US President Trump has announced his proposed tax changes with financial markets pricing in the likely impacts assuming at least a substantial part of these changes will be implemented. We look at what impact is expected for various sectors of the US economy and link this to some of the US corporate bonds on the FIIG menu
What are the proposed changes?
Donald Trump promises to cut the corporate tax rate from 35% to 15% and consolidate individual tax rates to 12%, 25% and 33%, as well as a host of smaller changes targeting simplification.
Impact on US economy
Median forecasts from leading economists and financial market analysts is a 6% climb in GDP over the next ten years, or an average impact of 0.6% pa. Given that the US economy is expected to grow at around 2% to 2.5% pa for the next ten years, this is a substantial impact.
Impact on US debt
After taking into account the additional tax revenue that comes with higher GDP growth, the total impact of Trump’s tax policies is estimated to be an additional $2.6 trillion over the next 10 years, or an additional 11% of GDP by 2025.
Likelihood of proposed changes being implemented
Financial markets have all but priced in the tax changes, unlike other Trump promises such as border taxes (tariffs on imports), which it remains sceptical about. The scope of the proposed bill hasn’t been done in the US for 30 years and the approval process is complicated. We will likely see a bill proposed inside Trump’s “100 days” with the vote around September.
Some of the major economic sectors are listed below, along with the average analyst’s view of the impact.
Winners and losers of Trump’s proposed tax changes
| Sector | Estimated impact on cashflow | Examples including bonds on FIIG menu |
| Consumer discretionary | 14.3% | CBS Corp; McDonalds; Ralph Lauren; Walt Disney |
| Telecommunications | 13.5% | CenturyLink; Frontier Communications |
| Materials | 12.6% | Emeco; Glencore Finance; IAMGold |
| Transportation | 11.5% | Hertz |
| Healthcare | 9.4% | Kindred Healthcare |
| Financials | 8.3% | Navient |
| Average | 8.1% |
|
| Technology | 3.3% | Dell; Diamond Finance |
| Energy | -0.1% | Enviva Partners |
| Real estate | -10.5% | GEO Group |
| Utilities | -10.8% | Talen Energy; TransAlta |
Source: Bloomberg, FactSet, FIIG Securities, JP Morgan, Merrill Lynch, Morgan Stanley, Zero Hedge
What if it doesn’t happen – what will the impact be on financial markets?
Financial markets have already assumed that at least most of the proposed tax changes will be implemented. If it fails or is wound back substantially, equity markets will likely fall back by 2% to 5% only, but it could also be a trigger for the long overdue end to the bull market. The equity price correction will be in line with the above, ie consumer discretionary stocks will fall hardest as they are the ones which the markets have priced in the most upside.
Bond markets have priced in more inflation and therefore higher bond yields, as a result of the fiscal stimulus and likely inflationary impact of Trump’s proposals. If unsuccessful, the bond market will likely see yields fall and prices rise.
Conclusion and investment strategies
The list of sectors and associated bonds above gives an idea of how to build your investment portfolio. However, it is important to understand where good value still lies – markets may have already built in these cashflow benefits. The best approach is to work with your dealer to understand where to find the best combination of upside in the company’s prospects and good value in current pricing.
Addition as of 21 February 2017
Since originally publishing this note we have received a couple of questions:
1. Is it necessarily true that all companies in a sector will be impacted in the same direction as the sector’s forecasted impact?
No, it is possible that a company like Talen might be positively impacted while the rest of the utilities sector is negatively impacted, or that the negative impact isn’t as large. It completely depends upon the specifics of the company’s revenue mix and deductibles. The largest factors driving the total impact on earnings are:
- A new corporate tax rate – proposed to drop to 20%, but could be 15% (almost all analysts are assuming 20% for now). At the moment, the utilities sector has an average effective tax rate of 32%
- Border adjustment tax (imports tax) – large negative impact on consumer products, clothing, electronics; very small impact on utilities, real estate
- Interest tax shield – part of the lower tax rate is a proposal to end the tax shield (deduction in Australian terminology) for net interest expenses. While it is reasonable to assume that all existing debt instruments will be grandfathered, this will have a negative impact on highly leveraged companies, hence the expected negative earnings impact on real estate and utilities. Some utilities will be able to pass any costs through to users – particularly where they are running regulated utilities like retail electricity – but many won’t.
Until we know the detail of Trump’s policy changes, it will be difficult to assess the specific impact on each company. All we can do is forecast based on broad assumptions. As more detail comes to light, we will start looking at specific credits and the likely impact given their current tax rate, imports and gearing profile.
2. Why is the utilities sector likely to be impacted the most and what are the consequences?
Utilities will be hurt by the proposed end to the net interest expense shield. The response from each company will depend upon their gearing, but will include a mix of the following:
- Pass through costs to users, however this depends upon each individual contract they hold
- Reduce leverage – existing debt is likely to be grandfathered and the utilities industry tends to have very long dated debt issuance. As each facility matures, leverage is likely to slowly come down, which will reduce the amount of bonds in the market and put downward pressure on credit spreads over time
- Reduce dividends. Lower deductibility will mean less cash is available for distributing to shareholders, forcing down dividend payments. This will likely have a negative impact on share prices.