THIRD QUARTER ECONOMIC OUTLOOK
July 11, 2018
U.S. & World Economy
Global trade wars and American protectionism are the current front-page business narratives – and whether perception or reality, they are upsetting the financial markets. My opinion is that we have seen classic President Trump gamesmanship, where if you want a puppy, first ask for a pony. While the headlines have been about new, higher U.S. tariffs, the chart below shows that in most cases, higher tariffs would only be catching up to existing tariffs imposed by China and Europe.
Most revealing (and hopefully the path to the future) is President Trump’s parting words at the G7 Summit on June 9th: “No tariffs, no barriers. That’s the way it should be,” (according to BBC). In a rare joint agreement, German car manufacturers are lobbying for the same thing. Could open global free trade be the real objective of all of this posturing?
There are only three tools in the investing world’s toolbox: Business (i.e. public or private stock), real estate, and lending (i.e. Treasuries, bonds, CDs, etc.). While all three took a tumble at the start of this year, only real estate and domestic small cap stocks have much to show for the first 6 months of 2018. At midyear, Wall Street believes that profit gains have peaked (along with long-term interest rates), that the recent strong U.S. Dollar will continue to rise, higher U.S. GDP growth will exceed foreign growth, and smaller domestic businesses will finally feel the positive effects of the tax cuts and deregulation. All of this should lead to a modestly positive second half of the year. However, we see potential for weakness next year due to the following: a flat or inverted yield curve, slowing growth following a 10-year economic expansion, a potential impeachment fight if the Democrats win the House back, and the continued reversal of the Fed’s $4 trillion post-crisis (aka “adrenaline shot”) balance sheet. We will keep the shark moving as we navigate these interesting times.
Midyear Tax Checkup
Summer has arrived! Since you have 6 months left to make a difference on your 2018 tax return, what better time to do some planning? Due to recent tax changes brought on by the Tax Cuts and Jobs Act (TCJA), planning is more important than ever. Here are a few things to think about:
- Review 2017 Income and Deductions:
Have either the thresholds or your income changed for 2018? It is wise to reevaluate your deduction eligibility: check to see if you lost any credits or deductions due to your income being above a certain threshold, and determine if deductions used last year are still available to you.
- Update Estate Plan:
The estate tax is still alive and well, so as part of your midyear review, take the time to update your trust and other estate documents as needed. The passing of the TCJA means the Federal estate tax will now apply to fewer people, with the exemption doubling to $11,200,000 per individual. Keep in mind that the current law is scheduled to sunset in 2025 bringing the exemption back to the $5,000,000 base instituted in 2011 (indexed).
- Evaluate Investment Portfolio:
Now is the time to review your holdings to see if any tax loss harvesting is available. This is something we do regularly for our clients. Also, keep in mind the holding period of your investments, as that will determine long-term capital gains rates vs. ordinary income tax rates.
- Determine 2018 Home Improvement Projects:
If you plan on making any improvement to your primary residence this year, determine deductibility under the new TCJA. Also, review any home equity loans to maximize your ability to deduct the interest using acquisition indebtedness rules.
- Adjust Retirement Plan Contributions:
Be sure to review last year’s contribution amounts and make adjustments based on 2018 limits. Maximum amounts have increased for some plans as of 2018. You can contribute up to $18,500 to a 401(k) (or $24,500 if over age 50), and up to $5,500 to an IRA (or $6,500 if over age 50).
- Perform Business Planning:
Plan your equipment purchases to benefit from the first year bonus depreciation (100%) for new and used qualifying equipment. Section 179 may also now be used on expenses related to improvements to nonresidential real estate, including items like roofing and ventilation.
The second quarter of 2018 brought back lower volatility and a small bounce to the U.S. stock market. As has been the case since the Great Recession, this second quarter market bounce reflects how European and Asian market recoveries lag behind the U.S.
I’m just back from visiting Europe where I witnessed first-hand how both EU members and non-members (Norway) handle sovereignty, diversity and adoption of increasing global forces on their countries’ policies and opportunities. My perception is that Europe is still in the midst of healthy economic expansion and stability despite pockets of depression and overextended balance sheets, regime changes, trade wars, immigration battles, Nationalism and Brexit. Global trade is here to stay but near-term, trade wars are Europe’s biggest threat.
Back home, U.S. GDP is estimated to have grown at a rate of 4% in Q2, up from 2% in Q1. Additionally, the average earnings of the companies in the S&P 500 were up 27% year over year. Yet all of this expansion and growth was not translated directly into the performance of our stock market for several reasons including the extraordinary run up we saw in 2017 stock markets (markets tend to reflect out 6 months ahead), a very strong rally in the U.S. Dollar, and trade uncertainty.
We monitor and analyze volumes of global economic factors such as: the U.S. unemployment rate at a low of 4%, U.S. inflation at a 6-year high (estimated 2% – 2.5%), currency fluctuations, U.S. tax reform, rising U.S. interest rates, a flattening U.S. yield curve (see Q2 newsletter) and global headwinds of trade-wars and political volatility. Through our analysis, we believe that during a low investment return environment as we are experiencing, there is a propensity for investors to be exposed to significant risk miscalculations in pursuit of unrealistic returns. Our philosophy remains to participate on upside but most importantly, to protect on the downside.
Q2 demonstrated to be a challenging period for Global Equities, including international equities and (especially) emerging markets. A big portion of the returns were due to the currency effects of the U.S. Dollar strengthening against other currencies and the trade war creating a negative impact on emerging market equities. Surprisingly, U.S. equities held up well during the second quarter, particularly growth stocks. Relatively speaking, U.S. stocks are at a historical high from a valuation standpoint making them expensive compared to other regional stocks.
The first quarter was very volatile for liquid Global Real Assets, making it the least advantageous asset class. In the second quarter this asset class bounded back powerfully, consisting of two REITs we have in our models. This asset class will be sensitive to rising interest rates, and any future rate increases could have a negative impact if not offset by rising inflation. The National Storage Affiliates (NSA) REIT was the highest performer at 24.09% while gold was the least effective performer at -5.58% return in second quarter.
Global Fixed Income had a challenging second quarter, and we postulate it will continue similarly due to the end of the prolonged bull market that is starting to close. International Bonds suffered due to the aforementioned effects on international currencies, while short-term and low credit qualities sustained as winners. We are expecting currency effects to normalize going forward; the trade war caused an unusual hit.
The Alternatives asset class exhibited mixed results. Our long/short equity fund suffered -8.35% in the second quarter due to the fund’s value factor. In 2017, this fund returned 15.73% with very solid investment process and an excellent team. We are monitoring this fund to make sure there are appropriate risk management processes in place. Most of the Alternative funds were positive, and the event driven fund is starting to picking up some return this quarter.
A strong U.S. economy has stretched asset values and caused a run-up in interest rates, leading the financial markets to one of the flattest first-half performances in recent history. We look for earnings to catch up to valuations and hope for a positive end to the global trade wars in the second half of this year. Most importantly, we remain adherent to our mission of optimizing your investment portfolios and planning for your ideal future.
As always, we are here for you. Please feel free to reach out with any questions that you may have.
All the Best,
Mark, Bart, Leslie & Stella