Taxes, tapering, timing and thresholds

“Nothing is certain but death and taxes” is a rather fatalistic proverb drawing on the inevitability of the life cycle to make a parallel with the inevitability of the fiscal burden. However, just like with Fed tapering, the key thing with any tax policy change is timing and thresholds. Our view is that the central bank will likely continue to stay accommodative and we’re more dovish on rate hikes than market pricing. And, even though the proposed capital gains tax hike in the US may potentially impact equity markets, we’d see these effects as transitory. To us, the economic outlook still supports the reflation thesis and, with it, cyclicality. However, with the US likely to record this cycle’s strongest rate of expansion in the current quarter, and with the rest of the world apart from China at an earlier stage of recovery, certain investment dynamics in the second half of the year may become more granular and differentiated across regions, sectors and styles. Let’s see how.

Tapering | Not yet: The key takeaway from the latest Fed meeting is what the central bank didn’t say: despite strong data so far this year, there was no mention that the committee is considering slowing the pace of asset purchases (tapering). To us, this signals to the market that the Fed is going to allow the economy to run on high pressure, supporting the reflation narrative. Our best guess is that, at the earliest, the central bank may talk about tapering at the Jackson Hole symposium in August, and then announce it in September – to start in late 2021 or early 2022 (our base case is next year). A timeline like this makes sense, in our view, because market pricing is all about sequencing: once the Fed does taper, the signal to investors is that what follows is a rate hiking cycle. Rate hikes would likely end the reflation mantra, so the Fed doesn’t want to rush it and needs to see “substantial further progress in the economy”, especially as it sees the current inflation spike as temporary.

Taxes | Entering the debate: The Biden administration has proposed more fiscal stimulus, but also an increase in the top capital gains tax rate for the highest earners to 39.6%. One interpretation is that a rise like this is basically an opening bid in what looks like a complex political process. From this perspective, it’s possible that the outcome is a more modest increase, perhaps under 30%, and that any change won’t probably apply retroactively to gains realised before May. Regardless of the numerical aspects, the empirical evidence we reviewed suggests that past capital gains tax hikes have tended to be associated with declines in equity prices and allocations, especially among the wealthiest households. So, if historical patterns hold, we would expect some extra volatility ahead. However, the research we surveyed also suggests that any hypothetical net selling in response to these tax changes typically proves short-lived and reverses during the following quarters.

Here’s why this matters:

Level of activity vs rate of change: The US economy should continue to recover strongly over the next several quarters and the policy impulse is still very supportive. But, with the peak in growth likely this quarter, it’s possible that US equity returns turn out to be somewhat more modest in the second half of this year and beyond. Sector-wise, we think the outperformance of cyclical assets has more room to run – as we’re more optimistic than the consensus on global and US economic growth, and expect the upcoming data releases to surprise to the upside. But the rotation in equity markets has already lasted for longer and been stronger for cyclicals versus defensives compared to the post-financial crisis average. So we think a further strong rise in economic and earnings expectations would be required for sustained cyclical outperformance beyond the period of peak growth.

US cycle vs rest of the world: The moderate rise in US bond yields we expect over the coming months – when Fed tapering likely gets discussed – is consistent with a further boost to cyclical assets (as long as activity stays solid) and beneficiaries of steeper curves. However, the fact is that US growth, while remaining strong, should peak ahead of most other developed and emerging markets. As and when this happens, it’s likely that the rest of the world would still be accelerating on the back of the lifting of restrictions once the pandemic is tackled. This may mean that global-facing cyclicals in the US would still be able to enjoy accelerating growth versus domestic-facing ones. In Europe and Japan, the dominant narrative would probably be reopening, while the US would find itself in a more mature cyclical phase. Commodities are likely to continue to benefit from these dynamics.

Meanwhile, it’s quite busy around the world…

A broad focus: The purchasing managers’ indices should suggest that manufacturing remains strong throughout the US, UK, euro area and Japan. In services, though, the divide between the US and UK on the one hand (where activity is now expanding rapidly), and the euro area and Japan on the other hand (where it’s stagnant at best) is likely to have continued. The US jobs report should reveal further employment gains and falls in the unemployment rate, though spare capacity still remains and wage growth is moderate, which is why we believe the ongoing inflation spike is transitory. The Bank of England is likely to keep the policy stance unchanged, but it should upgrade its macro forecasts. The current guidance is that the balance sheet won’t shrink until the policy rate reaches at least 1.5% – a review will likely be published in August. In Brazil, we expect the central bank to hike rates once again, and the market may focus on the meeting of the Turkish central bank too.

Daniele Antonucci | Chief Economist & Macro Strategist