In November, U.S. and foreign equity prices moved higher yet again. On the month, the S&P 500 Index rose 3.07%, while the MSCI All Country World ex-US Index was up 0.81%. Global economic activity generally continued to expand modestly, and U.S. GDP for Q3 was revised upward to have advanced at a 3.3% annualized rate. In this installment of Insights, we discuss our take on recent economic, investment, and legislative developments related to the crude oil markets, the U.S. government bond yield curve, and the proposed tax reform. We also provide a preview of our 2018 outlook, which we will explain more fully in our newsletter next month. The short version is that we continue to anticipate consistent economic growth, a moderate rate of inflation, and a largely measured and telegraphed U.S. Federal Reserve policy, with supportive global growth in Europe and emerging markets. All of these factors may contribute to largely stable market conditions albeit with the potential for an equity correction given somewhat elevated valuations and low current volatility.
U.S. equity performance was once again positive in November, and again the Dow Jones Industrial Average was the top performer in our list, up 4.24%. U.S. core and high yield bonds, however, declined in conjunction with continued strong economic data that supports the likelihood of a December rate increase by the Fed.
Foreign stocks continue to lead the broad U.S. stock market. The MSCI ACWI ex-USA has gained 24.4% in 2017 through November, and the MSCI Emerging Market Index is up 32.5%, the best YTD return in our table. Strong returns in recent months from domestic stocks have closed the performance gap between foreign and U.S. stocks this year.
Although U.S. bonds retreated slightly, emerging market bonds had mixed but positive returns. The JP Morgan U.S. dollar-denominated EM bond index eked out a 0.05% gain, whereas the local currency EM bond index rebounded from its 2.8% loss in October to rise 1.68% last month. The USD-denominated index remains up nearly 9.5% year-to-date, and the local currency EM bond index has gained nearly 13% for the year.
As a way of leading up to a preview of our 2018 outlook, which we will detail next month, we wish to discuss three recent developments in the economic, investment, and legislative arenas that help to provide a backdrop for our look ahead.
First, near the end of November, OPEC and Russia agreed to extend the crude oil production cap agreement for an additional 9 months (from March 2018 to December 2018), and they plan to re-assess global crude markets at a future meeting in June of 2018. The prevailing industry view is that a drop in crude oil prices would bring future cuts/coordination, while a rally of crude oil into the $70s may cause further production hikes. This recent OPEC agreement to extend production caps is undoubtedly good news for the U.S. energy sector and MLPs (master limited partnerships). MLPs have been in need of some positive headlines in part because of lower energy prices this year and various financial restructurings within the industry. The graph below shows U.S. crude oil production, the forecast in the dotted line from the U.S. Energy Information Agency (EIA), and in the orange shading the range of other analysts’ forecasts for future production. Both the range and the upward slope of the line are important to note.
The continued production cap, preservation in proposed tax reform legislation of preferential tax treatment for MLPs, increasing institutional purchasing interest in MLPs, and strong outlook on global oil demand could lift sentiment in the space, which is one of the few areas this year that has not performed well.
Second, from both an economic and investment perspective, the Treasury curve (i.e., government bond
s across the maturity spectrum) has been flattening this year. This means that yields of shorter- and longer-dated bonds have been moving closer together. The difference between the 2- and 30-year U.S. Treasury yields continues to push to new lows, recently moving below 1%, as of 12/4/2017 as you can see in this chart from The Wall Street Journal.
The debate over why the curve is so flat continues to rage. Bulls cite international rate conditions and Treasury short-term issuance as reasons. Bears have continued to warn that an economic slowdown is coming. It is quite possible that the yields on the longer-term Treasury bonds are mispriced (i.e., too low) because of buying pressure exerted after the ECB announced a more extended and dovish plan for its QE program than many expected. That is, yields on the United States’ 10-year note and 30-year bond remain attractive relative to comparable maturity Japanese government bonds and German bunds. The higher demand for U.S. government debt has thus been capping its yield. Also, the U.S. Treasury has continued to issue more short-term Treasury notes, increasing supply on the front end of the curve, thus driving yields higher relative to longer term bonds.
Why is this significant? Historically, when longer-term rates are lower than short-term rates (i.e., when there is an inverted yield curve), a recession has typically followed. A flattening yield curve can portend economic slowdown, although the data does not seem consistent with this possibility at present. At this point, we do not think that the current slope of the yield curve is cause for concern. We are of the opinion at present that low-yielding bonds of extremely safe-haven regions, namely Germany and Japan, continue to hold down yields of longer-maturity debt in the U.S. This is the case because investors will move their money into the higher yielding asset with similar perceived credit risk (i.e., U.S. Treasuries). The graph below on the next page shows the difference in the U.S. Treasury Yield curve from the end of last year through 12/5/2017.
