Given the unprecedented quick passage and signing into law of the new Tax Cuts and Jobs Act, it will likely be many months before tax attorneys and financial analysts are able to accurately and fully gauge the short- and long-term impact of the new legislation – both on individual and corporate taxpayers as well as the economy as a whole. To date, we’ve barely scratched the surface of the myriad opportunities and obstacles the new law will present.
For individual taxpayers, a lowering of income tax rates combined with an increase in bracket income thresholds are expected to translate into a $100 billion tax cut. Opinion is widely split; however, as to how much of that savings will actually translate into increased consumer spending that, in turn, could fuel GDP growth.
Ultimately, the new law’s effect on individuals and families will vary widely depending on income level and personal circumstances. Nevertheless, there are some broader market and sector implications that investors will likely want to consider.
Will this extend the bull market?
We’re fast approaching the nine-year anniversary of the current bull market which began in March 2009. This is now the second longest bull market in history, trailing only the bull market of 1987–2000. Major indices continue to post new highs, stock valuations are approaching historic levels, and market volatility has been almost nonexistent. It’s enough to make any investor wary. But the new tax law has the potential to further prolong this bull market.
For now, the consensus opinion among analysts is that reducing corporate tax rates from 35% to 21% and eliminating the corporate alternative minimum tax (AMT) will likely increase the average stock’s earnings per share by 10% or more. Enhanced earnings per share combined with the potential boost in GDP growth from increased consumer spending, could certainly help drive continued economic and market growth.
It is important to keep in mind, however, that reduced tax revenues without corresponding spending cuts will probably mean the budget deficit could rise precipitously. This means the Treasury will need to increase the money supply, thereby injecting inflationary pressure into the economy. In addition, a rising GDP may push wages higher and keep unemployment low, allowing the Fed to continue raising interest rates. Over the course of 2018, expect to see an additional two to four interest rate increases of 25 basis points each, bringing 10-year Treasury yields near 3%. Already, and in anticipation of Fed tightening activity this year, the yield on the 10-year Treasury has risen to over 2.7%.
How will various sectors react?
While the potential for higher interest rates and mounting inflationary pressures over the course of 2018 may help provide valuable momentum to the financial sector, the same factors may serve as a headwind for other sectors – in particular utilities, REITs and corporate bonds. Real estate may further feel the negative impact of new restrictions on state and local tax deductibility as well as mortgage interest deductibility. And new caps on business interest deductibility could serve to hold back both small-cap stocks and high-yield bonds.
In general, the new tax reforms should especially favor businesses that are currently paying a high effective tax rate, with the lion’s share of their earnings derived from U.S. operations. It’s a recipe that bodes well for the future prospects of the consumer discretionary sector.
As we’ve just witnessed, significant changes to the tax code can be implemented at any time. With that in mind, we believe it’s wise to be extremely cautious about making any major adjustments to a well-diversified portfolio. If you have any questions or concerns about the potential impact of the new tax law on your investments, however, please don’t hesitate to reach out to your BLB&B financial advisor.