Contributed by: Angela Palacios, CFP®, AIF®
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2017 in Review and Outlook for 2018
Fidget spinners, bitcoins, and Trump. If you have young children, you could not miss the fidget spinner craze that hit in April of this year. This simple toy rotates on a ball bearing. By the time I got around to getting my 10-year-old child one in mid-May for her birthday, they were SO yesterday. My major parenting fail of 2017! In the financial world, another mania took over. Bitcoin, while not brand new, certainly gained a ton of traction this year as an alternative cryptocurrency. The price of Bitcoin surged from below $1,000 per bitcoin to more than $19,000! This paved the way for many other cryptocurrencies (Bitcoin competitors) making their way to center stage with astonishing returns also. If you want more information, check out this blog Talking Bitcoin, written by Nick Boguth earlier this year.
The news cycle has also revolved around President Trump this year. While failing to overhaul Obamacare or U.S. trade policy, he was successful in getting some long-anticipated tax reform through to round out his first full year as our President.
The past year turned out to be far more bullish than many expected. International and emerging markets outpaced U.S. markets. Growth investing beat value investing, while Bonds returned little more than their yield. 2018 has a tough act to follow!
Tax Reform and its Impact on the Economy
Although the tax cut seems to favor corporations, much of the net tax cuts are going to the individual. The tax act should increase after-tax income for most American households both directly, through lower personal taxes, and indirectly, through the impact of higher dividends and stock prices resulting from the cut in corporate taxation. As people spend more, GDP should increase and unemployment should continue to decrease possibly causing the wage inflation we have been waiting for. This chart shows the level of unemployment (gray line) and the level of wage inflation the (blue line). The dotted lines for each color are average levels. You can see that both are below their average levels. Usually when unemployment is below average the wage growth line rises back to its long-term average level, but this has not happened yet. Retiring higher-paid baby boomers are being replaced with lower-paid millennials entering the workforce and this has had a significant downward pressure on wages keeping it well below its long-term average growth rate.
If wages finally start to increase, this could cause inflation to pick up somewhat. This would be a positive influence on the stock market in the short run.
Tax Reform and its Impact on Equities
Looking at the influence tax reform will have on corporations, smaller companies will likely see a more impactful tax benefit with the corporate tax rate cut to 21% (which consequently is just below the average of the countries in the OECD or the organization for economic co-operation and development). Currently, small cap companies pay the highest tax rates.
After a strong year for equities, the impact of tax reform could be more muted than you might think as the markets already anticipated some corporate tax reform passing. Quite often, equity prices factor these events in long before the pen hits the paper.
Tax Reform and its Impact on Fixed Income
Bond markets will have mixed implications from tax reform. Companies that over-levered and don’t have strong positive cash flow will be penalized. This new law places limits on the interest that corporations can deduct. This will likely affect companies who are issuers of high yield debt negatively. While companies investing for growth by making capital expenditures will be rewarded as, they are now allowed to expense a larger amount of these capital expenditures.
Municipal bonds should fare well next year with limits being placed on state tax and property tax deductions, especially in states with higher tax rates. Other opposing forces could affect supply within the municipal bond market in the coming year from tax reform. The law eliminates the issuance of advance refunding bonds that are used to retire old debt. These bonds help boost supply by 10-20% each year in the municipal bond market. On the flip side, corporations will be less incentivized to hold onto municipal debt as their tax rates have been slashed. If they sell these bonds into the market place that could increase supply, which could lower bond prices. However, these two forces may cancel each other out. It looks like the elimination of advance refunding bonds will likely offset any boost in supply from corporations selling.
Interest rates on the rise
The Fed raised short-term interest rates again in December, which was highly anticipated. They are planning to continue with three more rate hikes in 2018. The bond market already anticipates these rate hikes, which means they should be priced in. Jerome Powell is set to take over for Janet Yellen in February as the new Federal Reserve Chairperson. It is unlikely he will change the trajectory of increases expected in 2018.
The rate hikes have resulted in a flattening of the yield curve this year. The charts show side-by-side where the yield curve started 2017 and where it is finishing 2017. If you recall, an inversion of the yield curve, downward instead of upward sloping from left to right, or short-term rates higher than long-term rates, usually signals an oncoming recession. While we aren’t there yet, this can happen quickly, so it is something we are keeping a close eye on.
The exciting part of 2017 was the lack of excitement. 2017 saw incredibly low average daily moves in the S&P500. You can see from the below chart that standard deviation, or the variation of price movement by percent, for the S&P 500 is well below the typical range. It is currently below 6%, which has only occurred five times since 1940. Typically, it is between 10% and 18% each year.
During times like this, it is easy to get lulled into a false sense of security causing you to potentially reach for a little more risk to spice up your returns. But, it is important to remember that your risk tolerance isn’t nearly as stable as you think it is. Outside of our natural behavioral tendencies to want to chase great returns or hide from stocks after a sharp drawdown, our natural progression through life’s milestones can influence our tolerance for risk. Milestones like a house sale, job change, or death of a loved one can influence our desire to take on risk just like the market performance and volatility. This makes it hard to compare yourself and your portfolio’s returns to a static benchmark over the years. Before making any drastic changes to your investment strategy, it is important to discuss with your financial planner the importance of a diversified portfolio that fits with your unique long-term goals and tolerance for risk.
As we welcome the New Year, we don’t want to miss the opportunity to express our gratitude of the trust you place in us each and every day. Thank you!
On behalf of everyone here at The Center,
Angela Palacios, CFP®, AIF®
Director of Investments
Angela Palacios, CFP®, AIF® is the Director of Investments at Center for Financial Planning, Inc.® Angela specializes in Investment and Macro economic research. She is a frequent contributor The Center blog.
Check out our other Tax Reform articles:
The information contained in this commentary does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the professionals at The Center and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Investments mentioned may not be suitable for all investors. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The prominent underlying risk of using bitcoin as a medium of exchange is that it is not authorized or regulated by any central bank. Bitcoin issuers are not registered with the SEC, and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment. Securities that have been classified as Bitcoin-related cannot be purchased or deposited in Raymond James client accounts.