Q4 2017 Economic / Market Recap
The stock market train of 2017 kept rolling throughout the 4th Quarter. All the major global stock markets finished 2017 with strong performances. The US Bond Market continued to chug along in 2017 in spite of continued calls of a Bond Bubble. In our view, 2017 represented a bit of an anomaly in that market performance was not only strong, but very calm.
In short, 2017 represented the smoothest, most robust stock market performance since 2013. It would be difficult to point to any specific negative moment for markets as markets across the globe set numerous records and all-time marks in 2017. The reasons behind this performance are numerous. However, we would point to the main drivers being improving economic conditions in the US, Europe and Asia. Also, playing a significant role is the hope and optimism in legislative measures that could continue to act as a tailwind for economic expansion.
Republican Tax Plan Impact
Throughout 2017 investors had hope and optimism that Republican leadership in Washington, DC would pass a sweeping tax bill that could serve as an engine of economic expansion. Some in the media expressed doubt after Republicans failed to act in unison and repel the Affordable Care Act (i.e., Obamacare). However, markets seemed to rarely express any doubt. As even the direst of news on the probability of a tax overhaul was met with only fleeting anxiety.
So, what impact will the Tax Cuts and Jobs Act of 2017 (i.e., Republican tax bill) have upon the US economy? In short, we would anticipate this being positive for the US economy. There are online tax calculators available to provide taxpayers with a rough estimate of the impact, positively or negatively, of the tax bill upon their unique situation. We would strongly encourage clients not to use these as an exact or definitively indication, but they may get you in the ballpark.
Obviously, there are hundreds of areas that the tax bill addresses and it would be impossible to dive into all of them in this newsletter. However, we do feel that there are a few really critical areas that we see being impactful as it relates to our clients. First, on the individual side. The income tax brackets and deductions have changed. The highest tax bracket levels have increased from an income of $480k, under the old law, to $600k under the new law if Married and Filing Jointly. Increases will be implemented for Single filers. The Standard Deduction will roughly double in 2018. This should continue to lessen the number of filers that choose to itemize their tax deductions. In addition, there are items that tax payers previously were able to deduct that will either be reduced or eliminated.
Second, on the corporate side. We would anticipate the largest impact for C-corporations, which represent many of the largest domestic companies. Some of these corporate tax cuts are permanent. The corporate tax rate will decrease from 35% to 21%. In addition, the tax bill would change the US to a territorial tax system, which in theory would reduce the advantage of headquartering US corporations in foreign countries.
In summation, we would anticipate the tax bill to being a net positive, at least in the short to medium term, for the US economy. Said plainly, 2/3s of the US economy is based upon spending. If corporations and individuals have more money in their pockets to spend from reduced taxes, in theory the economy should expand. The Joint Committee on Taxation estimates that this tax bill will increase GDP output on average by 0.7% over the next 10 years. If this occurs, then 3.5%-4% annualized GDP growth is a possibility.
As we discussed above, the global stock market in 2017 experienced its smoothest ride with the least amount of volatility in a long time. The US stock market is currently at its longest point ever without experiencing at least a 3% decline! In short, the US stock market has been on cruise control since the 2016 Election. Investors have taken advantage of continued record corporate earnings and improving economic conditions. The Bureau of Economic Analysis in December revised 3rd Quarter GDP numbers up to 3.2%, which comes on the heels of a 2nd Quarter GDP number of 3.1%. These numbers make a 3% GDP number for 2017 a possibility. If that comes to fruition, that would be the highest GDP growth rate that the US economy has experienced in almost 10 years! Clearly, a recession is not on the immediate horizon. If the US economy is not near recessionary levels (3% GDP growth is not recessionary), then we would peg the probability of a stock market crash (i.e., 20% or more decline) as very low.
The counter to the above positive economic news is that by almost every relevant data point, stocks are extremely expensive. One of our favorite data points is Yale Professor Robert Shiller’s P/E (price to earnings) Ratio that measures stock valuations going back to the 1880s. Shiller’s P/E Ratio is currently priced at the second highest point ever behind only the Tech Bubble of the late 1990s and early 2000s. To be clear, according to this one matrix, stocks are now more expensive than Pre-Financial Crisis of 2007, Black Monday in 1987 and Pre-Great Depression!
The bright side is that just because stocks are expensive does not mean that a stock market crash is imminent. In fact, stocks can continue to be very expensive for some time. In 2007, stock valuations peaked in May. The stock market did not start its multiple year decline until about 5 months later in October. Having said that we would strongly suggest to clients to expect a return to more normal volatility in 2018. We would anticipate, and frankly welcome, a moderate correction (i.e., 7%-15% decline) at some point in 2018. This would cause stock prices to reach a more reasonable level, which could enable stocks to stage another level higher after the correction ends.
