Is This The Next Big Threat To Your Portfolio?

Is This The Next Big Threat To Your Portfolio?
Stéphane Renevier, CFA

almost 3 years ago4 mins

Mentioned in story

What’s going on here?

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.

US personal taxes vs GDP

What does this mean?

To better understand what’s going on, let’s break the issue down into four parts.

1️⃣ What taxes are we talking about?

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:

  • Increasing the standard tax rate on US companies’ domestic profits from 21% to 28% – still lower than the 35% pre-2017 level.
  • Raising the “GILTI” tax rate on US firms’ overseas earnings in order to crack down on companies shifting profits abroad.
  • Encouraging other countries to sign up to a global minimum rate of corporate taxation and penalizing US firms which stash cash elsewhere.

2️⃣ How likely is this to be implemented?

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.

3️⃣ What might this mean for US company earnings?

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.

Goldman at-risk sectors

4️⃣ How big could the market impact be?

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.

Why should I care?

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:

  • Lower your stake in US stocks compared to global equivalents. As discussed in previous Insights, US stocks are trading at a premium to their global peers, and higher taxes could prove a catalyst for repricing.
  • Lower your stake in those sectors most likely to be hit by tax hikes: communication services, tech, and health care. At the very least, make sure you’re not overly concentrated in these areas.
  • Assess the potential impact of higher taxes on specific stocks in your portfolio. Goldman Sachs has helpfully published a list of those it sees as being most at risk...
Goldman at-risk stocks


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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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