Unfinished business: challenges after tax reform

Deeper dive

Congress is on the verge of passing its first major piece of legislation under the Trump administration. Both the House and the Senate have passed a version of tax reform; these need to be reconciled before a final law can be sent for President Trump's signature. The UBS Office of Public Policy has increased its assessment of successful passage to 70%.

If final negotiations falter, there are downside risks, but our base case is for tax reform to add roughly 0.3% to US real GDP – and give a much larger 8% boost to corporate profits. In our view, US equities are pricing in about half of this boost, suggesting that successful passage could provide further upside of about 3–5%.

But passage of tax reform won’t mark the end of political challenges facing the US, with potential repercussions for financial markets:

  • Tax reform has made it this far with only Republican votes, but a bipartisan effort will be needed to pass a budget and keep the government running. A deal at the end of September authorized spending through 8 December, and another short-term extension is keeping the lights on for two more weeks. Eventually, the real fight over the budget will have to play out. In our view, given the level of acrimony between the parties, and Trump's demand to fund his priorities, the path of least resistance will be to increase spending so that everyone gets something they want. Focus has been on the fiscal stimulus coming from tax reform, but higher government spending could actually end up having a bigger effect on economic growth in 2018.
  • Another related issue is the debt ceiling. While raising the debt ceiling used to be routine, in recent years political grandstanding has made it difficult, especially ahead of elections. On current projections, the debt ceiling will become binding around the end of March, when politicians will be focused on the November elections. In our view, the risk of the debt ceiling not being raised is small. But the VIX Index has averaged just 11 in 2017, versus an average of 19.4 since the early 1990s. If negotiations come down to the wire, the debt ceiling could be a catalyst for a spike from these abnormally low levels.
  • The two parties appear to agree on the nomination of Federal Reserve Governor Jerome Powell to replace Janet Yellen as Chair. In our view, a Fed under Powell suggests policy continuity. This means the Fed will continue, gradually, to hike short-term rates. Expectations for policy gradualism are one factor helping keep long-term rates low, flattening the yield curve. In this case, a flatter curve doesn’t reflect concerns over future growth, and is unlikely to unsettle equity markets. Powell also favors bank deregulation, which has underpinned recent gains in US financials.

Against this backdrop, we remain overweight global equities, of which US equities form the largest proportion. In the US, we prefer financial stocks, which as well as the potential boost from deregulation and tax cuts are likely to go on benefiting from solid economic growth and benign credit quality. We expect the Fed to increase rates by 25 basis points this month, followed by two further hikes in 2018.

Mark Haefele

Global Chief Investment Officer WM

Brian Rose

Senior Economist Americas

Bottom line

We expect tax reform to pass by the end of the year, although some risks remain. Market reaction will depend on the details, especially the size of corporate tax cuts. Government spending could rise more than expected next year, as politicians prepare for the next election. Debt ceiling negotiations are a potential catalyst for a spike in volatility, but a Powell-led Fed suggests policy continuity and potential bank deregulation.

 

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