Published on Jan. 12, 2018
Stocks Move Higher to Close Out the Year
Stocks moved higher to close out the year, as the S&P 500 climbed 6.6% during the fourth quarter. Investor sentiment was boosted by economic data that continued to surpass expectations. Markets also reacted well to the passage of the GOP tax bill. We maintain our positive outlook as we continue to believe that healthy economic growth, strong corporate profits, and easing financial conditions should bode well for stocks moving forward.
For many investors, we believe that the tax bill was among the most eagerly anticipated policy initiatives of 2017, and that its progress and ultimate passage were likely key drivers helping to lift stocks during the fourth quarter. The tax bill also likely contributed to the sector rotation seen last month, during which cyclical and value stocks outperformed their growth stock peers. Details of the bill include a reduction in the corporate tax rate from 35% to 21%, lower individual rates, and the elimination of certain deductions in an effort to simplify the tax code. We believe that 2018 aggregate S&P earnings could see a boost of approximately $10 per share as a result of the lower corporate rate.
The extent to which passage of the GOP’s tax bill may boost the economy remains a topic of debate. Some critics of the bill point out that many corporations have effective tax rates that already approach the new statutory rate, and therefore they may not see a material boost to their net incomes. That said, in our view, smaller companies – many of which are domestically oriented and therefore typically pay higher tax rates – are likely to see greater benefits. Moreover, it is these smaller businesses which are typically the primary drivers of job growth. To the extent that these smaller businesses benefit from the new tax code, an already healthy labor market could get a further boost. Finally, we believe that small- and medium-sized businesses are likely to reinvest a significant amount of their tax savings, as opposed to increasing share buybacks or dividends. These investments have the potential to be another positive factor driving GDP growth in 2018.
The Federal Reserve will have a new chairman next month as Jerome Powell takes the helm from Janet Yellen. We expect that this will be a relatively smooth transition, as Powell has not dissented on any policy votes during his tenure as a member of the Federal Reserve Board of Governors, and his remarks have typically echoed the committee’s consensus view. In terms of any stock market impact, we view financial companies as potential beneficiaries, as we believe that Yellen is more hawkish with regards to banking regulations than Powell appears to be. In our view, should Powell relax banking industry regulations, it would likely enhance the sector’s earnings power.
The flattening yield curve has garnered a great deal of investor attention in recent months, with some wondering whether it is portending weaker economic conditions ahead. At this point, we are not overly concerned with this because, as we have noted in the past, it is not unusual for the curve to flatten while the Fed is raising rates. Moreover, we believe that very low government bond yields in other developed economies are also playing a role in depressing US yields. The flattening curve is more a reflection of divergent monetary policy and relative bond values in our opinion, as opposed to signaling an impending recession. However, we are keeping a close eye on this indicator. If the curve were to continue to flatten and ultimately invert, we would view this as a troubling sign and we would likely reassess our economic forecasts.
We continue to hold a constructive view on equities. Economic activity has picked up over the last few quarters, and more recent data has also been encouraging. Consumer confidence hit a cyclical high during the fourth quarter, and the labor market remains robust with both unemployment and job openings at multi-year bests. The ISM’s manufacturing sector index easily surpassed expectations for December, and its forward looking new orders sub index showed particular strength. Looking forward, we believe that consumption is poised to support future economic activity. With some tax relief on the horizon, in addition to minimum wage increases and many corporations having already announced special one-time bonuses, we anticipate strong consumer sentiment should continue to translate into healthy consumer spending.
International economic activity continues to firm coinciding with the domestic strength. This synchronized recovery, in addition to a US corporate sector which is generating strong profits, and financial conditions which remain quite accommodative, are the key underpinnings to our optimistic outlook.
There are, however, pockets of the US economy that we have concerns about. While the holiday season was a good one, we expect that mall-based retail will continue to weaken as more spending moves online. We also would not be surprised to see some reduced levels of activity in the housing and automotive industries, as they may have seen some unsustainable pent-up demand in the aftermath of last year’s severe hurricanes.
We are also keeping a close eye on currency markets, as we see several factors which could lift the dollar in 2018, potentially crimping corporate profits in the process. With the passage of the GOP’s tax bill, corporations may soon be repatriating large sums of money back to the US. Depending on the magnitude of these transfers, they may be sufficient to move the dollar higher, but we also see other factors such as Brexit and potential trade disputes which could magnify the effect. With valuations somewhat extended, earnings will likely have to meet expectations in order for stocks to continue to climb higher in 2018; a strong dollar would make this more difficult to achieve and we therefore consider this to be an important risk factor to monitor.
Many market strategists are calling for clients to increase their exposure to more cyclical holdings, based on the belief that strong economic momentum will enable these securities to outperform. While we share this optimistic view of the economy, we do have some concerns and believe that it is more prudent to take a diversified approach. We have therefore constructed our portfolio in a barbell fashion, whereby we are allocating material exposure to cyclical and value stocks, while also maintaining sizeable exposure to more defensive names that should help to protect the portfolio in the event of worsening economic conditions.