“It’s the most wonderful time of the year…” and that’s not only because everyone is a little happier around the holidays. Historically, the S&P 500 has been up 19 of the last 25 Novembers and 20 of the last 25 Decembers, and that held true for this November as well. The S&P 500 is up 26.3% since Election Day, and there’s one question that persists: “how much longer can this go on?” It’s a great question, and like many finance-related questions, the answer is … “it depends.”
There’s a lot of data we’ll cover to help answer this question, but there’s no doubt that at this stage in the cycle future economic gains will be greatly influenced by deals. Some of the most significant deals currently being negotiated include trade deals like the North American Free Trade Agreement (NAFTA), the Trans-Pacific Partnership (TPP), and the U.K.’s divorce from the European Union (aka “Brexit”). President Trump is looking to shore up American business with deals that his administration thinks are fairer to the U.S.
The deal that is garnering the most attention in Washington D.C. is tax reform, and there are actually two bills being proposed, a version drafted by Republicans in the House of Representatives and a version drafted by Republicans in the Senate. The House bill passed in mid-November and the Senate bill is still working its way through that chamber after some last minute delays on the final day of the month. There’s some variation between the two versions, but both would simplify marginal tax brackets, nearly double the standard deduction, repeal state and local tax deductions, expand the child tax credit, limit the mortgage interest deduction, repeal the Alternative Minimum Tax (AMT), preserve the estate tax (but the estate tax exemption amount would double), and cut the corporate tax rate from 35% to 20%. There’s a lot to consider, but put simply tax cuts may act as the next phase of stimulus as monetary stimulus via the Fed is on the wane.
All in all, economic readings are positive. The government revised its estimate of Q3 GDP growth up to 3.3% from 3%. That would be the fastest pace of quarterly growth in three years. An upward revision to business investment (up to 10.4% from 6.8%) was behind the bump higher. Consumer spending growth of 2.3% was little-changed from the initial estimate, and initial reports on Black Friday and Cyber Monday retail sales look positive. Consumer confidence came in at 125.9 for November while consumer sentiment dropped a couple of points to 98.5, which is still a very strong reading.
The unemployment rate fell to 4.1%, and employment gains usually contribute to about half of GDP. The lowest unemployment rate in the last 50 years was 3.8%, reached in April 2000. So we should probably understand that employment gains may have limited room to help GDP growth going forward. Inflation, both CPI and PCE headline inflation, still hovers near 2.0%.
News from the largest economies on the globe also suggests a positive outlook as we near 2018. Shinzo Abe was re-elected prime minister of Japan, which reinforced support for his economic reform, popularly known as Abenomics. Japan’s GDP expanded at an annualized pace of 1.4% in Q3, marking the seventh straight period of quarterly growth and longest uninterrupted growth in more than a decade. German GDP grew at an annualized rate of 3.3%, although negotiations to form a new government collapsed recently. This uncertainty for Europe’s economic heavyweight is something to monitor.
Argentina unveiled proposals for tax cuts, including lowering the corporate rate from 35% to 25% and reducing employer social security taxes. They, like the U.S., hope for GDP gains as a result of tax cuts. Negative news continues to come from Venezuela, a nation struggling with massive debt obligations. Its state-owned electric company defaulted on some of its debt, and the S&P downgraded Venezuela’s sovereign credit rating to “selective default” after failing to make $200M on global bond payments. Venezuela holds an estimated $100B-150B in outstanding debt, which they hope to restructure as soon as possible.
FactSet reports the following: “For Q3 2017 (with 98% of the companies in the S&P 500 reporting actual results for the quarter), 74% of S&P 500 companies have reported positive earnings-per-share surprises and 66% have reported positive sales surprises,” which is all good news. JP Morgan forecasts Q3 S&P 500 earnings growth of 9.5% compared to the previous year, the 5th straight quarter of earnings growth since the collapse in oil prices that began in 2014. Ironically, the Energy sector leads all sectors for Q3 earnings growth.
Concern regarding tax reform caused some downside pressure on small company stocks last month. The Russell 2000 declined -1.8% over the first half of November and then moved up 5.5% from that low. International stocks didn’t keep up with domestic stocks in November, but they still lead by a few percentage points for the year. Emerging Market stocks outpaced S&P stocks for the month and continue to lead for the year.
BONDS and INTEREST RATES
High-quality bonds (as measured by the Barclays Capital Aggregate Bond Index, or “the Agg” for short) are having a pretty typical year in regard to returns. The Agg experienced a 4.6% rise in value over the first half of 2016, only to be followed by a 5.3% drop over the second half of the year. The Agg has not moved very much in price this year, showing that volatility has been markedly lower for bonds as well as stocks this year.
