- About WCG
- Our Team
- Our Services
- Account Access
Note for October Investment Committee MeetingSubmitted by The Wealth Consulting Group on October 17th, 2017
Summary and Conclusion:
Asset prices rose during August. The S&P500 index of U.S. equity market prices increased by 3.3 percent. The VIX fell to its lowest levels of the year – well below the levels preceding the election. The yield on 10 year U.S. government bonds edged back up to 2.33 percent, only slightly below the level preceding the election, when Federal Reserve officials intimated that a rate hike in December is a possibility. (The latest release on core and headline inflation based on the PCE price index registered 1.4% (headline) in August relative to August of 2016 and 1.3% on core. The Fed’s target is 2.0%.) The dollar depreciated 0.3 percent against the major currencies -- a level 8.7 percent weaker than its January 2 reading. I attribute the weaker dollar to a combination of slightly stronger than expected growth abroad, weaker than expected growth in the United States, and the perception of President Trump’s views on trade policy. I believe the lack of volatility and the modest positive direction of the markets since the Presidential election are due to market participants waiting for the resolution of Tax Reform legislation that contain a hoped-for capital gains tax cut, and perhaps the removal of the ACA investment income tax. The bond market is telling us that nothing much has changed with respect to the real economy since President Trump’s inauguration; any decline in the 10 year bond rate is due to lower expected inflation. I believe that Trump’s de-regulation policies will have a positive effect on output (as we have seen in the energy industry), so I think that we will eventually have higher 10 year yields and lower bond prices as these regulatory policies boost productivity and economic activity.
Washington policy officials have failed to move forward on the policy agenda of the White House with the exception of de-regulation and hurricane relief. The Senate failed to pass health care legislation, preventing the movement of a health care bill to a Conference with the House bill. The House passed a Budget, thus enabling a tax bill to move to the Senate that requires only 50 votes to move to the White House for the President’s signature. The Senate still needs to pass a budget and both chambers must increase the debt ceiling before the end of the year to avoid the possibility of a fiscal crisis. Going forward, the President has reached out to the Democratic leadership in the House and Senate to re-start health care legislation. At this point the two sides appear far apart on their aspirations for the content of such legislation. In any event, the Democratic leadership appears hostile to the repeal of the ACA investment income tax, so any such repeal would have to appear in the tax reform legislation. During the next two months, the market’s focus will be on appointments to the Federal Reserve Board and the prospective Chair, as well as prospects for and the content of tax reform legislation. The Fed is down to three Board members. Thus, the FOMC now has only 8 voters and for the first time in my memory the majority of the voting members are Bank Presidents. The President and House and Senate leadership agreed to a continuing resolution on the budget and a suspension of the debt ceiling through mid-December. The T-bill market rallied to remove the uncertainty premium in the October contract but inserted an uncertainty premium in the December contract raising the yield and lowering the price.
Of primary interest to us is the fate of the ACA taxes and capital gains taxes. The House is still determined to find a way to repeal the ACA taxes, even if the repeal is attached to legislation not associated with Health Care. Some in the Senate want to extend the wider coverage of Medicaid and there are some reports that they will pay for this and subsidies to cover those with pre-existing conditions by retaining the ACA investment income tax. Now that the short-term issues of the budget and debt ceiling have apparently been postponed until December, the Senate and House can move on to crafting Tax Reform legislation. Given the dysfunction in both houses of the legislature, I would expect little progress on tax reform and a risk of a sell-off in equity and bond markets if market participants surmise that there will be no substantive legislation on the ACA taxes or on a reduction of the capital gains tax in tax reform legislation until 2019.
I still believe the most likely outcome is that sellers will be reluctant to enter the market until there is a resolution of the legislation relative to the capital gains tax rate – the investment income tax in the Affordable Care Act (ACA) and the capital gains tax rate in the personal income tax legislation that is expected to be part of tax reform legislation. (See Becky Quick’s interview with Warren Buffet on CNBC’s Squawk Box on October 4th for confirmation of this hypothesis.) Thus I still see equity markets rising slowly on little volume with a relatively low VIX, at least through October and November. Given the uncertainty to the policy outlook, the consensus forecast for U.S. GDP growth in 2017 is in my view too optimistic by about 0.25 percentage points, although growth will receive a boost from the deregulation efforts of the Trump Administration, and counter-intuitively, from the recovery activity from Hurricanes Harvey and Irma. (Hurricane Nate will have little effect on U.S. GDP because Puerto Rican economic activity – as well as that of the Virgin Islands and Guam – is not included in the U.S. GDP statistics.) Firms will be unwilling to invest and equity traders will remain on the sidelines (perhaps putting a floor on any attempt at a market correction) until there is more certainty about what is in the tax reform (and perhaps a provision in a bill unrelated to health care that repeals the ACA taxes) legislation and when or if it will pass. The administration seems keen on a middle income tax cut, but appears to be less enthusiastic about eliminating tax breaks – their outline includes retaining the deductions for mortgage interest and charitable contributions.
