Key Points
• Investors moved back toward a “risk-on” mode last week on expectations of improved economic growth.
• Details are scant, but we think tax reform is likely to pass early next year, boosting growth and equities.
• We expect both bond yields and equity prices to rise over the coming year.
Investors reacted positively to the release of President Trump’s tax reform outline, and the so-called “reflation trade” resumed last week as higher-risk areas of the financial market outperformed. Equities increased, with the S&P 500 Index rising 0.7%.1 Small cap stocks and the technology sector led the way, as we saw a rotation out of growth styles into value sectors.1 Treasury yields and the U.S. dollar also rose.1
Equities Should Benefit From Tax Reform
Since the beginning of the year, we have been suggesting that tax reform would be the only significant pro-growth initiative that would come to fruition before the 2018 midterm elections. With the collapse of the latest GOP attempt to overhaul health care, this view seems more likely.
The details surrounding President Trump’s proposal are scarce, but most members of Congress support the core objectives of rationalizing the corporate tax structure and reducing taxes to middle-income Americans. We are cautiously optimistic that a modest tax reform package will pass in early 2018.
It is hard to assess the possible economic and market effects on a bill that hasn’t been drafted yet. But should it come to pass, we think tax reform would be a plus for both the economy and for equity markets. If the corporate tax rate is reduced, we estimate that tax cuts and repatriation could add between $6 and $8 to S&P 500 earnings next year. More importantly, stronger economic growth coming from fiscal stimulus would finally take the burden off of monetary stimulus, allowing monetary policy to more easily normalize.
Weekly Top Themes
1. Economic data is likely to be volatile due to hurricane damage. Payrolls, retail sales wages and other data points are likely to be depressed in the third quarter, but should rebound in the fourth quarter and beyond.
2. We anticipate nominal economic growth will continue to accelerate. Nominal growth in the U.S. dropped below 3% in 2016, but has since increased as a result of easier lending standards, low credit spreads and slowing unit labor costs.2 We expect these factors will continue, which should help corporate revenues, allowing companies to increase capital expenditures and raise wages. In turn, this could lead to a pickup in inflation next year.