Take the Money and Run

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by Peter Jones, CFA
Vice President of Research

Week in Review

Global equity markets continued their hot start to the year with the S&P gaining 0.8 percent, Europe 1.25 percent and emerging markets up 1.65 percent. On the other hand, bonds declined slightly as interest rates moved higher with the 10-year U.S. Treasury yield finishing the week at 2.65 percent, its highest level since last spring.

Earnings season kicked off this week as most of the large-cap banks released full-year 2017 results and provided their expectations for 2018. With bank earnings, investors got their first look at how the recently enacted tax legislation would impact 2018 earnings, corporate balance sheets and capital allocation decisions. Although banks showed unanimous support for the tax bill, the impact of a lower tax rate effectively decreases the value of tax-loss carry-forwards left over from the financial crisis. “Tax assets” on bank balance sheets were written down by as much as $22 billion for Citigroup. Even though these write-downs are a non-cash charge, it lowers the asset base from which regulators judge the systematic risk of financial institutions. In the case of Goldman Sachs and American Express, the write-down was large enough that the companies informed investors that they would need to slow share buybacks for a few months to maintain adequate capital to satisfy regulators.

Take the Money and Run

On Wednesday, Apple informed the media and investors that through increased employment, wages and capital investment, it would be contributing $350 billion to the U.S. economy over the next five years. When pressed over whether this staggering figure was due to the recently passed Tax Cuts and Jobs Act of 2017, CEO Tim Cook replied, “There are large parts of this that are results of the tax reform and there are large parts we would have done in any situation.”

It can be assumed that the repatriation provision was one of the main factors driving increased investment from the world’s largest company. Under the former tax code, when U.S. companies booked profits overseas at a lower tax rate, the cash could not be returned to the United States without paying the difference between the tax rate of the country where the income was earned and the U.S. statutory tax rate of 35 percent. Because the U.S. has had a significantly higher tax rate than most other countries, multinational corporations avoided paying additional taxes by simply keeping their cash overseas in the hopes of an eventual tax break or foreign investment opportunity. The avoidance of bringing cash back to the U.S. has led to a massive cash hoard for many prominent U.S. companies, with the majority being in the technology and healthcare sectors. Apple, for example, has $240 billion in cash held overseas. With the Tax Cuts and Jobs Act becoming law, multinationals are now required to pay a one-time tax, due in the next eight years, on foreign earnings regardless of whether those earnings are repatriated back to the United States. Included in the press release, Apple noted that it would be paying $38 billion in taxes from foreign earnings and cash held overseas under the “deemed repatriation” provision. To put the magnitude of this tax payment into context, total federal tax receipts from corporations were about $300 billion in 2016. Along with the goal of making U.S. businesses more competitive by aligning U.S. corporate tax rates with the rest of the world, the hope is that freed up cash from overseas earnings will be reinvested into the U.S. economy through hiring additional workers, raising wages and capital investments. These actions should spur faster GDP growth along with greater productivity and innovation. In terms of creating sustainable, faster economic growth, the ultimate success of the legislation will hinge on whether U.S. multinationals choose to reinvest the windfall from lower taxes and repatriation back into the economy or if the lion’s share of additional cash will instead be returned to shareholders in the form of increased dividends and share buybacks.

Takeaways for the Week

  • Earnings season kicked off this week with the banks providing 2017 results and 2018 guidance, in line with investor expectations
  • GDP should grow at a sustainably faster pace if corporates choose to spend tax savings on hiring additional workers and capital projects