Consequences of Tax Cuts Starting to Impact Markets

When the changes to the tax rates were approved in Congress last year, I voiced my concerns about possible unintended consequences. One major concern was the one-time special treatment for companies to repatriate overseas assets back into U.S. dollars and how that would drive the dollar higher against other currencies. The rally in the dollar didn’t take place immediately, but from mid-April through late May it rallied sharply.

There are both pluses and minuses to having a strong currency. Importers, individuals and companies alike, benefit as the same number of dollars will buy a greater quantity or they can buy the same quantity for fewer dollars. Exporters suffer as their products become more expensive due to the dollar rising against other currencies. Emerging market economies tend to suffer when the dollar rallies against their currency and that is what we are seeing now.

Since the top in the S&P in January, we have seen the dollar rise. This has had an impact on the markets in several ways. The Russell 2000 has outperformed the S&P 500 and it has been less volatile this year as well. The Russell is benefitting because they are less susceptible to the ongoing tariff was, but also because small-cap companies are less likely to be major exporters. They are more apt to be net importers than large-cap companies.

The other impact has been on emerging market markets. The chart below shows how the iShares MSCI Emerging Markets ETF (NYSE: EEM) has lagged as the dollar has been rising. The EEM has lost almost 11% since January 26 while the dollar has gained 5%. During this same time period, the S&P is down 3.6% comparatively.

For now, the rising dollar hasn’t had an impact on earnings and nor have tariffs and counter tariffs. However if the dollar continues to strengthen and the trade war intensifies, it will have a major negative impact on the earnings of large-cap stocks. It will affect those with the greatest reliance on exports the most.

Small-cap and emerging market stocks will likely continue to move in opposite directions for a while, but if the dollar continues to strengthen and if the tariff war doesn’t get resolved, both the Russell 2000 and the EEM will likely move lower. The reason is that the dynamics of the global economy will have changed from what we have had for the last few years. If global trade is disrupted as it stands currently, inflation is likely to pick up worldwide and we run the risk of having a global recession.

Lower tax rates for corporations are certainly a benefit to the companies, but the rising dollar and a trade war would far outweigh the gains from lower taxes. There isn’t much the administration can do about the exchange rate now. The greater demand for dollars will drive the price higher. However, the administration can control the trade discussion.

I have asked the question before and I will continue asking it. How far is the Trump Administration willing to go with the tariff threats?

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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