[SOLVED] Tax Reform’s Effect on Equities

BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 31 to 32. 11811133The RIC ReportTaxes, politics and markets14 November 2017Tax reform heats up While the broad strokes of the House and Senate tax reform plans are largely similar, there are a few important distinctions, chief among them being when the corporate tax rate cut from 35% to 20% would take effect, the individual income tax brackets and rates, the deductions for state and local taxes, medical expenses and mortgage interest and the taxation of pass-through income. These issues may prove challenging to remedy in the House and Senate. So too is the price tag: in order for Republicans in Congress to use the budget reconciliation, and thereby prevent the possibility of a filibuster in the Senate, tax reform can add no more than $1.5tn to the deficit over the next 10 years. Our economists expect solid growth irrespective of Congress’ ability to pass tax reform.Tax reform’s effect on bonds The House and Senate tax reform proposals would likely boost the relative performance of investment grade corporates, which will benefit from reduced supply and economic growth. Municipal bonds may also benefit from reduced supply and individual tax rates that remain at or near current levels. Treasury yields may rise in the intermediate term from the increase in federal debt generated by the large proposed tax cuts. If reform fails, though, corporate bonds’ recent outperformance would probably reverse.Tax reform’s effect on equities The weak performance of the likely tax reform beneficiaries and small caps suggests skepticism either on the passage or the magnitude of any eventual tax reform. The differences in the latest proposals vs. the “Unified Framework” released in September are that the negative offsets (minimum foreign tax, limit on interest deduction) appear more watered down, implying slightly higher accretion to EPS, with a potential one-time negative offset from the House’s higher repatriation tax rates. US equity strategist Savita Subramanian estimates that either plan could boost 2018 S&P 500 pro forma earnings per share (EPS) initially by $18-19 (excluding a one-time charge for repatriation tax). But the recurring benefit could be much a smaller $11, as much of the benefit is likely to be competed away. Subramanian currently estimates 2018 S&P 500 EPS of $135 without any benefit from lower taxes. Regardless of tax reform, solid growth trends have boosted investor and consumer optimism and propelled markets higher.