Epoch believes fundamentals remain strong and maintain a positive economic outlook.
The historic tax laws that were passed in the United States in December 2017 herald a significant boon for US corporates and the broader US economy. In this article, John Tobin, managing director and portfolio manager at Epoch Investment Partners, shares the firm’s views on what these changes mean for the macro environment and global investors.
The tax reform bill, which was signed into law on 22 December 2017, is the most notable change in the US tax code since 1986 and achieves many of the long-standing objectives of the Republican Party. From Epoch’s perspective, it is extremely important in terms of its effects on the economy and how the company will evaluate investment opportunities going forward, as well as what it might mean for some of the companies already invested in.
From Epoch’s position as an investor and looking more broadly at the economic impact, it’s the corporate tax reform that’s most important – while there is a personal tax reform component, this is not the game changer. Interestingly, while business tax changes are permanent, changes for individuals expire.
What tax reforms mean for companies and investors
These tax reforms are good for business; after all, the tax rate has moved from 35% to 21%, providing companies with a permanent increase in trajectory of their net earnings and cash flow. When you consider that the stockmarket is a forward looking discounting machine, it is no surprise that the market reacted very positively to these reforms.
Figure one outlines the differences between the old and new tax code; in all, the reforms are most likely to boost earnings and free cash flow. Having said that, the reforms came together very quickly, so it’s likely there will be surprises and unintended consequences as the changes are implemented.
A major change is the treatment of non-US earnings. The old system kept money offshore – although earnings were still taxable at 35%, the previous tax laws allowed companies to defer them indefinitely, and not pay tax until those earnings were repatriated. As a result, the balance sheets of many companies carried expanding tax liabilities.
This is no longer possible. Companies now must pay tax on all undistributed foreign earnings, whether they choose to repatriate them to the US or not. ‘Deemed repatriation’ means that companies must determine their accumulated, unrepatriated foreign earnings and start to pay tax on those earnings. The reform has offered a one-off tax payment for repatriated – or deemed repatriated – earnings at 15.5%. Companies have eight years to pay tax liabilities on foreign earnings and cash currently held abroad which, as illustrated in figure two, has grown to approximately US$2.5 trillion since the early 2000s.
Many US companies have held cash offshore, which means earnings that have not been reinvested in the business. This cash is concentrated in 10 companies, mainly technology businesses, which generate a lot of cash through global operations, and faster than they can reuse it. A snapshot is provided in Figure three.
The Joint Committee on Taxation calculates that Treasury will receive $340 billion over ten years from deemed repatriation – important, because these tax cuts are going to create a trillion-dollar hole in the US budget.
Which companies benefit from tax reform?
While all companies will benefit from the lower tax rate, some benefit more than others. For example, those businesses that have a significant capital expenditure requirement can now expense capex in the year of purchase, rather than over several years.
Domestic US companies that generate most or all earnings in the US pay 21% tax from 1 January 2018. Examples of companies that benefit include:
- Healthcare companies, which tend to deliver their services in the boundaries of the United States – examples include biotech business AbbieVie and United Healthcare
- Regional banks and other financials such as Wells Fargo.
- Telecommunications companies, such as AT&T, which are double beneficiaries because they also tend to have high capital expenditure.
Also to benefit are non-US companies with significant earnings in the US; that portion of their earnings is now taxed at 21% instead of 35%. Includes industries such as:
- Aerospace – both Airbus and BAE systems do a significant amount of business in the US
- Global auto manufacturers – Daimler, BMW, Honda, Toyota – each of these has significant sales and earnings in the US
- Global financial services firms such as AXA and Allianz, which have many US-based clients, and therefore significant US-sourced earnings.
- Global pharmaceutical giants such as GlaxoSmithKline, AstraZeneca and Roche – a large part of their business is in the US market, so they too will benefit from the reduced corporate tax rate.
So, it’s a good thing for corporate America and a good thing for investors, particularly those using a shareholder yield strategy, which is premised on companies that have strong free cashflow – companies now have greater cashflow with which to reward shareholders through increased dividends, share buybacks and paying down debt.
Where will free cash flows go?
According to Epoch, there are five possible uses of free cash flow, as illustrated in figure four. Firstly, businesses can invest to grow organically, or to grow inorganically by acquiring businesses.
Epoch believes most will go to the owners of the business – the shareholders though dividends, share repurchase or debt reduction. From Epoch’s perspective, it is less likely to be used to fund capital expenditure or merger and acquisition activity because cheap debt has been readily available for many years and companies that want to do this have done so.
