Proposed tax hikes to cause jitters, but bull market likely resilient

Incoming economic data across various fronts continue to show notable strength, which underpins Fed Chairman Jay Powell’s latest comments that the US economy “is at an inflection point, and that’s because of widespread vaccination and strong fiscal support, strong monetary policy support.”

Even as economic data broadly surprised on the upside, we have seen a respite in the rise in yields over recent weeks with the 10-year Treasury yield trading range-bound between 1.60% and 1.75% since mid-March.

We forecast US Treasury yields to head gradually higher over the long term (our 12-month forecast is 1.90%), but over the near term the scope of a continuation of the sharp rise in yields is likely to be limited as current yield levels already reflect aggressive expectations for the Fed liftoff as early as 2022. Unless inflation begins to deteriorate sharply over the near term, to further bring forward expectations for a liftoff significantly would be premature at this juncture.

As the growth picture continues to improve and as yields trudge higher ahead, we expect more performance from cyclical sectors which have so far delivered a solid run, with value versus growth outperformance already approximately in line with the value rotations in 2009, 2012 and 2016.

The outlook for cyclical sectors also importantly hinges on the progress of President Biden’s USD2.3 trillion infrastructure investment plan, i.e., the American Jobs Plan. Various reactions to the White House’s proposal so far indicate that the legislative process for the American Jobs Plan will be more complicated than the USD1.9 trillion American Rescue Plan, although our base case expectation remains that the Democratic Party could pass an infrastructure bill using the FY2022 budget reconciliation process before the August recess.

We expect Biden’s infrastructure bill to evolve over the months ahead as negotiations continue. Notably, there has been concern over Biden’s proposed tax increases, which includes increasing the corporate tax rate from 21% to 28%.

While an increase in the corporate tax rate will form a negative factor ceteris paribus, funding the bill through tax increases is unavoidable, and they should be taken as part of an overall positive picture on a net basis.

As the economy continues to recover, improving corporate profitability and healthy liquidity conditions should help to buffer the negative effects of increased taxation. As shown in the following exhibits, the stock of liquid assets of the non-financial corporate sector as a percentage of GDP has increased to near its highest levels in two decades, and the share of taxes and interest expense as a percentage of sales for companies in the MSCI AC World Index is significantly below the 15-year average.

In our view, we remain risk-on through our overweight positions in equities, where we have a preference for the US and Asia ex-Japan, and in Emerging Market High Yield bonds, which still offer attractive carry and are a beneficiary of the global search for yield. We are underweight in both Emerging Market and Developed Market Investment Grade bonds, which face headwinds from a steeper yield curve.

Overall, the longer term outlook for risk assets remains favourable given that a vaccine-driven global economic recovery is firmly underway, super-charged by powerful US fiscal stimulus and ongoing support by major central banks, and we continue to recommend that clients stay invested through potential near term volatility.