Beware the double-edged sword of US tax reform

Tax reform in the United States has helped to spur on global economic growth, but investors should be aware of the double-edged sword that comes with the added exuberance, as already expensive share markets continue to edge higher.

While company earnings growth in the US – and indeed in Australia – are generally supportive valuations, according to Diana Mousina, AMP Capital’s Senior Economist, the continued strong run of equity markets means the chance of a correction this year remains high.

In the last year the US large companies index, the S&P500, has risen by some 20 per cent, with close to 5 per cent of those gains alone coming since the start of 2018. Our local share market has had more modest gains of around 5 per cent since this time last year.

Even though US tax cuts were “priced in”, the markets this year have taken another leg up and it’s been a very strong run over the past few weeks,” Mousina points out.

The global International Monetary Fund (IMF) specifically credited tax cuts in the US passed by the country’s Republican Party in December when it raised its forecast for world economic expansion in January to 3.9 percent this year and next, up 0.2 percentage point both years from its projection in October. The IMF raised its US growth forecast to 2.7 percent this year, 0.4 point higher than the it forecast in October.

As earnings season begins to play out in the US, it’s becoming clear corporates over there are going to benefit from the Republican Party measures even more than expected, Mousina points out.

There could also be a further boost to the economy in February as households see tax relief in their pay packets, Mousina adds.

Mousina highlighted the possible stimulatory effects to the global economy and share markets when US tax reforms were still in the works in October last year.

While the IMF’s upgrade for global growth is a positive that broad based global economic growth is returning, it comes at a time when investors are faced with “rich asset valuations and very compressed term premiums,” the Fund describes in an update to its World Economic Outlook in January.

As such, the IMF warns of a possible financial markets correction, especially if inflation prompts the U.S. Federal Reserve to raise interest rates faster than expected, which could in turn cause financial conditions to tighten around the world, especially in economies with heavy debt loads.

Mousina highlights that share markets in Japan and in Europe where valuations are more reasonable relative to the US share market.

“We see the risk of a [share market] correction in the US based on sentiment readings, which look like they’re at extremes as are valuation readings… the fear of a correction will persist over the next few months but overall earnings growth will continue to be supportive,” she says.