Epoch’s view is supported by the findings from a survey undertaken by Bank of America Merrill Lynch (BAML) in which CEOs were asked how they would use additional cash flow – refer figure five. Paying down debt and share buybacks topped the charts; interestingly, funding pension liabilities was also mentioned, paying debt in another form.
Equity demand by corporations – or, in other words, share repurchases – has been increasing since the Global Financial Crisis (GFC). Figure six shows the difference between forecast equity demand pre and post-tax reform. Epoch agrees that a lot of the money freed up by tax reform will be returned to shareholders in the form of share buybacks.
The world is changing, and technology is changing the way businesses operate; Epoch refers to this as a ‘capital light’ environment, where businesses don’t need to spend as much capital to maintain and grow their businesses. Capital spending as a proportion of corporate profits is declining. This view has been discussed in detail in recent articles Tech is the new macro – part one [https://adviservoice.com.au/2017/09/cpd-tech-new-macro-impacting-three-components-return-equity/] and Tech is the new macro – part two [https://adviservoice.com.au/2018/01/cpd-tech-new-macro-part-two/]
In the early 1970s, approximately 75% of a company’s earnings were allocated to capex – today, it’s more like 30-35%; this is a structural change, not a sign that businesses are failing to recognise business opportunities. Epoch believes that advances in technology mean less hard assets are required to increase payouts to shareholders in the form of share repurchases and dividends.
Case study
United Parcel Service (UPS) is held in Epoch’s shareholder yield portfolios because it pays an attractive dividend every year and buys back stock every year – in short, it has a very clear capital allocation policy.
UPS has been a leader in adopting technology. Its business involves the movement of thousands of items around the globe. Trucks full of boxes go to a distribution centre…from there smaller trucks head to another distribution centre…from there, parcels are loaded onto another smaller truck that takes the item to people’s homes or offices.
Significant logistics are involved, and UPS learned long ago that the best way to reduce their costs was to automate the process as much as possible – as such, the company invested in automating warehouse and distribution centres.
Profit goes up to the extent they can replace workers with machinery and automation, they use assets more efficiently and because they get more sales dollars out of existing assets, their asset utilisation is better. Accelerated use of technology by UPS has increased profit and asset utilisation, which means the company requires less equity to keep things going – therefore equity is freed up to be returned to shareholders.
The macro environment
Growth around the word is increasingly synchronised – as illustrated in figure seven, variability of GDP across countries is at its lowest since 1961. This is significant because a solid global cycle is a major positive for earnings growth, regardless of recent volatility in markets.
Although businesses need to invest less in a capital light world, there has been a marked upturn in capital spending. As shown in figure eight, it was a well-established upturn before tax reform, one which will now be turned up.
Add to that, US exports and industrial production are also on a strong growth trajectory – this growth was up before tax reform and will be well established post tax reform – these things have a way of being self-reinforcing. See figure nine.
Interest rates have a way of spooking the market, which is what happened on Friday 2 February. The employment report was strong, with an unemployment rate of 4.1%, which is close to full employment. The market reacted to hourly earnings growth, which led people to be concerned they are underestimating inflation risks and therefore, the likely interest rate trajectory.
While expecting a moderate increase in rates going forward, Epoch believes that even with synchronised global growth, it is relatively low growth – and a low growth world is generally characterised by low inflation, even if getting close to the 2% target adopted around the world. This then flows through to a relatively benign interest rate environment.
As illustrated in figure ten, Epoch believes this process will be gradual and it will be well telegraphed – by the Fed and other central banks around the world. There will be return to policy normalisation – need to move from quantitative easing (QE) to quantitative tightening (QT).
In all, despite the increase in market volatility in recent days, Epoch believes fundamentals remain strong and maintain a positive economic outlook. Central bankers have successfully staved off deflation, while inflation remains below 2% in the G7 and has declined markedly in emerging markets.
Although there is some upward pressure in the US due to labour markets, it is partially offset by technology driven deflation – a tug of war that keeps inflation under control.
Importantly, the macro backdrop remains positive and corporate fundamentals are strong, particularly for those companies based in, or doing business in, the US. Epoch believes that equities continue to be a good long-term investment but difficult to predict in the short-term; the team continuously monitors market developments but has not altered its view or made material changes to overall portfolio positioning.
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