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By Morgan Stanley's Chief US Public Policy And Municipal Strategist, Michael Zezas.

Sunday Start: When You Have Your Dessert Before Your Vegetables…

Investors had it good over the past year when it came to the influence of US public policy on the markets. Even if the US government had not delivered the tax cut fiscal stimulus in our base case, legislative gridlock would have preserved a status quo that was already featuring some economic momentum. Meanwhile, concerns about a trade conflict could be safely deferred to another day, as the trade investigations that could lead to tariffs and the NAFTA negotiations required time to play out. Not surprisingly, our colleague Mike Wilson’s bullish call on US equities was spot on as the S&P 500 rallied 20% in 2017.

But something’s different this year. As our cross-asset team has pointed out, volatility is back across a variety of markets. UST yields have climbed, as one would expect in anticipation of better growth and coincident Fed hikes, but the curve has flattened considerably, reflecting longer-term economic anxiety. And while we certainly can’t blame this all on public policy, we think it’s played a meaningful role. Yes, stimulus has been delivered, and deregulation has started, but the time has come for some of the tougher realities of these policies, and the challenges of the broader policy agenda, to be accounted for. Said differently, we had our dessert, now it’s time for our vegetables.

The elevation of risks from US trade policy is the most obvious example of this dynamic, but not the only one. For investors hoping that deregulation will deliver benefits in the near term, we’d note that risks are very much to the long side, given that, based on the historical average, rule rewriting takes four years. Fiscal policy is another area that could disappoint as time marches on. In the near term, we don’t have high hopes for more fiscal expansion from infrastructure, given the limits of the midterm campaign calendar, key issue disagreements within Congress, and our own questions about whether the size and incentives of the current proposal would actually increase spending. And while tax reform’s near-term benefits are clear, looking a bit further out, it also introduced some meaningful ‘cliffs’ in the economy, like the expiration of full capex expensing in 2023 and the switch to more stringent corporate interest deduction limits in 2022.

When considering what that means for markets, it feels less like ‘morning in America’ than ‘happy hour in America’. In that sense, we’re pushing back on the notion that US policy actions have meaningfully extended the market cycle, instead arguing that markets have already largely reflected, and are currently pricing in, the benefits they delivered. Hence, we see more volatility to navigate as we work through the other side of the policy agenda. In US equities, for example, tax benefits are clear in their scale, but their use is murky. The nearly 8% move in 2018e EPS following the passage of tax reform aligns with our US equity colleagues’ estimate for full potential earnings benefit for the S&P from tax reform (~7.6%), leading us to believe that estimates are baking in a full flow-through of tax reform.

But with our finding that 44% of companies plan to reinvest tax savings, it is possible that spending on capex and wage growth will prevent a full pass-through, meaning 2018 earnings expectations may be too high. Ultimately our strategy team expects a range-bound market multiple as there are few growth accelerants on the horizon in the near term. The silver lining here is a better opportunity for alpha as the effects of tax reform and late-cycle dynamics should create more performance differentiation among US corporates.

In fixed income, our interest rate strategists see opportunity in yield curve flatteners as we onboard both Fed hikes and increased macro uncertainty. Against this backdrop, we prefer munis over US credit. Whereas munis benefit from lagged fundamental deterioration and positive return effects, given a longer duration profile, in US credit our team still sees downside that’s been augmented by the pro-cyclical effects of interest-deduction limits and the limited stated intention of companies to use their tax benefits to reduce historically high leverage.