Will Tax Cuts (Finally) Reawaken Value?

A sparkler firework and sunset.

If you squint really hard, you can almost see value stocks beginning to stir. Large cap U.S. value has nominally outperformed growth month-to-date. That said, value is still trailing its sexier cousin, growth, by roughly 1500 bps (basis points, or 15%) in 2017.

The question many are now asking is whether that will change if tax cuts are enacted? Given that an untested faith in fiscal stimulus led to value outperformance in late 2016, perhaps an actual tax cut might provide a more durable rally in value? My view is probably yes, assuming you believe that tax cuts will impact the real economy.

Big discount

To start, a bit of history. As I’ve described in previous blogs, years of underperformance have left large cap value stocks historically cheap relative to large cap growth stocks. Since 1995 the Russell 1000 Value Index has typically traded at around a 57% discount to growth. Today the discount is nearly 70%, close to the lowest relative valuation since 2000.

Many would argue that the discount is justified given a wide gap in earnings growth and profitability. Value stocks are, by definition, values for a reason, i.e. they tend to be less profitable. However, even after adjusting for current differentials in profitability, value looks cheap.

Historically, the differential in return-on-equity (ROE) explains approximately 35% of the variation in growth/value relative valuations. Currently, the ROE on the Russell 1000 Growth Index is over 25%, versus less than 10% for the Value index. This spread of 16 percentage points is historically wide, but even that does not fully explain the value discount. If the historical relationship held, value stocks would be trading at around a 62% discount to growth, not today’s historically wide levels.

All of which suggests that value does look too cheap relative to growth. Unfortunately, one could have reached the same conclusion for most of the past three years and still underperformed by betting on value. As discussed back in October, what value lacks is a catalyst.

Term Premium Equity Valuations

A little bit of help from inflation

Tax cuts might provide the missing ingredient. The reason: Typically investors place a smaller discount on value when growth is faster, particularly nominal growth. In other words, a bit of inflation would help close the valuation gap between value and growth.

Looking back at the past 20 plus years, value has traded higher relative to growth when inflation, measured by the consumer price index (CPI), is higher (see the accompanying chart). Higher inflation would arguably be even more supportive if it were driven by higher oil prices, as energy companies appear particularly cheap today. In addition, to the extent higher realized inflation leads to higher inflation expectations—and in turn, higher interest rates—financial stocks, another big value sector, also benefit.

Bottom Line

Tax cuts can provide the necessary catalyst for value stocks, assuming they do more than just boost corporate profitability. In order to really impact style performance, they will need to boost nominal growth as well.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Will Tax Reform Hurt Tax-Exempt Bonds?

Sea salt in brown shaker; Shutterstock ID 369549524

Tax reform is high on the agenda of the new administration, leading to speculation about what changes could mean for the outlook for tax-exempt municipal bonds. The two areas of focus: A reduction in tax rates for both corporations and individuals, and the elimination or capping of muni tax exemption.

Lower individual taxes … and a grain of salt

The hard truth: Lower individual tax rates reduce the value of a municipal bond’s tax exemption. For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer.

To that salty dose of reality I would add two important provisos:

  1. The individual tax code is very complicated and politically difficult to amend, even under one-party control. Change may well come, but not likely in 2017 as Washington focuses on the comparatively easier task of corporate tax reform.
  2. A cut in individual tax rates would cause some adjustment in muni pricing (read on for our estimate). But the market has seen similar, and even more dramatic, tax changes before. The top marginal tax rate was reduced from 50% to 28% in 1986 and from 39.6% to 35% in the 2000s. And, under current conditions, muni investors still reap an after-tax benefit over taxable bonds, even at a 33% tax rate.

Muni Yields

Tax exemption not dispensable

The tax exemption of municipal bond interest is a key draw for issuers. And while it may be deemed alterable, we don’t see it as dispensable. States and municipalities rely on municipal debt as a low-cost, efficient way to finance capital improvements and fund infrastructure. The federal government hurts itself if it impedes state and local ability to create jobs, sustain their economies and improve the quality of life for Americans. As such, we see the elimination of muni tax exemption as highly unlikely.

Other proposals center on capping the tax exemption at 28%. The odds of such an outcome are anyone’s guess.