Economists look at the bond market’s yield curve to help predict the future. When short-term yields rise, and long-term yields hold steady, that’s called “yield curve flattening.” Some economists infer a future slowdown in growth from this data, while others expect longer-dated bond yields to rise, getting us back to a yield curve that looks more “normal.” Economic contraction is always a possibility, but it doesn’t seem likely in the near term, which seems to suggest rising long-term yields is the more probable outcome for the yield curve.
The White House will have a lot of influence on future Federal Reserve Bank policies, as the president will appoint up to 5 future Fed board members. President Trump nominated Fed member Jerome Powell to replace Fed Chair Janet Yellen next year. In her time as Fed Chair, Yellen has led 30 central bank meetings. During those meetings, eight different members have cast 20 dissenting votes to Yellen’s interest rate recommendation… and none were ever cast by Powell. What does that tell us? It probably means that we’ll see a smooth transition of policy philosophy from the head of the most important seat in the world of finance.
Overseas, the IMF urged Japan to maintain its massive monetary stimulus, and with Abe’s re-election, that seems very likely. Eurozone inflation remains below the European Central Bank’s target of 2.0%, and ECB President Mario Draghi recently said that the central bank needs to be “patient for inflation to return sustainably.” The Bank of England raised interest rates for the first time in 10 years, from 0.25% to 0.50%.
COMMODITIES and CRYPTOCURRENCIES
Ministers from OPEC and non-OPEC countries met in Vienna recently to discuss extending oil supply cuts into 2018. Continued supply cuts alongside steady demand-side growth would suggest higher prices next year. Oil prices continue to rebound in 2017, with Brent crude prices finishing at $63/barrel and WTI crude finishing the month at $57/barrel. But the most interesting oil-related news comes from Saudi Arabia, which continues to prepare for an IPO to sell off a portion of state-owned Saudi ARAMCO in an effort to diversify its holdings away from the energy complex. However, the IPO is not the interesting story.
On November 4th, over 200 princes, ministers, and businessmen were detained at the Ritz-Carlton in Riyadh. Crown Prince Mohammed bin Salman led an anti-corruption drive in the effort to clean house and recover as much as $100B. Some viewed it as a power grab by the prince, but others viewed it as a shrewd way for him to further his plan to shift Saudi Arabia away from being almost completely dependent on oil.
We covered Bitcoin in a feature earlier this year, and the cryptocurrency (which some liken to gold as supply is finite) has made major headlines recently by crossing over the $10,000 mark. Bitcoin’s rise in price this year is nothing short of meteoric, and starting mid-December Bitcoin futures contracts will be traded on the Chicago Mercantile Exchange (CME). The future is still very unclear for the volatile cryptocurrencies, but progress continues for wider adoption.
Classic beauty: porcelain skin, a slender nose, high cheekbones, and an intriguing smile. These are all physical characteristics that were used to build the robot, Sophia. Hanson Robotics developed Sophia to be a social-bot, to interact with humans, to develop relationships, and “to become super intelligent genius machines that can help us solve the most challenging problems we face here in the world,” according to creator David Hanson. Her artificial intelligence allows her to hold eye contact, recognize faces, and understand human speech. You can find stories and videos of her online, and she’s already been all over the world in her short existence.
On October 25, she was granted citizenship in Saudi Arabia, which might have been more for publicity than anything else, and yet it’s still fascinating. As Saudi Arabia strives to prepare for a future after big oil, it has begun focusing on tech, innovation, infrastructure, and tourism. But the story is less about Saudi Arabia, and more about technology, robots, and artificial intelligence and more about the range of outcomes we face as machines, machine learning, and machine consciousness will come to impact virtually every aspect of our lives. Advancements in A.I. raise a lot of questions. Will robots pay taxes? Could they own property? Will they have to deal with jury duty? These are rights and duties of “real” citizens.
Machines, be they citizens or not, have been a constant in business advancement over the last century, and all signs suggest that automation and technology will continue to help businesses advance in the marketplace. The upward revision to business investment mentioned above (some of that possibly being investment in newer tech) is a good indication that many companies are preparing for a healthy and friendly business environment in 2018. We believe that reduced corporate taxes and tax rules set to reward capital expenditure would increase economic expansion, which one would think would be good for the stock market. Typically, when the economy and stocks are doing well, the consumer does their part too, which results in more expansion and inflation.
In a sense, a signed tax reform bill removes a fair amount of uncertainty about current stock market valuations. Higher stock prices are justified by better and higher earnings, assuming that’s what happens. Failed tax reform would be an outcome that could magnify risk, or at least it would feel that way. Failed reform would suggest political turmoil and an inability to fix a system that all sides see as broken. That sort of failure could cause consumer and business sentiments to come down, which could curtail spending and investment and eventually take a toll on economic expansion. International trade negotiations will also be critical to global trade in the near term. Volatility has been remarkably low, but we think investors should prepare for choppier markets if politics prevent progress.