Wei Li, Global Chief Investment Strategist together with Elga Bartsch, Head of Macro Research, Kurt Reiman, Senior Strategist for North America - BlackRock Investment Institute and Scott Thiel, Chief Fixed Income Strategist, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
We see equities in developed markets (DMs) outside the U.S. as better positioned to capture the economic restart over the tactical horizon, as the powerful restart broadens out. Potentially higher taxes and more regulations could pose challenges to the strong performance of U.S. stocks, yet we would expect the eventual tax increases to be less than proposed by the administration.
The White House has signed on to a bipartisan infrastructure plan, a fraction of its original $4 trillion proposal that would be partially funded by higher taxes on corporations and high-income individuals. The U.S. has also endorsed a global minimum tax scheme, against the backdrop of an OECD initiative to tax cross-border digital services and limit multinationals from shifting profit to lower-tax jurisdictions. Higher taxes would have varied sectoral implications. Sectors with the lowest effective tax rates – or the actual rate paid after taking into account various tax breaks and deductions – have the most to lose, all else being equal. Information technology (IT), the largest sector on the S&P 500 Index, has a relatively low effective tax rate just under 17%. Energy, materials and consumer staples have tax rates above 20%. See the chart above. We see large-cap IT and healthcare – which typically benefit most from shifting profits to lower-tax jurisdictions – potentially taking the biggest hit to earnings if a global minimum tax is enacted. Tax increases less than proposed by the administration - our base case – could soften the blow. Relatively high profit margins and supportive structural growth trends in these sectors would help offset such risks, in our view.
Uncertainties abound on the administration’s tax plan despite last week’s bipartisan deal. This deal may still face hurdles in Congress, and there will likely be a larger package of spending and tax increases that Democrats would have to push through Congress unilaterally. A thin Democratic majority in Congress, conflicting priorities within the Democratic Party, and the looming 2022 midterm elections all pose challenges. We expect the eventual spending plan to be well below the price tag with less offsetting tax hikes than initially proposed. If the proposed 28% corporate income tax rate and a 21% global minimum tax were imposed, we estimate the earnings per share of the S&P 500 Index would be 7% lower in 2022 compared with a scenario without tax increases. A more moderate increase would have a smaller impact on earnings. Already, President Biden has signaled a willingness to consider a more moderate increase in the top corporate tax rate to 25%. The increase in the capital gains tax on high-income individuals will also likely be smaller than proposed, and any increases may be subject to reversal when political winds shift, in our view.
The U.S. has led the developed world’s economic restart – together with the UK – and its growth looks to be peaking as the restart broadens out. We see the potential for other DM markets, such as Europe and Japan, to pick up the baton and benefit more from the restart trade. These markets, which already have higher taxes and more regulations than the U.S., face more limited scope for additional taxes and regulation, in our view.
The bottom line: Uncertainties around potential tax increases are making it hard for investors to position for the potential impact for now. We see U.S. equities potentially coming under pressure from higher taxes and other factors, but still like small- and medium-cap U.S. companies as tax increases and regulations targeting large multinational companies are less likely to affect them. Higher taxes on individual capital gains could lead to a greater focus on after-tax portfolio construction, potentially driving up demand for tax-efficient strategies that allow taxable investors to better control the timing of their capital gains, including exchange-traded funds (ETFs) and managed accounts, in our view. Tax-advantaged U.S. municipal bonds may also benefit from increased demand, even as their valuations look relatively rich to us.
Euro area business activity accelerated at its fastest pace in 15 years in June as broadening vaccinations drive the economic reopening, last week’s purchasing managers’ index (PMI) data showed. The euro area has been catching up on the economic restart after the U.S. and UK have led it this year. Federal Reserve Chair Jerome Powell said the Fed would not rush to raise interest rates on inflation fears alone, after Fed officials embraced higher 2021 inflation as contributing to their policy objectives and opened the door to a 2023 lift-off of policy rates.
Markets will closely watch the U.S. jobs report this week to gauge how quickly the labor market is healing amid the economic restart. Vaccination-driven reopening is starting to lift output especially in services, but short-term labor market bottlenecks may lead to volatility in month-to-month data. We advocate looking through near-term market volatility and remain pro-risk, predicated on our belief that the Fed faces a high bar to change its easy monetary policy stance.
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