GOP tax cuts may not boost profits -- and stocks -- as much as hoped

Investors are on the verge of seeing the consummation of all that pro-growth, bring-on-the-tax-cuts excitement that first boosted stocks last November in the wake of President Donald Trump's surprise electoral victory. 

But for many on Wall Street, it's becoming clear all the good tax news has been priced into stocks over the past 12 months. Indeed, with the final GOP bill apparently set to become law, a "sell-the-news" dynamic is now setting in, with U.S. equities moving lower following reports that the tax plan could actually hit the foreign profits of tech giants like Microsoft (MSFT).

In a special report to clients, Barclays Capital analyst Maneesh Deshpande and team calculate that the benefit is less than it appears: While the statutory corporate tax rate is set to fall from 35 percent to 21 percent, the effective rate for S&P 500 companies (the rate companies actually pay after all the accounting trickery) is set to fall from 26 percent to 20.7 percent.

That's good. But hardly earth-shattering. As a result, Deshpande believes the cuts will have "limited supply-side effects and, therefore, believe it is unlikely to lead to potential long-term growth." The Barclays team estimates the lift to companies' 2018 earnings per share to be about 8.1 percent -- reduced to around 6.3 percent after accounting for items like one-time repatriation costs and deferred tax liabilities and assets.

Compare that to the near 30 percent gain the S&P 500 has enjoyed since last November.

Here's the kicker: The final GOP bill contains a move to a territorial-based U.S. tax system that incentivizes multinationals to move assets back home. But that means that companies in areas like technology and healthcare with large foreign cash and intellectual property holdings have less to gain from the bill than domestically focused companies like retailers. This realization drove the "sector rotation" dynamic seen late last month, selling out of year-to-date winners like Apple (AAPL) and buying into losers like Kohl's (KSS).

Capital Economics believes the tax cuts will provide only a temporary fiscal boost to the economy at a cost of $2.2 trillion over 10 years according to the Committee for a Responsible Federal Budget, bloating the national debt and potentially increasing interest rates as private borrowers are "crowded out" amid ongoing monetary policy tightening and interest rate hikes by the Federal Reserve.

Further weighing on interest rates could be the inflationary tailwinds that result from the tax bill's passage, since the labor market is extremely tight and the post-recession surplus of economic potential has run dry. Indeed, Capital Economics warns that the bill "may end up boosting inflation by more than it lifts economic growth" encouraging the Fed to be more aggressive with interest rate hikes in 2018.

And if there's one thing stocks probably aren't ready for, it's a hawkish Fed. 

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.