Why Tax Reform Could Crush Stocks in 2019

A lower corporate tax rate is a good thing, right?

For now.

According to a Jan. 3 report from BofA Merrill Lynch Global Research, tax reform will boost earnings for S&P 500 constituents in 2018. But by 2019, growth will slow as "some of the initial benefits are competed away."

That's in part because tax reform could become a headwind to growth in 2019, BofA said. Analysts expect average earnings to total $161 the year after this one, implying a 5% growth rate. That's half the pace of growth analysts expect for 2018.

Growth could slow due to several factors. "First, economic theory suggests that higher returns should incentivize additional competition, which should have a negative impact on margins over time, especially with many traditional industries already facing increasing disruption," analysts said.

Additionally, the Fed could become more aggressive with tightening strategy following a period of strong growth. More aggressive Fed actions could weigh on overall economic expansion.

"The bull case for earnings is that tax reform and deregulation could spark a sustained pick-up in growth from animal spirits," analysts noted. When tax reform was passed in 1986, the stock market posted two consecutive years of double-digits earnings growth -- but it wasn't enough to stop the 1987 bear market from happening.

BofA analysts expect GDP growth will slow in 2019, too. While GDP is expected to expand between 2.6% and 2.7% in 2018, analysts see that rate slowing to between 2.2% and 2.3% in 2019.

But concerns for 2019 growth slowing shouldn't hinder the tangible benefits of tax reform in 2018. BofA raised its earnings forecast for the S&P 500 this year by 10% to an average of $153.

"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," BofA said. Stock buybacks will account for another $3 of the average earnings estimate increase, analysts noted.

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