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Tax Reform May Not Be All Positive for Stocks

Likely passage of tax reform is lifting markets, but there may be negative economic consequences. Below are some portfolio shifts to consider.

Equity markets have rallied sharply now that a tax package looks increasingly likely to pass. While there are clear near-term positives for stocks in the current bill, there are some long-term economic consequences that could turn out to be decidedly more negative. 

My main concern is that the passage of the tax bill could bring the next recession closer. That’s because it will likely boost growth at a time when Gross Domestic Product (GDP) growth is healthy, the job market is already tight and inflation is starting to perk up. That could prompt the Federal Reserve to pick up the pace of rate hikes to keep the economy from overheating. We’re looking at a recipe for the kind of policy action that could bring on a recession sooner than later – possibly as soon as 2019.

Yes, the proposed reduction in the corporate tax rate will likely have a positive impact on earnings growth, but much of that has already been priced into stocks. Also, while there are benefits to individuals, most of them likely accrue to wealthier taxpayers, who are less likely to fuel the economy with new spending. The way I see it, tax reform could overstimulate an already strong economy.

I suggest investors watch for rising inflation and consider replacing some of this year’s growth stock winners with more value-priced financial, energy, industrial and older technology firms that are most likely to benefit if tax reform passes.

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Morgan Stanley Access Investing