To be sure, the tax plan as envisioned by the president will add to the deficit in the short term, but the thinking behind it is that it will serve to have the economy escape from the mediocre growth that’s been emblematic of the recovery. A plan introduced by Senate Budget Committee members Pat Toomey and Bob Corker could alleviate some of the tension surrounding the deficit, with a tentative deal that would “create $1.5 trillion in tax-cutting room as part of the budget resolution” and could “rescue the House from its familiar factional dysfunction,” according to the Wall Street Journal.
Now the hard part begins. But at least Congress and the White House are fully engaged in seeing tax reform enacted, and while the process may prove to be more difficult than health care reform, the country is fully behind updating the 1986 tax code that was signed by President Reagan. Whether the final plan is more tax cuts than actual tax reform remains to be seen, but the economy is in need of a strong dose of tax measures that could serve as a catalyst for growth.
It’s been popular to use the growing list of pages added to the tax code as a clear—and astonishing—example of how complicated and entangled the tax code has evolved over the years. The tax code included less than 30,000 pages in 1986. Today it is nearly 75,000 pages. The goal of the current tax reform effort is to reduce significantly the number of pages by simplifying the code in its entirety.
Wall Street has already drawn up lists of which sectors, and which companies specifically, would benefit from lower corporate taxes and/or repatriation of capital held overseas. There has been a resurrection of the pro-growth/pro-business Trump trade that followed the election, which had lost traction as investors questioned the ability of the White House to move forward with tax reform legislation. For example, small- and mid-capitalization stocks, particularly in finance and health care have delivered gains, as have the large diversified banks. The small-cap space should benefit from a more favorable corporate tax rate. Industrial, pharmaceutical, and technology companies with funds sitting overseas are seen as possible beneficiaries of the repatriation of capital as outlined in the tax framework. However, if the move towards passing a tax bill fails, many of these assets will lose momentum, just as they did earlier in the year. For the country at large, it’s the middle-class tax cut which would help the U.S. consumer, responsible for almost 70% of the country’s economy.
Juanita Duggan, CEO of the National Federation of Independent Business, has been vocal in her support for tax reform that would help the small business owner. In an op-ed piece in the Wall Street Journal, she wrote that “businesses with 500 employees or fewer are the cornerstone of the U.S. economy. There are 29.6 million of them in the U.S. and they represent 99.9% of all businesses. Small businesses employ 58 million Americans, or 48% of the workforce.”
In fact, it was small businesses that led the recovery as two out of every three jobs were created by the small business owner. Today, confidence among them remains strong, but they expect continued rollback of burdensome regulations, as well as tax cuts. As Duggan points out, “three-quarters of American small businesses pay taxes as individuals. Their top federal rate is 43.3%, which is substantially higher than the current top rate for large multinational firms. When state burdens are added, small businesses are sending close to half their income to the tax man.”
THE FOURTH QUARTER
As we enter the final months of the year, questions abound as to the resilience of the market to keep marching higher without a meaningful pullback, a pullback that was widely expected sometime in the third quarter. With the earnings season expected to deliver positive performance on both the top and bottom lines, it’s possible that the market has already priced in the better-than-expected reports, thereby taking away a reason to climb higher. In addition, investors and traders appear to be embracing the idea that tax reform is actually a viable possibility, and that could already have been discounted by the market, at least to some degree.
Disappointing earnings and corporate guidance could quickly change the market’s direction, as could disappointment over the path of tax reform. And there’s North Korea, soon to be met by more heated discussion over the Iran nuclear deal, which already has hit the headlines.
The Fed too, has the ability to worry the market, if they telegraph with certainty another rate rise in December, especially if inflation continues to drift lower. The European Central Bank is poised to signal its own taper of its own quantitative easing program, but the timing remains uncertain. What is certain is that it would incrementally add to the global monetary tightening that has begun in earnest—although gradually and slowly—with the Fed’s winding down of the balance sheet.
The market has witnessed a nearly continuous transition from sector-to-sector rotation, in what could be called a trader’s market, as each new sector leadership helps keep the market grinding higher. The recent move in small U.S. companies will be watched closely as confirmation that investors are projecting stronger growth, aided by tax reform.
The dollar, the Treasury market, gold, and financial conditions in general, are all factors in how the market feels about the global macroeconomic and political environment. The “risk off” and “risk on” moves have been orderly in the third quarter, providing some consolidation in overbought sectors.
Does this mean that we won’t enjoy the “Santa Rally” that typically visits in late November and early December? Santa can sometimes work in mysterious ways. But perhaps he and his elves need a rest before he arrives on the scene, a deeper market pullback that has investors grateful and happy to see him. And where they may truly appreciate the gift he delivers just in time for the new year to begin.
Quincy Krosby, Ph.D., is chief market strategist at Prudential Financial.