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Schwab Sector Views

Schwab Sector Views: Taxing Issues for Sectors

Key Points
  • The new tax law will likely affect all companies, but the size and direction of that impact will vary.

  • The tax code is only one part of a sector’s story and it’s important to continue to look at the entire picture.

  • We aren’t recommending changes at this point, but we will be watching earnings season to see what more companies may be thinking about the changes.

Schwab Sector Views is our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is designed for investors looking for tactical ideas. We typically update our views every two weeks.

Taxing Times

The parties are over, the decorations put away, the euphoria dying down, or, conversely, the tension is easing, the arguments and disappointments are dissipating, and life is returning to “normal.”  The holidays?  No—the tax reform process. After months of wrangling and arguing, often even within the same party, a tax reform package was passed by both chambers of Congress and signed by the President. Now that the euphoria—or disappointment, depending on your point of view—is dying down, it’s time to look at how the changes may actually affect your investments.  Don’t roll your eyes or be tempted to nod off at the mention of a discussion of taxes. I’m not an accountant and I didn’t stay at a Holiday Inn last night, so this discussion is going to be more of an overview than down in the nitty-gritty. And in some cases, accountants I have talked to have noted that there could still be tweaks to the new tax rules and how companies may react to certain changes is not yet known.

Lower...right?

Well, the one thing we do know for sure is that the corporate tax bill got reduced from a world leading 35% to a more competitive 21%. Or did it?  The tax rate did indeed get dropped by that amount, but whether the tax bill is actually reduced will depend on the company.  In fact, we’ve already heard from some major companies that they are initially going to take a fairly large tax hit due to changes in the way certain items are accounted for and now taxed.  For example, one seemingly overlooked issue is that the value of the deferred tax losses that many companies had on their books—including tech (from the tech bubble burst), financial (from the housing collapse) and energy (due to the crash in oil prices)—are now likely worth less as they only offset a 21% tax rate instead of a 35% rate. This doesn’t mean you should look to sell companies that may apply to—but it is something to watch out for.

Similarly, the change to the way international earnings are taxed may seem somewhat negative initially to certain companies with large amounts of assets outside of the U.S., such as tech, but should end up being beneficial if things proceed as we think they will. Initially, according to guidance from the IRS, cash and liquid assets of American companies held overseas will be taxed at a 15.5% rate, while illiquid assets will face an 8% tax—and payments for both could be spread out if needed.  That will result in a fairly large initial hit to some companies. Already, Bank of America announced it would take a $3 billion charge in the fourth quarter and Goldman Sachs said it would post a $5 billion charge in the same quarter as a result of the changes.  But after that, companies can move money currently held overseas—and all future money earned overseas—to the U.S. tax-free.  We believe this will result in a fair amount of money being brought back to the U.S. and at least some of that money will be used for capital expenditure purposes.

Additionally, the tax law also now allows capital expenditures to be expensed immediately instead spread out over a period of years—at least for the next five years.  This should also incentivize companies to pursue more capital spending plans they may have been putting off, in our opinion.  And we’re already seeing indications that companies are becoming more comfortable with the idea of adding to the expense side of the ledger, such as the jump in the New Orders component of the ISM Manufacturing Index and the capex plan question in the Empire State Manufacturing Survey.  So while much of the tech sector may take an initial hit from the new tax law, ultimately we think it will be a net positive as they are able to bring cash back to the U.S. and benefit from an increase in other corporate spending on tech-related gear

Spending plans appear to be increasing 

capex

Source: FactSet, Federal Reserve Bank of New York. As of Jan. 9, 2018.

The consumer side of the tax law also has the potential to benefit tech companies as well as other consumer-related names due to the lower tax bill many Americans are going to have.  There has been much discussion about whether the majority of Americans will indeed see a cut to their taxes, but according the research firm Strategas Research Partners, more than 80% of Americans are estimated to have a lower tax bill in 2018 than 2017. It stands to reason, at least to us, that some of that additional kept income will go toward spending. 

There has also been some concern about the lower cap for the mortgage interest deduction, with some fearing a “collapse” in the housing market as a result.  We believe those fears are overdone…way overdone! Under the new tax law, individuals will be allowed to deduct interest paid on new mortgages (issued after Jan. 1, 2018) of up to $750,000, down from the previous cap of $1 million.  Much of the U.S. housing market activity goes on below $750,000, and it seems those buyers are the individuals who would be most sensitive to this type of change in the tax code. But this change shouldn’t affect them. For those operating over that $750,000 mark, they may not be rich by some standards, but it is our belief that a change such as this won’t deter them from pursuing the home they desire. 

