11/21/2017
Stocks struggled for the second straight week, searching for direction while Congress wrestles with tax reform and the bond market wrestles with a spasm of risk aversion and a flattening yield curve.

The S&P 500 slipped just 0.1 percent, after shedding 0.2 percent the week before. Hardly cause for concern, but the index has now shed 0.6 percent while falling in five of the seven trading sessions since peaking on Nov. 8. If stocks are waiting for clarity on the details of tax reform, it is an open question on how much of a boost the final legislation is likely to provide. Certainly, final passage is not a slam dunk, nor are the most promising details for shareholders, including the 20 percent corporate rate. But both seem likely, suggesting the downside risk of failure is greater than the upside of passage.

If the lower corporate rate is made permanent, then the beneficial impact will be felt over time, as capital spending plans can be made with greater certainty about the future, at least as far as taxes are concerned. But whether the proposed drop from the current 35 percent statutory rate will provide an immediate windfall boost to corporate earnings is debatable, since the average effective tax rate of U.S. companies has been estimated by the Center on Budget and Policy Priorities to be around 24 percent. To be sure, that average itself is volatile, and it also masks a wide range of tax rates paid at the individual company level. So, some companies will benefit more than others and those names will change over time. A lower tax rate will certainly help, but whether it results in a surge in aggregate earnings in 2018 and beyond remains to be seen.

The Bond Market Prepares for the Next Rate Hike

The spread widening in lower quality bonds that had been underway since Oct. 24 paused last week. The option adjusted spread of the Bank of America Merrill Lynch High Yield index over governments was unchanged on the week at 376 basis points, but not before widening out to 397 basis points on Wednesday, and subsequently receding following the House’s passage of its version of tax reform on Thursday. Bonds rated in the C range followed a similar pattern, but still widened on the week by a slim 4 basis points.

The Treasury curve continued to flatten last week, falling to a new cycle low of 62 basis points. The move came because of the two-year note continuing to climb in anticipation of a Fed rate hike in December, and perhaps more to come next year, while the ten-year note has plateaued in the absence of discernable inflationary pressure. Since the start of October, the constant maturity two-year note yield has risen from 1.49 to 1.73 percent, while the ten-year note yield has risen all of one basis point to 2.34 percent. To be sure, a flattening is not as worrisome as an inversion, and there is nothing wrong with good growth with low inflation. And until that benign condition changes, a shallow sloping curve is fine.

What’s the Fed’s Next Move?

If the Fed continues its intended path of rate hikes in 2018, believing that inflation will soon percolate, the possibility of a policy mistake and an inverted curve is not out of the question. Investors are skeptical. As long as inflation remains a possibility rather than a reality, investors are betting that the Fed will once again be forced to scale back its forecast of the number of rate hikes it anticipates, and the benign backdrop of low inflation and low interest rates will persist.

The Fed will release the minutes of its November meeting on Wednesday, and presumably we will learn more about its current mindset. Investors have come to terms with the likelihood of a December rate hike and one more in 2018, not the three more that the Fed has penciled in. Keep an eye on the Nov. 30 release of the October Personal Consumption Expenditure deflator report, and average hourly earnings in the November jobs report on Dec.8 for further evidence of who is right, at least for now.    
  
Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Ameriprise Financial, Inc. and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.
Indexes are unmanaged and are not available for direct investment.
The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis (BEA).
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
Data on the employment situation is released monthly be the Bureau of Labor Statistics. 
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