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Q&A—Market Implications of Tax Reform

Wells Fargo Investment Institute - December 27, 2017

Key Takeaways

  • The Tax Cuts and Jobs Act was signed into law on December 22, 2017, and it is the most extensive overhaul of the U.S. tax system since 1986.
  • Our initial, high-level review shows more economic stimulus and potentially stronger equity-market support than indicated in our current forecasts, which we made after the House passed its version of tax reform in November.

What It May Mean for Investors

  • While it will take financial markets some additional time to digest the law's implications, some investment connotations are apparent. We recommend that investors looking to benefit from the new stimulus focus on cyclical equity sectors, which we already favor.

Download the report (PDF)

The Tax Cuts and Jobs Act was signed into law on December 22, 2017, and it is the most extensive overhaul of the U.S. tax system since 1986. This report addresses in detail whether specific tax reform provisions are positive or negative across a variety of asset classes. However, we are continuing our analysis of the magnitude of the impacts, and we will publish revised year-end targets in another report early in the New Year.

Equities:  Major equity-market benefits (and headwinds) from tax reform

What are the most important provisions of the new tax reform law for companies and equities? Which provisions impact earnings the most?

In addition to the significant decrease in the tax rate from 35% to 21%, businesses may write off 100% of their capital expenditures (capex) for the next five years. In this recovery, while the consumer has largely pushed the economy ahead, corporations have been hesitant to make meaningful capital expenditures. We expect more capital spending as the economic recovery develops.

Are there any negative provisions?

Yes, we believe that there are a couple of negatives in the new tax law. First, full deductibility of interest expense is replaced by deductibility limited to 30% of earnings before interest, taxes, and depreciation. In addition, the unrepatriated past foreign earnings back to 1986 are taxable, and at a higher rate than we initially estimated. We estimate the extra 2018 tax liability at approximately $35 billion.  

How could tax reform create opportunities in 2018?

We do see opportunities based on the new tax legislation. We believe that tax reform could extend the current cycle by a couple years more. Given that possibility, sectors that benefit from continued economic growth could offer more upside than previously thought. We also are anticipating more equity market volatility next year as the Federal Reserve (Fed) continues its rate hike cycle and investors wait for the anticipated increase in capex, consumer spending, and economic growth. In our view, pullbacks should be looked at as buying opportunities. There are many moving parts in the new legislation that are difficult to estimate quickly. Uncertainty often creates opportunity in the stock market.

What can be said about tax reform’s implications for the large-cap equity sectors?

If we are correct, and corporations increase their capital expenditures, the Industrials sector would be one of the main beneficiaries. Typically, late in a cycle, this sector benefits as capex increases and the international economy improves. We continue to recommend that investors overweight the Industrials sector relative to its weighting in the S&P 500 Index. Other sectors that likely will benefit are Information Technology and Health Care. These sectors both contain corporations that have large amounts of earnings retained overseas. We do expect that some of these earnings held overseas will be repatriated.

Overall, we continue to lean toward those sectors that are sensitive to the ebb and flow of the economy and that can benefit from a continuation of the recovery. In general, consumers also should benefit from the new tax code, and many will have more cash to spend. In addition to Industrials, we also are recommending overweight positions in the Financial, Health Care, and Consumer Discretionary sectors.

Fixed Income: Tax reform impacts, from municipals to corporate securities

What does tax reform mean for municipal securities?

The limits on state and local tax deductions could have a significant impact for investors in high-tax locations. Even though individual tax rates will move lower (and the standard deduction will increase), we expect that the effective tax rates for high-earning individuals in certain locations may increase. Individuals who reside in high-tax states such as California, New Jersey, and New York appear to face the biggest potential impact. We expect an increase in effective tax rates (i.e., average tax rate after deductions and exclusions to income) for some individuals in these locations to fuel the demand for tax-exempt income inherent in most municipal securities. Lower corporate tax rates may offset some of this new demand for municipal securities. Banks and insurance companies likely will find the effective benefit of municipal securities has declined—reducing their demand.

