The biggest risk to US equities isn’t peak growth. It’s higher taxes.
That’s the message from Goldman’s David Kostin, who raised his S&P target last month, after a blockbuster Q2 reporting season forced Wall Street strategists to reassess at least one key fundamental input.
To be sure, the growth outlook has deteriorated. Indeed, Goldman recently cut their forecast for the US economy, in part due to what the bank called “a harder path ahead” for the consumer.
Read more: US Consumer Faces ‘Harder Path Ahead’
Economic momentum pretty clearly peaked in the second quarter, raising questions about whether profits are poised to decelerate, especially given myriad headwinds to margins, which hit a record last quarter.
“At the depths of a contraction, multiples tend to be high as the market prices in a recovery in earnings [but] as the recovery unfolds, multiples compress, typically reaching a low as the cycle peaks and the market questions the sustainability of earnings at elevated levels above trend,” Deutsche Bank wrote last week, in a cautious note flagging the potential for valuations to come off the boil.
In his latest, Goldman’s Kostin said clients are concerned about the contrast between GDP downgrades and positive earnings and sales revisions. And yet, he pointed to rotations under the surface as evidence that the market has “for months… reflected the weakening economic environment.”
With benchmarks still sitting near records, you might scoff at that. But you don’t have to look very hard for evidence to support Kostin’s contention. Indeed, you don’t even necessarily have to look below the index level. You can just take the ratio of two indices (figure below).
It’s no mystery why the S&P continues to hold up despite the average stock being down 10% from 52-week highs. “The large weight of the S&P 500 in secular growth industries, with relatively low economic sensitivity and valuations that have benefited from falling interest rates, has supported the aggregate index’s performance,” Kostin remarked.
So, while growth concerns are arguably reflected (or at least “acknowledged”) by the market, tax reform is, at best, only partially priced in.
Betting markets show a 62% chance that the statutory corporate rate is hiked next year (figure below). Kostin said that although a partial reversal in a sector- and factor-neutral pair of baskets built around exposure to a statutory domestic tax rate hike suggests “about a two-thirds likelihood of a hike from 21% to 25%, similar to prediction market pricing, a pair of baskets exposed to tax rates on foreign income has recently traded sideways.”
At the same time, Goldman noted that “relatively stable” balances in money market funds and renewed outperformance from perennial winners (e.g., secular growth shares, which benefited as bond yields retreated from the Q1 highs) suggest investors aren’t preparing for higher capital gains taxes.
Kostin pointed to recent underperformance from stocks with the largest buybacks as evidence of some consternation around proposals to slap an excise tax on share repurchases, but wrote that because net repurchases “generally add roughly 2% to S&P 500 EPS each year,” any such proposal shouldn’t dent profits too much. What’s perhaps more concerning is the impact on equity demand, “given that corporates have been the largest buyers of US equities during the past decade.”
As a reminder, Goldman’s outlook incorporates a hike in the domestic statutory corporate tax rate to 25%, as well as a watered down version of proposed increases to the rate on foreign income. Ultimately, the mechanical impact to index earnings is 5%. Assumptions about tax reform account for the 3% shortfall in Goldman’s 2022 EPS forecast versus bottom-up consensus.
For what it’s worth, there is no consensus when it comes to the specifics of tax reform. “Of the 15 strategists who provided a 2022 profit estimate for S&P 500 companies in the latest Bloomberg survey, only one-third have factored in the impact of higher taxes,” Bloomberg’s Elena Popina wrote late last month.
“Almost half said their numbers don’t assume any tax increase, and two didn’t say which camp they are in,” she added.
I don’t want to defend current market valuations. But I would find it amusing if the triggering event for a crash or correction is a change in rates, particularly at the corporate level. An increase in the statutory rate from 21% to 25% would cause some increase in actual taxes paid for many corporations, but not nearly as much as the 4% hike would suggest. Many highly valued corporations pay little or no US income tax. (And, of course, the entire discussion assumes that most investors value corporations on the basis of discounted future after tax cash flows, which increasing feels like an assumption that a minority of old people like me make.) Changes in capital gains rates also do not seem to be great indicators of changes in market valuations. I’m not great at predicting the future. Goldman may very well be right. Maybe the next step in the story is that the market does the right thing for the wrong reasons.