Implications of likely 2023 budget and trade policies

Split Congress and split agendas: Tax policy in 2023

by Michael Taylor, CFA, Investment Strategy Analyst

Although comprehensive tax legislation failed to pass Congress in 2022, new tax provisions take effect this year alongside phaseouts from previous bills. A split Congress will make enacting new tax legislation challenging.

Key takeaways

• Several Inflation Reduction Act and SECURE Act 2.0 tax provisions take effect this year alongside a continuation of phaseouts from the Tax Cuts and Jobs Act.
• A split Congress will make passing comprehensive tax legislation challenging through 2024.
• Tax provisions of the Inflation Reduction Act may offer near-term benefits for the Energy and Information Technology (IT) sectors in our view. We believe tax burdens from a 15% corporate minimum tax will likely weigh on Real Estate and Mining.

Conflicting priorities

In August 2022, U.S. lawmakers passed the Inflation Reduction Act with tax provisions that took effect on January 1, 2023. Meanwhile, tax provisions of the 2017 Tax Cuts and Jobs Act continue to phase out, impacting the bottom lines of large U.S. firms. More recently, the SECURE 2.0 Act that passed Congress last month included tax provisos that we believe could impact investors.

With Republicans in control of the House, we expect lawmakers to focus on spending and the debt ceiling. Certain tax-policy agenda items could be on the docket, including repealing IRS funding from the Inflation Reduction Act for Republicans (see Sidebar 1) and an enhanced child tax credit for Democrats. A lack of bipartisanship should make enacting new tax legislation challenging.

Tax provisions and phaseouts

Although comprehensive tax legislation failed to pass Congress last year, we expect the following tax provisions from the Inflation Reduction Act should take effect this year:

• Clean-energy tax credits for homeowners are extended through 2032
• Rebates for electric vehicles are extended through December 2032
• Affordable Care Act subsidies for health insurance are extended to 2025
• 15% corporate minimum tax for firms with profits exceeding $1 billion
• 1% tax on stock buybacks for corporations

Meanwhile, we expect these provisions of the 2017 Tax Cuts and Jobs Act should continue to phase out this year:

• Capital expensing — The largest business hit is the end of full capital equipment expensing. Maximum early deduction drops to 80% this year and continues to decrease through 2026.
• Research and development (R&D) expensing — Full expensing of R&D was replaced by amortizing expenditures over five years, posing tax increases for the largest U.S. companies.
• Interest expensing — The cap on business interest deduction decreased last year while borrowing costs have risen alongside Federal Reserve rate hikes — a double whammy that will significantly impact manufacturers and capital-intensive firms.

SECURE Act 2.0

On December 29, President Biden signed into law the Consolidated Appropriations Act of 2023. Included in the bill is the SECURE 2.0 Act that aims to boost retirement savings. Individuals saving for retirement, retirees, and small business owners can potentially benefit from this legislation.

Highlights include:

• Required minimum distribution (RMD) starting age for individual and employer-sponsored retirement plans increases to 73 this year and to 75 in 2033
• Reduction in excise tax on certain (under-distributed) accumulations in qualified retirement plans and IRAs
• Effective this year, those aged 70½ and older can make a one-time qualified charitable distribution up to $50,000 from an IRA to a charitable remainder annuity trust, charitable remainder unitrust, or charitable gift annuity
• Additional 10% penalty-free distributions for pre-59½ distributions under certain conditions — emergency expenses up to $1,000, pension-linked emergency savings, terminal illness, domestic abuse, disaster recovery up to $22,000, and long-term care
• Beginning in 2024, 529 plan beneficiaries can make rollover contributions to Roth IRAs up to $35,000 under certain conditions
• Allows 401(k), 403(b), governmental 457(b), and SIMPLE IRAs to “match” student loan payments under certain conditions
• Catch-up contributions to workplace retirement plans increased from $6,500 to $7,500 for those aged 50 and older; beginning in 2025, special provisions take effect that will increase catch-up contributions for those aged 60 to 63, up to $11,250 annually
• Increased start-up tax credit for small employers — the provision increases the three-year small business start-up credit from 50% to 100% of administrative costs with a $5,000 annual cap

Economic and investment implications

In the near term, tax credits plus seed funding for alternative fuels as well as broad provisions for clean-energy equipment may benefit the Energy and IT sectors, respectively. We currently hold favorable tactical ratings (over the next 6 to 18 months) on Energy and IT. Meanwhile, we believe clean energy, home-energy efficiency, electric vehicle tax rebates for consumers, and a number of other elements may benefit the Industrials, Materials, Utilities, and Consumer Discretionary sectors over the long term as they are extended out 10 years. We hold a neutral tactical view on the first three and an unfavorable view on the last, respectively.

