Quarterly Market Update

Q&A

Q&A with BBVA Compass Global Wealth Chief Investment Strategist Dan Davidson, CFP and BWS Investment Strategist, Anne-Joëlle Viguier-Galley, CFAQ&A with Chief Investment Strategist for BBVA Compass Global Wealth Dan Davidson, CFP and Chief of Equity and Alternative Investments for BBVA Wealth Solutions, Anne-Joëlle Viguier-Galley, CFA 

In this edition of the BBVA Compass Market Outlook, Mr. Davidson and Ms. Viguier-Galley discuss 2017 Tax Reform.1 

1.  In the 4Q17 the anticipated 2017 Tax Cuts and Jobs Act was signed into law. What will be the general impacts?

This legislation has important implications for major corporations, small businesses and individual taxpayers in the short/ medium term mainly. It should impact both the U.S. economy and the federal budget, and maybe as an unintended consequence, the Federal Reserve interest rate policy will accelerate its tightening bias. The tax act will increase after-tax income for most American households either directly, through lower personal taxes, or indirectly, through investment impacts or higher wages. As a result, the heavily front-loaded tax cuts will have an impact on growth/consumption, unemployment and interest rates this year and maybe next year as well, but the positive effects may dissipate thereafter.

Per a recent article in the Financial Times, The Penn Wharton Budget Model expects at most a 0.1% uplift to annual GDP growth over the next 10 years. Goldman Sachs expects a 0.3% boost in 2018 and 2019, but “after that, the size of the tax cut flattens off and starts to decline somewhat, so we don’t estimate any additional uplift to GDP in 2020.” Per the BBVA Research Department, the potential long run GDP growth trend should revert to around 2%-2.2% based on expectations for labor (major factor being U.S. demographics, i.e. aging of the population), capital growth, and productivity.

2.  What are the effects of the “Tax Cuts and Jobs Act” on the federal debt?

In fiscal 2017, which ended on September 30th, the Federal Government ran a deficit of $666 billion, with debt in the hands of the public of $14.7 trillion, or 76.5% of GDP. Exact analysis of the impacts of the Tax Act is difficult. However, using an analysis done by the Joint Committee on Taxation (JCT) of the Congressional Budget Office (CBO), the debt could reach almost 100% of GDP by 2027 (see graph below)2 . Remember that in terms of “debt productivity” each additional dollar of debt has less and less impact on GDP growth as a larger percentage of the new debt has to be used to service the existing debt.

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3a.  How will the proposed tax laws impact corporations?

With the corporate tax rate declining from the 35% statutory rate to 21% under the current legislation, American companies may be among the biggest winners in the federal tax reform movement. Yet, because the effective tax rate paid by corporations is in fact generally lower than 35%, the effect will vary depending on the sector and company. For example, as per Bloomberg data, AT&T and Verizon show effective tax rates above 30%, while Alphabet and Apple show 19% and 25%, respectively. Some investment strategists believe that the effective rate will decline by only a few percentage points3 from what it is at present.

As you can see from reading our Equity section, tax reform will lift S&P 500 earnings for 2018, although we believe that quite a bit of the good news was already priced into the markets by the end of 2017. Uncertainties remain, in particular around the impact of specific provisions at the company level and how corporate behavior will respond to the new tax code: in other words, the sensitivity of each company’s earnings to the tax bill.

Competition for customers and labor may prevent the entire benefit of the corporate tax cuts from accruing fully into corporate earnings. So presumably, companies with superior pricing power and with a history of high and stable gross margins may find it easier to retain the benefits of lower taxes.

Banks, consumer staples, apparel, retail, leisure and supermarkets seem to show upside potential to their earnings from the tax cuts due to their sensitivity to the tax bill4 . Small-capitalization domestic companies may also benefit as they usually pay higher taxes than multinationals.

3b.  What about repatriation?5

Based on individual company reports, Goldman Sachs estimates that there is a total of US$2.5 trillion of earnings held overseas by U.S. multinationals. The tax on deferred corporate foreign income shall be allowed as a deduction for the taxable year in which an amount is included in the gross income of the U.S. shareholder corporation. The applicable rate on foreign cash positions is 15.5%. After paying such taxes, the remainder amount should boost earnings per share and these moneys can be either reinvested into the company or distributed to U.S. shareholders via cash dividends or share buy-backs.

3c. What about limits on interest deductibility?6

Limits on interest deductibility may incentivize companies to replace debt with equity in order not to exceed the cap on deductible interest. Issuing new equity or no longer buying back their own shares in order to shift their capital structures may result in lower earnings per share for some companies. This may affect smaller companies more than larger ones as there is a larger percentage of companies that pay more than the “new” 30% cap on interest expenses in the Russell 2000 than in the S&P 500.

4. What does the new Tax Plan generally speaking mean for individuals?7

Most Americans will see a tax cut starting in 2018. Generally speaking, families with incomes in the range of $50,000 to $60,000 a year will receive anywhere from $800 to $1,200 in tax relief in 2018. In some cases, it may be as high as $2,000, depending on individual circumstances. Meanwhile, high-income individuals living in high-tax states will generally see tax increases, largely because of the planned elimination of the state and local tax (“SALT”) deduction. The SALT provision expires at the end of 2025, leaving it for a future Congress to decide whether to resume the deduction.

5. What about individual deductions?

The following are the key provisions impacting individual income tax deductions, effective for taxable years 2018 through 2025:

  • The standard deduction has been doubled to $24,000 for married couples ($12,000 for individuals) and the personal exemption is eliminated.
  • Miscellaneous itemized deductions that were subject to the 2% floor (e.g., certain unreimbursed employee business expenses, tax-related expenses, and investment-related expenses) are suspended.
  • The overall limitation on itemized deductions is eliminated.
  • The Alternative Minimum Tax (AMT) for individuals is maintained with a higher exemption level of $109,400 for married couples ($70,300 for individuals).
  • The deduction for state and local taxes (SALT) has been limited. Taxpayers can deduct up to $10,000 in the aggregate for property, income and sales tax.
  • Taxpayers can deduct interest on mortgage debt up to $750,000 of acquisition indebtedness for a newly acquired principal or second home. Interest on home equity loans is no longer deductible.
  • 529 Plans are expanded. Effective for distributions made after December 31, 2017, 529 accounts may distribute up to $10,000 per student per year for tuition at a public, private, or religious elementary or secondary school.
  • The law imposing a penalty on individuals who don’t purchase health care insurance coverage is effectively repealed by reducing the penalty to zero. This change does not take effect until 2019.

6. Are there any estate planning opportunities in the new tax law?

Estate and gift taxes remain a part of the U.S. tax code. However, the exemption has been doubled to $11.2 million per transferor in 2018 ($22.4 million for married couples).8

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1Generally based on the 2017 tax reform act (“An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” Pub. L. No. 115-97; enacted Dec. 22, 2017)

2As per the Congressional Budget Office, Joint Committee on Taxation and J.P. Morgan Asset Management

3Studies performed by: Brinson, Hood & Beebower—1986; Brinson, Singer & Beebower—1991; Ibbotson & Kaplan—203 The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed. The statutory tax rate is the rate imposed on taxable income of corporations after deductions for labor costs, materials and depreciation of capital assets. (Source: Fidelity)

4As per a study by Goldman Sachs Investment Research published in December 21, 2017

5As per a study by Goldman Sachs Investment Research published on December 21, 2017

6As per a study by Goldman Sachs Investment Research published on December 21, 2017

7As per a study by UBS on the Tax Cuts and Jobs Act published January 21, 2017

8As per a study by UBS on the Tax Cuts and Jobs Act published January 21, 2017

BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).