Portfolios continued to gain in the third quarter as stocks and bonds generally rose in value across the board. The S&P 500 Index appreciated 4.5% during the quarter, gaining in July, August and September. In fact, through the end of September the S&P had appreciated in 11 consecutive months. Only three times in U.S. history has the S&P recorded a longer winning streak, the most recent of which was a 15-month run that ended in 1959. On a year-to-date basis through the end of September the S&P 500 return was 14.2%. Those who in 2017 followed the popular dictum, “sell in May and go away” may have regretted it. They often do.
As has been the case for most of the year, stock returns in the U.S. were highest for growth and technology oriented companies, though small cap and value stocks also appreciated. Investors often compare the relative valuations of growth and value companies to get a sense of which seems more attractive. By any reckoning, growth stock valuations are currently quite high relative to those of value stocks, although the differential is still not as pronounced as observed during the dot.com boom of the late 1990s.
As attractive as this year’s returns have been for U.S. stock investors, those who patiently endured years of relative underperformance in foreign stocks were rewarded for their investment discipline. Foreign stocks continued to rise in value at a rapid clip and, for the quarter, the EAFE index, one of the major benchmarks for developed market stocks overseas, returned 5.4%. This brought year-to-date developed market foreign stock returns up to an eye-popping 20.0%. Returns in the emerging markets were even higher, up 7.9% for the quarter and 27.8% for the year through September 30. U.S.-based investors who buy foreign stocks achieve returns that are a function of both security and currency price movements. 2017 has seen the gradual weakening of the U.S. dollar relative to almost all other major currencies, and that has been a major component of the outsized return in foreign stocks.
As ever, the Federal Reserve’s pronouncements about anticipated monetary policy dominated the financial press, and Janet Yellen and the Fed governors continued to telegraph their intention to shrink gradually the Fed’s bloated balance sheet. Investors already anticipated such developments, however, so they had little impact on bond prices. In the third quarter, interest rates fell modestly and bond prices inched ahead. The Bloomberg Barclays Aggregate Bond Index, our best known bond benchmark, rose 0.9% for the quarter, bringing year-to-date returns to 3.1%. Investors seldom give thanks for the safety of high-quality bonds when the stock market rises.
As we head into the fourth quarter, what has perhaps been most remarkable about 2017 has been the continued absence of volatility. In the U.S. since 1980, for example, the largest intra-year decline of the stock market (that is to say, the biggest loss that occurs from a “high” to a “low” within the calendar year) has averaged about 14%. The largest intra-year loss so far this year has been 3%.
After the stock market has gone up – or down – someone can always offer a clever explanation as to why the change in securities prices correctly anticipates the impact of some upcoming economic development. What seems to have many investors optimistic currently is the long overdue focus on corporate tax reform. The presumption is that a cleaner and less onerous tax regime will be a big positive for corporate America justifying investors paying higher prices to become owners (shareholders) of companies likely to thrive in a more permissive tax regime. This certainly all sounds like good news. The bad news is that passing tax “reform” of any kind is notoriously difficult, and when it comes to corporate tax reform even our most partisan politicians often struggle to understand how “winning” might look. In part this is because economists of various political inclinations struggle to answer a seemingly simple question: who bears the burden of corporate taxes?
Corporations of course have owners and you would think taxes most directly affect them. But corporations also have employees and customers. Were corporate taxes to be pushed higher, one might expect owners to make less money, and thus feel more pressure to pay their existing workers less, hire fewer new workers, and pass on increased costs to their customers in the form of higher prices. Were corporate tax rates to fall instead, one might expect businesses to be more profitable, increase wages and hiring, and perhaps also lower their prices (or stop raising them).
Regardless of how workers and consumers may fare when corporate tax rates rise and fall, there is no argument about the fact that after individual income and payroll taxes, corporate taxes are the largest source of revenue for the U.S. government. So if we want to cut corporate tax rates so that America is less encumbered (America’s 35% corporate tax rate is among the highest in the developed world), those concerned about the federal deficit will want to be persuaded that a lower tax rate can still produce an equivalent tax yield. Economists believe this can happen if either (a) we eliminate some of the many deductions and loopholes that exist in the system, or (b) the lower tax rate spurs more domestic economic activity.
As regards to the former, taking on dreaded “special interests” is of course something everyone agrees on until we begin to name the “special.” Not a lot of Americans favor eliminating the deduction for employee health insurance, for example, and certainly many Californians want to continue to provide tax credits for clean energy research. But the biggest loophole in corporate taxation is the deductibility of debt payments. Many believe that U.S. corporations raise too much capital by borrowing money instead of by issuing stock (selling and sharing ownership), and that an economy less dependent upon debt and leverage will prove more resilient than the one we have now. But eliminating the deductibility of debt would rock many parts of our economy, not least of which is commercial real estate. Just as the price of many houses would fall if buyers could not deduct the interest on the mortgage, so would the value of big buildings decline. As of this writing, the President of the United States has most of his wealth in real estate.
In terms of what can reasonably be fixed, among the most discussed aspects of the current tax code is that U.S. multinationals are required to pay taxes on foreign income when profits are brought home. When U.S. multinationals earn profits in foreign countries, they pay taxes to the countries where the profits were generated. If these companies then transfer this cash back to their U.S. headquarters, they are subject to additional U.S. taxes to the extent the U.S. corporate tax rate exceeds the tax rates in the countries where the profits were earned. This arrangement creates an incentive for multinationals to keep foreign profits overseas rather than repatriating the cash and potentially investing it in the U.S. Such investment might create more and better-paying jobs for Americans which would, in the turn of this virtuous cycle, allow the government to collect more taxes. Apple alone sits on $260 billion of overseas cash yet –in part due to the deductibility of debt payments- has nonetheless chosen to borrow $40 billion in capital markets since the beginning of 2016. It seems as if America ought to be able to do better.
Written by Jeffrey Lancaster, CFP®, Principal; [email protected]
|Index||Market||06/30/17 – 09/30/17||Year-to-Date 09/30/17|
|Standard & Poor’s 500||Large Co. U.S. Stocks||4.48%||14.24%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||3.11%||7.92%|
|Russell 2000||Small Co. U.S. Stocks||5.67%||10.94%|
|MSCI All-Country World ex U.S.||Foreign Stocks||6.16%||21.13%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.43%||1.58%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||0.85%||3.14%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||0.49%||2.27%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||0.64%||0.82%|
Key economic indicators compiled by Jeffrey Blanchard, CFA, Investment Analyst; [email protected]
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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