John Lynch Chief Investment Strategist, LPL Financial
After more than a year of political posturing and investor anticipation, Congress finally approved a $1.5 trillion tax cut, the most sweeping U.S. fiscal overhaul since 1986. The 2017 Tax Cuts and Jobs Act was signed into law by President Trump on December 22, 2017, meeting his pledge to deliver tax reform before Christmas. The complex 1,000-page bill features changes that are intended to spur economic activity through a reduction in both individual and corporate tax rates, and simplify the tax code by eliminating or trimming a variety of deductions and exemptions. In this week’s commentaries, we look at the likely impact of the final bill on the economy, monetary policy, and the financial markets in the coming years.
As we wrote in our Outlook 2018: Return of the Business Cycle publication, we believe the combination of improved business fundamentals and fiscal legislation should sustain momentum in the economy and equity markets in the coming year and potentially beyond. After years of depending on the largess of monetary policymakers, investors can now focus on fiscal levers that we believe will support consumption and spur new business investment over the next few years. The law has important implications for major corporations, small businesses, and individual taxpayers [Figure 1], and may shift the trajectory for economic growth, the federal budget, monetary policy, and perhaps most critically for investors—corporate profits.
As we wrote in our Outlook 2018, corporate profitability will likely be a significant beneficiary of any meaningful change in the corporate tax rate. Indeed, the reduction of the corporate tax rate from 35% to 21%, combined with businesses’ ability to fully expense their capital expenditures for the next five years, are powerful potential tailwinds for profits, which have already enjoyed a renaissance in 2017, powered by improved domestic and global demand. We believe this will help elongate the expansion, which has thus far been powered by the U.S. consumer. Going forward, we look for business investment and further gains in corporate earnings per share (EPS) to power the economy and equity markets.
Given the potential for an extended expansion due to the new tax changes, we encourage all diversified investors to remain diligent relative to their targeted allocations. To be sure, 2017 was a year of extremely low volatility and the coming year may not be as docile, particularly when considering the historic examples of financial markets tending to test new Fed chairs, as well as the volatile trading patterns leading up to midterm elections. But given solid global growth and firming corporate profits, we recommend that any market pullbacks be considered as an opportunity to deploy cash or rebalance back toward targeted allocations.
Size, Style, and Sector Implications
Entering the ninth year of this expansion, our view continues to favor small cap and cyclical exposure. Specifically, we prefer a slight overweight (relative to benchmarks) of small cap stocks and, despite the recent momentum supporting growth stocks, are positioning portfolios for a tilt toward the value style of investing. Small caps may benefit from the new law due to a typically higher tax burden relative to large caps [Figure 2]. Small caps would also be more likely to benefit should the dollar push higher due to the pickup in economic growth, since their more domestic focus makes them less vulnerable to the negative impact of a rising dollar on international profits.
We also believe the value style of investing should benefit from the new fiscal legislation. As investors search for opportunities, the recent gains in the price-to-earnings ratio (PE) for growth stocks should attract the attention of value seekers. The tax advantages combined with relative value should enable the value style to garner added attention, especially since many value names are in sectors that are poised to benefit from tax cuts, infrastructure spending, and reduced regulation.