U.S. President Donald Trump last week said he will soon make an announcement related to taxes. Our preference for reflation beneficiaries—or assets likely to benefit from rising growth and inflation—isn’t contingent on U.S. corporate tax reform. Yet such reform does have the potential to amplify this market theme. The chart below helps explain why.
We see reflation supporting more gains in U.S. small cap stocks. They have a history of outperforming during periods of rising rates, as we note in our Global Equity Outlook. Tax cuts would be an extra boost disproportionally benefiting small caps, given those corporations’ higher effective tax rates, as evident in the chart above.
Tax reform winners and losers
The reflation trade has waxed and waned since November along with expectations for U.S. tax reform. But any tax reform this year should only reinforce a reflationary environment already in place before the U.S. presidential election. Significant uncertainty shrouds the final tax plan, and the need to find offsetting revenue means tax reform will create winners and losers.
The border tax adjustment would effectively subject imports to a 20% tax to help pay for any corporate tax cut. Proponents argue the U.S. dollar should rise in response, offsetting the impact on trade or consumer prices. We see only a partial currency adjustment, which could help exporters and hurt retailers and consumers. How the U.S. dollar behaves in such a scenario will be key for markets and the U.S. economy.
We also believe another proposed reform, scrapping the deductibility of interest expense, would ultimately hurt highly leveraged companies and have major implications for how companies finance themselves in capital markets. Without offsetting revenue, large corporate tax cuts would increase the deficit, creating a reflationary stimulus that could lead to higher interest rates. We see potential for volatility in the coming months as more reform details emerge. Read more market insights in my Weekly Commentary.
The iShares Russell 2000 Index ETF (NYSE:IWM) was trading at $138.71 per share on Tuesday afternoon, up $0.41 (+0.30%). Year-to-date, IWM has gained 2.86%, versus a 4.38% rise in the benchmark S&P 500 index during the same period.
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