This week, Republicans in the US House of Representatives finally unveiled their tax bill—designed to be a compromise between the aggressive tax cuts introduced by President Trump weeks ago and treatment of deductions that have been called for by Conservatives in order to contain the budget deficit. Considering the magnitude of gains in US stocks this year, it is clear investors have planned on aggressive tax measures and not a watered down bill.
Unfortunately, the problem with pricing in expectations of a major tax overhaul is that even if all the measures were passed into law, the market could end up in a common predicament of ‘buy the rumour and sell the fact’. This is where all the positive aspects of a change, whether it be policy or even economic data, are built so much into the pricing of the market that there is nothing left to sustain prices even if the rumour or expectation is fulfilled. In the case of the much awaited fiscal stimulus plan it is even more problematic given the timing.
Had Washington delivered on tax reform in the first few months of the new administration, the initial move higher in stocks would likely have not only been sustained but would have been based on more viable expectations of stronger economic growth coming from the tax cuts. Suffice to say that the gains we have seen so far have been based on the notion that even the expectation of cuts would drive business and consumer spending, and to some extent that has happened. The problem is that the expectation tank is running dry. Even if we got aggressive stimulus passed before year-end, it will take time for it to show up in the economy and it’s not clear whether investors have enough patience to wait that much longer. If so, equities could still run into a wall before year-end.
If what passes is a lighter version of the tax bill, then that effect could be more pronounced as there would be a disconnect between the stimulus that has been priced in and what is going to transpire. Worse would be a complete breakdown in the process that pushes any passage of a tax bill into next year. As we have discussed before, the mid-term elections (next November) will start to heat up as we head into 2018 and there will be more focus by individual members of Congress to raise campaign funds and get re-elected. That could steal resources and time away from getting crucial tax reform passed.
As of today, it was looking like the outcome would be somewhere between a light version of tax reform being passed and outright failure. The Republican House bill has already started to gather criticism, mainly from business. The reason is because the stimulus on corporate tax is not as great as it appears on the surface. Not only are US multinationals going to be enticed to bring foreign profits home at a reduced rate, but their profits left offshore from now on will be subject to a 20% tax hit. There will also be a limit on interest deductibility.
It is also not clear how much the bill will stimulate the consumer and residential segments of the economy. Gone are state and local tax deductions, and mortgage deduction is gone for mortgages above $500,000. The impact of lower personal taxes (and reduced number of brackets) will be felt more in the higher income households, where the marginal propensity to consume is lower. Needless to say, the bill is going to change in the coming days and weeks before it is voted on in the House. Then there is the Senate’s version, which will likely be skimpier on tax cuts than the House bill.
The bottom line is that it will be hard for the market to continue this buy on a hope strategy for much longer. As investors watch the wrangling over this bill in Congress, there might be some scope for equities to grind a little higher. December may also deliver a Santa Claus rally in the first half, but given how over-extended valuations have become against the backdrop of a less-than-expected tax stimulus, there is a greater risk of a year-end sell-off. The last time there was tax reform in the US was 1986 under Regan. It actually passed, and helped markets, but even then the party didn’t last too long.
Canada: Ivey PMI, housing starts, building permits, new home price index
US: Consumer credit, wholesale inventories, Univ. of Michigan consumer sentiment
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