Hello and welcome to this month’s equity market review with me, Ritu Vohora.
The ‘January effect’ was alive and well and brought a classic risk-on rally to start off the New Year. In dollar terms, the global index delivered its third best start to the year since data began in nineteen eighty-eight. However, stocks sold-off in the last few trading days of January on concerns of rising bond yields.
Cyclical regions rallied the most in January, with Emerging markets the clear winners. Europe posted its strongest growth in a decade and started the year on a positive note. UK equities were the worst region over the month, however, small caps outperformed large caps which were hurt by a strengthening of sterling. The most notable market move was the US dollar which continued to weaken over the month, posting a 3-year low versus the euro.
Looking at sectors, as global macro data improved and the globally-synchronized earnings recovery continued - cyclicals led performance, while defensives lagged. Technology was the star performer in January, continuing its leadership from twenty-seventeen, with consumer discretionary and financials also performing well.
Across the majority of regions, high beta names rallied and momentum continued to do well.
As 2017 came to a close, President Trump enacted probably the most significant achievement of his presidency to date by passing the Tax Cuts & Jobs Act of 2017. While complex in nature, the tax bill is geared in large part towards corporates, slashing the statutory corporate tax rate for domestic companies from 35% to 21%. This brings the US closer to the OECD average of 24% - a step forward for US competitiveness. Additionally, the changes allow upfront tax deductibility with the full expensing of capital expenditure - a positive signal for investment.
The tax bill also aims to spur the repatriation of corporate cash from overseas, an estimated $3 trillion dollars of profits are currently held offshore by US corporates. Under the reform, companies will be incentivized to bring cash back to the US with an attractive one-time tax rate of 15.5% on cash.
How companies utilize the tax benefits represents a wild card for S&P 500 earnings. Will the windfall go into buybacks and shareholder-friendly activity or spark a wave of capex? In two thousand and four, companies used the tax repatriation to increase share buybacks. So far, more than 70 major US companies have announced increased investment plans, higher wages and/or one-off bonuses. Apple [CIRCLE APPLE] for example, gave its employees a 2,500-dollar bonus. It also promised to accelerate investment - part of a 350 billion-dollar direct contribution to the US economy over the next five years - as it ‘frees up’ 250 billion dollars of cash held offshore for tax purposes up to now. But we are yet to hear of specific steps.
The tax cuts are being echoed in signs that ‘animal spirits’ are finally kicking in. The US equity rally has been substantial since the reform was passed - market observers are now concerned with the speed of the run-up. But is a bad ending inevitable? Or will US tax reform give a stimulative jolt to an aging economic cycle? It’s too early to tell if any of this will give a meaningful boost to growth. Most agree the tax overhaul will be a net positive, at least in the short term. But just how much it ultimately moves the needle is up for debate.
The tax cuts, come at a time of an improving economy and very high business and consumer sentiment. Business investment has been the missing link in the economic recovery, but there are signs that investment could now start surprising on the upside. Capex at S&P 500 companies is expected to rise by 5.5% in 2018, according to FactSet data (up from 2.6% in September). Moreover, wages might also rise if increased domestic capital spending were to lift labour productivity, with the economy at full employment. Faster growth could result in rising inflation, higher treasury yields and steeper yield curves.
Upward revisions to earnings expectations from the tax plan will be front-loaded into Q1, whilst Q4 2017 results will be noisy due to upfront charges taken by companies. In recent weeks, consensus EPS estimates for 2018 and 2019 have noticeably risen, indicating analysts have begun incorporating the tax cuts into their profit forecasts. Last year bucked the trend of a steady downgrade to overly-optimistic analyst earnings estimates and it seems this year is going one better. Aided by synchronized growth and a cut in US corporate taxes, the pace of global earnings upgrades in 2018 is the fastest in at least a decade. While some of these factors may fade as the year progresses, the positive earnings back drop will remain a tailwind for equities for the next several quarters. However, part of the risk at this stage of the rally is interpretation of the tax law changes, how much is already priced in and how confident companies are in providing accurate guidance on the net effect for 2018 earnings. It will likely lead to more dispersion in analyst estimates, and hence potentially higher volatility in prices.
The tax cuts will create winners and losers in the corporate sector. Although the proposed tax cuts will reduce the impetus to keep cash offshore, companies’ bottom lines will be affected differently depending on their global earnings footprint. In contrast, domestically-orientated companies which currently pay taxes near the statutory rate and small-cap companies that often pay higher effective tax rates, should benefit most directly. Banks appear to be a big beneficiary from the reform as they pay high tax rates today - capturing much of these savings will help boost their net income. With tax reform adding to companies’ resources for deals in the US, this could also prompt takeover activity.
The full impact of tax reform on industries and companies will only be understood over time. Investors need to look closely at individual companies’ balance sheets, cash positions and competitive environment to understand which ones will reap the biggest benefits from tax reform in the coming years.
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That’s it from me and see you next time.