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Hopes pinned on tax cuts to shape final quarter for US stocks

As the final quarter of the year beckons, US stocks sit in record territory and market volatility remains subdued.

Having navigated months of political turbulence in Washington and drawn strength from the global economic upswing, equities will begin the fourth quarter with the agenda dominated by the chance of major corporate tax cuts that helped galvanise the market when Donald Trump won the White House. The Russell 2000 index of small companies, which are seen as big beneficiaries of tax cuts, has outperformed this month.

Tax reform, one of the pillars of Mr Trump’s agenda, has come back to the fore with this week’s unveiling of a “framework” to reduce the official corporate tax rate to 20 per cent from 35 per cent. The Russell, in turn, has gained nearly 6 per cent versus the 1.4 per cent gain for the S&P 500.

“What we are seeing now is the potential environment that people were prepared for and equity markets had accelerated to in January — that reflationary trade,” says Michael Underhill, chief investment officer at Capital Innovations. But I do not think you see a wildly speculative flow. It will be more steady and constant.”

A failure to pass tax reform will leave investors looking to other factors to shape the final quarter of a year which has seen the S&P 500 climb almost 12 per cent. These include corporate earnings growth, the outlook for technology shares, Federal Reserve policy and escalation in rhetoric between the US and North Korea.

Given Congress and the Trump administration have failed to repeal Obamacare this year, some investors are not raising their hopes for tax cuts. Bob Browne, chief investment officer at Northern Trust Asset Management, calls tax reform “almost a free option for the market at this point”. Instead, his focus is on the synchronised global growth that he believes has been a key driver of the rally.

“We continue to focus on the global growth story,” he says. “That fundamental underpinning is what allows the market to ignore noise coming out of Washington and geopolitical risk overseas.”

And in the absence of tax cuts that should underpin a rotation to cyclical sectors that benefit from a stronger economy, investors are left with a market whose performance this year largely reflects a surge in technology shares. The S&P 500 information technology sector is up by about a quarter.

It is a showing that has led some bank analysts and mutual fund managers to worry that large US technology stocks are becoming a dangerously crowded trade. Consensus opinion appears to believe the so-called FAAMG shares — a Wall Street acronym standing for Facebook, Apple, Amazon, Microsoft and Google (Alphabet) — are risky bets. All are up by at least 18 per cent year-to-date, with Facebook surging by 44 per cent.

Indeed, in June Goldman Sachs analysts noted how “this outperformance [of FAAMGs] has created positioning extremes, factor crowding and difficult-to-decipher risk narratives”.

However, as some voice anxiety about high-flying tech stocks, well-followed investors continue to hold large amounts of them in their portfolios. Stanley Druckenmiller, the former number two of George Soros who was famously burnt by going long technology stocks just before the bursting of the dotcom bubble, held 33.4 per cent of his family office’s long equity exposure in just four stocks at the end of the second quarter: Microsoft, Facebook, Alphabet and Amazon, according to US regulatory filings.

While shares in the FAAMGs have risen sharply this year, not all of them appear expensive relative to the wider S&P 500, with some actually still trading at a discount to it. Alphabet trades on a trailing free cash flow yield in line with the S&P excluding financial stocks of about 4 per cent, while Apple and Microsoft offer a significantly higher 6 per cent and 5.5 per cent respectively. Only Facebook and Amazon trade at significant premiums to the market on this basis.

The rationale for owning technology companies reflects their robust growth prospects and generation of huge cash flows, set against the backdrop of a sluggish economy. A sustained period of low government bond yields has led some to dub this the Tina trade or ‘there is no alternative’ as investors push the tech sector higher.

That heightens the risk for tech shares, as well as the credit market, should bond yields extend their recent rise. After threatening to dip below 2 per cent at the start of September, 10-year Treasury yields are closing the quarter above 2.3 per cent after more hawkish comments from Fed policymakers raised expectations of a December rate rise. Tax cuts would likely fuel an upward move in yields.

Indeed, some credit managers are concerned that the bond market still does not reflect the true risk of rising rates. “The market is priced for what we have seen already this year, not for what the Fed is telling us,” says Henry Peabody, a portfolio manager at Eaton Vance. “There is a great deal of risk in rates and in long only credit as well. People are not prepared for it.”

For much of the year investors wrote off the prospect of Washington delivering tax reform, including significant cuts in the corporate tax rate. If they manage to, it could yet shape the final chapter of a year that has been defined by tech stocks.

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