We believe the probability of some form of tax reform becoming law is rising. The White House’s latest proposal would cut the corporate statutory federal tax rate to 20% from 35%. However, many companies do not pay the statutory rate, as the S&P 500’s current median effective tax rate is 26%. Some estimates show that earnings on the S&P 500 could be lifted by as much as 8% from a 15%- cut. The question is whether this potential growth is already baked into current stock prices. Some say yes, and the S&P 500 could be as much as 3% overvalued based on expectations of tax reform, others say not at all. One observation is that the companies most levered to tax reform have been under-performing so far this year, suggesting that the equity market is being driven by other factors such as stronger global growth, higher earnings, and possibly less regulation. So despite all the talk of a massive tax cut the likes of which this country has never seen, the market currently appears to be looking for little more than a watered-down, drawn-out version—if it happens at all.
Where are we in the economic cycle? Influential economists Carmen Reinhart and Kenneth Rogoff suggest it takes 10 years to get back to normal after a financial crisis. With the past crisis having started in 2007, we are right in that sweet spot, with the next 12 months a potential breakout year. In other words, there could be a lot of life left in this expansion, now the third longest in U.S. history. In addition, because inflation is still low, odds are higher that the next recession is further out, aided by still accommodative global monetary policy.
Positives Good start to Q4. Despite lingering hurricane impacts, business activity accelerated in October, with Markit’s U.S. manufacturing Purchasers Managers’ Index (PMI) at its highest level since January and its companion services PMI at its second-highest level since November 2015. September durable goods increased well above consensus and for the third time in four months, with nondefense capital goods orders ex-aircraft—a good barometer of business capital expenditures (capex)—up the most since January. Core business orders climbed at the fastest pace in 5 years.
Very confident consumers. A week after the Michigan sentiment gauge for October hit tech bubble-era levels, the Conference Board consumer confidence index jumped to a 17-year high. Coming on the heels of strong back-to-school sales, which saw the biggest increase in consumer spending in September since August 2000, strong consumer sentiment bodes well for the holiday sales season.
New home sales surprise. Sales jumped nearly 19% in September to a new cycle high versus expectations for a decline. A rebound in the hurricane-affected South accounted for more than three-quarters of the increase, but strength was broad-based, with the Northeast looking even better than in the South. Inventories tightened further, adding to price pressures that pushed the FHFA gauge up nearly 7%year over year.
Negatives Job report disappoints. October’s nonfarm job growth of 261K came in at a well-below consensus, although an upward revision to September made up for most of the miss. Notably, hourly earnings were flat, causing the already subpar year over year rate to moderate further. No signs of wage pressures there, which should assuage any worries about the Fed being behind the curve. The participation rate also fell. The hurricanes may have been a factor but their impact appears to be diminishing, as weekly jobless claims fell to their third lowest level in 44 years.
Q3 GDP surprises but… The headline 3% increase in real growth easily beat consensus, and combined with Q2’s 3.1%, marked the best performance in nearly 3 years, but the market was underwhelmed by some of the underlying data. Capex and real consumption decelerated, possibly because of the hurricanes, while a jump in inventories could weigh on future growth.
Money supply continues to contract. If there’s a single indicator for the health of the markets and economy, money supply growth would be it, but with bank lending down in all areas, especially commercial and industrial lending and real estate loans, money supply continues to contract—the main reason why the Fed initiated quantitative easing in the first place. Now that the Fed is reducing its balance sheet, this will be a headwind for growth.
Global synchronized tapering? With developed market unemployment rates at 35-year lows, the days of easy money via zero-rate and quantitative-easing polices are numbered. The Bank of Japan and the European Central Bank are expected to switch gears next year and join the Fed in shrinking their balance sheets, resulting in global synchronized tapering that will send a strong deleveraging signal to the markets. This potentially represents one of the biggest risks to the coming New Year.
