Given that the United States has not had a tax policy change in over thirty years, this edition of our quarterly update will be a special version summarizing the changes. In a small newsletter like this we can’t cover everything that the new tax policy covers, but we will try to cover the policy change relative to the markets and the potential impact on the markets, and thus portfolios. Our allocation recommendations remain the same, so no changes there. Let’s take a look at the new tax policy summarized for the markets:
Expected Market Reaction: Every Wall Street brokerage house and pundit has released an opinion on the impact of the tax policy. Generally speaking, the expectation is that the new policy will be a positive impact for the stock markets, but a neutral impact on bonds. Because the corporate tax rate has been significantly lowered, the expectation is that earnings will go higher as less money pays for taxes. Fundamentally speaking, the old adage of “earnings drive stock prices” rings true, even if it may not always be an immediate impact.
Our Commentary: While earnings ultimately do drive stock price movement over the long term, in the short term there can be drops or skyrocketing prices due to investor emotions. The only real force that drives stock prices – or any prices for that matter – is the force of supply and demand. Sometimes demand is driven by emotion as humans are imperfect beings and get emotional (see the Tulip mania and the current Bitcoin craze), whether that be too overzealous, too pessimistic or the infamous “irrational exuberance” coined by former Federal Reserve Chairman Alan Greenspan. At other times, investors, or “Mr. Market”, as Benjamin Graham referred to investors comprising the market as, can be rational. And over the long term, it appears that emotions fade away and clear thinking comes back to investors. Thus, earnings drive prices over the long term, but one must realize that emotions can get in the way in the short term. All this being said, the economy is bigger than the stock market so in our analysis, we’ll break down the potential impact of the tax policy into three main categories: The Economy, Interest Rates and Stock Markets
Economy: The tax change should increase GDP by around .3%, getting us closer to a 2.5% GDP expectation for 2018. That’s a good thing as the slow-growth economy of the previous regime wasn’t near normal expectation levels of 3% GPD. That said, the policy will increase the budget deficit – not good, and it appears that the policy will impact the deficit more in the earlier years. We feel that this tax change will ignite more “animal spirits” in the economy, which is good to return us to a more normalized economy. That said, we don’t like the growing deficit and would like to see that addressed in the next election cycle. Bottom line is the economy should heat up.
Interest Rates (Bond Markets): Interest rates are one of the most interesting part of the economy as one can gauge the health and trajectory of the economy in one place. If interest rates are low, that means the economy should grow as the Fed is helping, i.e., “accommodating” the economy. We have very low rates compared to historical levels. That implies we should see more business growth, more real estate growth and more opportunities for employment. And that, in turn, helps the most powerful force in the economy, the consumer. Additionally, inflation has not been strong, keeping interest rate increases at bay. Rarely do we see an accommodative tax policy and monetary policy at the same time. Lastly, this means the bond market will likely generate low returns unless interest rates spike more than expected. We expect two quarter point rate hikes in 2018.
Stock Markets: Because corporate tax rates have decreased, corporations will keep more of their income. That means higher earnings and potentially more jobs. More jobs means a stronger consumer, thereby driving more sales. And, of course, more sales mean higher earnings, setting up a free market-style economy. That’s good for business and should be good for the stock market as well. That said, we expect the biggest change in the stock markets to be the return of volatility. As we return to a normal economy rather than one supported by quantitative easing and ultra-low interest rates, normal market forces should return. 2017 did not have a single market correction, which historically happens 2-3 times per year. IN other words, we are well overdue for a market correction. And we expect that correction to be slightly higher than the 10% normal correction amount. Bottom line is that we rarely see a situation where Fiscal Policy and Monetary Policy are aligned for growth like this. We expect a good stock market in 2018, just one with the return of corrections.
Our Investment Committee periodically monitors the markets and will continue to provide comments at the beginning of each quarter. Each portfolio is different and we recommend getting individual help, which we are happy to provide.
See you next quarter!
Brian Dorn, AIF – Chairman, Investment Committee
Bond Disclosure: Fixed income securities carry interest rate risk. Fixed income securities also carry inflation risk and credit and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Forward-Looking Statements: Certain statements contained within are forward-looking statements including, but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.
Opinions voiced are not intended to provide specific advice and should not be construed as recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial professional.
Indices are unmanaged measures of market conditions. It is not possible to invest directly into an index. Past performance is not a guarantee of future results.
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods. Past performance cannot guarantee future results.