U.S. tax changes and market valuations

As companies assess how U.S. tax changes could impact their bottom lines, investors should look to see which names have already run up in value in anticipation of the overhaul, says Peter Hardy, vice-president and client portfolio manager at American Century Investments in Kansas City, Missouri.

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Typically, companies with primarily U.S.-based businesses stand to benefit from a valuation standpoint, Hardy says, as do smaller companies that haven’t sheltered income in foreign entities–and therefore have had higher tax rates.

For these picks, the tax reduction could result in higher free cash flow yield, says Hardy, whose firm manages the Renaissance U.S. Equity Income Fund. “Sometimes a 15% reduction can be 20% or greater in terms of a valuation enhancement,” he adds.

Unfortunately, many of the companies that stand to benefit most “have already rallied many times in excess of the valuation that corporate taxes provide,” Hardy says.

The S&P 500 was up 2.9% after its first six trading days of 2018, registering an all-time high on each of those days. That’s the hottest start to a year since 1964, according to The Wall Street Journal.

U.S. Congress passed the $1.5-trillion tax bill late in 2017. The legislation lowers the corporate tax rate to 21% from 35%.

Read: U.S. Senate moves tax reform to brink of final passage

U.S. bull run

As the bull run continues into 2018, Hardy sees an overall valuation risk. As of mid-December, he found the VIX, or fear gauge, was at all-time lows. As a result, he said, the average name “in our universe of securities is selling at a 17% premium to its fair value or to our assessed fair value. We see a valuation risk, based on where the market is trading.” (On Jan. 3, 2017, the VIX Index closed at 12.85, compared to a Dec. 15 close of 9.42 and Jan. 9, 2018, close of 10.08.)

He also wasn’t sure whether market valuations would come back down in 2018 or later. So, he planned to continue “picking and choosing the best situations within our quality universe to arrive at a contour that’s risk aware and having positive performance versus the market.”

Hardy’s also looking at potential changes to monetary policy and how those could impact the market. The U.S. Federal Reserve makes its next rate announcement on Jan. 31, and CME’s FedWatch tool indicates a 98.5% probability, as of Dec. 10 at 10 a.m., of the Fed standing pat.

“There could be a corresponding offset from a valuation standpoint due to the fact that the Fed would maintain its less accommodative stance and continue raising short-term interest rates and reducing monetary easing,” he says.

The U.S. Federal Reserve raised interest rates three times last year. After its most recent hike, in December, the central bank said it expects the job market and the economy to strengthen further, and foresees three more rate hikes in 2018. Jerome Powell will succeed Janet Yellen as Fed chair in February.

Also read: U.S. consumer spending sees 0.6% bump in November

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