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Stock market ‘not even close’ to pricing in tax cuts, says UBS

Congressional Republicans still have a lot of work to do on taxes.

Think the stock market is already discounting a package of corporate tax cuts? Think again, say analysts at UBS, who argue that the tax measures likely to emerge from Congress aren’t priced in and could spark big gains, as well as a potentially violent rotation that would upend U.S. equity portfolios.

In a wide-ranging Tuesday note that laid out the Swiss bank’s outlook for U.S. stocks in 2018, analysts led by Keith Parker took a deep dive into the tax plan.

Divvying up the S&P 500 SPX, -0.55% into the firms with the most and least to gain from a cut in the corporate rate, they note that the top 20% of beneficiaries are trading at an 8% discount to the S&P 500, on a sector-neutral basis, while also underperforming the bottom 20% of beneficiaries since January. Likely tax-cut beneficiaries long ago wiped out the postelection outperformance that was centered on the initial investor euphoria over prospects for a tax overhaul. (See charts below.)

“Just getting back to the relative valuations at the beginning of the year would imply 6% relative upside for tax beneficiaries, let alone the full potential impact of 13%-plus relative upside,” they wrote.

While the Trump administration has insisted it won’t budge on its call to cut the corporate rate to 20% from its current 35%, the UBS analysis assumes the rate will ultimately come in at 25% — a level that would boost S&P 500 earnings per share by 6.5% in 2018 and by the same amount for the median company. The cash impact would be 5% of net income for S&P 500 companies in total, and 3.9% for the median company.

Telecom tops the winner’s table

Among sectors, telecom would be the biggest winner, they calculated, with an aggregate book tax benefit of 12% of net income and a cash tax benefit of 8%. Financials would see a 9.2% boost to earnings but also a lower cash tax benefit, they said, while consumer discretionary and staples would get a 7% to 8% book and cash tax benefit. Real estate and utilities wouldn’t reap much benefit from a lower rate, they said.

Among industry groups, retailing and food-and-staples retailing benefit the most on a cash and book basis, according to the UBS calculations, followed by transports and banks. Semiconductors and pharma/biotech stands to see the least benefit.

Small-caps

The small-cap Russell 2000 index RUT, -0.49% would get an 8% boost, outstripping the benefit to the large-cap S&P 500 but perhaps “less than might be expected given the higher U.S. exposure of U.S. small-caps,” UBS said. They noted that 17% of firms in the Russell 2000 have forecast pretax losses for 2018. That’s 12% of the small-cap index in terms of market cap versus less than 1% for the S&P 500.

S&P 500 growth and value indexes would both see a 6% boost to EPS from a lower tax rate, but growth would see a 5% cash boost versus 4% for value.

Stocks that stand to benefit from repatriation — and subsequent stock buybacks — are outperforming, the UBS analysts said, with the top 20% of repatriation beneficiaries outperforming the S&P 500 by 5% on average in the year to date and the bottom 20% of tax beneficiaries by 7%. That suggests that buybacks are largely priced in, they said.

‘Extreme disruption’

The UBS analysts doubt that tax cuts will be enacted before the end of 2017, but see a corporate cut as likely in 2018. They noted that the S&P 500 rallied more than 40% after the 1986 corporate tax cut.

But they also warned that a 13% to 14% difference in potential performance across industries and stocks could make for large and abrupt shifts.

“We see the prospect of a corporate tax cut as having the potential to cause extreme disruption to U.S. equity portfolios that are based on fundamental and secular factors,” they said. “The exogenous event could fuel a sizable rotation, and relative performance of winners vs. losers is likely to oscillate as plan probabilities shift, with bigger market impacts as the event gets closer.”


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