Tax reform and the Border Tax – A Quick Primer on SP 500 Earnings Impact

One of the risks with the time it takes to push through what might be the biggest change to the US tax code ever, is that businesses (and individuals, too) are waiting to see what the end product looks like, which means a further delay in business activity, which could potentially mean slower growth.

The Bank Credit Analyst (BCA) was kind enough to send me a report on the US Border Adjustment Tax (USBAT) a few weeks ago, and even after reading it a few times, it is daunting and complex. BCA sees a 50% chance “that some version of the proposal will be implemented”.

The key to the USBAT seems to be the link to the US corporate income tax:

  • Exports will subsidized and imports penalized will be offset with the expected US dollar appreciation. (Sounds like a good case for a long position in the UUP.)
  • The goal is that the trade balance would remain roughly unchanged
  • The transfer pricing mechanisms which are so prevalent today for companies with non-US operations would be eliminated.
  • The end game is that USBAT would encourage US production and US labor employment and thus (my thought) is that the border tax eliminates the incentive to relocate production in lower-cost non-US countries.

Under the US cross-border tax, Energy could be hit hard – basically any company that has a product consumed in the US, where that product is brought in from overseas (i.e. oil refining, auto manufacturing, retailers that manufacture apparel in China, etc.) would be on the “need to short” list.

BCA sees a stronger dollar from this as well as higher Treasury yields, but my own thought was that a higher US dollar is a de-facto tightening of US monetary policy thus a higher dollar MIGHT actually result in a Treasury rally initially, with the stronger expected economic growth that follows, potentially causing a rise in Treasury yields.

Owning the UUP in client accounts might be a hedge against the US cross-border tax.

Here is a note from BAML (found on ValueWalk: on the impact to SP 500 earnings by credible tax reform.

This link talks about the additional SP 500 EPS from what BAML calls “watershed tax reform”.

The first two paragraphs of the research piece talk about tax reform adding $5 – $6 to Sp 500 earnings in 2017. Given the work this blog does every weekend on SP 500 earnings, the current “forward 4-quarter EPS estimate” for the SP 500 of $131.95 could thus ultimately be $136 – $137. Further down the piece, BAML estimates that cash repatriation could add ANOTHER $3 to SP 500 EPS if just half the cash repatriated was used for share repurchases, which is consistent with what was written on this blog two months ago.

What I found interesting in the BAML piece was that – even of the corporate tax rate was reduced to just 25% – it is still a $0.70 to $1.90 increase in SP 500 EPS.

Potentially the SP 500 could see a $137 – $140 EPS in 2017 if all this “reform” gets enacted this year. On an SP 500 trading at 2,295 as this is being written, the “reform” P.E ratio is now 16.7(x), which doesn’t account for faster SP 500 earnings growth that might result from tax reform.

Summary / conclusion: Wrapping all this up, the cross-border tax is now less confusing. However the investment implications could be all over the map. Note BAML’s sector chart, and that probably doesn’t include another hot topic and that is the “infrastructure program”, or the “bridge to somewhere” to turn an old phrase.

It sure seems like a lot will happen this year between Congress and the President, and much of it positive from an economic growth and tax perspective.

However as each of these levers gets pulled, i.e. the dollar, Treasury yields, the trade balance, the deficit, etc. there will likely be unforeseen consequences.

All of these economic “hot topics” have to be incorporated into one broader scheme or plan, and until that happens, I would suspect US CEO’s and CFO’s and the Board’s may be reluctant to commit to investment plans.

Bottom-line is that despite the complexity and confusion, the ultimate objective of reform is bullish for the US economy and US corporate profits. Our basic client asset allocation hasn’t changed for many years, with this year clients potentially being able to win on both sides of the allocation. (Sorry I cant be more specific. Read the blog for sector bets, etc.)

  • Overweight US equity
  • Underweight bonds/fixed-income

Thanks for reading.

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