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Progress on the tax front could stoke animal spirits, says Morgan Stanley.
Expectations for strong corporate earnings and a rosy economic outlook have propelled the U.S. stock market to multiple records in recent weeks. But for stocks to make the next leg higher, Congress will have to get its act together and get the policy ball rolling, according to Mike Wilson, Morgan Stanley’s chief U.S. equity strategist.
“Tax legislation remains the most important political issue for the U.S. stock market as we get later in the year,” Wilson said in a Monday note.
For now, stocks are expected to continue grinding higher on the back of solid corporate results with second-quarter earnings projected to rise 6.7%.
Still, for the S&P 500 SPX, -0.01% to successfully test Wilson’s 12-month target of 2,700, the market’s metrics, such as price-to-earnings ratio, will have to improve and that largely rides on whether the politicians in Washington can get with the program, so to speak.
The stock market’s epic rally in the wake of the presidential election in November was credited by some analysts to the unleashing “animal spirits” on the back of widespread optimism over pending legislative changes that could rejuvenate the U.S. economy and boost the corporate sector. But much of that initial euphoria turned sour as investors grew impatient with the failure of the new administration to deliver the goods as quickly as expected.
As the chart illustrates, elation over the expectant policy boost fueled the market’s gains between November to February, but since March, the balance has shifted to earnings.
Efforts by Senate Republicans to pass a health-care bill this week suffered a setback in the wake of Sen. John McCain’s unscheduled surgery on Friday, burdening the controversial bill with more uncertainty. McCain’s absence from the Senate means that Republicans does not have enough votes to move ahead with a controversial plan to repeal and replace Obamacare.
The health-care bill is viewed as a critical step in paving the way for President Donald Trump to implement a business-friendly agenda that centers on slashing corporate taxes.
“No matter what gets passed in the next few months, we think just moving forward with a decision on the Affordable Care Act and taxes will provide the certainty necessary for companies and individuals to ‘act’ on their higher confidence readings which have remained elevated,” Said Wilson.
“Specifically, this could mean higher levels of borrowing, capital spending, and M&A which should provide rising confidence in 2018 earnings and the potential for higher multiples and equity prices,” he said.
The strategist believes investors have yet to price in the impact of tax cuts in 2017 earnings. As a result, any sign of progress on the policy front will be a major shot in the arm for the stock market.
“The most direct route to a late-cycle euphoric stage where multiples rise to 19 times is a renewed sense of confidence in the ability of Congress to make progress on ACA reform and then on tax,” said Wilson.
Karyn Cavanaugh, senior market strategist at Voya Financial, also believes that once the long-awaited tax reforms materialize, the stock market will see the beginning of a true Trump rally.
“We have not seen anything from Washington yet,” she said.