Tax reform, not waning economic growth forecasts, is the No. 1 threat to the U.S. stock market before the end of the year, Goldman Sachs warned clients. Investors have failed to appreciate the odds of Democrats enacting substantial changes to the tax code, the bank's chief U.S. equity strategist wrote in a note, meaning any forward progress in Washington could spell headaches for traders before the end of 2021. "Congress plans to raise corporate taxes to fund reconciliation legislation. However, the stock market is only partially pricing an increased tax rate in 2022," Goldman's David Kostin said in the note. He explained that Goldman's 2022 S & P 500 earnings forecasts include expectations for a scaled-down version of President Joe Biden's tax proposal. The bank sees the domestic corporate tax rate rising to 25% from 21% and the passage of about half of the proposed increase to tax rates on foreign income reducing S & P 500 earnings by 5%. What concerns Kostin most, however, is that his clients don't seem to be pricing in what he sees as a likely edit to the U.S. tax plan. Democrats are in the middle of drafting $4.5 trillion in fiscal spending between a $1 trillion bipartisan physical infrastructure package and a $3.5 trillion budget reconciliation bill plan aimed at tackling climate change and poverty. Moderate Democrats, including Sen. Joe Manchin, D-W.Va., have insisted that Congress pay for the deluge of spending and have voiced skepticism about the needs for trillions in additional appropriations. Manchin told Federal Reserve Chairman Jerome Powell last month he is worried that combined stimulus from the central bank and Congress "will lead to our economy overheating and to unavoidable inflation taxes that hard working Americans cannot afford." The House Ways and Means Committee is expected to outline revenue raisers associated with the reconciliation bill as soon as this week. The Biden administration has proposed a raft of potential tax ideas, including hiking the corporate rate, increasing the top rate on earnings to 39.6% and taxing capital gains like regular income. "The market appears to be only partially pricing an increased tax rate in 2022," he wrote. "The busy legislative calendar in September should lead to increased earnings estimate volatility in the near future." With an uncertain economic and tax policy backdrop, Goldman recommends investors think about snapping up stocks with stable earnings and strong balance sheets. In other words, Kostin is looking for quality. He highlighted several constituents of the Goldman High Quality Stock basket as potentially smart investments over the next few months. Google-parent Alphabet , Home Depot , Raymond James and UnitedHealth made the list as public companies with high quality scores. "The market already appears to be focusing on quality companies with stable earnings," Kostin wrote. "Since the start of June, high pricing power stocks have outperformed low pricing power stocks by 11" percentage points and the Goldman high-quality basket has topped the S & P 500 by 5 percentage points. — CNBC's Michael Bloom contributed reporting.
House Speaker Nancy Pelosi (D-CA) takes questions as she holds her weekly news conference with Capitol Hill reporters at the Capitol in Washington, July 22, 2021.
Elizabeth Frantz | Reuters
Tax reform, not waning economic growth forecasts, is the No. 1 threat to the U.S. stock market before the end of the year, Goldman Sachs warned clients.