With the Republican tax plan making headlines on a daily basis and the stock market steadily rising, it’s easy to assume the former is causing the latter. But does the market really consider tax cuts to be a “done-deal”? And will a failure to pass legislation mean almost certain doom for stocks?
To answer these questions, we have to first understand what a “bet” on tax cuts would look like. While few details are known, we think these trades would ultimately stand to benefit should tax cuts be enacted as planned:
- Buy Small Cap Stocks over Large Multinationals: Dropping the corporate tax rate to 20% will have a relatively greater impact on smaller companies (versus larger ones) since they currently pay a higher tax rate and generate most of their income in the U.S.
- Buy Foreign Bonds over U.S. Bonds: The Federal Reserve will be seen as more likely to raise rates in the U.S. should tax cuts be enacted, pushing U.S. bond yields higher (and bond prices lower).
- Buy Taxable Bonds over Municipals: A reduction in personal income tax rates will make tax-exempt municipal bond interest less valuable.
Is the market indeed making these “bets”?
The chart below shows the performance of these trades from:
- Jan 1st – Sep 4th (Congress primarily focuses on Healthcare reform)
- Sep 5th – Oct 31st (Congress returns from recess focused on tax cuts)
- Total Year-to-Date period
Two things become immediately clear: 1) All trades remain unprofitable over the course of this year, meaning, if anything, this year’s rally has been a bet against tax cuts, and 2) while the market has seemed to take greater notice of tax cuts more recently, the overall impact remains relatively muted.
Why is the market taking a wait-and-see approach?
While there is no doubt that tax cuts in general will provide at least a short-term boost to stocks, several factors are likely giving the market pause:
- Will it even happen in the first place? While there is a popular sentiment that the Republicans will pass tax cut legislation simply because “they have to” or face certain defeat in next year’s mid-term elections, that didn’t help them on Healthcare reform. The Mueller investigation provides yet another layer of uncertainty.
- What will the final tax cut package look like? Tax reform remains a complicated issue with many competing constituencies, meaning the only way to pass a bill may be to give something to everyone. That doesn’t bode well for the deficit and may force compromises elsewhere, such as implementing the corporate tax reduction over five years, versus right away. A 3% per year reduction (15% over 5 years) would be viewed very differently by the market.
- Is this the right time for tax cuts, anyways? It’s important to remember that these tax cuts are being proposed at a time when the economy is already very healthy. Will the Federal Reserve, with unemployment nearing 4%, even allow the economy to grow at a much faster rate? A strong acceleration in growth could cause the Fed to aggressively raise rates under the threat of inflation.
What should investors do?
While it remains a possible catalyst heading into next year, we ultimately don’t think tax cuts will make or break this market.
This year’s rally has been predominantly driven by strong earnings (particularly from large growth companies such as Facebook, Amazon and Apple) and the larger theme of increasing Global economic growth (see chart below for more on how global growth is impacting 3Q earnings). For the first time in a decade, the global economy (from Europe to Japan to Emerging Markets) is expanding in unison, and we think this will likely continue into the foreseeable future whether or not tax cuts are achieved in the U.S.
- iShares Russell 2000 ETF
- SPDR Dow Jones Industrial Average ETF
- Vanguard Total International Bond ETF
- Vanguard Total Bond Market Index ETF
- Vanguard Tax-exempt Bond ETF
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