The Federal Reserve left the Federal Funds rate unchanged at 100 to 125 basis points on September 20. The Fed statement indicated that the Fed would begin the process of reducing the size of the balance sheet in October by reducing its holdings of Treasury securities by $6 billion and that of mortgage securities by $4 billion. The Minutes of the meeting, to be released on October 11th, should give further guidance on the size of this so-called balance sheet normalization going forward. At this point in time, the size of the decline in reserves is smaller than the normal monthly movements of U.S. dollar international reserves held on foreign countries Central Bank balance sheets. While these relatively small reductions in the U.S. Federal Reserve Balance sheet should have only a relatively small dampening effect on equity prices, and toward a stronger dollar and weaker bond prices, these effects may well be offset or amplified by movements in the U.S. dollar international reserves of foreign Central Banks.
The balance sheet reduction will have more noticeable effect on asset prices when accumulated over a year. The FOMC raised its projection for U.S. GDP growth in 2017 to 2.4% from 2.2%, but maintained its long-term projections unchanged. While the median of FOMC members’ projections of the Fed Funds rate at yearend is 1.4 percent, the dot plots indicate that 4 members project a yearend rate of 1.15 percent – the current target rate. I doubt that the FOMC will raise rates with 4 dissents. Recent data on economic activity and inflation have come in weaker than the FOMC’s September 20 projection putting at risk the prospect of an additional rate increase this year. However, speeches and interviews of FOMC members have indicated that many still favor a December rate hike. Hence, the market has raised its estimate of the probability of a December rate hike to 77.9% from last month’s estimate of 31.3%. If the markets estimate of the probability of a rate hike remains in the 80%+ range, I believe the FOMC will raise the Fed Funds rate in December.
Recent Asset Market Behavior
Since the election, equity markets have moved upward on low volatility and unimpressive volume reflecting the expectation of lower capital gains tax rates (with at least the repeal of the 3.8% ACA investment income tax that had been expected to accompany a repeal or reform of the ACA). Thus, as the market finally climbed above the 2160-2240 level on the S&P500 in a sustainable way following the results of the Presidential election, sellers once again were motivated to step aside from the market in anticipation of at least a 16 percent reduction in capital gains tax rates. The result is an imbalance of buyers to sellers placing upward pressure on equity prices. (See Becky Quick’s interview with Warren Buffet on CNBC’s Squawk Box on October 4th for confirmation of this hypothesis.)
There is still some hope for a repeal of the ACA investment income tax and lower capital gains tax rates in tax reform legislation. House members have indicated that they plan to introduce legislation to repeal the ACA taxes on a bill unrelated to health care reform. My explanation for the rally in equity markets, which I assume will continue until tax reform legislation is passed or scuttled, is the perceived high probability that the 3.8 percent net investment income tax will be repealed either in tax reform legislation or an unrelated bill. This perceived high probability prospect means that a seller with capital gains can sell now and pay a 23.8 percent tax or sell later at a 20 percent tax (under Trump’s plan) or a 16.5 percent rate (under Speaker Ryan’s plan). That is, they can wait until the ACA investment income tax is repealed and pay at least 16 percent less in capital gains taxes. Since there are more buyers than sellers at existing prices as sellers wait for the lower capital gains tax rates, prices will continue to rise, although slowly, with restrained volatility, and with a reduced volume of transactions. At current valuations and the prospect that there will be some significant losers as well as winners in the business tax reform legislation, I would expect a selloff on relatively high volume once tax reform legislation is signed and implemented. (If the ACA tax is repealed effective 2018, I would anticipate a selloff in January 2018). I believe, net, the effect of the tax reform legislation will be negative in the short run and positive in the long run depending on the content of the legislation. There no doubt will be losers and my belief is that these losers (as well as those affluent tax payers that will enter the market to cash out capital gains at the prospective lower rates) will drag the entire market down until investors have a view of the quantitative effect of the legislation on the winners. That said, if firms believe that tax reform legislation will pass this year effective in 2018, we should begin to see firms postponing dividend payments and bonuses until 2018. We don’t yet see any evidence of this behavior, although Warren Buffet implied in his interview with Becky Quick that he may be contemplating such actions.
