January 31, 2023
Douglas Beath, Global Investment Strategist
Gary Schlossberg, Global Strategist
Michael Taylor, CFA, Investment Strategy Analyst
Jennifer Timmerman, Investment Strategy Analyst
Updates and analysis from Wells Fargo Investment Institute on what federal budget, regulatory, and trade decisions could mean for investors.
January 31, 2023
Douglas Beath, Global Investment Strategist
Gary Schlossberg, Global Strategist
Michael Taylor, CFA, Investment Strategy Analyst
Jennifer Timmerman, Investment Strategy Analyst
Although comprehensive tax legislation failed to pass Congress in 2022, new tax provisions take effect this year alongside phaseouts from previous bills. A split Congress will make enacting new tax legislation challenging.
In August 2022, U.S. lawmakers passed the Inflation Reduction Act with tax provisions that took effect on January 1, 2023. Meanwhile, tax provisions of the 2017 Tax Cuts and Jobs Act continue to phase out, impacting the bottom lines of large U.S. firms. More recently, the SECURE 2.0 Act that passed Congress last month included tax provisos that we believe could impact investors.
With Republicans in control of the House, we expect lawmakers to focus on spending and the debt ceiling. Certain tax-policy agenda items could be on the docket, including repealing IRS funding from the Inflation Reduction Act for Republicans (see Sidebar 1) and an enhanced child tax credit for Democrats. A lack of bipartisanship should make enacting new tax legislation challenging.
Although comprehensive tax legislation failed to pass Congress last year, we expect the following tax provisions from the Inflation Reduction Act should take effect this year:
Meanwhile, we expect these provisions of the 2017 Tax Cuts and Jobs Act should continue to phase out this year:
On December 29, President Biden signed into law the Consolidated Appropriations Act of 2023. Included in the bill is the SECURE 2.0 Act that aims to boost retirement savings. Individuals saving for retirement, retirees, and small business owners can potentially benefit from this legislation.1
In the near term, tax credits plus seed funding for alternative fuels as well as broad provisions for clean-energy equipment may benefit the Energy and IT sectors, respectively. We currently hold favorable tactical ratings (over the next 6 to 18 months) on Energy and IT. Meanwhile, we believe clean energy, home-energy efficiency, electric vehicle tax rebates for consumers, and a number of other elements may benefit the Industrials, Materials, Utilities, and Consumer Discretionary sectors over the long term as they are extended out 10 years. We hold a neutral tactical view on the first three and an unfavorable view on the last, respectively.
Many businesses may be impacted by the continuing phaseout of capital expensing and R&D expense amortization, coupled with Inflation Reduction Act corporate tax provisions. Tax burdens from the minimum tax levy will fall heavily on Real Estate (unfavorable tactical rating) and Mining (neutral), with net-tax hikes projected at 12.7% and 4.6% of income over the next decade, respectively.2
The bipartisan SECURE 2.0 legislation may help in an effort to bolster U.S. retirement savings and preparedness. Looking ahead, with a divided Congress, we do not anticipate major tax legislation during this congressional session and likely through the 2024 election cycle.
Certain provisions in SECURE 2.0 may have tax implications for investors. We encourage investors to work with their tax advisor.
Higher interest rates and expectations for reduced tax revenue will likely pull forward the debt-ceiling debate. The newly elected Republican Congress will focus on limiting deficits, but we expect an eventual compromise that aims to avoid a government shutdown, potentially benefiting certain equity sectors.
The $1.7 trillion fiscal year 2023 spending bill, on top of multi-trillion-dollar spending and debt issuance associated with the pandemic, has placed renewed focus on the U.S. budget deficit and long-term outlook. America’s fiscal health is also being scrutinized due to the recent spike in interest rates.
