economy, income, interest rates, retirement, risk management, Taxes

Trick or Treat? Revisiting The Potential Downside of Tax Reform for Investors

There is an old story that goes “beware what you wish for…” Things don’t always turn out as expected. Two years ago the President proposed and Congress approved a huge tax cut plan… the Tax Cuts and Jobs Act (TCJA). The results have been controversial.

Along those lines I watched a fascinating interview of Tom Lee, head of research at Fundstrat, on Bloomberg two years ago. His insight proved very valuable and accurate. (1)

His feeling is that a Tax cut, as it was being discussed, could be negative for investors long term. “There’s two reasons; First, when cutting tax rate you raise the after tax cost of debt. Leverage becomes a problem for a lot of businesses. Second, because you are cutting tax rates you are effectively giving cash to all businesses, even businesses where you want to reduce allocation.“

His observation was that companies that are currently struggling with cash flow will have a temporary life preserver tossed to them, but it will not change the fundamental issues facing a lot of industries. It will distort markets.

In fact that is exactly what happened.

Lee states that cuts to tax rates will “amplify negative return industries because they will get more free cash flow. “ But, again, it doesn’t change the fundamental issues that are making those industries less competitive. Examples can be seen in the struggles of brick-and-mortar retail vs online, as well as fossil fuel vs renewables.

In the two years since the tax cut the fossil fuel and retail sectors have been among the worst performing sectors. (2)

In addition, Larry summers, former Treasury Secretary, was quoted as saying this is the worst time to give a tax cut because of where we are in the economic cycle.

Lee continues by saying “Companies that benefit most, for example retail, that are invested in areas getting killed in digital age. “

Lee goes on to explain the impact of leverage and borrowing on companies and the market. “BB rated companies are borrowing at 50 bps less the US Treasury Bond. These are not companies with reliable cash flow. Junk grade companies in Japan borrowing at 10 bps over JGBs (Japanese Government Bonds). Central banks have made it possible for weak companies to borrow. “ Lee continues by saying many companies are, “Trading like they are never going to default.”

In fact leveraged loans have grown in the two years since the Trump tax reform bill. “The credit vehicles are seeing more covenant-lite deals, weaker investor protections and inflated earnings — all causes for concern.” (3)

Commenting on the risks of leveraged loans Barclays CEO Jes Staley said, “A couple of idiosyncratic deals have opened people’s eyes that it’s not a free ride right now.” (4)

The reality of Tax Reform had an impact on the performance of your portfolio over the past few months and years. The Tax Cut and Jobs Act added to the deficit, fueled corporate stock buybacks, with little benefit flowing to the majority of Americans. (5)

It is crucial to manage risk in an appropriate fashion. To discuss this topic and/or your portfolio in more detail please feel free to reach out to me.

If you feel uncomfortable investing in the market at these levels, please reach out to me to discuss options that can help you protect your lifestyle regardless of what happens in the markets.

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2019-88932 Exp. 10/21.