U.S. stock investors are trying to gauge the strength of a ‘storm’ on the horizon, while President Joe Biden is campaigning for tax increases that would partially reverse a historic windfall, which was passed on to the U.S. business community by his predecessor.
Stocks are heading for new peaks this week as fund managers shake off risks from fluctuating borrowing costs to rising valuations and a new wave of coronavirus spreading to parts of America and other leading global economies.
But Biden’s proposal to raise the corporate tax rate from 21 percent to 28 percent and introduce a global minimum tax is a new threat that some analysts warn could derail the gradual rise in U.S. equities.
“Everyone is currently on a picnic and you see the possibility of a storm coming in,” said Ann Miletti, head of active equity at Wells Fargo Asset Management. “But you are trying to determine the direction of the storm and whether it will hit you in 2021 or 2022 or not, or if it may miss you all.”
Tobias Levkovich, chief US equity strategist at Citigroup, added that “investment community is too excited” and that he does not “show any concern about possible tax increases proposed by the Biden government”.
The Trump administration’s tax cuts, passed by Congress in the waning days of 2017, have given a powerful boost to corporate bottom lines by lowering the legal federal tax rate by 35 percent.
The tax rate paid by average U.S. companies, which includes federal, state and local taxes, dropped to 27 percent in 2018 and has remained at that level of 40 percent previously, according to accountants KPMG.
America’s corporate titans, which are included in the S&P 500 index of large-cap stocks, pay on average even lower taxes because many international operations have them that enable them to take advantage of more favorable tax systems abroad.
The S&P 500 tax rate stood at 17.5 percent in the third quarter of 2020, while that of the technology sector, which has a particularly amorphous tax base due to its relatively small physical operations, according to Howard Silverblatt only 14, 8 percent was. S&P Dow Jones Indices.
The tax cuts adopted in 2017 increased S&P 500 business earnings by 10 percent next year, according to Goldman Sachs’ analysis in June 2020. “Since 1990, declining effective tax rates have accounted for 2 percentage points of the increase in “4 percentage points in net profit margins and 24 percent of the total earnings growth of S&P 500,” the New York bank noted at the time.
Now investment banks are offering clients research on the possible implications of a new tax regime.
Goldman estimates that if Biden’s tax plan is implemented in its current form, it could cut up to 9 percent of S&P 500 earnings per share next year. An increase in the corporate tax rate of just 4 percentage points – compared to 7 offered by Biden – could lower S&P 500 EPS by 3 percent compared to what analysts have suggested for the index this year, Citi’s Levkovich said.
“We see higher taxes as one of the biggest risks ahead in the middle of the year and in 2022,” said Emily Roland, co-chief investment strategist at John Hancock Investment Management.
She added that the impact could be significant enough to limit companies’ fundraising plans. “The risk is that as tax rates rise, businesses may not be fully compensated based on the impact on margins,” she said.
So far, any effect on stock prices has been dampened, with the S&P 500 reaching just several records in the past week. Analysts believe this is because Wall Street is in a wait-and-see mode about how a rise Biden could eventually work through with a razor-sharp Senate majority.
One Senate Democrat, Joe Manchin, has already rejected a 28 percent tax rate from the company and instead demanded a 25 percent ceiling.
Despite this potential headwind, the enormous strength of the economic downturn, coupled with the enormous fiscal and monetary support offered by policymakers, has sounded the alarm bells over the stock market record. The earnings of S&P 500 companies for the first quarter, which will start announcing in the coming weeks, are expected to increase by almost a quarter, compared to the same time last year, the FactSet data show.
This sparked a satisfaction that warned Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, to be dangerous in the end.
The expected volatility in US equities – as measured by the Vix index – has fallen sharply, with Wall Street’s fear indicator now moving below its long-term average of 20. Amid the unrest caused by the coronavirus, it rose so high in March. as 85.
“When the green light flashes brightly to invest and when there is unexpected bad news, the market cannot resist it,” Slimmon said. “The biggest risk is that investors seem to think the coast is clear.”