Tax reform: Prepare for a big 2018 equity rally

The U.S. markets have had an impressive 2017, with the major U.S. stock indexes continuing to set records.

While a big chunk of the U.S. market’s strength has been attributed to promises of a major tax overhaul, according to Wells Fargo’s Investment Institute, stocks have yet to fully reflect the positive impact that the tax reform will offer.

“It is likely that tax reform is only partially priced into the market,” according to research notes from Wells Fargo’s Investment Institute, with the bank adding that new tax rules could be significant for equities as they could raise consumer spending and revenues while a steep fall in corporate taxes could increase earnings.

While there is a split consensus on whether or not tax reform is fully baked into the markets, Wells Fargo laid out some convincing reasons why more upside could be in store.

“The S&P 500 index has appreciated significantly since tax reform began in September, yet the index has climbed steadily most of the year, and at least since June, and this increase correlates more closely with the U.S. economy’s pick-up – accelerating global growth, and large volumes of cash available for investing. Tax reform may be helping, but it is a relatively recent support, in our view,” the bank commented.

There are other reasons behind Wells Fargo’s belief that equites are not fully reflecting the impact from tax reform. For one, Wells Fargo pointed out that for much of the year the S&P 500’s highest tax companies have underperformed its lowest tax companies. This trend has just recently started to reverse. Also, the bank noted that “the Russell 2000 index has not outperformed the S&P 500 since the House passed its bill on Nov. 16.” The Russell 2000 index includes a concentration of companies that would benefit from tax reform, and therefore, if investors were really pricing the expectations for tax reform into equities, this trend should be different.

If all goes according to plan, the new tax rules will come into play starting in 2018, and it isn’t just equities that will benefit. The overall U.S. economy could also get a boost, and Wells Fargo sees the potential for a higher GDP.

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According to Wells Fargo, the compromise bill for $1 trillion in tax cuts would add a disproportionally large $200 billion to the deficit in 2018 alone, roughly 1% of GDP. “The extra 2018 stimulus is double the forecast we made after the House passed its tax bill in November, and should produce a stronger 2018 U.S. economic growth pace than the 2.6% estimate in November,” according to the bank’s latest research notes on tax reform.

U.S. President Donald Trump voiced a similar sentiment on Tuesday, taking to twitter to state that, "the Stocks and the economy have a long way to go after the Tax Cut Bill is totally understood and appreciated."