20 Nov 2017
Author: Johan Jooste, Chief Investment Officer, Bank of Singapore, Member of OCBC Wealth Panel
Tax reform is back as the market’s near term focus.
GOP lawmakers in the House of Representatives passed a bill last week that would lower corporate taxes to their lowest level since 1939 and cut individual taxes for most households in 2018.
A companion bill in the Senate may prove more difficult to pass, however. In the 100-seat Senate, Republicans can lose no more than two votes from their 52-48 majority if they hope to enact tax reform.
The Senate version has already faced criticism from several Republican lawmakers because of what is seen as unequal rates for small businesses and non-corporate enterprises known as “pass-throughs” versus corporations.
A final bill is due to be passed by year’s end.
The implementation deadline is ambitious and the actual scope of changes cannot be assessed just yet. This makes it much more worthwhile to watch than Donald Trump’s visit to Asia, which appears to have avoided any major blunders.
Treasury yields have backed up over the past week as some fears begin to surface about how sustainable tax breaks are from a policy point of view.
Does the U.S, economy really need additional stimulus at this stage? How would the Fed react? Some inflation may ensue, causing the Federal Reserve to take into account fiscal policy for the first time in a while.
As we approach the final Fed policy meeting in mid-December, our view is that the Fed will hike this time, and follow it up with three more times next year.
This view is slightly closer to market consensus than it has been, and partly due to rising concern about inflation. Admittedly, inflation has not really been a market factor for a while, but the steady growth in the U.S., a tighter labour market and now the possibility of fiscal stimulus have brought it back into discussion.
Risk markets had a slightly less buoyant ride recently, as credit spreads widened out somewhat and equity markets paused for breath after a good spell.
It is perhaps not too much of a surprise that the credit market is showing signs of fatigue. Credit generally is still the beneficiary of solid technical factors: strong liquidity (demand) and momentum.
Fundamentally, the lack of defaults remains a major plus. But, continued spread tightening does pose a potential medium-term risk. The market is not offering much by way of further capital gains, and the spread pick-up over government bonds is touching record low levels in many market segments.
Equities: Rotation strategies in China
Xi’s government will likely focus on financial deleveraging, poverty reduction and environmental protection (higher environmental standards for manufacturing) in 2018-2020. We are constructive on the consumption, environmental protection and information technology sectors but cautious on real estate sector.
While IT will offer medium and long-term structural solid growth, investors will have to be mindful of the valuations. We view any share price pullback in the IT sector as potential accumulation opportunities.
Fixed income: Shorten duration
Key portfolio actions include reducing overall portfolio duration and a move up in credit quality.
Foreign exchange: U.S. Dollar’s medium term outlook murky
As long as the market can hold on to hope for some mix of tax cuts and a more hawkish Fed composition, we suspect the greenback can firm going into the year-end.
However, there are limits to any U.S. Dollar bounce. But the U.S. Dollar’s medium-term outlook is increasingly murky and could give way to a more meaningful U.S. Dollar downtrend in two or three years’ time.
We suggest investors avoid concentrated, long U.S. Dollar exposure.
Commodities: Oil supported by tight supply
Growth in demand for oil remains sluggish, but prices have been supported by two areas where supply has been surprisingly tight. First, OPEC discipline is holding. Second, U.S. shale drilling has slipped. We doubt this will continue.
Markets are at a crossroad with good growth but stretched valuations. We suggest investors stay slightly defensive.
Use this time as an opportunity to do a portfolio health check: Remember to diversify strategically, de-risk tactically and de-lever as needed.
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