US tax reform has re-emerged as a market topic, taking centre stage as Congress and the Trump administration revealed drafts of plans. Financial markets welcomed the initial proposals, even though several months of negotiations will likely be needed for the details to be agreed on and any tax cuts implemented. Still, the outlines caused the US dollar to strengthen and the yield curve to steepen, which supported shares in US small caps and financials. Chair Yellen indicated the US Federal Reserve would look through recently weak inflation and stick to the path of monetary policy normalisation, pushing Treasury yields higher. This environment hurt emerging market stocks as well as gold, making them this week’s main underperformers (see chart).
In politics, a restive weekend in Catalonia, where central Spanish authorities sent police to halt what they had declared an illegal independence referendum, could mark the start of a constitutional struggle between the region and Spain and spell further difficulties for embattled Prime Minister Rajoy. In the context of Britain’s efforts to leave the EU after its Brexit vote and persistent populism in Europe, a decision by Catalans to persist in a breakaway from Spain could have unexpected ripple effects on financial markets, in particular for the euro.
Earlier in the week, Prime Minister Shinzo Abe called snap elections in Japan after his popularity got a fillip on the back of a strong stance on North Korea. At this point, he should not have any difficulties being re-elected, although Tokyo’s popular governor has joined a new party which is gaining in popularity and could challenge the hegemony of the ruling LDP.
WILL US TAX REFORM BRING THE TRUMP TRADE BACK AGAIN?
The Trump administration’s long-awaited framework plans on simplifying the tax code contained few surprises. The main points are a proposed corporate tax cut from 35% to 20%, relaxed rules on writing down capital expenditure, a one-time tax for companies repatriating profits held offshore and a tax cut for individuals. Details were scant and the plans will have to be debated with Congress, which should make implementation unlikely before year-end.
However, market participants welcomed the announcements. As we have pointed out before, the Trump trade (centred around pro-growth measures by the government) had been completely reversed for most asset classes after a number of initiatives floundered, setting the scene for a positive surprise on the back of any new plans. The mere start of talks on tax between Congress and the Trump administration was enough to resuscitate the trade.
The resultant gains by the US dollar hurt large-cap stocks, including large exporters, and caused small caps to outperform (see chart). Further momentum for the Trump trade came from news of a tough US tariff on Canadian jet-maker Bombardier for alleged unfair subsidies.
US Treasuries suffered as investors read Yellen’s comments as hawkish. She warned the Fed should be “wary of moving (rates higher) too gradually”, pointing to a tighter job market and the risk of the Fed being behind the curve and of developments such as increased leverage.
The comments lifted the implied probability of an interest-rate rise in December to about 70%. This hawkish turn may be reinforced depending on the announcement of Yellen’s successor, probably before month-end. One candidate, former Fed governor Kevin Warsh, has lambasted unconventional monetary policy. He could accelerate policy normalisation and spark a bond sell-off were he to replace Yellen.
LONG US SMALL CAPS VERSUS LARGE CAPS
Our long position in US small caps versus large caps is in line with our positive view on the US dollar. A weak dollar has benefited US large caps more than small caps, but as the currency starts to rebound amid an improving economy and with the Fed more on firmly on the road to policy normalisation, this trend should reverse. Such a turn would favour small caps, which are typically domestically focused and would outperform large caps were the dollar to rise further.
Further support for small caps comes in the form of Trump policy hopes. Market participants had priced out the Trump trade, but, as said, we expect it to regain momentum, in particular in the case of tax reform. If implemented, the indicated corporate tax cut should favour small caps since many large caps tend to pay a lower tax rate already.