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Equities soar on US tax reform hopes

By David Morrison  |  19/12/2017 16:10

”US
 Equities soar on US tax reform hopes

US and European stock indices soared on Monday as investors priced in an increasing probability that President Trump will deliver on his promise of tax reform before year-end. On Sunday evening Treasury Secretary Steven Mnuchin said that the president is looking forward to signing the tax bill before Christmas. Last week House Speaker Paul Ryan said he expects the House to vote on the legislation on Monday or Tuesday with a Senate vote coming on Tuesday or Wednesday. Trump said he would sign the bill once both Houses pass the proposed reforms.

Cost of tax reform

There is plenty of opposition to the bill. Democrats are united in their hostility saying that these tax cuts benefit corporations and the wealthy at the expense of the poor and middle class. Ahead of the weekend there were even a few Republican senators who said they couldn’t vote for the bill. But it appears that a few tweaks have been made which make it palatable to a slim majority which is all Trump needs. It also appears that the few fiscally conservative Republicans who previously baulked at the prospect of piling on over $1 trillion to the national debt (which already stands at $20 trillion) have been silenced. Yet away from Congress, analysts are concerned that the tax proposals have been rushed through with little consideration to cost. There is a feeling that the reforms will prove problematic in years to come.

Buyers pour in

But as far as the markets are concerned, it’s all good news. Buyers continue to pour in, convinced that the cut in corporation tax to 21% from 35% will lead to a tsunami of share buy-backs and dividend pay-outs. This is great for shareholders – at least in the short-term. But it’s a worry that corporations have little interest in reinvesting this windfall in updating IT, taking on new employees, training existing staff or investing in up-to-date plant and machinery. Some analysts have also suggested that the positive effects may prove to be less than expected. A report from the US Bureau of Economic Analysis (BEA) using actual tax revenues calculates that the effective US corporate tax rate is already around 21%, suggesting that companies won’t soon be wallowing in a huge cash windfall. On top of this, one has to wonder how much further equities can rally on the prospect of corporate tax cuts given how much they’ve moved already.

Holidays ahead

We’re now into the last full week before trading gets interrupted by Christmas and New Year holidays. Volumes are expected to slacken off as many market participants wind down their activity. But this is not to suggest that there’s little chance of big price moves. After all, illiquidity can lead to volatility. This could be pronounced if investors look to reduce their exposure and lock in substantial profits ahead of the year-end.

VIX at record lows

While Bitcoin may have grabbed all the attention over the past few months, stock market volatility (or rather the lack of it) could prove to be a major issue going forward. The VIX is a measure of short-term US stock market volatility, based on 30-day S&P options. It has been trending downwards for the last eight years and is currently trading below 10. For comparison’s sake it was just below 25 in the summer of 2015, just over 40 in July 2011 and came close to breaking above 90 at the height of the financial crisis. Meanwhile, US stock indices continue to hit fresh record highs on an almost daily basis. What this means in the present environment is that investors are comfortable buying equities (often on margin) and feel there is little danger of a downward correction. At the same time, there is a plethora of new financial products out there designed to take advantage of moves in volatility. Just a few months ago Artemis Capital calculated that there is around $1.5 trillion backing a continuation of the decline in volatility, a lot of it leveraged. Consequently, it wouldn’t take much of a jump in volatility to force some of these speculators to close out their shorts. This in turn could lead to a cascade of orders which would spill over into other markets, equities in particular. It may not be inevitable, but it’s worth bearing in mind.
 

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