There Are Ways To Profit From The US’s Proposed Tax Hikes – If You Squint A Little

There Are Ways To Profit From The US’s Proposed Tax Hikes – If You Squint A Little
Carl Hazeley

over 2 years ago3 mins

  • The US government’s tax proposal includes increasing the corporate tax rate to 26.5% and the tax rate on US companies’ foreign income to 16.6%.

  • There may be short-term opportunities to buy stocks that have been sold off in anticipation of tax hikes that might never happen, or to sell stocks that haven’t fallen and perhaps should have done.

  • Buying high-quality US stocks – those with a track record of high earnings growth and pricing power – should help insulate investors from higher tax rates over the medium term.

The US government’s tax proposal includes increasing the corporate tax rate to 26.5% and the tax rate on US companies’ foreign income to 16.6%.

There may be short-term opportunities to buy stocks that have been sold off in anticipation of tax hikes that might never happen, or to sell stocks that haven’t fallen and perhaps should have done.

Buying high-quality US stocks – those with a track record of high earnings growth and pricing power – should help insulate investors from higher tax rates over the medium term.

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With details having emerged on Monday of a US corporate tax hike, analysts have been trying to predict the toll it would take on company stock prices. So let’s take our own closer look at the tax hike, the popular predictions, and the opportunities that could arise from both.

What is the proposed tax hike?

There are a few elements to the government’s plan, but the most important for markets are twofold: an increase of the top corporate tax rate from 21% to 26.5%, and an increase to the minimum tax of US companies’ foreign income from 10.5% to 16.6%.

Source: Wall Street Journal
Source: Wall Street Journal

As for what that would do to stocks, Goldman Sachs estimates that a corporate tax rate hike to 25% (slightly lower than the government’s proposed rate) and a foreign income tax rate of around 15.75% (again, slightly lower) would reduce earnings of companies in the S&P 500 by 5% in 2022.

Has the market priced these tax hikes in?

Looking at data from just last month, only five of the 13 banks that shared their US equity strategists’ 2022 earnings forecasts with Bloomberg are currently incorporating a tax hike of any sort into their forecasts.

And looking at prediction markets, investors (rather than analysts who have published forecasts) appear to be pricing a 62% chance of higher US tax rates next year into the markets. More specifically, they’re pricing in a two-thirds chance that the corporate tax rate will rise to 25%.

That suggests there’s room for a negative move in stock prices if tax rises happen, and even more so if the government’s current 26.5% corporate tax rate proposal goes ahead. That’s especially true since stocks are only 1-2% short of record highs.

Two last things: investors also appear to be pricing in the possibility that these tax changes will affect share buybacks, with the companies that make the biggest buybacks having underperformed in the last few weeks. But they haven’t been pricing in the impact these hikes could have on income earned outside the US.

What’s the opportunity here?

In the short term, you could try to take advantage of any mispricing still out there.

Monday’s proposal didn’t actually include any tax changes that would affect share buybacks, for instance. So all else being equal, those that offer significant buybacks and whose shares have been underperforming lately should see that underperformance reverse. Of course, all else isn’t equal: American companies have been the biggest buyers of American stocks over the last 10 years, so higher taxes elsewhere should leave them with less cash to keep doing just that

Similarly, US companies that make large portions of the income outside the country are now facing higher taxes both home and abroad, which means they’re likely to underperform. You could short them, or just avoid them altogether.

But if higher taxes take hold by next year, you’ll probably want to buy “high-quality” US stocks – companies with a track record of compounding high earnings growth and able to raise prices without sacrificing sales. That “pricing power” is important because if their costs – or, more specifically, their taxes – go up, chances are it won’t send their profits down. High-quality companies can, after all, just increase the prices they charge their customers, who will have no choice but to accept them if they want the company’s essential or hard-to-replace product or service.

That tends to be the case in a handful of industries and for a handful of companies: Alphabet and T-Mobile US are in Goldman Sachs’ basket of high-quality communication services companies. Monster Beverage fits the bill in consumer staples, UnitedHealth and Thermo Fisher Scientific in the healthcare industry, and Mastercard and Accenture in information technology.

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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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