The Market Today
Yields, Stocks, Dollar Rise on Tax Reform Plans; Economy Expands 3.1% in 2Q
by Craig Dismuke, Dudley Carter
Today’s Calendar – Economy Expands 3.1% in 2Q, 3Q Data Looking Decent: In its final revision, the economy is now reported to have expanded 3.1% in 2Q, revised up from 3.0%. The 1/10th positive revision came from a larger build of inventories, revised up from +600 million to +4.3 billion. Personal consumption, as initially reported, rose a solid 3.3% for the quarter. Business investment ex. inventories rose 6.7% while residential investment (housing primarily) contracted 7.3%. Government spending was bolstered by an increase in defense spending but still contracted 0.2%. This marks the first quarter since 1Q15 and the ninth quarter of the 24 quarters during this recovery/expansion that growth has topped 3.0%. Going forward, inventories still have room to rebound in 3Q, personal consumption is unlikely to grow at such a strong pace in consecutive quarters, initial data on business investment points to another good quarter, housing activity appears to be weak again, and government spending is likely to remain somewhat flat. External trade should benefit from an improving global economy and weaker Dollar. As such, we project 3Q growth will come in close to 2.5%.
Also released this morning, initial jobless claims for the week ending September 23 rose from 260k to 272k, after bearing both the residual impact of Harvey and the full brunt of Irma. It appears, even with two hurricanes, that initial jobless claims will continue their streak below 300k. The August advance goods trade balance report showed a smaller-than-expected trade deficit along with a small deficit in the July revisions. This bodes well for the 3Q GDP report. Wholesale inventories were up a strong 1.0% in August further pointing to a 3Q rebound. On the Fedspeak front, Kansas City Bank President George will speak at 8:45 a.m. CT and Atlanta’s Bostic will speak at 12:30 p.m. Neither should have a material impact on the markets.
Overnight Activity – Mixed Global Follow-Through to U.S. Tax Reform Details: The degree of follow-through overnight from yesterday’s positive U.S. market response to the GOP’s tax plan has varied across asset classes. Global equities have traded mixed across Asia and Europe and U.S. futures pointed to an opening decline for U.S. indices. The Dollar initially added to yesterday’s gains but pulled back below yesterday’s closing level during European trading. Sovereign yields tracked yesterday’s U.S. updraft and Treasury yields have so far extended yesterday’s jump. The Dollar index’s broader rise and fall overnight tracked the trend in its most heavily weighted currency cross. The Euro has rebounded Thursday after touching its lowest level since mid-August on Wednesday. The European Commission’s economic confidence index improved more than expected in September. After four consecutive months of improvement, the index now sits at its strongest level since June 2007. In other news, the cost of U.S. crude has quietly climbed to its highest level since mid-April. The commodity is up 13% from its August 30 low (Harvey effect) and up more than 21% from its year-to-date low in late June. After this morning’s U.S. economic data, The 2-year yield is back down to unchanged while the 10-year yield remains higher by 2.5bps at 2.34%.
Yesterday’s Trading Activity – Markets Remain Optimistic after Tax Plan Details Released: U.S. stocks quickly erased an opening jump but bottomed and turned higher shortly after the GOP released the details of its plan for tax reforms (more below). The yield curve had already steepened on higher yields in optimistic anticipation of the tax reform announcement. While the political response was mixed down partisan lines, the markets seemed to adopt a net favorable take on the tax talk. For the day, the 2-year yield rose 3.5 bps on the day to 1.47% while the 10-year yield added 7.5 bps to 2.31%. The Dow gained 0.25% while the S&P rose 0.41%. Evidence of how the higher rates impacted U.S. stocks could be seen in the uneven sector performances. The financials sector rose 1.30% to lead the S&P. Since September 7, the 10-year yield has risen 27 bps. Over this same period, the financials sector has gained 8.0%. Technology was the second best performer within the S&P which helped explain the Nasdaq’s 1.15% gain Wednesday. Elsewhere in the S&P, bond-proxy sectors such as real estate and utilities faltered and dragged on the overall index. The Dollar held its daily gain which left the currency at its strongest level in a month.
Republican Tax Proposal Released: Republican leaders released a framework for overhauling the U.S. tax code, including simplified frameworks for both business and individual taxes. The Committee for a Responsible Federal Budget said the proposal would result in approximately $5.8 trillion in tax cuts over the next ten years offset by $3.6 trillion in increased revenues. The net tax cut would equal $2.2 trillion, or approximately $220 billion per year. According to the WSJ, “Many Republicans expressed optimism Wednesday. The conservative House Freedom Caucus endorsed the framework. But tax policy is notoriously thorny. Congress hasn’t overhauled the tax system in such an ambitious manner since 1986.”