EQUITY MARKET SUMMARY
October 2017 saw the S&P 500 index reach a new high. The S&P added 2.33% in the month of October for a year-to-date (YTD) total return of 16.91%. Similarly, the Dow Jones Industrial Average (DJIA) advanced 4.44% and the NASDAQ Composite 3.61%. Stock prices rose on continued corporate earnings growth as well as expectations of global and domestic economic growth. Developed foreign markets as measured by the MSCI EAFE index increased as well by 1.52% for the month while emerging markets stocks added to its yearly returns by 1.52%.
The third quarter 2017 corporate earnings season so far has shown 76% of companies are beating their earnings estimates and 67% beat on revenue estimates with an earnings growth rate of 4.7%. This shows that many companies have been able to obtain EPS growth from revenue growth and not just by cutting costs. Six sectors are showing positive earnings growth for the quarter, led by the energy sector. Large cap stocks continued to outperform small cap stocks for the month.
Stock market volatility remains low with the CBOE Volatility Index (VIX) ending the month close to all-time lows. Investors seem to show little concern about a possible stock market selloff in the near term. Improving economic conditions have led investors to own stocks over bonds. As merger and acquisition activity has started to slow, investors are looking to companies with more organic growth. One measure of this organic growth is increasing capital expenditures (capex), as it signals companies are investing in and growing their business.
Expectations for corporate tax reform should help drive the U.S. equity markets going forward. Investors debate whether the current year’s rally has already baked in reform or whether it has been driven by other factors such as global growth and earnings. Investors are focused on the potential cut to the corporate tax rate, which would be a boon to companies with effective high tax rates and overseas operations. Accelerating the ability to depreciate capex would also benefit companies dependent on capex for operations.
LARGE CAPS OUTPERFORM SMALLER CAPS YTD:
GROWTH OUTPERFORMING VALUE YTD :
|Large Cap||26.1% vs. 9.1%|
|Mid Cap||20.7% vs. 8.5%|
|Small Cap||18.0% vs. 5.3%|
Valuations on equities have generally moved higher in anticipation of higher growth. It is prudent to not overreact (and overinvest) in sectors that may have gotten ahead of improving fundamentals. Investors need to be realistic on returns going forward. Security selection will become increasingly important as markets move higher.
FIXED INCOME SUMMARY
The 10-year Treasury yield finished the month 5 basis points (0.05%) higher at 2.38%, although it flirted with levels as high as 2.46% shortly before the end of the month, well above its Sept. 8 low of 2.01%. This move up in such a short time reflects reduced geopolitical fears associated with North Korea, economic statistics such as the global PMI that suggest the most synchronized global growth since 2012-2013, a real chance of U.S. tax reform being passed early next year and the expectation of continued global rate policy normalization.
The Federal Open Market Committee’s (FOMC) most recent policy statement notes that while growth was impacted by the devastating hurricanes of late summer, it should bounce back. It also notes that inflation remains soft, which we know. It did not mention anything about raising rates in December likely because the market is already counting on it. The fed funds target range remains 1-1.25%.
Federal Reserve Chairman nomination. Concerning the leadership of the central bank, the nomination of Jerome Powell is seen as a continuation of Yellen’s policies, and should not create much of a market reaction. Trump might prefer him because he has experience at the Fed (close to five years as a governor) and came from Wall Street, not academia. On the other hand, all the speeches Powell has given have toed the Fed line, he has never dissented from a FOMC decision and he hasn’t really published anything, so few know what he really thinks. That being said, most see Powell as a safe choice.
Fixed income investment performance was muted for the month except for high yield. The Barclays Aggregate index returned 0.07% for the month of October and the Global Agg -0.38%. The Barclays Municipal index returned 0.24% for the month, while the Barclays High Yield index continues to be the strongest index up 0.42% for the month.
Year-to-Date Index Returns (as of 9/29):
|Barclays Global Agg||5.85%|
|Barclays U.S. High Yield||7.45%|
|Barclays Muni Agg||4.92%|