- Less than two years after a big cut in US corporate taxes, a strategist for Morgan Stanley says rates are about to start rising, which will create new challenges for much of the market.
- Strategist Michael Zezas identified two threats to US companies over the next few years: rising tax rates as pieces of the 2017 tax law expiry, and potential taxes overseas on digital activity.
- A handful of sectors will be affected by both threats, and Zezas said some of those companies might end up with a worse situation than they were in before the tax cut.
- Morgan Stanley breaks down which areas of the stock market will be most impacted. It provides investors with a playbook for what to buy, and what to avoid.
Barely a year after the US slashed corporate taxes, those cuts are starting to shrink in the rear view mirror and there are signs of trouble ahead.
Important features of the Tax Cuts and Jobs Act — the overhaul passed at the end of 2017 — start to lose power or expire in 2021 and 2022. That means many companies will get a tax increase that hurts their profits, said Morgan Stanley strategist Michael Zezas.
He added that several big sectors of the US market face a second tax challenge: Countries are implementing new digital taxes that could challenge the profitability of US companies in the future. That trend is likely to spread.
In his view, some companies in technology, health care, communications and the industrial sector are vulnerable to that one-two punch of higher taxes, leaving them worse off than they were before the tax cut.
It’s bad news for anyone who enjoyed the huge boost the tax bill gave stocks — a capital windfall that contributed to the huge profit growth US companies enjoyed last year. While the central provision of the law permanently reduced the US corporate tax rate to 21% from 35%, many other parts of the law have a limited shelf life because of Congressional budgeting rules.
"Expiring provisions from the Tax Cuts & Jobs Act will soon make capex and R&D more expensive," Zezas wrote in a recent note to clients. "Further, international reforms will start to hit US multinationals this year."
And while it’s possible Congress will move to make those cuts permanent, Zezas isn’t holding out hope. He says rising scrutiny of corporations from Democrats, high partisanship, and the fact that new permanent cuts would add hundreds of billions to the annual budget deficit will all combine to make that an unlikely outcome.
On a more granular level, the fading tax provisions could impact how companies expense capital spending and how they deduct interest expenses. The expiration could also affect a different part of the law that involves minimum tax rates for some multinational companies, as well as another that governs how firms can amoritize R&D costs.
For investors wondering what to do, Zezas broke down which parts of the market might feel the most pain if the provisions outlined above expire. They’re listed in this chart, which shows several sectors — most notably communication services, healthcare, industrials, and tech — are looking at big obstacles starting in 2021.
Morgan Stanley Research
"A potential rise in tax rates as TCJA provisions expire is just one more reason to believe we have passed the ‘boom’ from tax reform and that future effects will be less supportive of economic and earnings growth," Zezas said.
Even within those at-risk sectors, Zezas said some companies are far more vulnerable than others. He said the phaseout of the capital spending part of the law is likely to affect tech, manufacturers and telecommunications companies, while the changes in interest deductions could hurt drug companies, big hospitals, media, and energy exploration and production companies.
Further, the changes in the way R&D spending is amortized could affect a wide swath of companies, Zezas said.
"We see the semis, software, pharma, biotech, and media industries being the most exposed to these changes once they come into play in 2022," he wrote.
He added that some of the changes could push companies to spend money sooner, before the tax benefits fade or end. That could also reduce their profitability in the near term.
As if the situation wasn’t dire enough, for a few sectors, the effective tax hike is only part of the problem. The UK and France have already announced upcoming taxes on big internet companies, and other countries are likely to follow. Those taxes are likely to hit US tech giants like Amazon and Google first, with smaller companies feeling the effects later.
The sectors vulnerable to those taxes, he wrote, are tech, communications services, consumer discretionary, and health care companies.
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