Stocks Need Tax Reform Now More Than Ever
(Bloomberg View) -- Most equity investors I talk to put little hope in the passage of any corporate tax reform in the U.S. Congress this year. Moreover, their confidence that anything will pass in 2018 is dimming. They see more immediate issues, from debt-ceiling and budget debates to providing disaster relief for Texas and almost certainly Florida, as pulling Washington’s attention away from the longer-term necessity of revising the nation’s tax code.
At the moment, market participants don’t seem to care. Corporate profit growth remains strong, long-term interest rates linger near all-time lows, and global economic growth now appears to be synchronized to the upside. Yes, equity valuations feel stretched, but when earnings are high and rates are low, that is hardly a surprising outcome.
Step back, however, and you’ll see some worrisome trends. We are closer to a cyclical peak than a trough for earnings. Moreover, central banks in the U.S. and Europe are plotting their removal of financial-crisis-era stimulus, which should push long rates higher over time. The investment climate for domestic equities is fine today, and probably tomorrow, but it would be foolish to assume it mirrors the old joke about a Los Angeles weatherperson’s forecast: “Sunny and 75 degrees, next forecast in five days …”
Take those high (and still rising) profit margins for U.S. companies. They have allowed the S&P 500 Index to post earnings growth of 10.2 percent in the second quarter on revenue growth of just 5.1 percent. Incremental margins are the unsung heroes of this year’s rally, creating upside earnings surprises even when markets accurately forecast revenues. That translates into increased confidence for further gains in future quarters.
When you put the current levels of U.S. corporate profitability into historical context, the picture changes. Trailing four-quarter S&P 500 operating profit margins are 10.6 percent, and the second quarter was even better at 10.8 percent. Those compare with 9.0 percent at the prior peak in 2006, and just less than 8.0 percent in the late 1990s.
What could cause margins to revert back to longer-run averages? The most obvious answer is a U.S. recession, but the menu is longer. Commodity inflation may not be an issue at present, but the CRB Index has not made a new cyclical low for more than a year. Wage inflation is slowly rising, with the Federal Reserve Bank of Atlanta’s national wage growth tracker showing steady growth in 2017 at 3.3 percent for July.
Corporate tax reform is not a panacea for these issues, but it can certainly provide a useful counterweight to any eventual mean reversion in corporate margins.
Relief on repatriation of corporate profits is high on investors’ wish list, and for good reason. Consider Apple Inc., which held $246 billion in cash at its foreign subsidiaries at the end of its most recent quarter in July. That is 29 percent of its market capitalization.
This is a fundamentally important misallocation of societal capital. Critics of offshore cash tax relief say the money will just go for stock repurchases and dividends. Yes, but that’s exactly how capitalism is supposed to work. Companies that cannot effectively reinvest their cash flow should hand it back to shareholders so they can circulate it into other business that can use it more productively.
The next item to consider is lowering the U.S. corporate tax rate from 35 percent to something closer to the mid-20-percent range of other developed countries. Yes, effective rates in the U.S. are lower than statutory rates, but that misses the point of revising the existing code. The goal is to level the playing field between smaller (typically faster growth) companies with little access to global tax havens and put them on par with the larger ones that benefit from this non-economic differential.
The relative market performance of the Russell 2000 and the S&P 500 since the 2016 election highlights the problem. After a quick bounce in the weeks after the vote, the Russell has now underperformed the S&P by almost 7 percentage points in 2017, enough to push the five-year performance record for small caps below that of larger companies. Tax policy, in short, is a contributing factor in punishing investors for taking the risk of owning smaller companies.
Fixing corporate tax policy will not be easy. The problems do not lend themselves to the scoring process that consumes Washington decision-making. Nor do they immediately address the myriad of other economic or social issues that currently cloud every debate in the nation’s capital.
The best time to do anything is before events force your hand. With the U.S. economy on solid footing, a midterm election cycle in the offing, and a Republican Congress anxious to show results, now is the right time for Washington to pass corporate tax reform.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Nicholas Colas is former chief market strategist at Convergex Group LLC.
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