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European growth and US "tax holiday"

24 March 2017

Are markets under-appreciating a potential resurgence of growth in Europe or will politics undermine it?

Over the past few quarters, there has been evidence of an uptick in growth in the Eurozone with economic activity data, as measured by the Purchasing Managers Index (PMI), accelerating, particularly in France. On the other hand, core inflationary pressures are only approximately 1% and unemployment remains at elevated levels. Therefore the direction of travel appears to indicate an upswing in momentum and there remains some slack in the broader Eurozone economy.

Despite the pickup in economic indicators, any bullishness on European equity investments seems to have been tempered by the substantial political headwinds in the region and the legacy banking issues, most notably in Italy. However, of late, investors are becoming more constructive on the region and appear to be paying less concern to the political issues. Accordingly, the EuroStoxx index is up over 5% since the start of February.

The first major political event of the year resulted in a victory for the mainstream political parties, with populist Geert Wilders being beaten by the incumbent Mark Rutte in the Dutch election. However, it is important to note that one cannot discount political situations rocking markets in the near future. Despite the likelihood of Le Pen being rejected in the French elections, nothing is certain and if last year taught us anything, it is to be wary of pollsters underestimating populist candidates. Elections are also to come in Germany and in Italy where the Eurosceptic Five Star Movement are gaining ground. As a result, it is likely that the political risks will continue to drive some discount in valuations in the Eurozone for some time to come, despite the improving fundamentals.

What will be the impact of a ‘tax holiday’ for US companies bringing overseas cash back to the US? Who benefits most?

Over the years, US companies have built up large cash reserves abroad and issued debt to cover any funding requirements, including share buybacks, to avoid costly repatriation tax bills. This has been a bone of contention for the US government as it means that they will not receive any corporation tax on any of these overseas profits, estimated to be worth around 2 trillion dollars.

President Trump has proposed a tax holiday, which is a temporary reduced tax rate designed to encourage multinational companies to repatriate foreign profits. In an ideal world, the effect of this is extremely positive for the US economy. Companies repatriate these foreign profits and invest in Research and Development, initiate new projects and create new jobs, stimulating economic growth. In reality, as was the case for the US tax holiday in 2004, companies use these large cash balances to undertake share buybacks and offer special dividends, returning the cash to shareholders. Whilst positive for the economy as a one-off, this doesn’t have nearly as significant an impact on long-term growth potential.

Therefore, the key determinant of who benefits lies in the structuring of the policy. If conditions can be attached to ensure that proceeds are used to boost domestic growth, it could be extremely positive for both the government and the economy as a whole. If, however, companies freely return the proceeds to shareholders, it would do little more than support the US stock market and increase government tax receipts in the short run. 


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