Weekly Market Update (February 13 – February 17, 2017)

By Brittany Weissman February 17, 2017

Canadian stocks were higher, but lagged U.S. stocks, which closed at record highs on Friday and ended the week up 1.5%. The TSX is up 3.6% and the S&P 500 is up 5.0% year-to-date as investors continue to be captivated by possible changes to the U.S. corporate tax code and the regulatory environment, which are expected to boost global growth. Because expectations for policy changes continue to rise, delays or disruptions of these policy changes could cause market volatility. Be prepared for potential volatility by rebalancing your portfolio to the mix of stocks and bonds that will allow you to stay invested through bouts of uncertainty.

U.S. Tax Reform - Friend or Foe for Consumer Companies?

With U.S. President Trump now in office, there has been much talk about lowering U.S. corporate taxes. Both President Trump and Speaker Ryan have put forth proposals that entail a number of changes to the corporate tax code. Based on these proposals, it is difficult to predict which companies will benefit and which companies will be hurt by the proposed changes. We believe U.S. automakers and suppliers, apparel and footwear manufacturers, discount retailers, and retailers with large private-label offerings are most at risk of being negatively impacted. However, given the very high level of uncertainty of eventual changes and their impacts, we recommend investors do not make decisions based on speculated tax policy.

More Than Just a Lower Tax Rate
While both President Trump and Speaker Ryan's proposals recommend lowering the U.S. corporate tax rate, there are a number of other proposed changes that, for some companies, have the potential to more than offset the benefits of a lower tax rate. One of the most controversial changes suggested is the implementation of a border-tax adjustment. As an example, let's look at a hypothetical apparel manufacturing company:

Base Case:
The company makes a shirt overseas, which costs $80 to produce. The company then sells the shirt for $100. This equals a $20 profit. Under current U.S. law, the company would pay a 35% tax rate on its $20 of profits, for a $7 tax bill and $13 in after-tax profits.

Corporate Tax Rate Lowered to 20%:
Let's assume the corporate tax rate is lowered to 20%. In this scenario, the company would now pay a 20% tax rate on its $20 profits, for a $4 tax bill. The company benefits in this scenario from a lower tax rate and now makes $16 in after-tax profits.

Corporate Tax Rate Lowered to 20% + Border Tax Adjustment:
Now let's assume the corporate tax rate has been lowered to 20% and there is now a border-tax adjustment, as has been suggested in the current proposals. This means our apparel company must now not only pay taxes on its profits, but also on all the costs to make a shirt overseas. The company would pay a 20% tax rate on both its $20 profits and its $80 cost to produce the shirts overseas, for a $20 tax bill. In this case, the border-tax adjustment wipes out the company's profits.

Corporate Tax Rate Lowered to 20% + Border Tax Adjustment + Sharp Rise in the Dollar:
The reality of implementing a border-tax adjustment is more complicated than our last example and could have a number of effects that would meaningfully change how it impacts a company's profits. For instance, many economists believe that if a 20% border-tax adjustment is implemented, the U.S. dollar will increase by 25%. If this happens, it would increase a U.S. company's buying power overseas, effectively lowering the cost to produce overseas. In the case of our apparel manufacturer, a 25% increase in the dollar would lower the cost to produce shirts overseas to $64 (compared to $80 previously). If the company still sells shirts for $100, their profits before tax increase to $36. If we apply a lower 20% corporate tax rate and a 20% border-tax adjustment, the company's tax bill is $20, resulting in a profit of $16.

What Is the Likely Outcome?
There will likely be many modifications to the current proposals. Also, any changes to the tax code would have to be approved by both the House and Senate, meaning it will likely take time before we see any definitive changes. It is difficult to predict what changes will be made to the U.S. corporate tax code, the effect of those changes on currency and other markets, and ultimately what the impact will be on company profits. We do know that just because the corporate tax rate could be lowered, benefits will vary by company, and there is a risk some companies could end up paying more in taxes depending on what changes are made.

What Does This Mean for Consumer Companies?
We believe companies that manufacture or source their products in the U.S. and have mostly U.S. operations have the potential to benefit the most from corporate tax reform. We believe companies with large international operations would likely see a smaller benefit given they already pay lower tax rates. Lastly, we believe companies that source or manufacture products overseas are at the greatest risk of seeing their tax bills increase. In our view, consumer staples companies, media companies, restaurants and select domestic retailers are most likely to see neutral or positive impacts from changes in the corporate tax code. Meanwhile, we believe U.S. automakers and suppliers, apparel and footwear manufacturers, discount retailers, and retailers with large private-label offerings are most at risk of being negatively impacted. We have seen some companies in these industries underperform recently due to these concerns.

Recommended Action for Investors
We do not believe investors should base investment decisions on potential corporate tax code changes given that there are many unknowns and that the potential impact to earnings could be much different than the simplified scenarios we laid out above. There are several proposals for tax reform on the table, and each specific company has its own unique tax situation with its own complexities. The uncertainty surrounding the impact of potential tax policy changes should serve as a reminder for the importance of diversification. Investors should own stocks within a variety of sectors and subsectors to potentially limit the impact from specific industry risks. We strongly recommend not investing based on speculated tax policy, but rather we recommend investors focus on a company's long-term earnings growth potential.

The Stock & Bond Market

Index Close Week YTD
TSX 15,839
0.7% 3.6%
S&P 500 Index 2,351
1.5% 5.0%
10-yr GoC Yield 1.71% 0.01% -0.01%
Oil ($/bbl) $53.41 -0.8% -0.6%
Canadian US $0.76 -0.1% 2.6%

Source: Bloomberg. Past performance does not guarantee future results.

The Week Ahead

Next week, retail sales will be reported on Wednesday, and inflation data will be released on Friday.

Important Information

The Weekly Market Update is published every Friday.

Edward Jones does not provide access to past weekly summaries.

The S&P/TSX Composite Index and S&P 500 Index are unmanaged indices and cannot be invested into directly.
Diversification does not guarantee a profit or protect against loss
Dividends may be increased, decreased or eliminated at any time without notice.

Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk.

Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

The value of investments fluctuates and investors can lose some or all of their principal.

The content of this report is for informational purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

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Diversification does not guarantee a profit or protect against loss.

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