The U.S. national debt currently exceeds $30 trillion, more than 100% of gross domestic product (GDP), and is expected to reach 110% of GDP in 2032, according to projections from the Congressional Budget Office (CBO). While these current and projected debts are very high from a historical perspective, we believe it likely that the U.S. can support a meaningfully higher debt level given the country’s dominant global economic position and the dollar’s role as the world’s primary reserve currency. Another key factor why investors have been comfortable buying Treasury securities is that 40% of the debt is owed by the U.S. government in various trusts such as Social Security, while an additional 35% is financed by U.S. investors.
Interest on the debt is another concern. Ultralow interest rates reduced the cost to finance the federal budget from a high of 15.4% in 1996 to a 2022 projection of just 6.8%. Current CBO projections show the debt service increasing to over 13% of the federal budget by 2032, based on assumptions for modestly higher interest rates. Under this scenario, interest expense costs should remain manageable, but the larger share of the budget going to debt service may potentially limit the assistance that the federal government could provide if any new crises should arise.
Even if Treasury bonds transition to a higher-yielding cycle, we routinely adjust our long-term strategic guidance to consider corporate bonds and preferred securities that we expect should continue to pay a premium over Treasuries — and, combined with active management, potentially balance additional yield with the additional risk. In our view, rising government debt levels could also result in more volatile equity prices than in the past 14 years, but we still expect equities to return more than bonds.
With the passage of a $1.7 trillion spending bill, Congress averted the threat of government shutdowns until next July. In the meantime, higher interest rates and expectations for reduced tax revenue due to a significant decline in shareholder wealth from 2022 will contribute to a deteriorating fiscal situation. As a result, we believe the debt-ceiling debate is likely to be pulled forward.
This in turn should have the greatest impact on companies that generate the most revenue (as a percentage of sales) from government spending, which could include pharmaceutical (pharma) and defense manufacturing companies. We already hold an unfavorable outlook on pharma but have been favorable on defense since the Russian invasion of Ukraine.
As in previous episodes, this debt-ceiling debate will be about process. Republicans generally want spending cuts, while the president and House Democrats oppose spending cuts. Important questions for investors will include if and what sectors will be cut, and if they will be targeted or “across the board”. We believe it’s too early to predict how the debt ceiling will impact equity sectors. Case in point: Defense stocks outperformed in 2022 but have underperformed significantly this year on fears of a potential debt-ceiling showdown. Yet, several Republican House members oppose freezing defense spending.
Our base case remains that a debt-ceiling debate will ultimately lead to some compromise without a government shutdown, default, or cuts to Social Security, Medicare, or veterans’ benefits. However, we favor not jumping to conclusions about the exact timing or which sectors may potentially benefit. Since the 2011 debt-ceiling fight, Congress has repeatedly had to face raising the debt ceiling. In each case, they have been successful, even though investors worried about default. The key factor for investors is to see in advance not “whether” they raise the debt ceiling, but “what they trade off” to do it. It’s too early to know what the ultimate compromise will be.
Renewable energy and technology are among the most visible beneficiaries of a more eclectic U.S. foreign-trade policy, shaped as much by national security, environmental, and other domestic concerns as by traditional internationalism. Trade’s support for the Information Technology (IT) sector helps support our favorable strategic view of higher-quality U.S. technology companies.
U.S. foreign-trade policy is evolving away from the free-trade principles of traditional internationalism toward a hybrid approach shaped as much by domestic, geopolitical, and environmental priorities as it is by purely economic considerations. We expect contours of change could affect trade policy in these ways:
We believe frontline technology and renewable energy industries should benefit from U.S. subsidies in the 2022 Inflation Reduction Act and CHIPS and Science Act favoring domestic and foreign companies investing and producing in the U.S. Support from recent Inflation Reduction Act legislation reinforces our favorable view for larger, well-capitalized, and diversified companies with renewable-energy exposure. Our favored sub-industries applicable to this theme include Electric Utilities, Industrial Gases, Integrated Oil, and Multi-Industrials. We view these companies as well-positioned to expand market share without the financial risk faced by pure-play firms in the industry.
