BANK OF AMERICA: Tax reform could be a drag on company profits by next year

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  • Equity strategists at Bank of America Merrill Lynch, like many others, expect the corporate tax cut to boost company earnings.
  • But BAML thinks the boost will be short-lived, probably not beyond 2018.
  • More profits would mean more competition that could drive down margins, and the Fed could speed up interest rate hikes, the bank said in a note on Wednesday.

Equity strategists at Bank of America Merrill Lynch raised their forecast for corporate profits this year, thanks to the expected boost from lower corporate taxes.

But they're not anticipating a boost to growth far beyond December.

In a note on Wednesday, a team of strategists led by Dan Suzuki said they raised their 2018 S&P 500 earnings per share target by 10% to $153. They'd already lifted the target late last year, just before President Donald Trump signed the Tax Cuts and Jobs Act into law.

"The biggest impact on earnings from tax reform comes from the lowering of the federal tax rate from 35% to 21%, making up roughly $10 of the $14 increase," Suzuki and his team wrote. "Buybacks represent another $3 of the increase, with some modest offsets from the minimum foreign tax rate and the cap on interest deductions."

This boost, however, is less than the full tax-cut benefit they estimated last year, as some companies have already announced how they plan to spend their windfall, including one-time employee bonuses .

And beyond 2018, the strategists think tax reform could in fact be a deterrent to earnings growth.

They cited three reasons. First, companies would be able to compete better with higher returns. While that's usually good for consumers, the downside is that the drive to increase market share could hurt company margins over time. Some industries like retail are already facing this predicament.

Secondly, BAML argues that stronger growth could prompt the Federal Reserve to raise interest rates faster than it is expecting, which could then turn around and be a drag on the economy.

One of the biggest criticisms of rate increases has been low inflation, the reasons for which Fed Chair Janet Yellen has said are mysterious . But with most major economies around the world solidly in expansion, and in a tight US labor market, many strategists have flagged that 2018 could be a year when inflation becomes an issue to deal with again.

Also, BAML recalled that tax reform was passed in 1986, one year before the slump into a bear market and shortly before the savings and loan crisis. Sure, the stock market got double-digit earnings growth from the tax law, but it didn't stop the descent.

"Our economists expect only a modest lift to GDP growth from tax reform over the next couple of years, with growth slowing from 2.6-2.7% in 2018 to 2.2-2.3% in 2019," Suzuki said.

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