What Trump's Tax Cuts Mean For ETFs
Analysts say corporate earnings will rise and debt issuances are likely to decline following changes in the tax code.
Corporate taxes are going to go down under a Trump administration; that much is certain. But exactly what form those tax cuts take is still an open question. The president-elect has proposed cutting the current statutory rate from 35%―the highest among developed nations―to 15%.
That's a bit lower than the 20% rate that Paul Ryan, speaker of the House of Representatives, has proposed in his plan.
In any case, taxes are going down and corporate profits are going up, though not necessarily as much as the headline rate cut would suggest. That's because while the U.S. has a statutory rate of 35%, the effective rate―the amount that corporations actually pay in taxes―is several percentage points below that due to deductions and other tax benefits.
Trump's plan calls for an end to most corporate deductions and loopholes, except the research and development credit. It also gives manufacturers the choice to immediately expense capital investments (rather than over time, as they are expensed currently) if they forgo the deduction of net interest expenses.
Ryan's plan provides no choice, automatically making the cost of capital investments to be immediately deductible, while eliminating the deductibility of net interest expenses (with special rules for financial services and real estate companies that rely heavily on debt financing in their businesses).
Ryan also favors moving to a "territorial system," where corporations aren't taxed on their foreign income, only domestic. Trump is less specific on this point, but has been vocal in calling for a low one-time repatriation tax of 10%, so that corporations can bring their overseas profits into the U.S. Ryan's plan would tax existing offshore earnings held abroad at a one-time rate of 8.75%.
Bullish For Profits
While it's impossible to ascertain the impact on corporate earnings from any changes in tax policies before they are even hashed out, a number of analysts have tried to give it their best shot. The result is usually bullish for profits.
For example, Goldman Sachs estimates that a cut in the statutory rate from 35% to Trump's 15% would lead to a 16% increase in S&P 500 earnings, while a cut in the statutory rate to Paul Ryan's 20% would lead to a 12% increase in earnings.
The earnings gains are only slightly reduced when factoring in a repeal of net interest deductibility and the creation of a territorial system, to 15% and 10%, respectively.
Given those big potential gains in earnings, it's no wonder large-cap funds such as the SPDR S&P 500 (SPY) rallied so hard following the November elections. Since Nov. 8, SPY has returned 6.4% as investors rushed to at least partially price-in the coming tax cuts.
But as good as the gains have been in the S&P 500 and in SPY in the past few months, small-cap indexes and ETFs have done even better. The iShares Russell 2000 ETF (IWM) jumped 14.3% in the period since the elections amid speculation that the tax cuts will be even more of a boon for small companies.
Returns For SPY & IWM Since Nov. 8
"The effective tax rate for the Russell 2000 is 32%, and the S&P 500 we calculate at 26%," Lori Calvasina, chief U.S. equity strategist at Credit Suisse, told CNBC. "There's three reasons [small caps] rallied so hard —valuation, the domestic exposure and the corporate tax rate."
Impact On Dollar & Bonds
Aside from the impact on stocks, the coming tax cuts will have ramifications on other asset classes as well. The U.S. dollar is seen by some as beneficiary, as lower taxes boost economic growth and companies repatriate at least some of the $2.6 trillion they hold offshore (though others argue the latter won't be a bullish factor for the dollar).
Another asset class that could be impacted from the tax cuts is bonds—corporate bonds in particular. According to analysts at Bank of America, the elimination of net interest deductibility as proposed in Paul Ryan's plan could reduce the size of the investment-grade corporate bond market by 30% from a current level of $4.87 trillion.
Without the benefit of being able to deduct interest, corporations will simply have less of an incentive to issue debt, according to the analysts. Instead, firms could look to raise capital with more equity, including preferred stock.
At the time of writing, the author did not own any of the securities mentioned. Contact Sumit Roy at [email protected].
