As the Tax Cuts and Jobs Act of 2017 was formed and eventually enacted, many mid-cycle, economically dependent equity sectors, such as consumer discretionary, industrials and technology outperformed. Consumers receiving tax cuts should increase spending on discretionary items including technology. Although technology firms will have to pay some taxes for repatriating overseas cash, their ability to write-off 100% of capital expenditures plus other corporate spending to take advantage of this provision will be positive for the sector. Industrials also benefit from accelerated expensing.
iSectors has stated that we are moving from a mid-cycle to late-cycle phase in the economic cycle. The mid-cycle is characterized by strong economic growth, enhanced by accommodative monetary policy that fuels credit growth. In upcoming quarters, we expect to see economic growth peak and begin to decline as the Federal Reserve more aggressively tightens the economy (by accelerating the pace of raising short-term interest rates and lowering its balance sheet size) to fight potential inflation. This late-cycle behavior is also characterized by tightening credit availability, increasing loan defaults, and rising inventories.
As financial advisors search for ways to maintain client gains by increasing diversification, iSectors recommends investing in late-cycle sectors that benefit from the tax cut act and are defensive in nature.
Three sectors – energy, financials, and utilities – should prove to be attractive investments in 2018.
Tax Acts Greatest Winner: Energy
The energy industry has historically been the highest-taxed sector. According to MarketWatch, the sector’s median tax rate has been almost 37% compared to an average S&P 500 corporate tax rate of 30%. Therefore, the decline in the corporate tax rate to 21% is a boon to energy companies.
The sector will be a tremendous beneficiary of the provision to expense 100% of capital expenditures for tax purposes. Energy firms are some of the most capital expenditures intensive companies around. This tax break should allow them to increase spending on exploration, production, refining, and distribution.
And if that wasn’t enough, the bill opens portions of the Arctic National Wildlife Refuge to oil exploration. The Interior Department must hold two lease sales over the next seven years. Although it only affects the coastal plain that consists of less than 10% of the Refuge, it is estimated that it contains over 10 billion barrels of oil. On the other hand, litigation by environmental groups may slow down the implementation of the lease sales
Besides the tax benefits, oil prices and energy company profits are benefitting from the rise in global demand for petroleum during a slowdown in crude supplies. Emerging markets are leading this demand growth. Experts believe that the energy supply/demand balance will continue throughout 2019.
Large Tax Cuts Flowing to Financials
Banks, insurers and asset managers will all benefit from lower corporate tax breaks. Most financial firms will see a 12+ percentage point reduction in their marginal rate. Although consumers may receive price reductions or more income from financial products (especially from insurers), shareholders should see earnings increase from previously expected levels.
Banks could become even bigger winners if economic growth accelerates. This could result in a spurt in lending activities that increases fee and spread income. Also, the spread between deposit rates and lending rates could widen if the economic boost results in higher interest rates.
In addition, the current administration is lowering regulatory burden on the sector. These changes should push financial company valuations to higher levels.
Utilities Will Lead Infrastructure Movement
Unlike the other sectors discussed, utilities will not directly benefit from the corporate tax rate reduction. But, the lower taxes will likely be passed on to ratepayers. It is unlikely that utilities will be able to keep the rate base unchanged very long because they will likely ask state utility regulators for the ability to invest the savings into capital expenditures. Future rate-reducing projects such as gas-fired generators, enhanced power grids and renewable energy projects could receive significant levels of investments.
In addition, the utility sector received a special provision on interest deductibility. Most companies are now restricted on the tax deductibility of interest expense to 30% of operating cash flow. Regulated utilities received an exemption from this rule and can continue to deduct 100% of interest paid. Since other companies will be slower to add debt to their balance sheets, utility debt issuance will be needed to balance corporate bond supply and demand. This could lower the interest cost of utility debt.
Besides the tax breaks, utilities are benefitting from the increased demand for their products from the growing U.S. economy. Also, the sector’s stocks pay attractive dividends, making it a great defensive market investment. Given attractive valuations relative to other sectors in the market and accelerating growth prospects, utilities should be owned in client portfolios.
iSectors ImplementationsBeing in the late cycle of this economic recovery, advisors should search for client solutions that will take advantage of the tax cut legislation and yet be defensive in nature. Here are our recommendations:
iSectors Post-MPT Growth*and Moderate Allocations: Both strategies can be a first step to introducing clients to liquid alternatives. Post-MPT Growth and Moderate are based on the same rules-based process that focuses on minimizing downside risk in bear markets and corrections. This will allow advisers to keep their clients fully invested in down markets and eliminates the need (or temptation) to time the markets.
Both portfolios are invested in low-correlated sectors and include non-equity benchmark asset classes such as Treasury bonds and gold stocks. Post-MPT Growth is a dynamic liquid alternative strategy that is currently overweights energy, financials, and utilities. Post-MPT Moderate also has significant allocations to financials and utilities. Both strategies have Treasury bond holdings at the current time.
For more sophisticated advisors, iSectors recommends:
iSectors Liquid Alternatives Allocation: This is a diversified portfolio with access to hedged strategies, real asset, alternative equity and alternative fixed income mutual funds and exchange-traded funds. Liquid Alternatives owns energy, financial and utility stocks.
iSectors Inflation Protection Allocation: In the late cycle, inflation often accelerates. This allocation invests in asset classes that historically have responded well in periods of high inflation. Inflation Protection holds commodity funds that have significant investments in energy.
How Should Advisors Incorporate These Allocations in Client Portfolios?
Christopher Geczy of Wharton in the Journal of Portfolio Management suggests that advisers reduce their client equity investments by ten percentage points and fixed income holdings by five percentage points and invest the proceeds into alternative strategies. Historically, these asset class changes reduce risk and increase return. One or more of Post-MPT Growth, Post-MPT Moderate, Liquid Alternatives, or Inflation Protection would be ideal for this alternative allocation.
If you are a financial advisor that wishes to learn more about effective methods to reducing downside risk, please contact Scott Jones at 800-869-5184 or [email protected]. Alternatively, you may wish to register on our website www.isectors.com to review information on the iSectors Allocations described above.
Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.
*The iSectors Post-MPT Growth Allocation is also available as an exchange-traded fund (ETF). For more information, visit https://isectors.com/isectors-etfs.