Equities have outperformed other assets classes in 2017

While the equity markets are looking stable thanks to hopes of tax cuts in the US, the road ahead is not entirely clear of challenges

Traders gather on the floor of the New York Stock Exchange (NYSE) in New York. In the first nine months of 2017, global equity markets have outperformed other asset classes. Brendan McDermid / Reuters

Global growth is on the mend with a broad-based recovery underway according to the IMF, taking in advanced economies and emerging ones including here in the GCC. Against this background the dollar is firm, interest rates are edging higher, global equities are improving and oil prices are also enjoying some stability.

For the moment at least financial markets are putting the geopolitical risks behind them and focusing instead on the positives of increasing economic momentum in the world economy. In the first nine months of 2017, global equity markets have outperformed other asset classes on the back of a broad pick-up in economic growth, improved earnings trajectories and, for the most part, geopolitical tensions that have so far failed to bite. Furthermore ample liquidity has overall been maintained in an environment in which inflation has remained becalmed.

Now, rising hopes of tax cuts in the US are the latest catalyst behind US equities reaching record highs, for over the 50th time since the start of the year, and for the dollar continuing to strengthen. The passage of a 2018 budget resolution bill through the US Senate last week is seen opening the door for tax cuts in the coming year, which is helping to buoy sentiment at a time when growth in the US economy is already strong and improving.

Significant tax cuts would certainly enhance growth expectations further and benefit financial markets. After all, without any significant legislation being passed so far in 2017, growth has already picked up momentum, earnings have been strong and the Fed has raised interest rates twice with another hike still looking likely before the end of the year. Any additional fiscal stimulus would cause growth forecasts to be raised again, but it may also increase the likelihood of interest rates rising faster as well if inflation begins to accelerate. This might create a dilemma for equity markets down the road, but for now merely the enhanced prospect of lower corporate taxes is proving sufficient for equity investors to take heart.

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Not surprisingly bond markets and the dollar are also reacting to the prospects of lower taxes and of potentially higher interest rates, with both yields and the dollar continuing to firm, albeit cautiously as inflation remains elusive. Until there is greater evidence of broad price pressures returning, the currency and bond markets will probably remain more guarded. They may also want to see who President Trump nominates to be the next Fed chair, with an announcement expected in early November. However, the indications currently are that they broadly like what is being promised on the policy front and are now waiting for policymakers to deliver.

The implications for oil prices are not necessarily straightforward, but they should also see some benefit from an environment of rising confidence which might eventually be manifest in increasing global demand. Of course the progress that Opec has made in helping to reduce the overhang of oil inventories is the main source of current oil price firmness. The extent to which this rebalancing continues to benefit prices might be seen as more of a positive for other financial markets, as another indicator of recovering sentiment, rather than the other way around.

However, markets may have to consider what might happen if the White House ultimately fails to get its way with Congress in passing a significant tax reform bill. After all Mr Trump has notably failed to pass any major legislation this year, even with majorities in both Houses of Congress, and there remain many inside the Republican Party who will be uncomfortable with tax cuts if they only succeed in adding $1.5 trillion to the budget deficit. US treasury secretary Steve Mnuchin has argued that tax reform should unleash much stronger growth that will prevent a widening in the budget deficit, but this view is not universally shared even amongst Republicans. Mr Mnuchin has also gone as far as to say that without tax reform US equities would be at risk of going into reverse. There is probably still a long way to go before Trump and the markets are likely to get their wishes over tax, but also plenty of time in which this latter prognosis might also get tested.

Tim Fox is the chief economist and head of research at Emirates NBD