We would also point out to clients that while the US stock market appears to be overvalued other global markets seem to be more fairly priced. Several top money managers favor non-US markets over US markets. In their 2018 Outlook, The Capital Group (American Funds’ parent company) stated, “In fact, market levels suggest that these better investment opportunities may continue in non-US markets.” Kathryn Koch, of Goldman Sachs, says, “Investors need to move beyond US borders to where there are interesting growth opportunities at much better valuations.” This is not to say international markets are cheap and primed to shoot up like a rocket, but rather that they are more fairly priced than US markets.
Federal Reserve Actions & Interest Rate Movement
The Federal Reserve continued its goal of normalizing interest rates in 2017. The Federal Reserve raised short-term interest rates to a range of 1.25% to 1.50% at their December meeting. The consensus amongst most economists to that the Federal Reserve will increase interest rates 3-4 times in 2018. This is significant as 3-4 hikes would put the interest rate yield curve at a near flat level (i.e., when short-term interest rates and long-term interest rates are very similar). While no one data point should be used to forecast potential market movements, interest rates along the yield curve has a fairly good track record to pointing out future recessions. The last three times the yield curve became flat a recession occurred relatively soon thereafter.
If the Federal Reserve increases interest rates 3-4 times in 2018, then the yield curve would be pretty close to flat by the end of 2018 to early 2019. At that time, it is possible, based upon historical data, that the economy may begin to show initial signs of slowing down. The importance is that market crashes are most often associated with recessions. If you can figure out the increasing probability of a recession, then you can figure out the increasing probability of a stock market crash. One caveat that must be made is that stock market crashes do not always coincide with recessions. In the early 1990s, the US economy experienced a recession, but the US stock market did not crash. Again, confirming the long stated adage that you can’t predict the stock market.
The other significant Federal Reserve event in 2018 is that Chair Janet Yellen’s term will end in February. Yellen’s term as Chair of the Federal Reserve has been marked by a very accommodative interest rate approach and fairly clear messaging as to the Federal Reserve future plans. This is significant because the two things that markets hate the most are surprises and uncertainty. Yellen did a good job in telegraphing the Federal Reserves’ intentions to markets.
Yellen’s successor is Jerome Powell. Powell became a member of the Board of Governors for the Federal Reserve in 2012. He has past experience in President George H.W. Bush’s administration and in the private banking world. The Chair of the Federal Reserve is the most powerful single person when it comes to the day-to-day function of the US economy. What can the US economy expect from Powell? Probably a similar path as the one under Yellen’s leadership. Powell has a reputation of building bridges across political aisles. While Powell is a Republican he does not have a history of disagreeing with Yellen’s policies. Again, markets do not like surprises or uncertainty. If Powell is able to continue Yellen’s strategy, then at least for the short-term, markets should approve of the change.
Markets in 2017 were able to provide investors with positive returns and little to no drama. A truly rare combination!
We would not anticipate this to continue throughout 2018. We would suggest to clients that market volatility is normal and healthy. It is not something that we should fear or run from. Currently, we hold low volatility positions in most client accounts. The strategy is that as market valuations improve we can, and will, deploy those positions into growth orienated strategies at a more attractive price. We believe that long-term investment success comes from staying committed to your own personal goals and risk tolerance, but also trying to take advantage of opportunities as they arise. We are ready to do that should those opportunites present themselves.
Over the medium-term, we would suggest to clients that the probability of significant storm clouds emerging over the next couple of years is high. Markets are now almost 9 years past the last Bear Market. That is getting on the longer end of normal. In addition, according to Robert Shiller’s research when stock valuations are this elevated, market performance over the medium term (10-15 years) is significantly below average. With that being said, we would suggest that investors banking on an average return of 10%+ from stocks over the next decade or so will be disappointed.
That is not to try to depress anyone, but to serve as a gentle reminder that markets seem to have a way of averaging themselves out over the long-term. As for the present, we do not foresee a major stock market crash on the immediate horizon short of some type of geopolitical crisis (i.e., North Korea, Iran, major terrorist attack, etc.). The economy simply looks too solid and corporations are mostly well positioned financially.
As always, we hope that you have a properus 2018!
Thank you for your continued trust and confidence.
https://www.wsj.com/articles/the-senate-tax-bill-has-a-cure-for-corporate-inversion-1511823252 “Marcoeconomic Analysis of the Conference Agreement for H.R. 1, The ‘Tax Cuts and Jobs Act’”. Joint Committee on Taxation. December 22, 2017. JCX-69-17.
http://www.multpl.com/shiller-pe/table?f=m“Outlook.” Capital Group. January 2018. Smith, Anne Kates. “Investors, Find Bargains
Overseas in 2018.” Kiplinger. January 2018.