The situation is still worth monitoring, however, if lower rates lead to other weaknesses, but we do not see those concerns at this time.
Third, on the legislative front, the House of Representatives and the Senate have each passed its own respective, and in some places very different, tax bills. Currently, the legislation process is entering into the reconciliation phase. The House and Senate must form a committee to smooth out differences between the two independent pieces of legislation; then the single tax reform bill must pass both the House and Senate votes before being sent to the President for signing. It is important to emphasize that and there could be potentially significant changes to material provisions of the final bill before any single tax reform bill is enacted into law.
The main message to our clients and friends is that we still do not have a final view of what the single tax reform legislation will entail, and it would be premature to draw too much in the way of investment inferences before reconciliation concludes. Still, we do want to address briefly questions that have arisen about municipal bonds in connection with tax reform. The primary inquiry is how municipal bonds may fare under the new legislation. The answer is that there could in the future be a decreased supply of tax-exempt munis and an increased demand for them. The reason for this potential development is as follows, as explained by Baird, which specializes in fixed income:
One key component of both the House and Senate tax plans is that municipalities would lose the ability to “advance refund” their debt in the tax-exempt market. This simply means that after year end, if a municipality wanted to refinance any outstanding debt more than 90 days prior to its maturity, it will have to do so in the taxable market.
Even before this provision appeared in the GOP tax reform plans, expectations were that supply would decline next year as the volume of bonds available for refunding is declining. However, if tax-free advance refundings were no longer allowed, then issuers would be forced into the taxable market to refund their debt, reducing the interest savings a municipality would otherwise realize. Tax-free supply could decline by as much as one-third next year as a result.
This decreased supply of tax-exempt munis and increased demand is quite possible, but it will not happen overnight. Still, in anticipation of the enactment of this legislation, there could be some increased demand in the muni market before year-end, and some activity along those lines is in fact emerging. Moreover, we see this possibility as something that would be supportive of tax-exempt municipal bond prices; however, this support might merely help to offset downward price pressures on intermediate-term and longer-dated munis that could come from rising interest rates. Therefore, we do not interpret this potential development as a strong or clear-cut case for stocking up on (tax-exempt) munis, that is, in terms of shifting from one portion of the portfolio to another in order to overweight core tax-exempt municipal bonds. We see this supply/demand dynamic as potentially helping to limit downward price pressures that munis might face from Fed tightening.
In recent monthly installments of Insights, we have written that we believe that economic and investment conditions are largely stable and positive, albeit with equities in the U.S. running slightly above average valuation levels and without having had a major pullback in equities this year. We continue to believe that this remains the case, and as such it forms the foundation of our outlook. As the nearby chart shows, 2017 is the first year since at least 1987 in which there has not been a single monthly decline in the S&P 500 Index.
How will tax reform translate into U.S. economic growth? We think that the economic effect will likely be modest and transitory. Some of the tax cutting provisions will expire, in current forms of legislation, in either 2022 or 2025. Short-term, corporations may begin to invest in capital expenditure or hiring projects because of the certainty gained about the tax landscape just because the process will have been completed. But two caveats are in order in this connection. One is that U.S. equity markets have likely risen this year, and especially through the fall, in anticipation of some tax reform at both the personal and corporate levels. This means that investment gains from tax reform through stock market appreciation may have, to some degree, already been baked into the current valuation levels.
Second, if there is some economic growth or multiplier effect from the tax reform beyond the modest level that we anticipate, and then if wage pressures and inflation rise and if unemployment drops much farther into the 3%-level, the economy could begin to overheat, or the Fed could tighten too quickly. And the result could be an economic contraction as a leveling response. We do not anticipate this outcome, but it is a risk of too much economic stimulus from potential tax code changes.
Overseas, China has emerged from its party congress with President Xi more fully entrenched in his position of authority and more concentrated power. Politically, China is taking a more prominent role on the global stage, which it formerly avoided, just as the United States seems focused on retreating from global economic and policy fronts. Growth has been steady this year, but debt levels continue to pose an eventual risk, although we are not concerned near-term. A stable political and economic China is good for global growth as a whole and the emerging and Pacific Rim regions in particular.
Economic momentum is positive globally. Inflation in the U.S. and major foreign nations remains contained and healthy. The U.S. Federal Reserve is widely expected to raise rates again this month and then four more times in 2018. The pace of rate increases could be faster or slower than this, and a faster increase would pose a potential risk to both fixed income and equities. However, as the pace and magnitude of rate increases develop, we think that the Fed will continue most of its current policy framework as the current Chair Yellen’s term expires and Jerome Powell, the current nominee to replace her, takes the reins.
We will have more to say about our full-year outlook for 2018 in January. Until then, and as always, we want to emphasize how much we appreciate your business, interest, and support throughout the year.
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