09/11/17

Investors size up U.S. tax reform after Democrats gain in elections

NEW YORK (Reuters) - If the election of Donald Trump as U.S. president was a big catalyst behind a 23 percent rally in the S&P 500 over the past year, Tuesday’s first wide-scale retesting of his agenda with voters could signal the clock is ticking for Republicans to deliver on a range of so-far unkept promises before a much larger ballot showdown next year.

Markets are growing increasingly skeptical Republicans can pull it off.

On Tuesday, Democrats handily won governors’ races in New Jersey and Virginia, picked up more than a dozen seats in the Virginia House of Delegates and nabbed full control of the Washington state Senate.

Omer Esiner, chief market analyst at Commonwealth FX in Washington, called the election results “a resounding victory for Democrats.”

“It can be viewed as the latest signal of the president’s waning popularity,” Esiner said. “An increasingly unpopular president could give some Republicans the cover they need to vote against the tax plan.”

Trump’s election one year ago - which gave Republicans control of the White House in addition to control of Congress - unleashed what many analysts described as the market’s “animal spirits.” In the following days and weeks investors gobbled up a wide range of stocks, betting that Trump’s promises of tax cuts, deregulation and an overhaul of the healthcare system would untether an economy growing at anemic rates.

On the day after last year’s election, for example, investors dove headlong into bank stocks, positing they would soon profit from healthier demand for credit and from financial deregulation. They gave a cold shoulder to shares of consumer staples companies, which often do better in a low-growth environment.

The S&P bank index .SPXBK shot up nearly 5 percent. The consumer staples index .SPLRCS dropped 1.3 percent.

Fast forward a year and the inverse occurred following Tuesday’s results. Staples gained 1.1 percent on Wednesday; banks slid 1.1 percent.

Still, some analysts read Tuesday’s results as lighting a fire under congressional Republicans to get their legislative act together before Election Day 2018, when all 435 seats in the House of Representatives and 34 Senate seats are up for grabs.

“Some are saying this is a shift in support and it may accelerate some kind of tax bill,” said Bucky Hellwig, senior vice president at BB&T Wealth Management in Birmingham, Alabama.

“If it looks like the Republicans are in trouble, they could get a wakeup call that they really need to move on the tax cuts, which would be bullish for the (stock) market.”

After repeated failures by Republicans in both the House and the Senate to deliver on their promise to repeal and replace Obamacare, Republicans have promised to pass a tax plan by year end.

Achieving tax reform remains a tall order, however, and signs of investor skepticism over Republicans’ ability to deliver were already evident heading into Tuesday’s elections.

Shares of smaller companies , seen as the biggest beneficiaries of a corporate tax cut, have underperformed their larger peers .SPX by nearly 4 percentage points over the last month alone.

The Treasury yield curve, which provides a snapshot comparing the rates of shorter- and longer-duration government bonds, steepened dramatically after Election Day 2016 as markets bet on accelerating growth. It has flattened substantially since Trump took office in January, typically a harbinger of a tepid economy. The gap between the yields of benchmark 2- and 10-year Treasury notes US2US10=RR is the narrowest in a decade.

U.S. long bonds, which typically are less favored in a fast-growth environment, are on a tear. The 30-year bond US30YT=RR has delivered a total return of close to 4 percent in just the past two weeks.

In another sign of pessimism, the U.S. dollar is on pace for its poorest year in a decade, down 7.2 percent year to date. On Wednesday, the greenback slipped on worries over possible delays to tax reform.

“Last night was a preview, it’s a confirmation of what people are starting to think. (Republicans) have had a couple of shots and failed so far at both in two big agenda items – healthcare and now taxes,” said Ken Polcari, director of the NYSE floor division at O’Neil Securities in New York.

“Not that I think there is going to be a crash, but a realization we bought this (stock) market up in anticipation of all these good things happening and we are not getting them. So we have to just re-price the assets.”