Importantly, however, our analysis suggests that any market correction to overcome a 28% cap on the tax exemption, or a drop in the highest tax rate from 43.4% to 33% for that matter, would be manageable. By our estimates, the market might need to offer some 15 basis points (front end) to 50 basis points (long end) in higher yield to compensate for the reduced tax benefit. See the chart above. The market has digested adjustments of this magnitude in the past without a material change to the overall demand dynamic.

Corporate tax reform as an offset

Notably, corporate tax reform could be an important offset to any or all of the above. Current law allows companies to deduct interest payments on bond income. Under reform proposals, that benefit may be repealed to compensate for lower corporate tax rates. This could conceivably lead to lower corporate bond issuance. Munis, in turn, would become a greater source of supply for income-seeking investors. The associated uptick in demand would mute the effect of other tax changes.

There’s another wrinkle, however: The impact of corporate tax reform could vary for banks and insurance companies (relatively large holders of munis) depending on where corporate rates settle and what happens to the Alternative Minimum Tax, or AMT. This could have a negative impact on their need for municipal bonds.

Ultimately, “tax reform” is a series of potential scenarios featuring many variables and offsetting factors. Which reforms are implemented and to what degree will determine the extent of the market impact. Uncertainty is perhaps the only certainty. But this we can say with enough confidence: Munis will retain some tax-exempt benefit—and there will always be an appetite for that very unique feature in an investment asset.

Peter Hayes, Managing Director, is head of BlackRock’s Municipal Bonds Group and a regular contributor to The Blog.

In today’s environment, consistent investment performance and low fees are critical to achieving your fixed income investing goals. Click here to learn more.

 

Investment involves risk including possible loss of principal. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Using “Asset Location” to Reduce Your Tax Bill

Taxes

Growing your portfolio isn’t only about selecting the right investments; it’s also about maximizing how much of the gains you can keep and minimizing how much you have to give to the government. Therefore understanding the tax implications of your investments is a key part of taking control of your wealth. Fully utilizing tax-advantaged accounts (such as 401k and IRA accounts) is important, but it’s not the only step in achieving better after-tax investment returns.

Different investments can be treated very differently by the taxman. Dividends from stocks (or funds that invest in stocks) are generally taxed at a much lower rate than interest payments from bonds (or funds that invest in bonds). Funds that have a high “turnover” (meaning they frequently rearrange their underlying investments) will often generate more taxable income than funds with lower turnover. Most income from municipal bonds is exempt from federal income tax (and sometimes state income tax too).

If you have a mix of tax-advantaged accounts and regular accounts, you can benefit from the tax differences by putting more of the high-tax investments in the tax-advantaged accounts and the low-tax investments in the taxable accounts. This tactic is called “asset location” (you’re locating your assets in accounts where they’re most efficient from a tax perspective). Done properly, it can let you retain more of your wealth and make it easier to achieve your financial goals.

It’s Not Too Late for a 2014 IRA Contribution

Piggy Bank 2

Taking advantage of tax-advantaged accounts, such as 401(k) and IRA accounts, can be one of the most effective tactics to get on track to reach your retirement goal. But if you forgot to make an IRA contribution for the 2014 tax year, it’s not too late. You actually have until tax day (April 15th) of this year to make an IRA contribution for 2014.

Like with most issues relating to taxes, the rules relating to IRA contributions aren’t exactly simple. But here are the basics:

– The yearly contribution limit into IRA accounts for anyone under the age of 50 is $5,500. For those 50 and over, the contribution limit is $6,500. Those are the limits for all your IRA accounts combined, so you can’t contribute $5,500 each to two different IRA accounts in the same year.

– For traditional IRA accounts (where your initial contribution is generally tax-deductible but you pay taxes when you withdraw the money in retirement), whether you can get the tax benefits from the IRA depend on whether you (or your spouse) are covered by a retirement plan at work as well as how high your income is.

– For Roth IRA accounts (where your initial contribution isn’t tax-deductible but you don’t pay taxes when you withdraw the money in retirement), whether you can contribute depends on your income. You can make a Roth IRA contribution up to the limit if your tax filing status is “single” and your income is less than $114,000, or if your tax filing status is “married filing jointly” and your income is less than $181,000.

You can find more details on the IRA contribution rules on the IRS website.