Many businesses may be impacted by the continuing phaseout of capital expensing and R&D expense amortization, coupled with Inflation Reduction Act corporate tax provisions. Tax burdens from the minimum tax levy will fall heavily on Real Estate (unfavorable tactical rating) and Mining (neutral), with net-tax hikes projected at 12.7% and 4.6% of income over the next decade, respectively.

The bipartisan SECURE 2.0 legislation may help in an effort to bolster U.S. retirement savings and preparedness. Looking ahead, with a divided Congress, we do not anticipate major tax legislation during this congressional session and likely through the 2024 election cycle.

Potential impact on interest expenses and the debt-ceiling debate

by Douglas Beath, Global Investment Strategist

Higher interest rates and expectations for reduced tax revenue will likely pull forward the debt-ceiling debate. The newly elected Republican Congress will focus on limiting deficits, but we expect an eventual compromise that aims to avoid a government shutdown, potentially benefiting certain equity sectors.

Key takeaways

• The spending bill for fiscal year 2023, on top of multi-trillion-dollar spending and debt issuance associated with the pandemic, has placed renewed focus on the U.S. budget deficit and long-term outlook.
• Our base case remains that a debt-ceiling debate will ultimately lead to some compromise without a government shutdown or default.
• The key issue for investors is to anticipate how the two parties will navigate spending priorities in order to reach an agreement.

Rising servicing costs on the national debt

The $1.7 trillion fiscal year 2023 spending bill, on top of multi-trillion-dollar spending and debt issuance associated with the pandemic, has placed renewed focus on the U.S. budget deficit and long-term outlook. America’s fiscal health is also being scrutinized due to the recent spike in interest rates.

The U.S. national debt currently exceeds $30 trillion, more than 100% of gross domestic product (GDP), and is expected to reach 110% of GDP in 2032, according to projections from the Congressional Budget Office (CBO). While these current and projected debts are very high from a historical perspective, we believe it likely that the U.S. can support a meaningfully higher debt level given the country’s dominant global economic position and the dollar’s role as the world’s primary reserve currency. Another key factor why investors have been comfortable buying Treasury securities is that 40% of the debt is owed by the U.S. government in various trusts such as Social Security, while an additional 35% is financed by U.S. investors.

Interest on the debt is another concern. Ultralow interest rates reduced the cost to finance the federal budget from a high of 15.4% in 1996 to a 2022 projection of just 6.8%. Current CBO projections show the debt service increasing to over 13% of the federal budget by 2032, based on assumptions for modestly higher interest rates. Under this scenario, interest expense costs should remain manageable, but the larger share of the budget going to debt service may potentially limit the assistance that the federal government could provide if any new crises should arise.

Even if Treasury bonds transition to a higher-yielding cycle, we routinely adjust our long-term strategic guidance to consider corporate bonds and preferred securities that we expect should continue to pay a premium over Treasuries — and, combined with active management, potentially balance additional yield with the additional risk. In our view, rising government debt levels could also result in more volatile equity prices than in the past 14 years, but we still expect equities to return more than bonds.

Debt-ceiling debate

With the passage of a $1.7 trillion spending bill, Congress averted the threat of government shutdowns until next July. In the meantime, higher interest rates and expectations for reduced tax revenue due to a significant decline in shareholder wealth from 2022 will contribute to a deteriorating fiscal situation. As a result, we believe the debt-ceiling debate is likely to be pulled forward.

This in turn should have the greatest impact on companies that generate the most revenue (as a percentage of sales) from government spending, which could include pharmaceutical (pharma) and defense manufacturing companies. We already hold an unfavorable outlook on pharma but have been favorable on defense since the Russian invasion of Ukraine.

As in previous episodes, this debt-ceiling debate will be about process. Republicans generally want spending cuts, while the president and House Democrats oppose spending cuts. Important questions for investors will include if and what sectors will be cut, and if they will be targeted or “across the board”. We believe it’s too early to predict how the debt ceiling will impact equity sectors. Case in point: Defense stocks outperformed in 2022 but have underperformed significantly this year on fears of a potential debt-ceiling showdown. Yet, several Republican House members oppose freezing defense spending.

Our base case remains that a debt-ceiling debate will ultimately lead to some compromise without a government shutdown, default, or cuts to Social Security, Medicare, or veterans’ benefits. However, we favor not jumping to conclusions about the exact timing or which sectors may potentially benefit. Since the 2011 debt-ceiling fight, Congress has repeatedly had to face raising the debt ceiling. In each case, they have been successful, even though investors worried about default. The key factor for investors is to see in advance not “whether” they raise the debt ceiling, but “what they trade off” to do it. It’s too early to know what the ultimate compromise will be.