Corporate Tax Code Proposal
1) 20 percent top corporate rate
2) 25 percent rate for pass-through businesses
3) immediate expensing of new capital investments in depreciable assets
4) one-time repatriation rate to draw foreign cash back to the U.S. then a territorial tax system
5) repeal or restriction of various deductions
Individual Tax Code Proposal
1) reduction from seven to four brackets: 12%, 25%, 35%, and a TBD rate set by Congress for the highest earners
2) increase in the standard deduction to $12,000 for single filers and $24,000 for married taxpayers filing jointly
3) increase in the child tax credit and introduction of a $500 credit for the care of non-child dependents
4) repeal of AMT and the death tax
5) elimination of most itemized deductions excluding mortgage interest and charitable donations
6) retain benefits for college savings and retirement accounts
Pending Home Sales Continue Run of Weak Housing Data: Pending home sales continued this week’s run of weak housing data, dropping 2.6% in August. Pending sales have now fallen in six of eight monthly reports in 2017 and YoY sales are down 2.6%. While Hurricane Harvey is likely to blame for the 3.5% drop in pending sales in the South, every other region of the country showed declines as well. Sales in the Northeast fell 4.4%, sales in the Midwest fell 1.5%, and sales in the West dropped 1.0%. Like the new and existing home sales data, Hurricanes Harvey and Irma are likely to impact the September pending sales data as well. The broader weakness, excluding the storm-related impact, is a growing concern with news sales down 12%, existing sales down 6%, and pending sales down 4% since March.
Brainard Avoids Policy, Bullard Says He is the Biggest Dove: In her Wednesday comments, Fed Governor Lael Brainard avoided almost any mention of the current outlook. St. Louis Fed President James Bullard, however, continued to push his low-rate regime approach to monetary policy in remarks on Wednesday afternoon. Bullard crowned himself the Fed’s biggest dove and remained persistent in his call for noncombative monetary policy. He said the current rate level is likely to remain appropriate in the near term and stressed the fact that the Fed – with inflation surprising to the downside this year and inflation expectations uncomfortably low – doesn’t need to be preemptive with policy tightening. In other tidbits, Bullard mentioned potentially stretched equity prices, indicated concern about the difference between market rate expectations and the Fed’s dot plot (credibility), and said the labor market is “probably as good as it gets”. Whether it was the lack of surprise at Bullard’s less-than-bullish stance on future rate increases or the fact that markets were more focused on the tax plans, fed funds futures ignored his dovishness. The implied rate path rose marginally in a continuation of the last week’s tendency.
Rosengren Wants to Keep Raising: In his Wednesday’ evening comments, Boston Fed President Eric Rosengren implied his dot likely landed above the median in the Fed’s September dot plot. Rosengren, who has recently been one of the more hawkish Fed officials, again showed support for continued gradual tightening. He said the U.S. economy “risks pushing past what is sustainable” and therefore “regular and gradual removal of monetary accommodation seems appropriate.” Rosengren said he expects the unemployment rate may remain below what the Fed expects longer term and that this will eventually push up wages and inflation. As to the recent weakness in inflation, he falls in the camp of those that believe the Fed should not overreact to a transitory downturn. He did say, however, that the lower inflation gives the Fed the flexibility to tighten more slowly.
Banking Agencies Release Proposed Rule to Reduce Regulatory Burden on Community Banks: The Federal Reserve, OCC, and FDIC jointly issued “Proposed Simplifications to the Capital Rule Pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of 1996” yesterday. According to the Federal Reserve, the proposed rule is “intended to reduce regulatory burden by simplifying several requirements in the agencies’ regulatory capital rule. … Most aspects of the proposed rule would apply only to banking organizations that are not subject to the ‘advanced approaches’ in the capital rule, which are generally firms with less than $250 billion in total consolidated assets and less than $10 billion in total foreign exposure. … The proposal would simplify and clarify a number of the more complex aspects of the existing capital rule. Specifically, the proposed rule simplifies the capital treatment for certain acquisition, development, and construction loans, mortgage servicing assets, certain deferred tax assets, investments in the capital instruments of unconsolidated financial institutions, and minority interest.”