Reducing Your Capital Gains Tax Bill

Calculator

The end of the calendar year can be a good time to try to reduce the amount you have to pay in taxes. You have to pay capital gains taxes on your investments that have been sold for a profit during the year (at least in standard investment accounts; you don’t have to worry about this in tax-advantaged accounts such as 401k, IRA, and 529 accounts). But if you also have investments that have declined in value, you could potentially sell some of these before the year ends to create “capital losses” to offset the capital gains. This tactic, called “tax-loss harvesting,” can lower the amount you pay in taxes and therefore boost the size of your portfolio over time.

Unfortunately there are a few nuances that can make successful tax-loss harvesting more difficult. The first is that you can’t sell an investment to lock in the loss and then immediately buy it back. The IRS calls this maneuver a “wash sale” and prevents you from getting any tax benefit from it. Instead you have to wait more than 30 days before re-purchasing the same investment (or any investment that the IRS considers to be essentially the same). Capturing the tax benefit from capital losses without creating a distorted portfolio while you wait for the 30-day period to end can be difficult.

A further complication is that the tax rate on capital gains can be different for different people, or even for different investments held by the same person. For example, the tax rate on gains from investments held more than a year (“long-term capital gains”) is lower than the tax rate on gains from investments held less than a year (“short-term capital gains”). That means that figuring out how much you can actually save through tax-loss harvesting can be tricky.

The bottom line is that tax-loss harvesting can potentially be an effective way to reduce the hit to your portfolio from taxes. But with so many subtleties involved in successfully implementing it, having a professional financial advisor guide you through the process may be a good idea.

How Much Should You Put Into Retirement Accounts?

Piggy Bank

Taxes can be one of the main drags on the growth of your portfolio. That’s why tax-advantaged accounts such as 401(k) and IRA accounts can be such a boon when you’re saving for retirement. But how much should you put into these accounts as opposed to regular taxable accounts? The answer is “as much as you can” in order to minimize your tax bill, though there are a couple key constraints on how much you “can” allocate to these accounts.

This first constraint is that there are usually large penalties if you withdraw money from tax-advantaged retirement accounts when you’re under the age of 59 ½. Therefore any money you think you’ll need to pay for expenses before that age shouldn’t be put in a tax-advantaged account. You should also make sure you have money set aside outside of retirement accounts to act as a buffer against unexpected expenses. Once you’re established this buffer, you should put as much money into tax-advantaged accounts as you can afford to.

The second constraint is legal: the government puts a cap on how much you can put into retirement accounts each year. The annual limit on how much you can contribute depends on the type of retirement account. In 2014 the contribution limit for 401(k) accounts is $17,500, for example, while the limit for IRA accounts is $5,500. These contribution limits are higher for people over the age of 50.

Putting as much money into tax-advantaged retirement accounts as you can, while avoiding the penalties you’d have to pay if you withdraw money early or exceed the annual contribution limits, can make it substantially easier to meet your retirement goal.

The Pros and Cons of MLPs

Pipeline

Most stocks are fundamentally the same kind of investment: they’re shares of ownership in a corporation. There are a few exceptions, however. One is “Master Limited Partnerships” (MLPs), which are popular among many investors because they tend to have very high yields. MLPs trade on stock exchanges just like other stocks, but there are important differences from both a legal perspective and an investment perspective.

MLPs are mostly energy companies, such as companies that operate the pipelines that transport oil and gas across the US. They’re technically “partnerships” rather than “corporations” so their profits can go straight to their shareholders without being taxed at the company level. As a result of the tax laws related to this difference, MLPs distribute a large portion of their profits to shareholders, making them very high-yielding investments. They also have additional tax advantages: for example, a large portion of the distributions are usually taxed when you sell the investment rather than immediately when the distributions are paid.

Of course there are plenty of drawbacks to MLPs as well. Since MLPs are generally energy companies, having too much exposure to them can make your portfolio vulnerable to a downturn in the energy sector. Furthermore, since MLPs distribute almost all of their profits to shareholders, they regularly need to raise new money to maintain and grow their business. This can make them sensitive to problems in financial markets: many MLPs struggled to raise funds at attractive rates during the financial crisis.

In sum, MLPs can be an effective way for investors to generate income from their investment portfolio and get some tax benefits to boot. But like most types of investments, having too much exposure to MLPs can create substantial risks.