Tax Reform: Don’t Expect Immediate Impact to the Investment Market

From a broad market perspective, the effect of the tax bill may be more muted than many expect and largely already reflected in prices. There is limited immediate impact expected on the US Treasury bond market; however, the prospect of higher budget deficits may drive bond yields higher, as higher issuance is required to fund the deficit. The reduction in bond purchases by the Federal Reserve will concurrently provide a modest push upward as well. Fiscal stimulus when the economy is at full employment could also result in higher inflation (although this prospect has been largely dismissed by the markets, judging by the breakeven inflation rate on TIPS).

All of these could result in more upward pressure on rates over the longer term than is currently expected. The impact on general after-tax profits is probably already priced into equity markets, so the direct effect on stocks is likely already realized. However, there could be some downward pressure on stocks if bond yields eventually rise. A potential counteracting to this would be a greater positive impact on the economy and spending than is currently expected, which would increase profits.

A more direct consequence of a reduction in corporate taxes driving down debt issuance would be even further tightening of credit spreads. Fewer bonds being issued would lower supply of stronger credits, driving up prices. However, such an effect would likely not be notable for a few years.

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