BLACKROCK INVESTMENT INSTITUTE

Tax reform and the reflation trade

Global weekly commentary
13/feb/2017 / By BlackRock

Key points

  1. U.S. corporate tax reforms could reinforce a reflationary environment already in place before last November.
  2. Some “Trump trades” partly unwound early last week, while political uncertainty sent French and Italian bond spreads wider.
  3. Fed Chair Janet Yellen’s testimony before Congress this week could raise market expectations of a March Fed rate increase.

1. Tax reform and the reflation trade

Our preference for reflation beneficiaries – or assets likely to benefit from rising growth and inflation – isn’t contingent on U.S. corporate tax reform. Yet such reform does have the potential to amplify this market theme.

Chart of the week
Median effective U.S. corporate tax rates, 2016

Chart of the week

One example: We see reflation supporting more gains in U.S. small cap stocks. They typically outperform during periods of rising rates, as we note in our Global Equity Outlook. Tax cuts would be an extra boost disproportionally benefiting small caps, given those corporations’ higher effective tax rates.

Tax reform winners and losers

The reflation trade has waxed and waned since November along with expectations for U.S. tax reform. But any tax reforms this year should only reinforce a reflationary environment already in place before the U.S. presidential election. Significant uncertainty shrouds the final tax plan, and the need to find offsetting revenue means tax reform will create winners and losers.

The border tax adjustment would effectively subject imports to a 20% tax to help pay for any corporate tax cut. Proponents argue the U.S. dollar should rise in response, offsetting the impact on trade or consumer prices. We see only a partial currency adjustment, which could help exporters and hurt retailers and consumers. How the U.S. dollar behaves in such a scenario will be key for markets and the U.S. economy.

We also believe another proposed reform, scrapping the deductibility of interest expense, would ultimately hurt highly leveraged companies and have major implications for how companies finance themselves in capital markets. Without offsetting revenue, large corporate tax cuts would increase the deficit, creating a reflationary stimulus that could lead to higher interest rates. We see potential for volatility in the coming months as more reform details emerge.

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  • Some “Trump trades” partly unwound amid policy uncertainty. Emerging market assets outperformed, U.S. Treasury yields fell sharply mid-week and U.S. value stocks underperformed a flat market.
  • Political uncertainty sent French and Italian government bond yields to multi-year highs relative to their German peers. Half of the European firms that have reported earnings have beaten estimates.
  • Oil fell to a near three-week low under the pressure of growing U.S. crude inventories, but pared some losses. China’s PMI data showed expansion in both services and manufacturing sectors.

 

 

  Date: Event
Feb. 13-17 European firms, mainly defensives and financials, report earnings
Feb. 14 U.S. NFIB Small Business Optimism Index; China Consumer Price Index (CPI)
Feb. 14-15 Fed Chair Janet Yellen gives her semiannual monetary policy testimony before Congress
Feb. 15 U.S. retail sales, U.S. CPI

Markets are likely to react to any signals from Yellen regarding a March Federal Reserve rate rise, the odds of which we believe markets may be underpricing. NFIB’s report will show if small business owners’ economic confidence remains at a 12-year high.

Richard Turnill
Managing Director, is Global Chief Investment Strategist for BlackRock
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active Equities business ...

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