Three Key Thoughts:

Markets Rally on Tax Rate Cuts
Fed Speeds Ahead
Where’s the Inflation?

Twelve months ago, our heads were spinning from a 2016 filled with surprises, culminating in the election of Donald J. Trump as president. What has been most surprising about 2017 is that the financial markets and the economy greeted the Trump presidency with optimism, good results and low volatility, despite daily headlines filled with plenty of potential distractions. For now, the markets have focused on the marginal change in direction in Washington: away from more regulation and higher taxes and toward less regulation and lower taxes.

The tax bill that President Trump promised before Christmas became a reality, to our surprise. The big headline for the markets is the corporate rate cut from 35% to 21%. While there are an enormous number of details to work through, this cut will clearly benefit the earnings of a large swath of US public companies. Perhaps more importantly, it makes the US far more competitive on the world stage and will allow a redirection of resources away from tax avoidance to more productive ends.

In the near term, there will be some accounting shakeout as companies adjust to changes in deferred tax assets and liabilities and book tax liabilities associated with future repatriations of cash held overseas. But we expect the bottom line impact on corporate earnings will be very positive. If this number is, as some have predicted, 10%, then the US equity market got cheaper by that amount overnight. Of course, since the market looks ahead, it has more than fully discounted all of this improvement in the rally we have had since the middle of 2016.

We are not as sanguine about the potential benefits of the tax law changes for individuals. First and foremost, the changes are not permanent – they expire at the end of 2025 – which we think is generally bad policy. Second, the changes are complex so they will take some time for the professionals to fully understand and translate. Third, the changes will affect consumers across the country in wildly different ways, depending on their personal circumstances. For now, all we know for sure is that the tax accountants and lawyers will be working more overtime for a long time to come.

While the stock market proved positively exciting in 2017, the bond markets just let out a big yawn. The only commonality between the two sets of markets was the lack of volatility. Comparing year end 2016 to year end 2017, rates on the US Treasury ten year note were flat and the thirty year bond yield actually declined a quarter of a point. The action was at the short end, where the two year note rate rose nearly three-fourths of a point, in line with the Fed’s three interest rate hikes.

So long as the Federal Reserve’s three boxes remain checked, we expect it will continue to raise rates consistently throughout 2018 and reduce its balance sheet at a deliberate, well-publicized rate. Strong economy: check. Solid employment numbers: check. Inflation at target: mostly a check. As the stability in longer term rates demonstrates, the bond market doesn’t seem as convinced as the Fed, particularly about inflation.

For those old enough to remember Clara Peller and the Wendy’s tagline “Where’s the beef?”, bond investors may be applying to same level of disdain in asking “Where’s the inflation?” With unemployment low and the employment market strong, economic theory and history tell us that we should be seeing much higher wage inflation. Yet we haven’t seen it and the bond market is waiting for a clear signal on inflation before adjusting longer term rates higher. History also tells us that this adjustment could be swift and harsh when it does come. For now, we remain cautious on longer term fixed income investments, with the view that the primary risk is rising rates and falling bond prices.

As we have been have been saying for some time, international stock markets had everything going for them except sentiment. That changed in 2017, with many international markets outpacing the strong returns put up by the US stock market. Part of this story is currency – weakness in the value of the dollar has played a significant role in developed markets’ excess returns. But more important, we believe, is that these markets have found what they were missing previously: better sentiment. The better growth, better earnings and reasonable valuations pieces of the puzzle had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for some time. That said, some markets may have already gone too far in the short term.

Finally, 2017 was a cautionary tale about letting the divisiveness of politics color one’s investing approach. A year ago, a great deal of uncertainty reigned, with all sorts of wild predictions about the bad things that might happen. Yet, as usual, the institutions of our democracy and economy remained intact, if a bit shaken, and we are enjoying a strong economy, low inflation and relative peace. That is certainly not to say that there aren’t risks but it is important to keep them in perspective. Markets tend to move on the basis of the expected marginal change in the environment and, so far, that judgment has been that the environment for investors has gotten better. This phenomenon wasn’t limited to the US: one of the best places to invest in 2017 was South Korea, where the stock market gained more than 40%.

In client portfolios, we remain underweight in fixed income as we believe the risks far outweigh the small potential rewards. We have let our already substantial weight in international stocks continue to grow and have held onto US stock positions while carefully minding relative valuations. Finally, we are fine-tuning our line up of hedged strategies to focus on managers we expect to deliver better returns than bonds but with less risk than stocks.