Following the election, long-term (but not short term) interest rates (the 10 year and 30 year) rose substantially (and bond prices fell) but rates have retreated and bond prices rallied somewhat this year, and 10 year Treasury yields stand at pre-election levels.. I believe this outcome is based on the belief of faster growth under a Trump administration based on deregulation, increased investment, higher productivity growth and higher inflation. As difficulties with executing the Trump agenda became apparent, investors’ expectations of higher growth and inflation cooled, and long-term interest rates declined. I believe 10 year rates will increase as the economy responds favorably to President Trump’s de-regulation policies, and the Federal Reserve begins balance sheet normalization and raises the Federal Funds rate.
I believe that volatility will pick up once we see more specificity in the content of the tax reform legislation and a better idea of the likelihood and the timing of tax legislation passing. Market participants are now more certain of Federal Reserve interest rate policy in 2017 (a 78 percent probability of an additional rate increase in December).. The Fed dot plots project 1 additional rate increase during 2017 by 12 of 16 FOMC members – 11 of 15 if we discount Stan Fischer’s vote. The Fed left the Fed Funds rate unchanged at 1.15% at its September 20 meeting. The Fed will release the minutes of the September 20 FOMC Meeting on October 10th. These minutes should include additional information regarding the timing and size of its plans for balance sheet normalization.
The President’s (and Congress’s) Policy Agenda
At this point in time, the President’s focus is on national security, immigration issues, and changes in staffing in order to implement his agenda and communicate his message to the electorate. He appears to be taking a more aggressive stance on deporting those residents with no or expired immigration documents. The Administration also has restricted H-1 visas presently given to skilled tech workers and demanding preferences to U.S. workers (presumably citizens rather than permanent resident visa holders). Thus at this point in time, it appears that the Administration will move to restrict legal immigration as a means of protecting the incomes of American workers – both laborers and professional and technical workers -- rather than encourage more legal immigration as a way of raising economic growth and providing the necessary tax revenue to support Mr. Trump’s stance of saving old age pensions, disability payments, Medicare, and Medicaid. The Attorney General used such an argument to defend the Administration’s decision to end the DACA program. President Trump has directed reductions in both financial and environmental regulations. We are hearing little regarding infrastructure investment except for the privatization of Air Traffic Control. Commerce Secretary Wilbur Ross has been working to revise U.S. trade policy and the Administration is in the process of re-negotiating NAFTA. The re-negotiating of NAFTA is not going smoothly.
The contentious issues regarding the Budget and the increase in the Debt ceiling have been pretty much ignored by the financial press. With the poisonous political atmosphere in Washington, smooth reconciliation of both issues is not assured, even though the resolution deadline has been moved back 2 months. A rocky resolution could give markets the jitters – especially bond and credit markets. Thus, December and January could be vulnerable months for the bond and equity markets, especially if market participants know more about the content and the probability of passage of tax reform.
Foreign exchange markets have also remained relatively stable. The key managed exchange rate countries increased their international reserves a combined $20 billion last month, contributing to the depreciation of the dollar. This is twice the size of the Fed’s proposed October balance sheet reduction under the balance sheet normalization program.. (The dollar depreciated 0.3% last month against major currencies and has depreciated 8.7 % since the beginning of the year.) This is in stark contrast to the $123 billion drawdown of reserves relative to last August by a combination of China, Saudi Arabia, and Japan that led to an appreciation of the U.S. dollar.
The path of oil prices and the pace of development policies, especially in China, have contributed to a recovery in emerging market countries and a reduction in the U.S. merchandise trade balance. China maintained its level of international reserves since the beginning of the year, but their reserves are still $78 billion lower than in August 2016. (Net, international reserves increased last month contributing to the depreciation of the dollar by 8.7 percent since the beginning of the year.) The decision of the People’s Bank of China (PBOC) to stabilize the value of the Renminbi could lead to further volatility in asset markets if the outlook for economic activity in China changes. Most economic forecasters have not yet updated their predictions for 2017 and 2018. They appear to be awaiting the release of the IMF Global Economic Outlook on October 10. Without the previously assumed fiscal expansion in the United States, most forecasters see 2017 looking much like 2015 and 2016. Growth in Japan is projected to be higher, Russia is expected to recover due to the rise in oil prices and the recession in Brazil is projected to end. The outlook for the global economy in 2018 looks a little brighter as higher growth in the Advanced Economies with continued low dollar interest rates and a depreciated dollar has reduced the risk of financial crises and gives a slight boost to emerging market economies.
