2018 Investment Outlook: Could tax reform provide a boost to value stocks?

As 2017 nears its end, U.S. value stocks are mired in their longest stretch of underperformance versus U.S. growth stocks since the Great Depression, held back by low interest rates and easy monetary policy. In my view, the top issue that will help determine whether that trend continues or abates is U.S. tax reform.

In late September, Republicans unveiled their proposal, which addressed corporate taxation, household taxation and the repatriation tax:

• Lowering the repatriation tax rate for U.S. companies’ foreign earnings would be a positive for business, but it would be a one-time jolt, not an ongoing benefit
• Reducing the number of individual tax brackets would simplify the structure of household taxes, but consumer spending has been relatively strong since 2010, so I would not expect a dramatic economic impact
• The real economic benefit, in my view, could come from the proposed drop in the corporate tax rate – from 35% to 20% or 25%

Such a corporate tax reduction may stimulate job creation, confidence and wage inflation – which would be especially important as so many Americans continue to be underemployed. In turn, that could give a boost to the 10-year Treasury yield, which historically has been a positive development for value stocks and active management.

Markets are looking for pro-growth legislation

I expect that Republicans will rally around this issue. Health care reform has been stymied, and as of this writing, there has been no movement on an infrastructure proposal. The Republicans will be looking for a major legislative accomplishment before the midterm elections in 2018.

Assuming tax reform is passed, I believe the market will continue its positive tone, especially for deeper value companies within pro-cyclical sectors such as financials, industrials, energy and materials. (Although certain pockets of the equity market are still inexpensive, valuations in general are slightly above their long-term averages, so it’s hard to see the overall market going up dramatically next year, even with a tax reform package.)¹

On the other hand, if tax reform does not pass, I expect a negative reaction from the market, which has been riding on the hope of a pro-growth policy agenda. In this scenario, I would expect high-quality, dividend-paying stocks to outperform within the value space.

Other areas to watch

In addition to monitoring tax reform, I’m watching several issues that could impact markets in 2018:

• The Federal Reserve: The Fed is entering uncharted territory with its plan for balance sheet normalization. Fed Chair Janet Yellen has put together a careful plan for slowly reducing the Fed’s reinvestment in mortgage-backed securities and Treasuries, and I do not believe that this gradual plan will have a large impact on markets. While there were four open seats on the Fed as of late 2017, I do not anticipate that the new Fed members will reverse the current normalization plan. (This includes Jerome Powell, who was nominated in November to replace Yellen as chair.)
• North Korea: U.S. relations with North Korea definitely bear watching, including the potential for China to act as an intermediary.
• Populism. The wave of populism that began with Brexit has continued, with recent examples including German Chancellor Angela Merkel’s tighter-than-expected election victory in September 2017. If changing politics results in policies that isolate growth, that would be a negative for world equity markets, in my view.
• Rising rates: The low interest rate environment that we’ve experienced for years has been conducive for passive strategies. Low rates can act as a “rising tide that lifts all boats,” which makes it harder for active managers to distinguish themselves through stock-picking. On the other hand, rising rates can cause more disparity between the outperformers and the underperformers, which I believe is good for active managers.