Although markets have been preparing for the notion of tax hikes, a flurry of recent legislative activity may suggest where tax policy will eventually land.

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Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, September 15th, at 10:30AM in New York.

A flurry of legislative activity over the past week revealed a lot about where tax policy is likely going in the U.S. And while it’s not new news that taxes are likely going up, there are key market observations to be gleaned from the new details that have emerged.

First, as we’ve long expected, tax hikes appear to be falling short of the original White House request, reflecting the reality of what every Democrat, including moderates, could support. For example, the House Ways and Means committee’s proposals call for the corporate rate to go to 26.5%, not the 28% asked for. They also call for the highest capital gains rate to go up 5%, not the nearly 20% asked for. These numbers aren’t final, but from here we wouldn’t expect them to move higher. And that’s important for bond investors. In the short term, this means the total amount of revenue these measures can raise probably cannot offset the amount of spending being planned. That means some deficit expansion, and more bond supply could join with other macro factors, like improving growth and a fed on pace to taper, to push bond yields higher over the balance of the year.

Second, while the net fiscal package should mean deficit expansion and thus support for growth, the higher taxes could strain equity markets in the very near term. As our colleagues in cross asset strategy have pointed out, the substantial rally in U.S. stocks has left valuations stretched. Further, stocks could be sensitive to a slowing down in the goods economy as the growth cycle matures. Add new taxes to the mix, even the more modest hikes we expect, and it means that stock returns risk lagging for a bit as investors adjust to this more mixed, albeit still positive, macro outlook.

A final thought here: while we expect tax changes like these to come through, they are most certainly not a done deal. There are plenty of negotiating hurdles left to clear, and so we wouldn’t expect any finality on the debate until the 4th quarter of this year. We’ll, of course, keep you informed as the situation develops.

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