US tax plan and protectionist fears upset stock market rally

The US stock market rally paused on Wednesday and even the major tech companies in the US saw stock prices slip, as the market digested Trump’s tax plans and news that the President would formally begin the process to take the US out of the Nafta trade agreement.

Why Trump’s tax plan is an economic risk too far

The trouble with Trump’s tax plan is that it was basically identical to the one he proposed during the election campaign, which was estimated to cost $7 trillion. When you have a budget deficit of 77% of GDP and have already hit your debt ceiling, then this type of tax plan is most likely unworkable. The pause in equity market gains could turn into a longer period of soul searching, as investors’ wait to see what Trump’s clout is with Congress.  

Investors’ were willing to give him the benefit of the doubt with the healthcare debacle, this time patience could run out, and risky asset prices could be vulnerable to policy implementation risk in the coming days and weeks, especially if Trump’s tax plan is torn to shreds by Congress’s deficit hawks, both Republicans and Democrats. The markets have been banking on a tax cut, and without one that is big enough they could be left disappointed.

A debt-ceiling debacle can be costly in many ways

But even if Trump’s tax plan is passed, this could be bad news for stocks down the line. An unfunded tax cut of this scale would increase the potential for a Congressional standoff over the budget deficit and the debt ceiling in the coming years. Although Congress is expected to pass a budget to extend the debt ceiling until September at the end of this month, this kicks the can down the road. It is worth remembering that the US debt ceiling crisis in July/ August 2011 caused a massive 16% drop in the S&P 500, and the market didn’t truly recover until the start of 2013. Thus, with or without a change to the US tax code, the Trump trade is starting to look vulnerable.

Protectionist fears hit markets  

The second thing to weigh on markets was confirmation that President Trump will sign an executive order that would take the US out of the Nafta agreement with Mexico and Canada. This harks back to Trump’s inauguration speech, which stoked fears of a protectionist agenda from the Trump administration. Financial markets fear protectionism, so we could see a deeper reaction on Thursday. US equity futures are negative at the time of writing, and the dollar index dipped below 90.0 on the news, while US Treasury yields reached their lows for the day, although the key 2.3% has held as support for the 10-year yield.

Why the Nafta news might only impact the markets in the short-term

But, there is good reason to assume that a withdrawal from Nafta might not have a long-term market impact.  According to Global Trade Alert, the US has actually implemented the most protectionist measures since the start of 2008, closely followed by Russia and India. This hasn’t stopped US markets from marching to fresh record highs. Although we expect some weakness in risky assets and the dollar on Thursday, this may be symbolic due to the political significance of the Nafta deal. Some also think the plan to withdraw from Nafta, could be a negotiating tactic to give the US the upper hand in future trade negotiations with Mexico and Canada, which could limit any sell off in stocks.

At this stage, it looks like Trump’s much anticipated tax plan could be a larger risk to the markets compared to his protectionist trade policies.