Economic activity in the Advanced Economies is moving along its full employment growth path. Most analysts have reduced estimates of growth in 2016 due to weaker data for trade among the Advanced and Emerging Market economies. The U.S. economy grew 1.8% (Q4/Q4) during 2016. The third estimate of 2017Q1 GDP growth was 1.2 percent, somewhat below its estimated full employment growth rate. The BEA’s third estimate of 2017Q2 growth is 3.1% yielding growth during 2017H1 of 2.1%, SAAR. The Atlanta Fed’s estimate of 2017Q3 growth (GDPNOW) is 2.7%. Growth in 2017Q3 will be affected negatively by perhaps 0.2 of a percentage point due to the effects of Hurricanes Harvey and Irma. This negative effect will be more than offset by the recovery activity during 2017Q4 giving U.S. GDP a net positive effect on GDP during 2017H2. The consensus forecast for U.S. growth in 2017 is 2.2%, a bit below the last FOMC forecast of 2.4 percent; but above the full employment growth rate given recent anemic readings on productivity. (The Fed has gradually reduced its estimate of full employment growth to 1.8 percent.) I would expect U.S. growth just above 2.0 percent during 2017 as the economy receives a boost from deregulation and the hurricanes – especially in the energy sector and construction. Investment will experience a headwind from tax reform, especially if tax reform legislation does not take effect until 2018 (and tax reform legislation includes expensing of investment expenditures). Note that despite an average growth rate of 2.1% during the past 4 years, the unemployment rate has declined by 2 percentage points. Thus it is doubtful that the full employment growth is as high as 2.1%. In addition, with the 1 percent growth rate of the economy during 2016H1, the unemployment rate was steady. The combination of slow GDP growth combined with healthy gains in employment is easily explained by our convergence hypothesis. As firms shift the higher productivity manufacturing jobs abroad, new service oriented firms hire workers for lower productivity jobs at lower wages thus accelerating the convergence process. In the more sclerotic labor markets of Europe, the result of the process is more unemployment. This shift in manufacturing jobs abroad will likely slow or even reverse due to demographic and wage inflation headwinds in China – Chinese firms are shifting jobs abroad to Viet Nam, Indonesia, and other ASEAN states and even to the United States – and a shift in U.S. trade policies in a Trump Administration. Forecasters that assume a positive U.S. fiscal stimulus next year project U.S. growth in the 2.5-to-3.5 percent range for 2018. Forecasters that don’t assume a fiscal stimulus (such as the FOMC) project U.S. growth in the 2 percent range.
Wage inflation, hence U.S. goods and services inflation, declined during the past two months. U.S. core PCE prices rose 1.3% (Aug17/Aug16). The increase in wages appears to be the pass-through of minimum wage increases as wages have shown their sharpest increases at the beginning of the year when the increases take effect. There are also indications of a tight labor market in the construction industry which has been explained in part as a reaction to the Administration’s immigration policies. Many technical jobs are remaining unfilled as employers are unwilling to offer a high enough wage to attract qualified candidates.
The Euro Area is estimated to have grown at a 1.8% rate in 2016, despite the BREXIT vote. The Euro area as a whole has recovered from its latest recession but the migration crisis along with the political fallout from the influx of migrants lends a distinct down-side risk to the outlook for 2017. Most economists have reduced the negative effect of BREXIT on Euro area growth and have raised the growth outlook to the 2.2% range for 2017 and 2.0% for 2018.
The consensus estimate for U.K. growth in 2016 has been lowered to 1.8% due to the outcome of the vote to leave the European Union. Economists assume a negative effect of BREXIT on U.K. growth in 2017 and 2018, and project 2017 growth at 1.6%, and the 2018 outlook to 1.0%..
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.6% in 2016 and are projected to advance 2.1% during 2017. With a U.S. fiscal stimulus, Advanced Economies are expected to grow 2.0 percent during 2018. Without U.S. fiscal stimulus, Advanced Economies are projected to grow 1.8 percent in 2018.
