POTUS 45. Tax reform investment implications. Economics

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1 Tax reform investment implications Chief Investment Office Americas, Wealth Management 20 December :11 pm GMT Jeremy Zirin, CFA, Head of Investment Strategy Americas, David Lefkowitz, CFA, Senior Equity Strategist Americas, Edmund Tran, Equity Strategist Americas, Leslie Falconio, Senior Fixed Income Strategist Americas, Barry McAlinden, CFA, Senior Fixed Income Strategist Americas, Kathleen McNamara, CFA, CFP, Senior Municipal Strategist Americas, Justin Waring, Investment Strategist Americas, Following months of debate and negotiations, Republican leaders are on the verge of passing the most sweeping tax legislation in more than 30 years, highlighted by a large reduction in corporate tax rates and extensive changes to personal income tax rates and deductions. We expect the tax package to boost US real GDP growth by about % per year in both 2018 and This reduces the already-low recession risk over this period. The solid economic backdrop underpins our global equity overweight. It also strengthens the case for our overweight to US large-cap value stocks, which stand to benefit from an acceleration in economic growth. With tax benefits included, we forecast S&P 500 earnings per share to rise by 15% in 2018 to USD 151. As such, we lift our 6 month S&P 500 forecast to 2800 and expect further market gains to the range by the end of next year. While added fiscal stimulus could boost inflationary pressures, we still expect only a gradual rise in interest rates. Select provisions in the bill have resulted in a year-end jump in municipal bond issuance. We expect this effect to fade in the New Year. Be sure to read the Advanced Planning team's guide for how tax reform may impact your personal and business taxes The acronym POTUS (President of the United States) came into use during the late 1800s by telegraph operators and is now commonly used in media. Donald Trump is the 45th POTUS. Economics The legislation will modestly stimulate the US economy, adding about % per year to real GDP in 2018 and 2019 and further diminish the probability of a recession over the next couple of years. In addition to providing more disposable income for consumers, stronger growth momentum, a lower corporate tax rate and accelerated depreciation of capital expenditures should also boost business spending. At an expected cost of about USD 1 trillion over the next 10 years, the cumulative federal government debt increase amounts to less than 5% of GDP, so we don't expect this to materially alter the outlook for government finances. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.

2 Equities All told, we estimate that the tax reform package will boost S&P 500 earnings per share (EPS) by 6-10% next year. We had been forecasting 2018 S&P 500 EPS of USD 141 (8% year-over-year) without any tax benefits and we now raise our forecast to USD 151 (15%) the fastest pace of earnings growth since the early years of the expansion. The lower corporate tax rate, which falls to 21%, is the primary driver of this earnings boost. Earnings growth will also benefit from the repatriation of USD 1 trillion of overseas cash, as much of this will likely be used for corporate share repurchases. Offsetting some of these benefits, there are a number of "base erosion" provisions, which aim to limit the ability of US multi-nationals to shift income into low-tax, overseas jurisdictions. These provisions are complex and publicly-traded companies don't disclose enough information for outside analysts to fully assess their implications. Therefore, investors will be keenly interested in management commentary about tax reform impacts, which we expect will be forthcoming during the fourth quarter reporting season that begins in midjanuary. Our EPS estimates incorporate higher international taxes for US multi-nationals as a result of these provisions. Still, other uncertainties remain. It is unclear how much of the tax benefits will be retained by shareholders. Our forecasts have assumed that nearly all of the benefits flow to shareholders. However, in very competitive industries, companies may decide to reinvest some of the tax savings into lower prices or to boost investments in marketing, research and development, or capital spending. In less-competitive industries, shareholders should capture the lion's share of the benefits. But our forecasts should not be seen as a "best case" scenario for corporate profits; we have not accounted for a potential increase in economic growth stemming from the tax bill. Further upside potential for stocks but it may take time We believe US markets have priced in about half of tax reform's earnings benefit. As we show in Fig.1, a sector-neutral basket of stocks with the highest tax rates has outperformed the broader market by about 5% since the November 2016 election. We estimate about a 20% tax reform earnings boost for these stocks, so this basket could outperform by another 5% as the market fully appreciates the uplift. From another perspective, the S&P 500 is up about 4% since the House passed its tax bill in mid-november, which is about half of the earnings boost we expect for the broader market. Fig. 1: High-tax firms have outperformed as the bill reaches the finish line Performance of stocks with high tax rates relative to the market 6% 5% 4% 3% 2% 1% November 2016 election 0% Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Oct-17 Dec-17 Source: FactSet, UBS, as of 18 December 2017 While we do see additional tax-driven upside for the market, it may not materialize right away. As we highlighted above, investors will need further disclosure from corporate management teams in order to fully understand all of the implications of the tax reform package. Companies may not offer this guidance until the fourth quarter reporting season in January and February. In addition, it may take even longer for the second-round effects of potentially faster economic growth to materialize. So it may take at least a couple of months 2