Recent and emerging developments in trade policy likely are mixed, but we view as positive, on balance for the IT sector. Combined with opportunities for further digitalization and U.S.-company strengths in the global market, policy has supported our favorable strategic view of U.S. technology stocks. We look for semiconductor manufacturers with their own fabrication plants are among the most visible beneficiaries of the move to reshore critical industries to the U.S. under the CHIPS and Science Act.
We currently maintain a favorable rating on the Semiconductor Equipment sub-industry, in part because of the long-term benefit from the U.S. policy focus on more domestic production. Added support to the semiconductor industry came from a decision at the North American summit in Mexico on January 10 – 11, 2023, to foster cross-border supply chains to facilitate reshoring of technology firms to the U.S.
Our overall view of the trade agenda is positive for the IT sector, even though not all the news is likely to be good. National security’s elevated role may have a damaging effect on U.S. technology sales to China in our view. High-end technology firms (keyed, for example, to leading-edge chips for supercomputing and artificial intelligence) and sales of semiconductor equipment manufacturers to China are among the most exposed to export controls. We believe technology sales could be cushioned modestly by incremental benefits to output of so-called NAND flash-memory chips, and by sales of semiconductor and related equipment diverted to the U.S. market.
An added counterweight for the technology industry is the decision by the European Union (EU) to move ahead with a 1.5% – 7.5% digital sales tax and a 15% global minimum tax. The EU announcement hits hardest at large U.S. tech and other multinational companies operating there. Action by the U.S. on its own minimum tax, to retain domestic revenues, isn’t likely until the expiration of several tax provisions in 2025, effectively exposing technology and other multinational companies to higher taxes abroad. To reiterate, in our view these negative considerations do not outweigh the positives described above.
Look for the unexpected in this year’s trade debate, too, as we and our trading partners react to foreign economic-policy changes in the past year. For example, Europe’s new multinational taxes could invite retaliation by the U.S. Progress toward further regional integration in North American trade could be slowed by festering disputes over Canadian restrictions on U.S. dairy and soft-lumber imports, and on U.S. energy and agricultural sales in Mexico. By contrast, we view the Biden administration’s decision to maintain Trump-era levies on steel and aluminum imports as part of a global tilt toward industrial policies favoring subsidies rather than the opening round of another trade war with our commercial partners, having little impact on our neutral tactical view of Industrials.
1 See “Secure Act 2.0: What You Need to Know About New Retirement Savings and Distribution Rules,” Wells Fargo Bank Advice and Planning, for full details.
2 “Who Gets Hit by the Inflation Reduction Act Book Minimum Tax?” Tax Foundation, August 12, 2022.
Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.
Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market.
Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest. Unlike U.S. government securities, agency securities carry the implicit guarantee of the U.S. government but are not direct obligations. Payment of principal and interest is solely the obligation of the issuer. If sold prior to maturity, both types of debt securities are subject to market risk.
Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.
Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security.
S&P Aerospace & Defense Select Industry Index comprises stocks in the S&P Total Market Index that are classified in the GICS aerospace & defense sub-industry.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
Wells Fargo Investment Institute (WFII) guidance definitions
Most favorable: WFII’s highest conviction guidance that indicates a strong desire to overweight an asset class (or sector) within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as offering investors a very attractive risk/reward opportunity.
Favorable: Guidance that indicates a desire to overweight an asset class within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as providing investors with an attractive risk/reward opportunity.
Neutral: Guidance that indicates a desire to maintain an asset class near the long-term (strategic) allocation guidance within a portfolio. It also communicates that, over a tactical time frame, WFII views the asset class (or sector) as providing investors with an acceptable risk/reward opportunity.
Unfavorable: This WFII guidance level indicates a desire to underweight an asset class (or sector) within a portfolio. It also communicates that, over a tactical time frame, WFII does not view the asset class (or sector) as providing investors with an attractive risk/reward opportunity.
Most unfavorable: WFII’s highest conviction guidance indicating a strong belief in underweighting an asset class within a portfolio. This also communicates that, over a tactical time frame, WFII views the asset class (or sector) as offering investors a very unattractive risk/reward opportunity.
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