet. “One reason commonly cited for the recent increase in the value of these indices is renewed optimism that Congress will pass tax reform legislation soon.”

During each corporate earnings season, it’s not unusual for companies to comment on subjects that had an impact on their earnings and revenues for a given quarter, or may have an impact on earnings and revenues for future quarters, Butters said.

Given the renewed focus on tax reform, 13 of 52 S&P 500 companies tracked by FactSet commented on the issue during their earnings conference calls for the third quarter. That number is higher than in recent quarters.

“Ten of these thirteen companies expressed some positive sentiment about the potential passage or potential positive impact of tax reform,” Butters said.

For example, FactSet cites Federal Express, which stated on its conference call: “We’re still waiting to see on tax reform what that might do, and that could have an impact on our spending as well.”

Then there’s Accenture: “We still believe that we're going to see tax reform or some evolution that's going to be good for the business.”

Don't Get Crazy

However, investment experts say client portfolios strategies shouldn’t change on a single issue, even on one as big as tax reform.

“The truth is that investing is a long-term game plan,” said Jeff White, financial analyst at FitSmallBusiness.com in New York City. “There’s a school of thought that investing in the stock market should be looked at as a minimum of a five-year horizon.”

That’s not stopping the ultimate market influencer from waxing both positive and poetic on tax reform and what it could mean for the U.S. economy.

“Under our new framework, we will dramatically cut the business tax rate so that American companies and workers can win against those foreign competitors who are winning, in many cases, because they have an unfair advantage,” Trump said on Oct. 11.

“It’s time to end this unfair disadvantage and to give American companies and workers the level playing field they so richly deserve.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at brian.oconnell@innfeedback.com.

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