Well it’s time for another update on how corporate America intends to spend the windfall from the GOP tax cuts which the Trump administration variously pitched as a “middle class miracle” despite the fact that trickle down economics literally never works out as planned and despite the fact that independent analysis shows that the benefits of the tax cuts will accrue disproportionately to the wealthy.
As a reminder, here’s what your “middle class miracle” will look like in terms of the distribution of benefits within 10 years:
So by 2027, Trump’s tax cuts will actually raise taxes on 53% of households. Here’s the tax policy center’s assessment:
On average, taxes would be little changed for taxpayers in the bottom 95 percent of the income distribution. Taxpayers in the bottom two quintiles of the income distribution would face an average tax increase of 0.1 percent of after-tax income; taxpayers in the middle income quintile would see no material change on average; and taxpayers in the 95th to 99th income percentiles would receive an average tax cut of 0.2 percent of after-tax income. Taxpayers in the top 1 percent of the income distribution would receive an average tax cut of 0.9 percent of after-tax income, accounting for 83 percent of the total benefit for that year.
But hey, that’s fine, right? I mean after all, labor gets a one-time $1,000-ish bonus (or, more to the point, a rounding error on C-Suite paychecks) and also free Ding Dongs for a year. And you can’t really put a price on free Ding Dongs.
As far as investors are concerned, the question is how companies are going to spend their tax savings. The short answer is that a lot of it is going to be returned to shareholders, but there’s some good news on the capex front. Nominally speaking, capital spending will be the largest single use of cash. Here’s Goldman:
MMM, JNJ, and NOC are examples of companies that intend to increase investment spending in 2018 as a result of corporate tax reform. Aside from tax-related optimism, the fundamental drivers of capex also remain firm. Lending standards are easy: the Federal Reserve Board’s Senior Loan Officer Survey indicates lending standards continued to loosen during the past 12 months. S&P 500 return on equity (ROE) excluding Financials and Energy equals 21%, the highest level in more than 40 years. In addition to growing capex investment, we expect companies will increase R&D expenditures by 10% to $325 billion (13% of total cash spending).
But before you get too excited, remember that this isn’t really anything new in terms of what the largest single use of cash is and when you look at the projections for y/y growth in capital usage, what you’ll find is that the projected growth of buybacks in 2018 is more than double the percentage increase in capex:
As Goldman goes on to note, the recent market dip has seemingly catalyzed a veritable bonanza on the buyback front. This was tipped a week ago, but in a note out Friday the bank has updated things. To wit:
Tax reform and the recent market correction will fuel 23% growth in buybacks to $650 billion. The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017. New repurchase program announcements will also support buyback growth. Authorizations have surged by 100% YTD vs. 2017. AMGN, MTD, PG, and SWKS all recently announced new repurchase programs that they specifically attributed to the new tax law. Notably, CSCO announced that it plans to repurchase its entire authorization of $31 billion during the next 6-8 quarters (15% of market cap).
Goldman does note that at this stage in the rally and given the prevailing macro backdrop, the market should begin to reward capex and R&D more than returning cash to shareholders.
Investing in companies returning the most cash to shareholders via buybacks and dividends has been a winning long-term strategy. However, since the start of 2016 investors have rewarded firms prioritizing capex and R&D.
Firms investing the most for future growth should outperform in the current economic environment. Our Capex + R&D factor has the highest correlation to rising 10-year bond yields, while our Cash Return factor has historically underperformed alongside rising rates (Exhibit 4). The Capex + R&D factor also outperforms when the USD weakens.
Let’s revisit this in 12 months and see how it’s panned out.
One thing’s for sure, the temptation to plow excess cash into EPS-inflating buybacks certainly isn’t going to dissipate, especially not in cases where management’s compensation is equity-linked.