This Week's Themes: Tax Reform and Key US Economic Data

Stocks should be helped this week by tax reform talk from Trump and key US economic data that confirm moderately strong economic growth and low wage/price inflation.  The low inflation data should keep open the possibility that the Fed will skip hiking in September, keeping Treasuries little changed. 

The Republicans face two objectives with regard to tax reform.   They understand that some form of tax reform is important to pass before the 2018 congressional elections.  But, they feel constrained by their desire not to blow out the Federal Deficit.   A small tax cut, one that is estimated to boost Real GDP Growth by a modest 0.25-0.5% in the first year, might meet both objectives.  It also might be the best result for the markets and economy.   Stocks would be helped, while Treasury yields would not climb so much as to significantly raise the odds of a recession in 2019 or 2020.

Why is a Small Tax Cut Better Than a Large Cut?
Smaller is better in this case because the economy is operating near full employment.  As a result, a large boost to the economy from tax cuts would elicit a sharp rise in longer-term yields and aggressive Fed tightening.  However, the fiscal boost would fade over time, while the drag from higher yields would worsen over time.  Arguably, then, the larger the tax cut, the higher the risk of recession a year or so from now.  

On the corporate side, a cut in the tax rate may be preferable to the full expensing of a capital investment being discussed.  (Full expensing allows companies to deduct the cost of an investment from taxable income in the year the investment is made, rather than spreading the cost over a number of years.)  To be sure, full expensing should have a larger bang for the buck than a rate cut in terms of stimulating business spending.  But, again, a large boost to business demand would likely be quickly offset by higher yields.  Moreover, a simple rate cut would eliminate much of the wrangling between capital-intensive and labor-intensive companies that full expensing would likely spark.  And, full expensing would be subsidizing companies' actions to cut labor costs, contrary to the Administration's presumed goal.

This Week's US Economic Data
The key data will be released Wednesday through Friday.  Consensus estimates are probably in the ball park, although the risk is that the 0.2% m/m estimate for Average Hourly Earnings is too high.  The Fed will be faced with the same quandary as before: moderately strong growth with no inflation.

                                                                        Consensus
Weds      ADP Estimate                                   183k m/m
              1st Revision to Q2 Real GDP            2.7% from 2.6%


Thurs     Core PCE Deflator                            0.1% m/m

Fri         Nonfarm Payrolls                              184k
              Unemployment Rate                         4.3%
              Avg Hrly Earnings                            0.2% m/m
              Mfg ISM                                           +0.2 pt to 56.5