Markets underpricing impact of tax reform, says BAML

“I think the market is not appreciating the risk of growth,” says David Woo, head of global rates and FX

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Growth potential: BAML’s Woo believes US growth could surprise to the upside

Markets are underpricing the potentially positive impact of US tax reforms, which could translate into more economic growth in the US than participants currently expect, says David Woo, head of global rates, foreign exchange and emerging markets fixed income and economics at Bank of America Merrill Lynch.

“The market doesn’t seem to be all that impressed,” he says. “My view is the market is much too complacent about the market implication of this tax reform.”

Congressional Republicans recently settled on a $1.5 trillion tax cut. While the measure is proving unpopular with middle-income voters, the reform is firmly aimed at corporates and is expected to boost repatriation flows.

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David Woo

This could cause a surge in short-term flows back into the US, while the move to a territorial tax system encourages faster repatriation. If these flows filter through to the economy through dividend payments and stock buybacks, US growth could surprise on the upside.

“I think the market is not appreciating the risk of growth. US growth will probably surpass to the upside, which means the Federal Reserve will be hiking more,” Woo says.

“The market is ignoring what is in front of their eyes right now… Immediately after tax reform passes, you’re going to hear this sucking sound and money is going to come back very quickly. That’s why we have the dollar going up,” he adds.

The market is ignoring what is in front of their eyes… Immediately after tax reform passes, you’re going to hear this sucking sound and money is going to come back very quickly
David Woo, Bank of America Merrill Lynch

Higher US rates and a stronger dollar would also have an impact on emerging market currencies, as higher rates have a negative impact on carry trade opportunities. Still, Woo says more volatility in EM pairs could make options attractive, particularly in those looking cheap at the moment, such as USD/TRY and USD/CNH.

China might see capital outflows as a result of tax reforms, and USD/CNY could depreciate next year, falling as low as 6.90 by the end of the year, Woo says.

EM headwinds

Anne Milne, a managing director in emerging markets corporate research at BAML, says the stance for 2018 is to be overweight in high-yield countries such as Argentina, Brazil, Colombia, India, Kazakhstan, South Africa and Ukraine.

Still, emerging markets face several headwinds next year. In addition to higher US rates and a short-term dollar rally, there is the potential for a slowdown in China and tapering by the European Central Bank. As a result, investors will need to be more selective when it comes to emerging markets.

Claudio Irigoyen, head of Latin America economics and fixed-income strategy at BAML, says he sees a lot of growth pickup in emerging markets, particularly in economies that still offer a high carry.

“Local markets should yield higher next year,” he says. “Argentina has the opportunity to become the star of the emerging markets.”

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