Are Markets Getting Too Excited about Tax Reforms?
Trump signals tax reform
Just as markets were writing off the possibility of any tax or fiscal spending reform, the Trump administration sprung a surprise, stating that a draft for proposed tax reform would be ready by end of September. In this draft, Trump proposed to lower taxes for corporates, small industries, and individuals. He has also mentioned the possibility of a one-time low tax window that would enable companies with overseas profits to repatriate them.
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Market reaction to this announcement
As lower taxes could help improve profits for companies, US equity markets rose sharply overnight. The proposed tax cuts for small industries are likely to benefit small-cap US companies (VBR), most of which are part of the Russell 2000 Index (IWO). This small-cap index appreciated by 2% in a single day after the announcement was made. In bond markets (AGG), yields rose in reaction to the announcement. The possibility of higher rates and repatriable cash has also increased demand for the US dollar in currency markets, with the US dollar (UUP) appreciating against most major currencies.
Should investors be excited about this announcement?
The fact that the Trump administration has struggled to push through any reform in almost nine months could be troubling to investors. The proposed tax plans need to be approved by Congress, which is likely to be a mammoth task. The Trump administration continues to struggle passing healthcare reform and could face similar hurdles with tax reform.
Members of Congress, both Republican and Democrat, could question the higher deficit that would result from these tax cuts. Longer-maturity bond yields (TLT) have already risen due to fiscal deficit worries. In the next part of this series, we’ll discuss the risks of high valuation in US equity markets.