Euphoria and F.O.M.O. 1st Quarter 2018
Happy New Year to all. 2017 ended as one of the better years for market returns, but also presented a number of issues for investors leading into 2018. The S&P 500 returned 17%, the Federal Reserve raised interest rates from0.50 % to 1.25 % , yields on 10 yr US Notes were unchanged at 2.47% but traded in a range from 2.05% to 2.62% and the US Dollar Index fell 10%. The S&P 500 set 71 new highs in the year, on average more than once a week without a 3% correction which is highly unusual. Towards the end of the year, Congress passed a massive tax overhaul, mostly geared toward corporations and lowering their overall tax rate. The US government also suffered a brief shut down.
What does all this mean for 2018 going forward? Initially, euphoria and FOMO (Fear Of Missing Out) resulted in a massive inflow of funds into US Equity markets for January, reportedly more than $30B. The tax cut is causing the US Treasury to have to increase issuance of debt. According to the Wall Street Journal, the Treasury Borrowing Advisory Committee (TBAC) estimates the Treasury will need to borrow $955 Billion in fiscal 2018, up from $519 Billion in 2017. They expect this to rise to $1.083 Trillion in 2019 and $1.128 Trillion in 2020. This has caused 10yr yields on Treasuries to rise to 4 year highs. The yield on the Notes is now equal or greater than the yield an investor would receive from dividends on the S&P 500.
The recent tax overhaul is expected to have positive effects on the bottom line for US corporations. The repatriation of overseas funds might lead to increased stock buybacks or special one time dividends, both which could favor stockholders. US workers are experiencing one-time special tax bonuses and announcements of increased wages. I think this was evident in the latest employment report from the Labor Department which saw wages rise at almost 4% year over year. While some economists have interpreted this as wage inflation, I think it would be prudent to examine the next 2 monthly reports to see if this continues. Wage inflation is something the Federal Reserve watches to warn of inflation creeping into the economy.
The remainder of 2018 should provide opportunity for investors. The sell-off experienced on Friday has been long in coming and is a normal and necessary function of the market. I believe that there should be more of a normal trading pattern for equities, i.e. both rallies and retracements. Thus far this year earnings have been decent with an interesting development. Over 80% of the companies have reported revenues that have exceeded Wall Street’s expectations. After the banking crisis, most companies appeared to boost earnings by slashing the expenditures of the company. The increasing revenues may imply an increase in both consumer balance sheets and sentiment both of which should help boost the economy.
I believe that the rates on US Treasuries are rising in response to these economic developments, GDP is believed to be slowly heading to 3% annual growth. Corporations, especially small and mid-cap companies, have yet to feel the full effect and benefit of the tax law. Inflation is still contained at near 2% and doesn’t appear to be accelerating. A slow and normal rise in rates should not spook the market and could be interpreted as a positive for the equity market as it might signal economic growth.
Small and Mid-Cap companies could benefit from the tax law changes as they tend to pay a higher effective tax rate and its overall reduction would help them more than Large Cap companies that have a lower effective rate, hence not as much benefit. The technology sector of the market could also benefit, with their large overseas cash hoards that they can bring back it opens lots of possibilities for return on capital.
Concerns in the market place are that Central banks are slowing their buying of Fixed Income assets, which could push rates higher. There is always a concern over global hotspots affecting the market. North Korea and the Middle East are two areas that could spark a risk off movement in the market. There is also a worry that the new Federal Reserve Chair is unproven and the risk could be that they tighten further and faster than the market has priced in. Finally, a dysfunctional Washington risks upsetting the apple cart by threatening debt ceiling limits and government shutdowns
As always, please feel free to contact me with any questions,