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17th of January 2018


Forget stocks, it’s the bond market that could feel US tax cuts

John Authers

December 20, 2017

With the passage of a landmark US tax bill, we can expect that the country’s headline corporate tax rate will fall to 21 per cent, along with measures that will greatly affect US corporate profits next year. What next?

This tax cut was mostly priced in. In the past few days the S&P 500 high-tax rate companies, which should gain the most, have at last moved to outperform the S&P 500 as a whole, when measured since election day. But the margin is narrow and there should be a little more to follow.

The US market had lagged behind the rest of the world until the chances for a tax cut began to perk up in September. The gap has now almost been erased. The prospect of a tax cut has raised US stocks in absolute and relative terms.

The chaotic circumstances of the law’s passage more or less guarantee that a few big individual winners and losers remain hidden in the small print. Stockpickers will need to nose them out over the next few weeks. There is idiosyncratic stock risk, and there is a good chance of a return on an investment in a painstaking read of the final law. But direct equity effects should be shortlived. Earnings per share forecasts need a one-off upgrading, as more will stay with investors. Then the market can continue as before. And the direct effect should not be that big. According to Barclays, the effective tax rate paid by S&P 500 groups will move from 26 to 20.7 per cent. After repatriation, this should lift 2018 earnings per share 6.3 per cent.

This will not be uniform. Higher-taxed sectors at present include relative laggards financials, industrials and energy. Recent winners, such as healthcare and technology, derive a lot of earnings from outside the US and will not be helped as much. So there is a chance that the tax cut will usher in changed sector leadership, previewed last month when tech shares fell and others rallied.

Credit Suisse’s Holt group points out another possible effect, on deals. M&A has been falling as stocks have hit new heights. In the last big cash repatriation in 2004, most was spent on acquisitions. Companies have been disciplined in the face of high valuations — but more cash will test that. This could at least be good for potential targets.

Less direct effects on other asset classes could be more profound. Start with the dollar. A US fiscal stimulus should, all else equal, lead to higher rates next year. That means higher rate differentials, and therefore a stronger dollar (bad news for US multinationals if it happens).

Repatriation could be more important, as US companies no longer have any tax advantage in stowing money overseas. They might well bring their money back quickly.

A strong dollar in relative terms will be good for dollar-denominated investments compared with the rest of the world. But a sharp strengthening would also be good news in absolute terms for European and Japanese stocks, which benefit from a weak currency. Emerging markets would be different. Many of their currencies appeared at the point of tipping into crisis when Mr Trump won the election. Dollar weakness averted that crisis. Now, that risk is back.

Most important will be the impact on rates. The more the tax cut acts as a stimulus, or is perceived to do so, the more it will raise bond yields. It is already popular to predict that 10-year Treasury yields will hit 3 per cent next year, as central banks end monetary stimulus. Going beyond 3 per cent would raise the risk of a financial accident, crimp stock valuations and press the dollar higher.

Bonds globally are suffering a sharp sell-off this week. It is widespread, so it is hard to attribute it entirely to US events. This rate effect has swamped tax effects within stocks, with rate-sensitive sectors falling most.

If the tax cut affects behaviour as little as many fear, it will not move rates much either. Once the rise in next year’s earnings has been priced, nothing much will change. If it does have an impact, it could raise rates, which could more than counteract any positive fiscal stimulus from the tax cut.

One painful conclusion is hard to avoid. Despite the excitement over tax, the central issue for markets remains the same. As we enter the ninth calendar year of the recovery, can rates possibly stay at such low historical levels?

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