What is the potential impact on the supply of municipal bonds?

In the final tax package, private activity bonds still will qualify for exemption under most circumstances. Yet, advance refunding issues will no longer qualify for tax exemption going forward (existing bonds will be grandfathered). Without advance refunding issuance, we could see new municipal supply drop by up to 25% in 2018. In anticipation of the new tax policies next year, municipal issuance has spiked in recent weeks. We believe that this offers investors attractive valuation opportunities.

Will companies change the mix of their capital structures, now that their interest deductibility is limited?

Yes, we likely will see some changes over time. A lower corporate tax rate and a cap on business interest payments that exceed 30 percent of adjusted taxable income deductions could impact lower-rated companies, specifically those that employ significant leverage. For companies that are in decent financial shape, a lower corporate tax rate is likely to be a positive, and has typically led to higher earnings and an increase in free cash flow. Companies that are lower on the credit spectrum, especially those that are significantly leveraged, may find that the cap on interest deductibility further strains their already challenged balance sheets.

Are there now more advantages to working with active fixed-income managers?

Yes. In our opinion, the changes and new dynamics of the new tax law may present additional advantages to working with active fixed-income managers. Professional money managers have teams that are dedicated to performing credit and market research. These teams thoroughly review bond covenants and the financials related to debt issuance (and loan issuance) deals. Managers also will analyze the impact of the new law on various taxable and municipal securities. Additionally, they will determine how their corresponding managed portfolios should be adjusted based on the perceived risks and opportunities created by the tax law, in relation to the objectives of the portfolios.

Real Assets: The varying tax-reform impacts on Real Assets

Does tax reform impact commodities?

Only marginally. Commodities are global in nature, so we doubt that U.S.-specific tax reform will have much of an impact. If there is an impact, we see it leaning negatively for commodity prices in general. U.S. commodity producers, with lower overall tax bills, may find more production projects hitting return targets. This potential to add more supply, could, on the margin, hurt commodity prices.

Does tax reform change our commodity outlook?

No. We still see the commodity bear super-cycle as the main driver of the group in 2018. We maintain an underweight recommendation for commodities.

Do real estate investment trusts (REITs) benefit from tax reform?

Yes, U.S. tax reform looks to be marginally positive for REITs. REITs “pass through” the majority of their earnings to investors in the form of dividends, in exchange for no corporate tax rate. REITs generally should benefit from the proposed maximum pass-through tax rate on REIT dividends of 29.6% (37% top individual tax rate and 20% deduction). The maximum tax rate on REIT distributions previously was 39.6%.

Are there any other tax law developments that benefit REITs?

Other primary positives include: interest deductibility on real estate maintained, like-kind exchanges on real property maintained, the home mortgage deduction being preserved (but reduced to $750,000 of mortgage debt), and reduced foreign withholding on capital gains distributions (35% to 21%).

Does this change our outlook for REITs?

No, the tax law does not change our outlook on REITs. We maintain an overweight to public real estate, which encompasses both domestic and international REITs.

Master limited partnerships (MLPs) are pass-through entities as well. Will they experience the same benefits as REITs?

U.S. tax reform does not look like it will benefit MLPs significantly. MLPs are “pass through” entities, like REITs. Yet, the earnings that are “passed through” reach investors in different forms. The majority of a REIT’s earnings “pass through” comes to REIT investors in the form of income. The majority of an MLP’s earnings “pass through” comes to investors in the form of a return of capital.  Return of capital payouts are mostly tax deferred, which leads us to believe that MLPs will not benefit from U.S. tax reform to the degree that REITs will.  

Any there other potential consequences for MLPs?

MLPs also may be at a disadvantage to comparable businesses that are structured as C-corporations (C-corps). C-corps, which are taxed at the corporate level, should benefit from lower taxes. We may even see an acceleration of MLPs transitioning to C-corps as this structure can provide the flexibility to diversify business operations, and it gives access to larger investment pools.

