Tax reform has been a big priority in the US in 2017, and a series of unexpected situations have made this one of the most important macro events to watch in the global markets.
On Oct. 19, the US Senate passed the 2018 budget with 51 votes from the Republicans vs 49 votes from the Democrats, which included the tax reform framework that the Trump administration had been pushing for. Just as investors were relieved, the US media reported at the end of October that some Republican senators might not support tax reform.
Looking at these, one cannot help but ask, why is the US tax reform so important? And, how will it impact China’s equity market?
The single most important driver of this year’s global market rally has been an unexpected fall in the US interest rates under an environment where the Fed has resumed rate hikes and begun its balance sheet reduction. To a large extent, it reflects the market’s disappointment over Trump’s capability to implement reform measures, taking a view that rapid economic growth and rising inflation will not materialize.
There are a few key proposals in the tax reform. The number of tax brackets for individual income tax will be reduced from seven to three, offering tax relief to the middle class. The current 35 percent corporate tax rate will undergo a drastic cut, coupled with tax incentives to encourage multinational companies to bring overseas profits worth of US$2.5 trillion back to US shores. If the Trump administration gets its way with tax reform, US companies’ competitiveness would improve, stimulating an increase in capital expenditures, jobs, as well as household consumption.
Tax reform, however, does come with a price. Lower financial revenue will lead to a bigger US fiscal deficit if balancing measures, such as tax base broadening and federal spending reduction, are not implemented. This means that the US Treasury will have to raise interest rates and issue more sovereign bonds, driving up capital costs in the global financial market.
Looking specifically at the impact on Chinese equities, one should not underestimate the effect of changes in the dollar exchange rate and interest rate.
Our research shows that tax reform will moderately strengthen the dollar, while the impact on interest rates will be minimal, with US sovereign bond yields on a gradual upward trend.
Under such conditions, strong domestic demand in the US will prompt more global trade, benefiting sectors impacted by US imports such as China’s IT components, auto parts, ports and logistics. Financials and certain cyclical stocks may also benefit from this moderately inflationary environment.
A very radical reform that significantly expands the US deficit, pushing up US interest rates and accelerating the dollar appreciation, is a less probable scenario. If this happens, it could trigger a change of direction in the equity market – investors may take profits in Chinese property plays and US-listed technology stocks that have rallied earlier and are sensitive to RMB exchange rate, and then turn to defense sectors like telecommunications and F&B.
It is difficult to precisely anticipate how corporates and households would respond to tax reform.
For example, are US tech companies going to use the repatriated overseas profit on special dividends, share buybacks, R&D expenditures or M&A? And with the tax relief, would the middle class choose to reduce consumption instead given the healthcare reform?
With the huge uncertainty over the final proposal of the tax reform, our recommendation is to closely monitor the developments and adjust the investment strategies as the reform progresses and the capital markets evolve.
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