Fourth quarter observations
During the fourth quarter, the U.S. enacted the first major overhaul of the federal tax system in more than 30 years. The primary impact of tax reform on stock prices should be increased corporate earnings through a reduction in the corporate tax rate from 35% to 21%. To a lesser extent, stock prices could increase from share buybacks following the one-time repatriation of cash held overseas. Tax reform should be viewed as a positive for the U.S. stock market as a whole, but companies that have historically paid higher effective tax rates should receive a greater benefit than companies that have paid lower effective tax rates. While tax reform beneficiaries outperformed in the final months of 2017, it was lower taxed companies that won for the entire year.
To evaluate the impact of tax legislation on stock returns, we developed a Tax Rate Factor, which sorts the U.S. stock market into quintiles based on effective tax rates. We then looked at the cumulative performance spread of the first quintile, representing the top 20 percent highest taxed companies in the universe (tax reform beneficiaries), versus the fifth quintile, which are companies that pay the lowest effective tax rate.
Tax reform had its first major impact on stock returns following the U.S. election in late 2016 (charts 1&2). During this time, investors began pricing in reflationary themes, which included expectations of tax cuts under the newly elected administration. However, this theme reversed throughout most of 2017 as markets were led by lower taxed sectors such as Technology and Health Care. It wasn’t until the fourth quarter of 2017 when significant advancements in new tax legislation led to the repricing of tax reform beneficiaries. The outperformance of tax reform beneficiaries was more pronounced in the U.S. small cap market than the U.S. large cap market, with tax reform beneficiaries recovering all of 2017’s underperformance during the final two months of the year (chart 2). In contrast, tax reform beneficiaries in the U.S. large cap market have underperformed by roughly 10% over the last 2 years on a cumulative basis (chart 1). While it’s still debatable exactly how much of tax reform has already been priced in, equity markets will react as investors digest the impact of U.S. tax reform on corporate earnings. We are continuing to research this issue and monitor the performance of the Tax Reform Factor, and are positioning our client portfolios to take advantage of tax reform.
Fourth quarter overview
U.S. equities recorded their 14th consecutive month of positive total returns in December, and finished with their best year of performance since 2013. While the stretch of positive performance continued at the broad market level, underlying factor returns shifted during the fourth quarter.
U.S. Tax Reform
While Growth outperformed Value for most of 2017, U.S. tax legislation triggered a mid-quarter rotation from Growth and Momentum into Value. As corporate and personal tax reform progressed, Value companies outperformed Growth companies due to their greater composition of domestic revenues and higher effective tax rates.
Quality and Beta Persevere
For most of the year, the Growth and Momentum rally supported both high beta and high quality stocks (which sometimes do not trade together). Despite Growth and Momentum slowing down in the fourth quarter, the combination of rising interest rates and U.S. Tax Reform drove continued strength in Beta and Quality. First, rising rates led to higher beta stocks with positive interest rate sensitivity (such as Financials) outperforming lower-beta bond proxies such as Utilities. In addition, tax reform benefitted higher quality companies with domestically oriented business models, such as Industrials and Consumer Discretionary stocks.
Underperformance of Small Size
Larger companies outperformed smaller companies during the quarter and trailing year. This was true across the market cap spectrum, as well as within size categories. In general, earnings growth for large companies led that of small companies as improving global economic growth was a greater benefit for larger multi-nationals.