almost 3 years ago • 4 mins
Benjamin Franklin once said that nothing in this world is certain except death and taxes – and for investors, the latter often presents a scarier prospect.
That may now be looming larger than ever. While financial markets have reacted positively to the new US administration’s post-pandemic recovery plan – which includes commitments to major infrastructure spending – they don’t appear to have fully accounted for the “how we’ll pay for this” part.
With the ratio of US public debt to GDP (a.k.a. the size of the country’s economy) already hitting all-time highs, in common with much of the rest of the world, I think investors should be alert to the fact that tax hikes are likely on the way – and position their portfolios accordingly.
To better understand what’s going on, let’s break the issue down into four parts.
America’s economic recovery plan only explicitly mentions changing taxes for companies, and not personal income or wealth taxes. While these may well go up at a later stage, as the chart above suggests, the US is focusing for now on three non-personal tax changes:
While some parts of the plan could be directly implemented by the US Treasury, the majority of it will have to pass through Congress, where the president’s Democratic Party lacks a strong enough majority to guarantee the proposals will pass. As Joe Biden himself put it, “Debate is welcome. Compromise is inevitable. Changes are certain.” In other words, full passage of the plan as currently constituted is unlikely – but at least some of it should eventually become reality.
Investment bank Goldman Sachs estimates that full implementation of the tax plan would reduce 2022 earnings for S&P 500 stocks by 9% on average. As already mentioned, however, the actual impact is likely to be somewhat smaller.
But whatever the precise scale of the effects, they look set to vary considerably across sectors. The tax hikes pose a larger threat to those firms that benefited the most from the 2017 tax cuts, as well as those with lots of overseas earnings. Goldman reckons the sectors most at risk are communication services, tech, and health care.
It’s important to start by assessing what’s currently “priced in”. Stocks in Goldman’s three most tax-sensitive sectors barely moved after the plan was announced at the end of March, suggesting that investors are either doubtful the plan will come to fruition or confident that any earnings impact will be limited. In short, while the recovery plan’s good news seems to be priced in, the potential negative impact from higher taxes may not be – leaving room for unpleasant surprises among investors in the sectors and stocks most at risk.
Two things have really struck me since I started managing money in earnest: how important narratives are in driving market movements, and how the market only seems to be able to focus on one narrative at a time.
So while I agree that the impact of higher taxes on US company earnings will most likely be limited, I do think that investors’ current bullishness, as well as the extreme levels of optimism built into their expectations, mean risks are currently tilted to the downside in a way that’s not being fully appreciated.
A shift in attention away from the positive economic effects of infrastructure spending and towards the risks posed by higher corporate and, eventually, personal taxes could cause investors to take profits off the table – and, in my view, create a stock market correction.
While that could very well be temporary, I think there are three simple things worth doing to protect yourself from any more significant shift in narrative and in markets:
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