In a bout of self-doubt, the equity market appears to be stalling in its advances and investors are now weighing up where the opportunities lie should the tax cut to 22% or 20% be achieved.
Bond investors are weighing where the opportunities lie and they appear mixed. The opportunities don’t lie so much in government bonds as they are fully priced and most likely are going to rise from here but in the corporate bonds and especially so, in my view, with investment grade bonds.
The reasoning is rather simple. A tax cut to 22% or 20% removes a significant tax shelter for many companies. Debt for a long time has been the preferred method as debt is cheaper than equity. Debt is enhanced by the deductibility of interest. For multinationals, they can defer paying up to 35% in taxes on foreign earnings as long as those earnings are kept in foreign subsidiaries. That all changes with the new tax bill. It is forecast that issuance could fall by as much as half once the law is passed.
The loss of deductibility is material. For example, a $3bio issuance would result in an interest payment of $97mio and at a tax rate of 35% allow a deduction of $34 mio. Under the new bill, that deduction would reduce to $20.7 mio. This does not mean that issuance will cease, rather it will slow issuance.
High yield will be affected as deductions are limited to 30% of earnings before interest, taxes, depreciation, and amortisation. Something to watch.
On the day, the Nasdaq slipped once again, albeit marginally. The equity market was somewhat affected by the inclusion of alternative minimum rate for business. Equity markets were subdued and tracked down over the course of the day.
Bond investors are now starting to focus on the Government’s need to issue more treasuries as the weight of debt drains the budget. U.S net-interest costs rose to $274 bio for fiscal 2017 and the highest on record (U.S. Government Accountability Office). This is expected to increase to $528 bio by 2022 and would account for 10.9% of total outlays up from 6.8%.
Greater issuance will lead to greater borrowing costs. More issuance eventually means much higher rates. For a budget to be neutral and that requires in excess of 3.3% GDP growth, this will be difficult to achieve over a longer period of time. No wonder there are some sceptics in the GOP. One also wonders how the hawks were placated. If growth is not maintained at 3.3% then the U.S. bond market will be asking some very nasty questions.
On the day bonds rallied in the longer maturities and the yield curve flattened. The prospect of several tightenings appear to be priced in a two rate hikes expected for 2018, as Fed Fund Futures remain sub 98 until Dec 19 when the rate finally trades with a handle of greater than 2%. The market did react to U.S. trade deficit which is widening and to confuse the market the Institute for Supply Management (ISM) said it’s non-manufacturing sector fell in November.
However, there is still a reason to be careful. Agreement has to be reached on a budget accord by Friday if a government shutdown is to be avoided.
If Trump declares Jerusalem as the capital of Israel and subsequently looks to relocate the U.S. embassy there, then a number of key U.S. allies may feel somewhat jilted. Certainly, the Saudis won’t be happy nor a number of key Middle Eastern allies. Should this announcement be made expect a significant amount of unrest in the region. Such an announcement would lift Iran’s prestige in the region and diminish the Saud’s influence.
Equities: The S&P 500 fell 0.3%. The Dow fell 0.45% and the Nasdaq fell 0.2%. The Stoxx 600 also fell 0.2%.
Currencies: The Bloomberg Dollar Spot Index was rose 0.32%. while the yen fell 0.2%.
Bonds: The 2-year rose to close at 1.82%. The U.S. 10-year closed at 2.358% a fall of 1bp. The 30-year closed at 2.735 %. The 2/10 closed at 53.1, the 2/30 at 91.2 bp and the 10/30 closed at 38bp. There was a sharp flattening of the curves. The European 10-year benchmark closes were, gilts closed at 1.26%, bunds at 0.32% and OAT’s 0.47%.
Commodities: Gold fell 0.7% and WTI rose 0.3%. The Bloomberg Commodities Index fell 2.7%. Copper fell 4.4%. The fall can be attributed to rising inventories, a stronger dollar and falling demand as China’s anti-pollution drive takes effect. This is the largest drop in 2 years.
Aussie Market Today.
Aussie bonds will be mixed. Bonds should stage a slight rally and will be somewhat mindful of what impact a government shutdown in the U.S. would have on bonds globally. Longer bonds should rally and 1 -2 year bonds could weaken with the effect of the yield curve flattening further.
Equities will be mixed. Given the recent fall in commodities the miners will most likely lose some ground. Overall the trend should be to fall a little on the day.
Credit remains in demand as investors hunt for returns.