There is an old story that goes “beware what you wish for…” Things don’t always turn out as expected. In 2017, President Trump 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 four 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. Companies that were not profitable and not healthy continued to borrow and live off of debt instead of reforming their business models.
This trend continued with COVID… When the economy and markets faltered in the Spring of 2020 due to COVID, the Fed and Congress stepped in to support businesses. As a result of extraordinary measures, businesses continued to borrow enormous amounts of debt at historically low rates of interest, especially in high yield and junk debt.
In 2017, Lee stated 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 businesses, as well as fossil fuel vs renewables.
In the four years since the tax cut the fossil fuel and retail sectors have been among the worst performing sectors. (2)
Lee continues by saying “Companies that benefit most (from the Trump Tax Cuts), 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 four 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 is Tax Reform had an impact on the performance of your portfolio over the past few years. But the Tax Cut and Jobs Act also added to the deficit, fueled corporate stock buybacks, with little benefit flowing to the majority of Americans. (5)
A recent WSJ article pointed to record issuance of speculative grade loans to finance dividends hit $72 billion in 2021. This is not prudent corporate behavior. (6) “The record marks one sign companies are becoming more comfortable with their cash-stuffed balance sheets and the economy’s trajectory, analysts said. Leveraged loans are typically issued by companies with significant debt relative to their earnings, making them more sensitive to the economy’s trajectory.”
Issues around debt sustainability have become more elevated with the unfolding financial crisis in China generated by the default of Evergrande and other Chinese real estate firms. As a result, credit markets have begun to tighten. Steven Van Metre, CFP with Atlantic Financial, stated “keep in mind… what if the economy rolls over? If the economy rolls over these companies are going to have a massive problem with their debt.”
Not everyone was in favor of the Trump Tax Cuts in 2017… 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. As politicians struggle with the debt ceiling in the Fall of 2021, many are pointing out the negative impact the Trump Tax Cuts had on the federal budget and issues around tax fairness.
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