Alternative Investments: Winners and losers in the alternatives space

Does tax reform change carried interest taxation (capital gains versus ordinary income)?  

No, the tax law retains carried interest taxation at the capital gains rate. However, the tax law requires that the underlying investment be held for at least three years to qualify for the capital gains rate. Shorter holding periods would be treated as short-term capital gains (rather than being taxed as ordinary income). This three-year holding period may favor certain private capital strategies with typically longer-holding periods (such as buyouts and private infrastructure) over hedge funds or those private capital strategies with typically shorter-holding periods (such as distressed debt and direct lending). 

Does the tax reform law offer advantages to private capital over other alternative strategies, by virtue of the former as job creators?

Yes, the tax reform law is more advantageous to private capital strategies, such as venture capital and growth equity. These strategies are expected to benefit from the preservation of the tax treatment of equity-based compensation, which is key to early-stage growth companies—and also from the tax law’s provisions that make it easier for employees of start-up companies to exercise their stock options.

Do hedge funds or private capital qualify as pass-through entities that offer their owners the ability to deduct 20% of their income before paying taxes based on the individual rate?

Yes, most hedge funds and private equity funds, as well as law, consulting, and accounting firms, are partnerships, which qualifies them as pass-through entities. The tax law includes a provision permitting non-corporate owners of certain partnerships, S-corporations, and sole proprietorships to claim a 20% deduction against qualifying business income.

Are there any other issues to address?

Yes, we believe that corporate tax-rate deductions are generally positive for existing private capital holdings. While corporate tax-rate reductions are generally positive for existing private capital holdings, they may lead to increased valuations. Lower interest deductions are expected to reduce the portion of debt used for private equity buyouts. In buoyant markets, reduced portfolio company debt likely would lower equity returns, while in down markets, reduced portfolio company debt would be expected to minimize losses. Certain private debt strategies involving lending to sponsored transactions may have lower transaction volume as a result. Furthermore, the repeal of advance refunding bonds may have a large impact on short-term funding for multi-asset portfolios (such as those held by endowments and foundations).

What conclusions should investors draw?

This law of nearly 1,100 pages is not quite the tax simplification that congressional leaders originally sought. There are many complex provisions, especially relating to international activities. Therefore, we will evaluate our market targets thoughtfully to reflect the effects of the most meaningful fiscal policy change in more than 30 years. But investors should keep in mind both our conclusions from above, as well as the political risks that remain for 2018 (discussed below).

Tax reform should be a strong positive and may help to insulate financial markets from some political risks in 2018. Political developments may still create volatility. Some of that news may be positive for markets, particularly if the administration continues to deregulate the economy. Yet, there is room for disappointment if infrastructure improvement initiatives or financial deregulation fails in Congress. Possible immigration limitations and trade restrictions pose other negative risks. Investors also may face new uncertainties if inflation unexpectedly accelerates and raises questions about the pace of Fed interest-rate hikes.

Some conclusions already are apparent, as discussed above:

  • Tax reform favors an improving economy and our equity sector recommendations mostly align with that improvement outlook. Tax rate cuts and repatriation provisions favor the sectors we already list as our top picks—including Industrials, Consumer Discretionary, Financials, and Health Care. Of the potential beneficiaries of tax reform, only Information Technology is not among our favorites (but is a neutral sector in our view).
  • We continue to see strong support for municipal securities and observe advantages to working with active managers.Tax reform may encourage commodity producers to add to excess production. Meanwhile, REITs may benefit from new pass-through provisions, but MLPs may be at a disadvantage to firms structured as C-corporations.
  • Among the alternative investment strategies, private capital strategies with typically longer-holding periods (such as buyouts and private infrastructure) may hold an advantage over hedge funds or those private capital strategies with typically shorter-holding periods (such as distressed debt and direct lending).

Wells Fargo and its affiliates are not legal or tax advisors. Be sure to consult your own legal or tax advisor before taking any action that may involve tax consequences. Tax laws or regulations are subject to change at any time and can have a substantial impact on your individual situation.