“Depend upon it, sir,” as that most quotable of English literary figures, Samuel Johnson, put it, “when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.”
Lawmakers in Washington may not be facing the noose in a fortnight, but many of them are facing midterm elections in 13 months, with no visible legislative achievements yet to show their constituents. If that isn’t concentrating minds yet, especially among the Republicans who hold majorities in both houses of Congress, it may do so soon.
When one more bill to repeal the Affordable Care Act was set aside last week, a rancorous process gave way to the marginally less partisan project of tax reform, just as the clock on midterms began to tick. The potential for progress on tax is important for investors not only because of the economic and business impact new measures would have, but because financial markets appear to have become skeptical of the current Washington leadership.
Be Cautious around the Big Trends of 2017
By the beginning of September, the U.S. dollar index had collapsed by 11% since the start of the year. U.S. small-cap value stocks were breaking records for relative underperformance, lagging large-cap growth stocks by almost 20 percentage points.
That reflects investors’ appetite for companies that either benefit from global growth and a weaker dollar, or can grow earnings without broader economic growth: exporters, multinationals and the so-called “FANG” stocks from the technology sector. In contrast, small-cap value stocks tend to be geared more to the U.S. domestic economy.
We would caution against assuming these trends must continue. There may or may not be progress in Washington, but the possibility is now discounted so heavily that building some exposure to it appears to carry very little downside risk.
A Modest Proposal from the ‘Big Six’
What shape might that progress take? Last week, President Trump, who showed a surprising willingness to horse-trade across the aisle on the debt ceiling, set out the aims on tax identified by the “Bix Six” drivers of the effort: the House and Senate leaders, the chairs of the House and Senate tax committees, the Treasury secretary and the director of the National Economic Council.
Their proposal would reduce the number of individual tax brackets from seven to three, with the top rate set at 35%, down from 39.6%. The corporate tax would be cut from 35% to 20%, and businesses would be able to write off capex for five years. Overseas profits could be brought back to the U.S. at a reduced tax rate, with details still to be confirmed.
Getting this enacted will be a challenge. Taking the easier route of “reconciliation,” which allows simple majority voting on tweaks to budgetary legislation, would of course require Congress to pass a budget in the first place—which it hasn’t for eight years. Creating tax legislation will require 60 votes in the Senate, which implies bipartisan support.
Still, this proposal falls well short of root-and-branch reform, and some of the measures for individuals are surprisingly progressive—perhaps as an olive branch to Democrats in Congress. While the high probability assigned by markets to pro-growth legislation at the start of 2017 has all but disappeared, our view is that the probability of something modest but worthwhile getting done remains 50/50, or even better.
Risk Skewed to the Upside
Does that mean we believe that investors should be positioned for a boost to U.S. growth and U.S. equities? Yes and no.
As my colleague, Joe Amato, wrote a few weeks ago, even a modest tax package “could provide a helpful spark to the aging U.S. equity bull market;” and at the recent quarterly meeting of our Asset Allocation Committee, the report from which will be available shortly, our outlook for the next 12 months did translate into a slightly riskier set of portfolio tilts.
Nonetheless, at the large-cap end of the scale we currently find more opportunity in international, rather than U.S., equity markets. It is within the U.S. allocation, where we remain more favorably disposed toward small caps than large caps, that we express our view on the potential for a breakthrough on tax: These companies would be the main beneficiaries, and their recent underperformance has skewed much of their risk to the upside.
That combination, to borrow Samuel Johnson’s phrase, should concentrate investors’ minds wonderfully.
In Case You Missed It
- Case-Shiller Home Prices: July home prices increased 0.7% month-over-month and increased 5.8% year-over-year (NSA); +0.3% month-over-month (SA)
- U.S. New Home Sales: -3.4% to SAAR of 560,000 units in August
- U.S. Consumer Confidence: -0.6 to 119.8 in September
- U.S. Durable Goods Orders: +1.7% in August (excluding transportation, durable goods orders increased 0.2%)
- U.S. 2Q 2017 GDP (Final Estimate): +3.1% annualized rate
- U.S. Personal Income & Outlays: Personal spending increased 0.1%, income increased 0.2%, and the savings rate is flat at 3.6% in August
What to Watch For
- Monday, 10/2:
- ISM Manufacturing Index
- Wednesday, 10/4:
- ISM Non-Manufacturing Index
- Friday, 10/6:
- U.S. Employment Report
Statistics on the Current State of the Market – as of September 29, 2017
|S&P 500 Index||0.7%||2.1%||14.2%|
|Russell 1000 Index||0.7%||2.1%||14.2%|
|Russell 1000 Growth Index||0.7%||1.3%||20.7%|
|Russell 1000 Value Index||0.8%||3.0%||7.9%|
|Russell 2000 Index||2.8%||6.2%||10.9%|
|MSCI World Index||0.4%||2.3%||16.5%|
|MSCI EAFE Index||0.0%||2.5%||20.5%|
|MSCI Emerging Markets Index||-1.8%||-0.4%||28.1%|
|STOXX Europe 600||0.1%||3.3%||23.2%|
|FTSE 100 Index||0.9%||-0.7%||6.6%|
|CSI 300 Index||0.0%||0.5%||18.2%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||-0.2%||0.5%|
|Citigroup 10-Year Treasury Index||-0.5%||-1.6%||2.4%|
|Bloomberg Barclays Municipal Bond Index||-0.3%||-0.5%||4.7%|
|Bloomberg Barclays US Aggregate Bond Index||-0.1%||-0.5%||3.1%|
|Bloomberg Barclays Global Aggregate Index||-0.7%||-0.9%||6.3%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.3%||2.3%|
|BofA Merrill Lynch U.S. High Yield Index||0.3%||0.9%||7.0%|
|BofA Merrill Lynch Global High Yield Index||0.0%||0.8%||9.3%|
|JP Morgan EMBI Global Diversified Index||-0.1%||0.0%||9.0%|
|JP Morgan GBI-EM Global Diversified Index||-1.6%||-0.3%||14.3%|
|U.S. Dollar per British Pounds||-0.8%||4.1%||8.6%|
|U.S. Dollar per Euro||-1.2%||-0.6%||12.1%|
|U.S. Dollar per Japanese Yen||-0.6%||-2.2%||3.6%|
|Real & Alternative Assets|
|Alerian MLP Index||1.3%||0.7%||-5.6%|
|FTSE EPRA/NAREIT North America Index||0.6%||0.2%||2.7%|
|FTSE EPRA/NAREIT Global Index||-0.5%||0.3%||10.8%|
|Bloomberg Commodity Index||-0.4%||-0.1%||-2.9%|
|Gold (NYM $/ozt) Continuous Future||-1.0%||-2.8%||11.6%|
|Crude Oil (NYM $/bbl) Continuous Future||2.0%||9.4%||-3.8%|
Source: FactSet, Neuberger Berman.