Investment Review for Third Quarter 2017

The first three quarters of 2017 have been great for investors. In the third quarter alone, global stocks appreciated 5.2%, bringing their gains to 17.3% for the year. In particular, emerging market and foreign developed stock returns (helped by appreciating foreign currencies) have been most impressive, rising 27.8% and 20.0% respectively for the year.

Major asset class returns.

The U.S. dollar and its effects on returns.

Foreign asset returns have two components: the return of the stock or bond itself and the appreciation or depreciation of the currency. While often overlooked, currency appreciation or depreciation can be a significant component of total return in any given year and over time. In fact, since early 2009 foreign currency changes have reduced U.S. investor returns by 16% and 27% for foreign developed and emerging market stocks respectively. With foreign currencies rising and the U.S. dollar falling in 2017, U.S. investors holding assets abroad are benefiting for the first time in several years.

Diverging monetary policy.

In October, the Federal Reserve will begin the process of normalizing its balance sheet, which grew from under $1 trillion in 2007 to roughly $4.5 trillion today. This process will involve slowly reducing the size of the balance sheet by a few billion dollars a month as securities mature. In contrast, the European Central Bank (ECB) and the Bank of Japan (BOJ), whose balance sheets are both larger than the Federal Reserve’s, continue to buy assets on a monthly basis. With the global economy continuing to strengthen, it is likely ECB and BOJ will begin to reduce and potentially eliminate their asset purchases in 2018, leaving the economy and financial markets to function without the extraordinary amounts of monetary stimulus to which they have become accustomed.

Risky bonds.

Investors holding risky bonds receive additional compensation in the form of higher interest payments than they would otherwise receive from government bonds. The amount of additional compensation, however, has been dropping steadily over the past few years. Today we are at the point where many believe the reward is no longer worth the additional risk.

Tax reform.

President Trump and GOP congressional leaders outlined their plan for an overhaul of the tax code. While details are yet to be determined, the plan outlines reducing personal tax brackets to three (12%, 25%, and 35%), increasing the standard deduction, and eliminating the Alternative Minimum Tax. Unfortunately, individuals would also see the elimination of exemptions and most deductions, including the deduction for state and local income taxes. On the estate planning front, both estate and generation-skipping transfer taxes are eliminated.

For businesses, the framework reduces the corporate tax rate to 20%, eliminates corporate Alternative Minimum Tax, and creates a new 25% rate for certain pass-through businesses. To offset the large rate reduction, many business deductions and credits would be eliminated. Finally, the framework would shift corporate taxation to a territorial system, ending taxation of future profits earned outside the U.S., while allowing the repatriation of past profits at a discounted rate.

While lower rates and simplification would be welcome, basic arithmetic remains the biggest obstacle to tax reform. Tax cuts for individuals and businesses without significant new sources of revenue would be extremely difficult. With special interests (including state and local governments) fighting to protect their deductions and loopholes, it is difficult to see where the revenue will come from. As such, congressional deficit hawks who are already concerned about the $20 trillion federal debt level may find the resulting legislation difficult to support.

Business surveys vs. business spending.

Following the election, both small business owners and purchasing executives became increasingly optimistic about the U.S. economy. This optimism, however, has translated into only modest amounts of increased economic activity. In fact, both capital goods orders and non-residential construction spending are up a modest 3%. As we move through Q4 and into 2018, it will be interesting to see how legislative progress on tax, healthcare, trade, and regulation affect business surveys and spending, as well as asset prices.