3 if not longer for the equity market to fully reflect the upside that we expect. Nonetheless, we raise our rolling six month S&P 500 price target to 2800 and target a range of by year-end Fig. 2 summarizes our assessment of the impact of tax reform across equity market segments. With a greater proportion of total earnings produced domestically, small- and mid-caps should benefit more than large-caps. And value stocks also look well-positioned, given both a larger domestic footprint as well as their tendency to outperform during a cyclical growth acceleration. Within large-caps, financials, consumer discretionary (specifically media, retailers and restaurants), industrials (transports), and telecom stand to benefit the most. But it's important to note that the impact can vary dramatically within sectors. What we'll be watching We'll be closely watching management guidance and how this gets incorporated into analysts' earnings expectations. In our view, the current consensus "bottom-up" S&P 500 EPS estimates for 2018 and 2019 largely excludes any tax benefits. If profits next year increase by 15% to USD 151 as we suspect, the market is trading at a forward P/E of 17.8x. Fixed Income To the extent that the economic stimulus leads to firmer inflation, this could provide additional support for central banks' normalization of monetary policy. We maintain our view that the Fed will raise rates twice more in 2018, and three times in We also expect the 10-year Treasury yield to remain largely range-bound around 2.5% in Municipal bonds It's important to stress that the small decrease in the top marginal income rate (from 39.6% to 37%) doesn't materially impact the demand for tax-free income from individual investors, the dominant buyer base for munis. In fact, the USD 10,000 cap on state and local tax (SALT) deductions should increase the demand for in-state municipal bonds, especially for high-tax states such as California, New York, and New Jersey. Municipal bond income remains tax-exempt, so the SALT limit could make this tax advantage marginally more attractive. By contrast, the cut in the corporate tax rate to 21% from 35% may prompt institutional investors (banks and insurance companies) to curtail their future purchases of tax-free muni bonds in favor of taxable securities. On the supply side, there were two important provisions that we were watching throughout the debate. The first was a proposed change to the issuance of Private Activity Bonds in the final version of the bill, tax exemption for these bonds is preserved. But there was a change to Advance Refunding Bonds: existing bonds are grandfathered, but after 31 December 2017 newly issued bonds will no longer be eligible for federal tax exemption. Municipal bond issuers will be permitted to refund outstanding bonds on a current basis but may not issue 3

4 tax exempt refunding bonds more than 90 days in advance of the first call date. This change prompted a significant burst in municipal bond supply in recent weeks, but this effect will likely fade in the New Year. We believe that this limited supply of tax-exempt bonds will be supportive of bond prices. Corporate bonds Although we view the overall tax reform as positive for investment grade (IG) credit, we believe the net impact on spreads will be marginal. The reduction in the corporate tax rate will result in a higher after tax income and when combined with access to repatriated funds, should lower the amount of leverage through less corporate borrowing. This overall is a positive for credit spreads, as it reduces the large corporate supply the market has witnessed over the past few years. However, we do see other factors that will limit the credit benefits. First, while the lower leverage may ultimately enhance the underlying credit, we still see the bulk of funds being used for investment and shareholder rewards. Second, risks such as increased M&A activity may counter the slight spread benefit via tax reform. Nonetheless, the expectation over the longer term is for an approximate 40bps of IG tightening over a 10 year period due to the recent reform. For high yield (HY) companies, the effects will be more bifurcated. The benefit of the lower tax rate and immediate capex expensing is generally greater than the limit on interest expense for most doubleb rated companies and some single-b rated issuers. These companies also have time to adjust to the stricter EBIT threshold that occurs after On the other hand, the most highly leveraged issuers that fall largely in the CCC rating category stand to be hurt most by the interest limitation. The spreads for CCC issuers have underperformed since earlier this year, which should limit the extent of further taxrelated re-pricing. CIO turns to the overall economic fundamentals as the main guide to our credit outlook. We remain neutral on IG and HY corporates and anticipate tepid, but positive total returns over the next year. 4

5 Fig. 2: Tax reform has a greater benefit for domestically-oriented US equity segments Equity segment Large-caps Impact Comment Benefits from lower domestic corporate rate and repatriation of overseas cash, offset by limitations on tax strategies used by some multi-national corporates. Mid-caps Greater benefits versus large-caps due to greater domestic exposure, less use of multinational tax strategies. Small-caps Greater benefits versus large-caps due to greater domestic exposure, less use of multinational tax strategies. Greater benefits from repatriation offset by larger limitations on tax strategies used by some multi-national corporates. / Less negatively impacted by limitations on tax strategies used by some multi-national corporates but overseas cash holdings are smaller. Could benefit from expectations for faster economic growth and firming inflation. High domestic exposure benefits retailing, media, and restaurants. Possible pick-up in consumer spending would also be supportive. Large-cap growth Large-cap value Large-cap sectors Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials High domestic exposure benefits food and staples retailing. Mega-cap multi-nationals also benefit from repatriation. However, competition may limit gains for shareholders. Limited Limited benefits. Larger players have high overseas exposure, while domestic producers pay little tax due to existing allowances. Certain domestic-based refiners, oil services, and equipment manufacturers may benefit from a lower US corporate tax. High domestic exposure. Key potential beneficiary of any pick up in expectations for faster economic growth or firming inflation. Health insurers (managed-care organizations) likely benefit most due to high domestic exposure. Pharma and med-tech are more international but benefit from repatriation. Domestically exposed transports, industrial distributors, and environmental services will benefit most. Pick-up in capital spending could boost capital goods manufacturers. Information Technology Limited change to overall tax rate (lower domestic rate will be offset by limits on shifting profits to low tax overseas jurisdictions). Key beneficiary of cash repatriation. Materials Less domestic exposure than the average sector. Real Estate REITs don't pay corporate taxes, so limited direct impact to funds from operations. However, could benefit from a pickup in economic growth and REIT dividend tax rates will fall, enhancing the appeal for taxable investors. High domestic exposure. Benefits from immediate capex expensing. However, competition may limit how much of the benefit will be retained by shareholders. Telecommunication Services Utilities Limited Lower tax rates are passed on to consumers for regulated utilities. Source: UBS, as of 20 December

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