U.S. tax cuts have been on the agenda since President Trump was elected. Now, with both House and Senate bills passed, tax reform might soon be a reality. (For differences between the two bills, read this BMO report.)
The anticipation of tax reform has helped fuel the recent bull charge in equities on the Dow and S&P. There’s also another winner: smallcap stocks, says Nick Exarhos, director at CIBC World Markets, in a weekly economics report.
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“There’s good reason for that, since the median tax rate faced by firms in the Russell 2000 index is roughly 32%—four percentage points higher than the median firm on the S&P,” he says.
That leaves room for potential outperformance of the Russell into year-end, he says, adding that the benefit extends to the S&P as well.
That’s because most of the broader economic benefits of tax reform are slated for 2019, “which will limit the lift to smaller, more domestically focused companies, while relief on repatriation taxes will benefit larger firms in 2018,” he says.
In a weekly economics report, TD economist Katherine Judge adds: “Financials have posted stellar earnings growth this year and are among the corporations that stand to benefit the most from the proposed tax cuts.”
U.S. markets face risks, however.
“We’re still a fair distance from enacting a tax plan,” says Derek Holt, vice-president and head of capital markets at Scotiabank, in a weekly economics report. Further, for the U.S., he says that “debt ceiling and spending appropriations deadlines loom alongside government shutdown risks.” He also cites the investigation into Russian meddling with the U.S. election.
In a weekly economics report, BMO’s Douglas Porter, chief economist, says what really matters for the markets isn’t tax reform but “an increasingly robust global economy.”
“U.S. stocks have been rolling along through good times and bad on the prospects of tax relief,” he says. “And emerging markets have been on fire, while both Germany and Japan have knocked down powerful gains as well—and U.S. tax reform will do little to help those economies.”
The OECD estimates global GDP rose by 3.6% this year—the best performance since 2010, notes Porter. “The broader economy is quietly seeing a late-cycle roll.”