Markets Gain on Tax Talk

The Week in Review

  • Growth Persists
  • Legislative Agenda Shifts
  • Tax Talk Impacts Bond Market
  • Looking Ahead

Investors shifted their focus from geopolitics and hurricanes to interest rates and fiscal policy this week as the first iteration of a GOP tax reform was released on Wednesday.

A positive GDP report didn’t hurt and as the curtain falls on 2017’s third quarter, U.S. stock indices are at or near record highs. The Dow Jones Industrial Average and S&P 500 are poised for their eighth straight quarterly gain, the longest such streak in 20 years. Small-cap stocks, as gauged by the Russell 2000 index, rose 2% Wednesday after the release of the GOP’s tax plan—smaller companies face a relatively higher tax burden, and thus benefit more from tax cuts.

For the year through Thursday, the Dow Jones Industrial Average has returned 15.3%, while the broader S&P 500 index has gained 13.8%. The MSCI EAFE index, a measure of developed international stock markets, is up 19.3%. As of Thursday, the yield on the Bloomberg Barclays U.S. Aggregate Bond index sits at 2.54%, down from 2.61% at 2016’s end, and is unchanged from the same time last week. On a total return basis, the U.S. bond market has gained 3.2% for the year. All told, despite exogenous events both real and feared, Mother Nature’s diabolical worst, and daily political and geopolitical firestorms, growth and gains continue.

Growth Persists

The final revision to GDP showed the economy grew at a 3.1% annualized pace in the second quarter—the best quarterly growth rate in two years. Consumers spent more, while businesses did their share by boosting investment in equipment, commercial space and software. Given a labor market that is at or near full employment, businesses are demonstrating their willingness to spend on improving efficiency and productivity as the pool of available and qualified labor tightens. New orders for capital goods—longer-lasting products used by businesses—rose 3.3% through the first eight months of 2017. Businesses typically don’t invest to build more capacity if the demand’s not there.

Legislative Agenda Shifts

Washington’s attention has moved from health care repeal-and-replace—even as President Trump says he has a health care executive order up his sleeve for next week—to tax reform.

In broad strokes, the proposed changes would cut the number of tax brackets from seven to three and eliminate the alternative minimum tax. The corporate tax rate would drop to 20% and there may be a one-time tax break allowing companies to repatriate profits held overseas. But while the broad outline of the tax proposal is now public, it’s the details that will matter, and no outcome is guaranteed.

One early takeaway: You’ll probably hear a lot about how reduced corporate tax rates will benefit investors. But the cuts may not be as dramatic as they appear at first glance. While there’s talk about cutting the corporate tax rate from 35%, the average U.S. corporation currently pays only 22% in taxes—far less than the rate paid by many of the overseas corporations that are often held up as examples of why our tax regulations are unfair.

Proposals concerning abolishing the estate tax as well as disallowing deductions for state and local taxes are sure to fire debate in the coming weeks. From an investment perspective, that discussion is just beginning, so being patient and allowing politics to play out is the course we’ll continue to follow. One potential benefit: Corporate earnings could be bolstered by those lower tax rates, thus lessening fears of an “overvalued” market.

Tax Talk Impacts Bond Market

With continued economic growth and the Federal Reserve’s announcement that it will begin “quantitative tightening” by gradually unwinding its balance sheet, the bond market remained under pressure this week. Fed Chair Janet Yellen’s comments over the last two weeks about the prospects for another interest-rate hike this year sent market expectations for a rate increase to over 70%—up from 50% before the Fed’s mid-September meeting.

The yield on the 10-Year U.S. Treasury, which dropped close to 2.00% earlier in the month, rose to 2.31% Thursday, its highest level in over two months. (Remember, as bond yields rise, prices fall.)

Looking Ahead

As the year’s final quarter opens next week, investors will be served a full plate of meaningful data, including ISM manufacturing and service sector reads on overall activity (and hiring), as well as purchasing managers’ indexes, construction spending and car sales, ADP’s private sector jobs report, the government’s nonfarm payrolls and unemployment reports, factory orders and consumer credit.

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Please note: This update was prepared on Friday, September 29, 2017, prior to the market’s close.

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