Third Quarter 2017

October 5, 2017 / Market Newsletter

Global equity markets continued their upward trend in the third quarter. As in the first half of the year, international stocks, especially Brazil, Chile, Russia and other emerging markets led the way. The S&P 500 index of large US stocks gained a respectable 4.5% and the Russell 2000 index of small US stocks gained 5.3%.

Equity markets advanced in spite of tensions regarding North Korea and the uncertainty of whether US tax reform will be passed, and if so, what form it will take.

International returns were helped as foreign currencies strengthened about 3% on average compared to the US dollar and 9% since the beginning of the year.

After two increases in rates earlier this year the Federal Reserve maintained its short term “federal funds” target of 1.0% to 1.25%.  The rate on long term ten year US Treasury bonds also remained relatively unchanged, closing the quarter at 2.3% slightly lower than the 2.4% in June and considerably higher than the 1.4% low last July.

The Fed also announced that this month it will begin reducing the $4.5 trillion in US Treasury and mortgage securities that they acquired during the financial crisis. They will initially reduce bond holdings by $10 billion per month and gradually increase that to $50 billion per month.   If anything, this planned reversal of QE (quantitative easing) would be expected to increase long term rates, but that has not happened yet.  Some economists believe that since most of the bonds the Fed holds are sitting as unused bank reserves, the QE reversal will have little impact on the economy or interest rates.

Bonds achieved modest returns with the US Aggregate Bond Index advancing 0.7% during the quarter and are now up 3.1% since the beginning of the year.

Returns for key indexes were:

 
3rd Qtr

2017

9 Months

2017

Dow Jones Industrials index 5.6% 15.5%
S&P 500 index 4.5% 14.2%
NASDAQ 5.8% 20.7%
S&P 400 mid-cap index 2.8% 8.2%
Russell 2000 small-cap index 5.3% 9.9%
Total International, excluding US 5.9% 21.6%
Dow Jones Global Stock index 4.7% 15.5%
Barclays US Aggregate Bond index  0.7 % 3.1%

 

Economic and Market Outlook   Although economic growth remains sluggish, the US economy appears healthy and resilient.  The slow growth has often been attributed to the increase in government spending and regulation.   Interest rates remain low by historic standards and US unemployment is a low 4.4%.

Tax reform will be a key item on the Congressional agenda this year and a significant reduction of the corporate tax rate would make stocks more attractive. Yet the US is still running a significant budget deficit, even after eight years of economic expansion, which leaves very little wiggle room for true tax cuts.  Historically the country would be running a budget surplus at this stage of the economic cycle, but both the size of the government and government spending have grown at least as fast as the economy.  This leaves little room to cut taxes now and little “ammunition” to use during the next economic downturn.  Our elected representatives seem to have forgotten that “budget surplus” is not a four letter word.  Increasing the deficit by cutting taxes without reducing spending will compound the problem.  Perhaps a prudent and face saving way would be for Congress to cut tax rates while also eliminating deductions, leaving tax collections little changed.

The earnings of US S&P 500 companies are expected to grow about 6% to for calendar year 2017, which is also a reasonable estimate of their long term growth. Over the long term, financial theory predicts that unless the price-earnings ratio changes, stock prices will grow in line with the sum of the rate of  corporate profit growth  plus dividends (currently about 2%), or a total of about 8%.  Since the price-earnings ratio of US stocks is relatively high, it will be unlikely for US stock returns to continue at their current pace for much longer.

Foreign stock markets, especially emerging markets are now more attractively valued than the US, and should produce better returns over the intermediate term. Of course they are also subject to more political risk and currency risk than US stocks.

Most economists expect interest rates to continue to rise, which will reduce the value of existing bonds. This will impact long term bonds more than short term bonds.  If the increase is slow, as expected, it will present a mild headwind for fixed income investors and most bonds (and bond funds) should continue to produce positive returns as interest income more than offsets the loss in value.  A significant increase in interest rates would likely produce volatility in the stock and bond markets.

We remain cautiously optimistic for the remainder of 2017. Because of the many political uncertainties here and abroad, it would be prudent to invest cautiously and expect that higher returns will come from outside the US. 

The growing government debt burden     Governments are prone to make promises they can’t keep and spend more than they take in. Over time, these annual deficits have become sizable debts.  Sometimes this debt can be disguised or not shown on financial statements.  On a national level, this has occurred in our Social Security and Medicare commitments.  On a state and local level this occurs in pensions and healthcare benefits promised to government workers and retirees.  The extent of the problem varies from state to state and locale to locale.  Every year, the non-partisan Truth in Accounting organization rates the states and for 2016 rated CT, IL and NJ in the worst shape.  CT and IL have liabilities of approximately $50,000 per tax payer and NJ over $67,000 per tax payer.  Municipalities such as Detroit and Stockton CA have already gone through bankruptcy.  Hartford and other cities which have made generous promises to government workers may face the same prospect.  This will pit taxpayers against government employees and bond holders.   Property values will fall and bondholders, tax payers, government workers and retirees will suffer.  Human nature suggests that the government will avoid taking responsibility and instead point fingers at others, including those who held office before them. Bond holders, property owners, tax payers and employees in cities and states which have promised more than they can deliver may face a challenging future.

Disadvantages of Variable Annuities   Variable Annuities (VA’s) can be an extremely complicated contract between an investor and an insurance company.  Besides being overly complicated, they are often illiquid and an expensive way to invest. Another troublesome aspect is that although taxes on gains are deferred until funds are withdrawn from the VA, all gains are taxed as ordinary income, rather than capital gains.  And upon death, there is no “step-up in basis” as with a taxable account, so your heirs may face a needlessly high tax bill when they liquidate the VA.


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.