But that doesn’t mean there aren’t some potential losers as a result of the tax changes.  Among them is the potential for companies with a higher debt load to take a hit—such as the telecom group.  According to the Wall Street Journal’s breakdown of the law, interest on debt above 30% of EBITDA (earnings before interest, taxes, depreciation and amortization) won’t be deductible for the next four years. After that, interest expenses above 30% of EBIT will no longer be deductible.  In our view, that could hurt high-debt shareholders in two ways—first, the higher tax expense due to the lower deductibility, and second, the potential for equity stakes to be diluted as companies look to issue more equity instead of debt in order to finance their operations.

Finally, we are looking at a potential upgrade to the real estate sector due to the changes in the tax law, but since taxes are only one aspect of our analysis we have enough concerns to keep it at underperform for now.  It can get a little complicated so I won’t wade into the details too much. But a point worth covering is the changes in the pass-through income rate. As a result of the changes, the amount an investor in the new top bracket of 37% would have to pay on REIT  (Real Estate Investment Trust) dividend income, as long as it’s not return of capital, is 29.6%, according to the National of Association of REITs and the Wall Street Journal. We have a feeling a lot of REITs are held in tax deferred accounts due to the income stream that typically comes from them, but it is something we’re watching.

Suffice it to say that this isn’t by any means an exhaustive study on the new tax law but it should give you a starting point of things to think about.  But we also believe the important thing to remember is that the tax situation of any given sector is typically a relatively small part of their overall picture so we urge caution in making any knee-jerk moves simply because of a tax law change.

Schwab Sector Views: Our current outlook

Sector

Schwab Sector View

Date of last change to Schwab Sector View

Share of the
S&P 500 Index

Year-to-date total return as of 01/09/2018

Consumer discretionary

Marketperform

07/17/2014

12%

3.51%

Consumer staples

Marketperform

05/07/2015

8%

0.14%

Energy

Marketperform

11/20/2014

6%

4.21%

Financials

Outperform

05/07/2015

15%

2.29%

Health care

Outperform

01/26/2017

14%

4.00%

Industrials

Marketperform

01/29/2015

10%

3.81%

Information technology

Outperform

04/29/2010

24%

4.37%

Materials

Marketperform

01/31/2013

3%

3.94%

Real estate

Underperform

01/26/2017-

3%

-2.46%

Telecom

Underperform

09/12/2013

2%

-1.82%

Utilities

Underperform

05/23/2013

3%

-2.56%

S&P 500®  Index (Large Cap)

 

 

 

2.96%

Source: Schwab Center for Financial Research and Standard and Poor’s as of 12/31/17.

Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations.

What is Schwab Sector Views?

Schwab Sector Views is our three- to six-month outlook for 11 stock market sectors, which are based on the 11 broad sectors of the economy.

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

  • Outperform: Likely to perform better than the rest of the market.
  • Underperform: Likely to perform worse than the rest of the market.
  • Marketperform: Likely to track the broad market.

How should I use Schwab Sector Views?

Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor’s 500 allocations to each sector, listed in the chart above, as a guideline.

Investors who want to make tactical shifts in their portfolio can use Schwab Sector Views’ outperform, underperform and marketperform ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.

Schwab Sector Views can also be useful in identifying stocks by sector for potential purchase or sale. When it’s time to make adjustments, Schwab clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide an objective and powerful approach for helping you select and monitor stocks.

Talk to Us

To discuss how this article might affect your investment decisions:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.
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Consumer Discretionary Sector Rating: Marketperform

Important Disclosures

Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.

Performance may be affected by risks associated with non-diversification, including investments in specific sectors. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

All expressions of opinion are subject to change without notice in reaction to shifting market and other conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Empire Manufacturing State Index is a regional, seasonally-adjusted index published by the Federal Reserve Bank of New York distributed to roughly 175 manufacturing executives and asks questions intended to gauge business conditions for New York manufacturers.

The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of Morgan Stanley Capital International Inc. (MSCI) and Standard & Poor’s. GICS is a service mark of MSCI and S&P and has been licensed for use by Charles Schwab & Co., Inc.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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