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First Quarter 2018 - Pinnacle Investment Management, Inc.

First Quarter 2018

April 6, 2018 / Quarterly Newsletters

Global equity markets began the year on a strong note, but quickly reversed course as economic and political uncertainty led to market volatility.  Most equity markets ended the quarter with small losses as investors became concerned that the course of the Mueller investigation, rising interest rates and the possibility of US tariffs would lead to a trade war.  After a “Goldilocks” 2017 with attractive returns and low volatility, equity markets appear to have returned to a normal state, where temporary declines of 5% to 10% in an otherwise rising market are routine.  The S&P 500 index declined 0.8% for the quarter, while a broad index of foreign markets declined 0.2%.  Emerging Markets, especially Brazil and Thailand posted the strongest international advances while India and Canada suffered declines.

 

In 2017, there were only eight days in which the S&P 500 moved up or down by 1% or greater.  (Four days were advances and four were declines).  In 2018 that was tied in early February and more than doubled in the first three months of the year.

 

The Federal Reserve raised short term interest rates by 0.25% in March (to a range of 1.5% to 1.75%), an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability.  Many economists expect that the Fed will raise rates two more times in 2018 and continue raising them in 2019.  As a result of a strengthening economy the interest rate on ten year US Treasury bonds rose from 2.4% at the beginning of the year to 2.7%.  Rising interest rates created a headwind for bond and stock investors and the US aggregate bond index lost 1.5%.

 

Returns for key indexes were:

Full Year

2017

1st Qtr

2018

Dow Jones Industrials index 28.1% 2.0%  
S&P 500 index 21.8% 0.8%  
NASDAQ 28.2% 2.3%  
S&P 400 mid-cap index 14.5% 1.2%  
Russell 2000 small-cap index 14.6% 0.1%  
Total International, excluding US 27.5% 0.2%  
Dow Jones Global Stock index    21.8% 1.4%  
Barclays US Aggregate Bond  index    3.6% 1.5%  

 

Economic and Market Outlook   The reduction in the US corporate tax rate in 2018 is contributing towards very positive earnings growth.  It is estimated that US corporate profits will grow an estimated 15% to 20% this year making US stock valuations more attractive.  Since it is unlikely that tax rates will be lowered any further, this should be considered a one-time boost to earnings.

 

The US economy appears healthy and resilient, although economic growth remains sluggish.  Interest rates remain low by historic standards and the US job market continues to strengthen.  Unemployment is 4.1%, the lowest level in seventeen years.   Inflation, which often moves in the opposite direction of unemployment, still remains low.   It is somewhat unusual to have low unemployment combined with low inflation.  The Federal Reserve’s goal is to raise interest rates sufficiently to avoid inflation and an “over-heated” economy yet without raising unemployment or tipping the country into a recession.  Historically this is a task that has not been easy for the Fed to do and a miscalculation may pose a risk to the economy and the financial markets.

 

In addition to raising interest rates, the Fed is reducing the $4.5 trillion in US Treasury and mortgage securities they acquired during the financial crisis under a program termed QE (“Quantitative Easing”).  QE had never been tried before and there are significant differences of opinion among economists as to what the impact (if any) of QE has been so it is also not clear what the result of the QE reversal will be.

 

The Fed’s moves to increase short term interest rates, the reversal of QE and a strong labor market, make it extremely likely that both short term and long term interest rates will continue to rise through 2018 and into 2019, creating a headwind for both stocks and bonds.

 

Although the US economy is growing, there is a good deal of political, economic and market uncertainty resulting from a host issues, including:

 

  • Will the Federal Reserve’s moves to raise interest rates lead to a recession?

 

  • Will the recent imposition of US tariffs lead to a trade war?

 

  • Will the “Facebook backlash” resulting from a data breach cause significant changes in user behavior and / or spill over to other technology or social media firms?

 

  • Will the Federal Reserve’s actions to reverse Quantitative Easing (by not purchasing new bonds as their current holdings mature) lead to any unintended consequences?

 

  • Will the continuing shake ups in the White House lead to decisions or statements which may jolt the financial markets?

 

  • What course will the Mueller investigation (and other legal issues facing the President) take?

 

  • Will the S&P 500 be able to continue its winning streak and advance for ten years in a row?

 

Future long term US economic growth will be significantly limited by the anticipated very low growth in the US working age population (both natural born and immigrants).  This could be remedied by increasing immigration but that appears to be unlikely given the current political climate.

 

Both developed and emerging overseas markets are more attractively valued than the US.   The S&P 500 index is currently valued at about 16.1 times anticipated 2018 earnings, in line with their 20 year historic average.  In contrast, a popular index of international stocks is currently valued at about 13.3 times expected 2018 earnings, below the US,  and also below the 20 year average of 14.5 for the same index.  While international stocks would also likely suffer in a trade war, the valuations make them compelling investments.

 

In spite of the risks mentioned above, the US economy should be resilient if we can side step any significant political miscalculations.  If so, the equity market is likely to advance modestly in 2018 albeit with continued volatility.

 

“Reading tea leaves” resulting from statements from the White House may be a risky business, but I suspect that the current saber rattling over tariffs and trade will turn out to be posturing and not result in a trade war.  If that is correct, any market declines following White House (or Chinese) statements regarding tariffs will represent a buying opportunity.

 

Charitable donation strategies under the new tax law  Although the new tax law changed some rules, you should not reduce donations to worthwhile causes.  Charitable donations are still deductible under the new tax code, however state and local taxes are limited to a combined deduction of $10,000 for both single and married and the standard deduction has been increased to $12,000 for singles and $24,000 for married.  It is likely that fewer people will find it beneficial to itemize, and if they don’t itemize, they may not receive a tax benefit from their donations unless they become creative.  A few strategies for optimizing tax benefits from charitable contributions include:  (1) grouping your donations (and other deductions) into alternate years (making 2 years worth of donations in a single year) so in total they exceed your standard deduction, (2) Establish a Donor Advised Fund (DAF) so you can make one large contribution which you can distribute to charities over the course of multiple years and (3) If you are over 70-1/2 donate directly from your IRA.  Whenever possible, donate appreciated securities rather than cash to avoid a capital gain tax when you sell the security.


About the author

John Eckel: CFP®, CFA is President of Pinnacle Investment Management Inc. of Simsbury. He has been included in BusinessWeek.com’s list of the Most Experienced Independent Financial Advisors, has been named four times to Worth Magazine’s list of Top Financial Advisors, included twice in Medical Economics list of Top Financial Advisors for Doctors and named twice in JK Lasers list of Top Professional Advisors for Baby Boomers.


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