Tax Plan and GDP in Focus But Market Appears Ready for A Breather

Markets start Thursday near record highs after Republicans unveiled tax reform details. Today brought a strong reading on quarterly economic growth, but stocks appear ready to take a breather after Wednesday’s rally.

The big news early Thursday was the government’s final estimate for Q2 gross domestic product, which rose to 3.1% from 3% last time out. While the number didn’t change much, it could reinforce perceptions that the economy continues to improve. It’s the first quarter with 3% growth in two years. The question is whether this strength can continue.

Investors appeared happy yesterday with what they saw in the tax plan, judging by market reaction. Still, a lot of details remain to be ironed out and there’s no guarantee the plan presented Wednesday will resemble its current form when finalized. Think of yesterday’s proposal as kind of being like the first bid on a house. It’s just the opening of negotiations.

Bottom line: Tax reform remains a potentially bullish factor. But the devil’s in the details, and it’s early to make predictions about how it might ultimately come out.

All the major indices rose Wednesday after Republicans presented their tax plan, but the biggest gains came in the Russell 2000 (RUT) index of small stocks, which rolled up a nearly 2% increase to another all-time high. The RUT is up more than 10% in just over a month, and that could partially reflect hopes for tax reform. One school of thought suggests that tax reform could help small stocks more than bigger ones, mainly because smaller companies tend to do most of their business within the U.S. Additionally, these companies tend to pay, on average, a higher tax rate than big corporations.

The info tech sector, which had been flagging, also stormed ahead Wednesday to come in second on the sector leader board behind only financials. Both info tech and financials climbed more than 1%, and consumer discretionary and energy — considered cyclical sectors — also posted strong gains, while the so-called “defensive sectors” trailed. So far this week, the market seems to have regained some of the “animal spirits” that fueled its rally earlier this year. Perhaps seeing more details of the long-awaited tax plan helped provide the spark.

Financials might have gotten a lift in part from the tax plan, but a crumbling bond market looks like the bigger story for that particular sector. Bond prices continue to face pressure early Thursday, with the 10-year yield climbing to 2.33%. That’s the highest it’s been since late July. Expectations for another Fed rate hike by the end of the year stand at above 82% after Fed Chair Janet Yellen’s comments earlier this week. There was a somewhat hawkish tone to Yellen’s remarks, and that seems to be pushing the bond market lower and chances of a rate hike higher. Financials tend to do well in a rising rate environment.

From a broader market standpoint, pre-market trading turned lower early Thursday. It’s hard for the market to keep this type of upward momentum we’ve seen lately day in and day out. As investors, it’s important to not set unrealistic expectations, and make sure to be prepared for both positive and negative action.

Data-wise, tomorrow brings August Personal Consumption Expenditure (PCE) prices, and research firm CFRA looks for a light gain of just 0.1%, continuing the trend of weak PCE price growth. On the plus side, CFRA sees personal income rising 0.3% in August, just below the prior month’s growth of 0.4%. Be on the lookout for this key data at 8:30 a.m. ET Friday, and watch the bond market and Fed funds futures for any potential reaction. The Fed is said to closely watch PCE readings.

Over in commodities, gold rose a tad early Thursday but remains below the psychological $1,300 an ounce mark. Meanwhile, oil futures have been on a tear lately, trading above $52 a barrel. The $55 level remains a significant one for front-month U.S. oil, because prices haven’t spent much time above that in more than two years. Yesterday’s weekly supply report from the government showed a surprise dip in stockpiles at a time of year when the supply build usually starts getting underway. That could be a hint that demand remains strong, a potentially positive sign for the economy.

FIGURE 1: TAX HOPES HELP FUEL SMALL-STOCK RALLY. The Russell 2000 (RUT) index of small stocks climbed nearly 2% Wednesday and is up more than 10% since mid-August, likely in part from hopes that tax reform could bring big benefits to smaller companies. The Nasdaq Biotech Index (NBI), represented by the purple line, has also posted big gains amid talk that lower corporate taxes might spur industry M&A. Data source: FTSE Russell, Nasdaq. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.    

Biotech Bonanza

Info tech might draw most of the headlines, but one industry sub-sector that’s up even more this year is biotech. By early this week, biotech stocks had risen 40% since Jan. 1, sparked in part by new drug approvals, industry consolidation, and talk of tax reform that some investors hope might spur even more mergers and acquisitions. This might end up being the case if the Republican tax plan allows big pharma companies to repatriate foreign profits, potentially putting more money in their pockets to consider new M&A, some analysts say. Back in 2015, biotech took a big slide amid worries about political pressures to lower drug prices. This hasn’t gone away entirely, and indeed President Trump has been a vocal advocate, but to some extent these concerns aren’t quite as prevalent compared with the more bullish factors moving the market.

Defense Running To the Sidelines?

There seems to be a little more appetite for risk in the markets this week, perhaps reflected by gold falling back below $1,300 an ounce Wednesday and the dollar coming off of recent lows. Bonds have also fallen sharply, sending 10-year yields back toward the high end of their recent range. Additionally, some of the more aggressive stock sectors like industrials and financials have been moving up. Even the info tech sector, which had sold off over the last few weeks, began gaining on Wednesday. The question is whether this so-called “risk-off” trading continues. One thing to watch is 10-year yields. If yields stay above 2.3% and manage to hold those levels for a while and gold remains below the psychological $1,300 level, it could indicate that investors have more confidence in economic growth.

High Home Prices Weigh on Real Estate

On a less positive economic note, the real estate market looks like it’s struggling amid high home prices, the negative effect of hurricanes, and limited availability. The most recent indication was Wednesday’s pending home sales for August, which fell a steep 2.6%, compared with Wall Street analysts’ expectations for a drop of 0.5%. That followed August new home sales on Tuesday that came in below expectations as well, in part due to Hurricane Harvey. The real estate sector sagged Wednesday, and lags the broader market by a wide margin over the last three months. On the plus side, mortgage rates are near their yearly lows, so perhaps that could get buyers more interested. High prices, however, remain a potential impediment. Briefing.com warned this week of the possibility of a “broader slowdown in the housing market related to affordability constraints.” The next real estate number to watch is mortgage applications this coming Wednesday.