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The political impasse that killed off efforts to restructure Obamacare will enable Washington to refocus on tax reform, which was always more important to the markets longer term, and for investors to refocus on corporate profit reports in the coming weeks. It is likely to take months before the prospects for tax reform become clear. In the meantime, ongoing economic growth and rising profitability should provide support for prevailing stock prices.
There are several elements to any prospective reform of our tax structure. Corporate tax rates are too high, which encourages American firms to relocate offshore, taking jobs and tax revenues with them, while it discourages capital investment. Profits earned offshore by American companies are trapped there to avoid the high tax liabilities firms would incur if they wish to repatriate that capital. And the tax code is needlessly complicated, because it is rife with deductions to encourage specific corporate activities, while constraining firms from exploiting tax deductions to avoid those high tax rates. Such conflicting objectives needlessly complicate all tax filings. Lowering the corporate tax rate would also render tax avoidance schemes less attractive, so simplification would serve multiple objectives. Nonetheless, corporate tax reform does get complicated quickly, partly because of how such taxes interact with taxes on household income, notably earnings of small businesses. Many small firms are structured as partnerships to avoid double taxation. Also, the burden of paying for tax reform has become a bit more difficult, since roughly $1 billion in cost savings on healthcare won’t be available and the border equalization tax, which would be worth more than $1 billion in increased revenue, is highly contested.
Some elements of the tax reform effort are extremely straightforward, including lower tax rates and repatriating foreign profits. So, it is entirely possible that the Administration will be forced to retreat to this lowest common denominator that should attract some support from Democrats, particularly if it is paired with a policy that some Democrats can support, such as infrastructure spending. The entire tax reform venture is highly political, of course, so Democrats might oppose it anyway. But the Administration should be able to find enough support for such a deal. In any event, it is likely this effort will take time, potentially several months, and it will periodically attract or capture the full attention of investors. But, investors should not lose focus on the ongoing gains in corporate profits that really provides a solid underpinning to stock valuations.
Profits are growing, the economy is expanding at a solid pace, overseas economies are performing better, and the prospect for some form of tax reform can’t be dismissed entirely. All of this is supportive for stock prices. The market may experience small setbacks, but such fluctuations are well within the normal range of market volatility. They are distractions.
The real risk to stocks is the possibility that inflation will be allowed to increase more significantly, so that the Fed is forced to raise interest rates far faster than it has projected. Indeed, at least a few Fed officials are willing to take this risk, since they favor allowing inflation to increase somewhat above the Fed’s 2% target. But once inflation goes above target, it could continue to accelerate to ever higher levels, which would soon become a serious economic problem. But, it appears most Fed officials understand the risks with this approach, so we expect them to maintain a steady upward trajectory to policy interest rates to contain higher inflation. We remain vigilant in watching how the Fed proceeds with policy and what they permit to occur. Unless or until we see unfavorable outcomes, we remain constructive on the outlook for equities.
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