While moves to push forward with tax reform in the US have been well-received by the market, North American Income investment trust managers Ralph Bassett and Fran Radano remain cautious over its potential impact.
Tax reform was one of Donald Trump’s main campaign pledges and was partly behind the so-called ‘Trump Bump’ following his election win. However, after failing to secure backing for ambitious healthcare reform, the new president’s tax plans were thrown into doubt.
“Following the inability to build consensus on healthcare reform, Republicans scrambled in late September to advance tax reform legislation,” Bassett and Radano said.
“The financial markets applauded the attempt, given the growth earnings implications for US corporations.
“Small-cap stocks surged given their relatively higher tax rates relative to those of large-caps, as did companies with high overseas cash balances due to the potential for a repatriation holiday.”
As the chart below, the index rose by 4.38 per cent in the three months to 24 October, despite the increased volatility in August caused by Trump’s war of words with North Korea over its missile and nuclear weapons programmes.
Performance of index over 3mths
Source: FE Analytics
However, while the market reacted positively to recent moves on tax reform, Bassett and Radano noted that building a consensus in Washington DC remained difficult under the Trump administration.
Although the market had factored in expectations of lower corporate taxes driving higher earnings and lower personal taxes stimulating higher personal consumption, the pair remain cautious until the proposals have won approval.
The pair highlighted the difficulty in securing a deal on healthcare reform given the “fractured political environment”, despite Republicans controlling the presidency and both houses of Congress.
They also said many details of the tax reform plan still need to be fleshed out as it represents just a framework currently.
“Most importantly, in our view, it is still somewhat unclear how president Trump’s proposed tax cuts will be financed, as enhanced economic growth is forecast to compensate for much of the expected revenue shortfall,” they added.
“Some Republican senators have already announced that they will vote against any proposal that definitively adds to the deficit.”
Bassett and Radano said they expect tax reforms to need “major reworking” to secure passage through the legislature and are anticipating volatility in the markets “as the likelihood of any bill’s passage waxes and wanes”.
“Despite the difficulty in Washington and lack of clarity on major issues such as healthcare, tax reform and increased infrastructure spending, it seems that US companies are unfazed and aggressively allocating capital to growth initiatives,” they said. “We find this to be mildly surprising.”
The pair noted that M&A market remained robust with cash-rich companies taking advantage of weakened competitors or market dislocations.
“We believe that part of this increased confidence on the part of US companies has been driven by better growth expectations, both domestically and abroad,” they added.
Additionally, Bassett and Radano thought the Federal Reserve would cautiously reduce its balance sheet of bond holdings “in a way that should create relatively little immediate concern for markets”.
“Consequently, we believe that the environment remains conducive to continued growth on companies’ top and bottom lines, but we are now on guard for evidence that interest rate policy may progress too quickly or too slowly,” they added
“We have flagged margin compression and possible wage inflation as areas of concern, though neither of those issues has aggressively manifested itself yet. We will continue to monitor these concerns.”
Over three years, the North American Income Trust has returned 66.44 per cent compared with a 67.57 per cent rise in the S&P 500 benchmark and a 47.09 per cent gain for the average IT North America Equities sector.
However, the trust has struggled to outperform the benchmark so far this year, returning just 3.85 per cent compared with a 9.32 per cent rise for the S&P 500.
Performance of the trust vs sector & benchmark over 3yrs
Source: FE Analytics
The trust is currently trading on a discount of 7.9 per cent and is 6 per cent geared. It has an ongoing charge of 1.05 per cent, according to the Association of Investment Companies.