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Who said the stock market rally was over? After a slow start to the week, the S&P 500 hit another all time high. As of writing, the index is up 1.3% compared to last week’s close. Equities were helped by strong earnings and better than expected economic data. But interestingly, bond yields dropped on the news. At the time of writing, the 10-year Treasury yield was down nine basis points compared to last week. Usually, bond yields rise in response to strong data. The fact that yields drifted lower might seem like an anomaly but is likely due to the market already having priced in the economic recovery and inflation expectations. Meanwhile, growth stocks behaved as expected. Lower yields tend to increase future earnings of growth-oriented companies. So, tech stock rebounded as yields dropped.
On to one of economists’ favorite topic these days, inflation! Consumer prices jumped in March (Chart 1). Inflation rose 0.6% month-on-month (m/m), pushing headline inflation to 2.6% year-on-year (y/y). Meanwhile, core inflation (ex. food and energy) was up 0.3% compared to the previous month and 1.6% higher compared to a year ago. The rise in inflation was mostly due to energy prices which went up 5.0% on the month. Energy prices will continue to keep the headline inflation number elevated over the next few months. In fact, year-on-year inflation numbers are likely to push through the 3% mark given the drop in prices in the second quarter of 2020.
Still, its too soon to sound the inflation alarm. The unemployment rate is still 2.5 percentage points (ppts) higher than its pre-recession level and there are roughly eight million fewer jobs. The 5-year U.S. breakeven – a measure of inflation expectations based on the spread between nominal and inflation adjusted Treasury yields – has cooled since hitting its highest point since 2008 in March. Rest assured the Federal Reserve is watching this and other measures of inflation expectations closely. In fact, Fed Vice Chair Richard Clarida said that if inflation expectations were to “drift up persistently […] that would indicate to me that policy would need to be adjusted.” Clarida also added that the Fed’s “metrics of success” on inflation is keeping inflation expectations anchored at 2%. According to the Vice Chair, inflation expectations most recently stood at 1.96%.
Meanwhile, income supports, accelerated vaccine rollouts and loosening restrictions helped retail sales end the first quarter on a high note (Chart 2). Retail sales surged by 9.8% month-on-month in March, almost four ppts more than market expectations. The level of retail sales was a whopping 17.1% higher than February 2020, just before pandemic-induced restrictions took hold. Going forward, spending is likely remain robust as the job market strengthens and Americans tap into accumulated savings..
Sohaib Shahid, Senior Economist | 416-982-2556
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Corporate taxation has been the topic du jour for policy makers in recent weeks. In addition to President Biden's push to raise the U.S. corporate tax rate to 28%, Treasury Secretary Janet Yellen recently proposed a global minimum tax for larger multinational corporations, in order to "level the playing field" and avoid tax leakage.
This push comes after years of governments around the world actively reducing tax rates in order to attract corporate investment. Since 2004, the average global corporate tax rate has declined from 29%, to 23.7% in 2021 (Chart 1). For the U.S., it was only four years ago that the Trump administration passed one of the largest corporate tax cuts in modern history. The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the U.S. corporate tax rate from 35% to 21%, with the intent of triggering a corporate investment boom. Corporate investment has disappointed, but the policy did result in a greater percentage of profits being retained by large corporations. To be exact, corporate earnings after tax and interest payments rose from 67% of total operating earnings at the end of 2017, to 75% by the end of 2018. Corporations retained a larger share of the pie, while investors in these companies saw a valuation adjustment and strong price appreciation.
The international story is also telling. U.S. companies have spent years setting up and investing in holding companies (non-bank) domiciled in lower taxed countries. Indeed, roughly half of U.S. foreign investment has been in holding companies, with the majority of this investment in Europe. The TCJA eased this trend by lowing the corporate tax rate to more competitive international levels. Conversely, the Biden administration is proposing a different approach by proposing to raise the tax on overseas profits from 10% to 21%. The new strategy will calculate the minimum tax on a country-by-country basis, which should help address the tax avoidance issue.
Policy analysts know that U.S. corporate taxes are both controversial and convoluted. From an economic perspective, it is imperative the Biden administration strikes the right balance to ensure that corporate incentives to invest remain in place. Assuming the administration is successful in unwinding a large portion of the Trump administration's corporate tax cut, it must also make sure it does not erode U.S. competitiveness. Hence the focus on rewriting the rules globally. Thus far, we have seen supportive voices from Europe, stating that an agreement on corporate taxation could bring about stability. While there is a big difference between voicing support for ending tax avoidance and actually signing onto a U.S.-led agreement, this is a step in the right direction.
James Orlando, CFA, Senior Economist | 416-413-3180
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