The Emerging Market Countries growth has been slowing down, but is expected to pick up a bit in 2017. Brazil and Russia have been in recession but are expected to recover during 2017, although Brazil’s recovery is expected to be weak. Brazil is struggling from poor policies and a political crisis due to corruption (in Petrobras no less); Russia is slowing down due to sanctions and low commodity prices, but should be helped by the rise in oil prices. China’s economy is slowing from its 7.3% pace of 2014, but there is little consensus on how much they have or will likely slow down (as well as little belief in the validity of their published numbers). The data currently circulated for China estimate growth in 2016 of 6.7%. China’s economy is projected to grow 6.7% in 2017 and 6.3% in 2018. China’s international reserves declined by $78 billion since August of last year but have increased $11 billion last month contributing to an appreciation of the RMB with respect to the U.S. dollar. The increase in China’s reserves and small increases (net) in the reserves of other managed exchange rate countries has allowed the dollar to depreciate since the end of December. Saudi Arabian international reserves continued to decline at a steady pace and have dropped by $68 billion during the past year (August17 – August16).
In addition to U.S. and China monetary policy actions, oil prices will also move with news of OPEC and non-OPEC producers production decisions. Oil prices will end up where the Saudi’s are comfortable with the combination of price and Saudi output levels. The Saudis signaled to other producers at the recent (May 2017) OPEC meeting that they are comfortable with the current higher oil prices, as well as with cutting production. While higher oil prices that signal higher aggregate demand are on balance good for equity markets (because of the higher aggregate demand), higher oil prices due to cuts in production reduce aggregate demand and reduce profits, raise long term interest rates, and are therefore negative for both bond and equity prices. Thus far, U.S. shale production is offsetting much of the effects of OPEC cuts in production.
The consensus forecast of economic growth in the Advanced Economies appears promising, as most forecasters project an acceleration of growth in the United States in 2017. I remain skeptical that growth will rise above its potential rate, which is somewhere between 1.5 and 2 percent, although the economy should receive a boost in energy production from the Administration’s de-regulation efforts and in construction from the recovery programs for Hurricane Harvey and Irma. The United States expansion is getting ‘mature’, so U.S. growth should advance close to potential barring a pro-growth fiscal policy action. Therefore, I would expect growth during 2017 to be close, but still below, to the Fed’s projection of 2.1%. In addition, I don’t expect the past election outcome (the combination of Presidential and Congressional) to be positive for U.S. economic growth in the short run (2017). In the medium-term (2018 and beyond), growth should improve as long as the Fed increases interest rates and the legislature passes comprehensive tax reform which should stimulate investment and productivity growth. (In the short run, capital adjustment costs will likely depress growth.) The weak investment on machinery and equipment, both past and current, dictates continued low productivity growth – consistent with our convergence thesis, and with our view of the way that low policy interest rates affect inflation and savings and investment. Without higher productivity growth, it will be difficult to reach above 2% GDP growth absent an unanticipated large growth in the labor force.
If the Trump Administration’s economic policies provide incentives for private investment and legal immigration, then economic growth should begin to improve in 2018 and beyond. However, the uncertainty over the content of tax reform legislation and trade policy could give us more of a negative bump in 2017 than is contained in the consensus of forecasts of the U.S. economy. While tax reform should be bullish for economic growth and equity prices in the medium term, the uncertainty of the effects of complex legislation often results in short-term slower growth due to capital adjustment costs and declines in equity prices in sectors most negatively affected by the legislation. With a lower rate of potential output growth, it is more likely that a significant shock will push the economy into a recession. One such shock occurs when firms and individuals defer income given the prospect of lower taxes the following tax year(s). I see no evidence of firms deferring profits, dividend payments, or individuals postponing income into 2018 as yet. We should pay attention to this possible development. (At this point it does not make sense for firms to defer dividend payments to 2018 until tax legislation on tax reform and the ACA are passed.) To the extent that markets price in higher productivity growth from Trump’s policy agenda, the higher outlook for productivity growth should reinforce the increase in long-term bond prices as the FOMC continues to raise short-term rates. The other Advanced Economies face headwinds similar to those experienced by the U.S. economy from 2010 to 2014, so growth above potential in these areas seems a bit of a ‘rosy’ scenario.
William L. Helkie
William Helkie is not affiliated with LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Stock investing involves risk including loss of principal.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
No strategy assures success or protects against loss.