Runnin' Down a Dream (of Tax Reform)

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by Peter Jones, CFA
Vice President, Research

Weekly Wrap Up

After eight consecutive days of positive returns, U.S. equities closed slightly lower Friday and finished the week up 1.10 percent. Emerging markets, up 2.75 percent, extended the lead as the best performing asset class of 2017 with a total return greater than 30 percent. Multiple Fed governors conveyed confidence in the medium-term inflation outlook and tightening trajectory which helped push 10-year U.S. Treasury yields higher to close this week at 2.36 percent. Regardless of Fed commentary, robust economic data support both higher interest rates and equity prices. The ISM Manufacturing PMI, a monthly survey of manufacturing optimism, came out Monday. The survey’s reliability in predicting corporate earnings growth has made it one of most followed leading indicators among economists. This week’s reading of 60.8 is the highest since the spring of 2004.

Runnin’ Down a Dream (of Tax Reform)

Beginning in late August and coinciding with the preliminary release of tax reform guidelines, small cap stocks have increased 10 percent, outperforming their large cap peers by 6.5 percent. While the long-term drivers of relative performance are numerous, the most recent bifurcation can be attributed in part to renewed optimism around the eventual passage of tax reform. Last year, we observed a similar phenomenon with small cap stocks returning 17 percent versus 8 percent for large caps from the time of the election through year-end.

Why do small cap stocks outperform when optimism around fiscal stimulus increases? The most straightforward explanation comes from differences in the effective tax rate. Large cap stocks pay an effective tax rate of 27 percent while small cap stocks pay 31 percent. If the proposed 20 percent corporate tax rate were to come to fruition, small cap profits would receive a larger boost. While overseas profits and tax deductions make it unrealistic to generate precise calculations, the table below illustrates the greater benefit to small caps from the proposed changes in the tax code.

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History tells us that fiscal stimulus is effective in increasing economic growth, at least for a period of time. Small cap stocks carry higher operating and financial leverage than large caps and are thus more sensitive to fluctuations in economic growth. In other words, small caps have a larger fixed (instead of variable) cost base. Therefore, a greater portion of incremental top line growth resulting from fiscal stimulus drops to the bottom line. When the U.S. economy accelerates relative to other regions, the dollar also tends to strengthen. Although a stronger dollar is a headwind to large and small cap stocks alike, small caps generate a smaller portion of sales internationally. To that end, small cap stocks are a winner from the primary components of fiscal stimulus; lower taxes, higher growth and a stronger dollar. This reality can be observed by plotting the relationship between the relative performance of small cap stocks and the U.S. dollar. In the end, it remains to be seen whether the nature and magnitude of fiscal stimulus that ultimately comes out of Washington is correctly reflected in asset prices.

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Takeaways for the Week:

  • Small caps are the largest beneficiary of corporate tax reform
  • Economic data continue to show strength

Disclosures