U.S. stocks had their best quarter of the year as corporate earnings remained strong and the Tax Cuts and Jobs Act of 2017 was signed into law. U.S. firms have benefited from higher economic growth domestically and overseas. The latest U.S. GDP figures showed economic growth over 3% for the second consecutive quarter. Improving economies overseas have also been a boost to U.S. firms as the weaker dollar has made U.S. products relatively more attractive to foreign buyers.
The tax cut bill was not signed into law until December 22nd but stock prices rose in anticipation earlier in the quarter as it became evident that some form of corporate tax cut was likely to pass. (See ‘A Taxing Situation’ below for more on the investment implications of the law.) The S&P 500 Index gained 6.64% during the quarter and was up 21.83% for the year.
U.S. large company stocks outperformed U.S. small company stocks for the quarter as larger firms were better positioned to take advantage of increasing global growth.
Foreign stocks underperformed U.S. stocks during the quarter but still had solid gains. The MSCI AC World ex US Index rose 5.00% over the period and was up 27.19% during the year. Stocks in Japan were particularly strong (+8.49%) during the fourth quarter as Japanese exporters are expected to benefit from higher global economic growth.
Emerging market stocks were the best performing asset class during the quarter as higher global growth provided a tailwind for emerging market companies that export goods and raw materials. The MSCI Emerging Markets Index gained 7.44% for the quarter and 37.28% for the year.
The yield on the 10-year U.S. Treasury ended the quarter at 2.41%, up 8 basis points from the prior quarter. Yields for shorter maturities rose as the U.S. Federal Reserve raised the Fed Funds rate in December for the third time in 2017. The Fed is currently projecting that they will raise rates three times in 2018, citing continuing low unemployment and higher expected inflation. Higher inflation expectations were a tailwind for Treasury Inflation Protected Securities (TIPS) which outperformed conventional Treasuries during the quarter.
The Bloomberg Commodity Index was up 4.71% during the quarter as improving global growth increased the demand for energy and industrial metals. Energy prices were also supported by OPEC’s decision to extend existing output caps by another six months into 2018.
The Tax Cuts and Jobs Act of 2017 is the largest overhaul to the U.S. tax code in decades and will have an impact on virtually all households and businesses in the country. A bill of this scope will also affect investment markets. In fact, the tax bill likely contributed to the strong stock market gains in the fourth quarter. Given the speed with which markets react to new information, the tax bill’s direct impact should already be largely reflected in asset prices. Nevertheless, it’s reasonable to expect the impact of this bill to affect the broader economy in ways that could further impact asset prices.
The tax law should stimulate the U.S. economy, at least in the short-run. The law may increase after-tax income for most households through lower tax rates. Households that invest in stocks may also benefit from higher dividend payouts. Some portion of this increased after-tax income will likely be spent, which would increase U.S. economic growth. In addition, some corporations may use some of the money saved on taxes to increase their capital spending. Some analysts estimate that the tax law may add 0.3% – 0.6% to economic growth in 2018.
Higher growth, however, could bring higher than expected inflation. The tax law was enacted during a period of historically low unemployment in the U.S. economy. If growth accelerates, companies will have to hire new workers from a shallow pool of available skilled labor. This could drive wages higher which could lead to price increases as companies attempt to pass on the higher costs. An unanticipated spike in inflation would lead to higher bond yields which could trigger a decline in stock prices.
One key element of the new law is the tax break for the repatriation of foreign profits by U.S. corporations. The law sets a one-time mandatory tax on foreign profits held overseas at a reduced rate. The expectation is that this will trigger a wave of corporate cash being brought back to the United States, but what will the corporations do with the cash? Some believe that a large portion of the cash will be returned to shareholders through stock buybacks or increased dividends which is generally supportive of higher stock prices. Other possible options are using the cash to pay down debt, increase capital spending, acquire other firms, or increase wages.
A great deal has been written about which asset classes and industry sectors will do better or worse given the details of the law, but these predictions seem a bit simplistic given that they focus only on the tax savings certain investments are likely to receive. While it’s worthwhile to consider the potential effects of the new tax bill, it’s important to recall an old cliché in investing, “Don’t let the tax tail wag the dog ”, and to remember that taxes are only one consideration among many that drive future returns on investments.
Written by Jeffrey Blanchard, CFA, Investment Analyst; Jeffrey.firstname.lastname@example.org
|Index||Market||09/30/17 – 12/31/17||Calendar Year 2017|
|Standard & Poor’s 500||Large Co. U.S. Stocks||6.64%||21.83%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||5.33%||13.66%|
|Russell 2000||Small Co. U.S. Stocks||3.34%||14.65%|
|MSCI All-Country World ex U.S.||Foreign Stocks||5.00%||27.19%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||-0.30%||1.27%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||0.39%||3.54%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||-0.65%||1.61%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||1.20%||2.03%|
Key economic indicators compiled by Jeffrey Blanchard, CFA, Investment Analyst; email@example.com
Data Sources: Morningstar; Econoday; Bloomberg.com
(1) Source: MSCI. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. MSCI data may not be redistributed or used as a basis for other indices or investment products.
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