How will the US tax reforms impact US stocks and the dollar?

With the US tax reforms almost across the line, what will be the impact on US stocks and the dollar throughout 2018?

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Source: Bloomberg

With the US tax reforms just one step away from completion, there is an understandable optimism within financial markets, evident through the regular record highs seen in US stock markets. However, with implementation of this new tax structure expected in early 2018, what will the plans mean for stocks and the dollar going forward?

The Republican reforms will hit most Americans in one way or another, with the argument over whether it is geared towards the rich or the working class likely to rumble on for years to come. However, the corporate tax side of the matter is a little clearer, with the planned reduction seeing the rate cut from 35% to 21%, raising the prospects of a bout of bumper earnings reports throughout 2018.

It is important to note that the benefits of this tax cut will be inconsistent across different industries and firms, with the percentage of a company’s business taking place in the US key to understanding how much they will be impacted by this measure. It is also notable that certain companies are currently paying more tax than others, even within the same industry.

How the new funds will be utilized is also likely to differ from company to company. On one side, a host of share buybacks and bumper dividends will be likely to provide a boost to stocks throughout 2018. On the flip-side, there is likely to be a host of firms who increase their costs (increased wages) or reduce their margins (lower prices), in a bid to retain key staff and gain a competitive advantage in the marketplace. As such, the market benefits are going to be varied, given the range of ways each firm will utilize any windfall.

On the demand side, the income tax reforms should also have an impact on corporate profitability, with consumer demand expected to be higher. This is likely to be more prominent in the luxury end of the spectrum, given the greater benefit afforded to the wealthier citizens in this bill.

With many firms expecting to see profitability improve amid higher sales, and lower costs, the resulting earnings reports, share buybacks, and higher dividends will likely drive investors towards US stocks and indices. With that in mind, it is unsurprising that we have seen the US indices gaining ground over the past year, with the Dow Jones (+26%), S&P 500 (+20%), Nasdaq (+34%), and Russell 2000 (+13%) all gaining significant ground in 2017, with record highs being set on an almost monthly basis. The fact that we have seen such gains is clearly a sign that much of the benefits of such a tax cut will have already been realised. As such, while 2018 is likely to see corporate profitability rise, the degree to which this has already been priced in will be crucial. With the income tax reforms disproportionately helping wealthy individuals, there is also a strong case for greater participation in the stock markets as a result. This should be supportive of US indices.

Looking at the S&P 500, the uptrend has been a very consistent and clear one. With the passing of this bill, the reaction of the markets will be interesting. The possibility of a ‘buy the rumour, sell the fact’ move could bring about some form of retracement. However, unless we see the price break below 2556, the likeliness is that such downside would be bought. As such, it makes sense to buy the dip, as long as the trend remain in place for US stocks. 

Looking at the US dollar, things should be simpler. The value of the dollar is relative to the strength of the US economy, and thus given the improvements in the US economic growth story, and a Federal Reserve (Fed) raising rates, it would make sense to see the dollar appreciate. However, we have seen quite the opposite, with the dollar index losing over 9% in 2017, despite three rate hikes and the prospect of a bout of tax reforms. Much of this will be attributed to the inability of President Donald Trump to actually pass any meaningful policies, driving market skepticism. Now that the US tax reform policy is near enough across the line, could we see a resurgence for the US dollar in 2018?

The monthly chart below highlights that recent months have started to show some signs of life for the dollar following a consistently poor first eight months of the year. With the price having sold into trendline support, there is a chance we could begin to turn higher in the near future. The ability to break through 9493 will be crucial in setting up a strong year for the dollar.

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