U.S. trade policy at a crossroads?

by Gary Schlossberg, Global Strategist; Jennifer Timmerman, Investment Strategy Analyst

Renewable energy and technology are among the most visible beneficiaries of a more eclectic U.S. foreign-trade policy, shaped as much by national security, environmental, and other domestic concerns as by traditional internationalism. Trade’s support for the Information Technology (IT) sector helps support our favorable strategic view of higher-quality U.S. technology companies.

Key takeaways

• We view trade policy as a net longer-term positive for IT, supporting our favorable strategic rating, despite potential drawbacks. As for Industrials, we believe the harmful effects of U.S. tariffs are part of a neutral overall outlook on the sector.
• Supply chains tied to renewable energy and technology reshoring and nearshoring support ancillary businesses, such as chemicals and gases for semiconductor manufacturing and other materials and semi-processed goods used in those two sectors.

Investment implications of an evolving trade-policy debate in 2023

A different kind of internationalism

U.S. foreign-trade policy is evolving away from the free-trade principles of traditional internationalism toward a hybrid approach shaped as much by domestic, geopolitical, and environmental priorities as it is by purely economic considerations. We expect contours of change could affect trade policy in these ways:

1. A more protectionist tilt, using subsidies, other trade preferences in key growth industries, and outright tariffs closely allied with a move toward greater reshoring and, to some extent, nearshoring
2. An elevated role of national security in trade-policy decisions shaped by growing economic and geopolitical competition with China, stoked by grievances over that country’s unfair trade practices
3. Fallout from simmering trade disputes with U.S. allies in Europe, Canada, and Mexico

A closer look at the issues

We believe frontline technology and renewable energy industries should benefit from U.S. subsidies in the 2022 Inflation Reduction Act and CHIPS and Science Act favoring domestic and foreign companies investing and producing in the U.S. Support from recent Inflation Reduction Act legislation reinforces our favorable view for larger, well-capitalized, and diversified companies with renewable-energy exposure. Our favored sub-industries applicable to this theme include Electric Utilities, Industrial Gases, Integrated Oil, and Multi-Industrials. We view these companies as well-positioned to expand market share without the financial risk faced by pure-play firms in the industry.

Recent and emerging developments in trade policy likely are mixed, but we view as positive, on balance for the IT sector. Combined with opportunities for further digitalization and U.S.-company strengths in the global market, policy has supported our favorable strategic view of U.S. technology stocks. We look for semiconductor manufacturers with their own fabrication plants are among the most visible beneficiaries of the move to reshore critical industries to the U.S. under the CHIPS and Science Act.

We currently maintain a favorable rating on the Semiconductor Equipment sub-industry, in part because of the long-term benefit from the U.S. policy focus on more domestic production. Added support to the semiconductor industry came from a decision at the North American summit in Mexico on January 10 – 11, 2023, to foster cross-border supply chains to facilitate reshoring of technology firms to the U.S.

Our overall view of the trade agenda is positive for the IT sector, even though not all the news is likely to be good. National security’s elevated role may have a damaging effect on U.S. technology sales to China in our view. High-end technology firms (keyed, for example, to leading-edge chips for supercomputing and artificial intelligence) and sales of semiconductor equipment manufacturers to China are among the most exposed to export controls. We believe technology sales could be cushioned modestly by incremental benefits to output of so-called NAND flash-memory chips, and by sales of semiconductor and related equipment diverted to the U.S. market.

An added counterweight for the technology industry is the decision by the European Union (EU) to move ahead with a 1.5% – 7.5% digital sales tax and a 15% global minimum tax. The EU announcement hits hardest at large U.S. tech and other multinational companies operating there. Action by the U.S. on its own minimum tax, to retain domestic revenues, isn’t likely until the expiration of several tax provisions in 2025, effectively exposing technology and other multinational companies to higher taxes abroad. To reiterate, in our view these negative considerations do not outweigh the positives described above.

Look for the unexpected in this year’s trade debate, too, as we and our trading partners react to foreign economic-policy changes in the past year. For example, Europe’s new multinational taxes could invite retaliation by the U.S. Progress toward further regional integration in North American trade could be slowed by festering disputes over Canadian restrictions on U.S. dairy and soft-lumber imports, and on U.S. energy and agricultural sales in Mexico. By contrast, we view the Biden administration’s decision to maintain Trump-era levies on steel and aluminum imports as part of a global tilt toward industrial policies favoring subsidies rather than the opening round of another trade war with our commercial partners, having little impact on our neutral tactical view of Industrials.

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