So much for the calm of 2017.
Financial markets during the first quarter of 2018 jumped up, dove down and then went all over the place. It seemed as though a month’s worth of market-moving news occurred each week. Consequently, there is a lot to digest to better understand how your portfolio should be structured going forward. I will attempt to help you do so here, while remaining neutral about the political landscape. I’m just going to give you the facts and possible implications, from our point of view.
From Trump Bump to Thump.
Soon after Donald Trump took over as President, while the Republicans remained in control of both the House and Senate, the markets enjoyed a euphoric rise. The response was typical. In general, the Republican platform of lower taxes, smaller government, fewer regulations and pro-growth policies are typically pro-business and thus good for stock valuations. Usually, bumps in financial markets take place during the course of election years because markets are good at anticipating election outcomes. This time, however, the market got it wrong, thinking that Hillary Clinton would win the election. That’s why the market enjoyed a “Trump bump” after his surprise victory and not during the year before.
Interestingly, not much was accomplished by Congress in 2017. There was a “calm” gridlock, but always the hope that meaningful bills would soon be passed. There wasn’t a lot of news to cause the markets to lurch one way or the other. General optimism held sway as the markets inched their way upward every month. Meanwhile, throughout the rest of the world, populist movements lost momentum and nearly every economy gained strength. It appeared that the worst of the Great Recession was finally over.
So the stage was set for 2018. We entered the year on a strong note. Every major national economy was firing on all cylinders. A large-scale tax reform package got through Congress. The business tax cuts were essential because corporate tax rates were no longer competitive with the rest of the world. Company earnings were held hostage overseas by an onerous repatriation tax. And business incentives within the law provided a significant boost to earnings with the market now expecting earnings to rise by double digits.
Predictably, the financial markets took off. At least at first.
Once they digested everything, the focus turned to secondary effects and their unintended consequences. The tax reform bill also lowered personal tax rates. Yes, everyone loves a tax break, but the timing was unusual. Never before (at least during my career) had Congress passed a stimulus tax bill while the economy was running at full strength. Since the Great Depression, our fiscal policy has always run counter-cyclical. During good times, tax rates would rise to lower the debt level. During poor economic times, stimulus measures would help stoke the fires to get the economy moving out of the doldrums. The last recession was a whopper, of course, and required unprecedented fiscal stimulus, which greatly added to our nation’s debt load. Now that good times are here, the expectation has been that we would apply the brakes to slow things down, especially considering the structural debt issues we face with Social Security and Medicare during the coming decade. To make matters worse on the debt front, Congress then passed a rather large spending bill. Once again, our fiscal policy moved toward even more stimulus at a time of full employment.
Clearly, we have a President and Congress that does not fear debt.
This is a dangerous game. Although our economy is large, diverse and certainly strong enough to handle considerable debt, there comes a point when the interest burden starts to take its toll and hijacks the nation’s capital from necessary investments. And remember, Social Security and Medicare are two programs that are simply not going away. The Baby Boomers are entering retirement with fewer workers paying into the system behind them. Thus, even if we were to cut all discretionary spending out of the budget for the next decade, our debt levels would likely rise. Some might argue to cut Social Security and Medicare. However, over half of all 50-year-olds have not saved a penny for retirement, and they constitute a voting block so large that they make it virtually impossible to drastically alter either program. Thus, adding to our debt levels during boom times looks irresponsible.
For one thing, it puts the Fed in a precarious position. Unnaturally low interest rates helped to maintain the economy during a very tumultuous period. It also allowed the cost of our nation’s debt to be minimal. Now, our economy is at full employment, inflation is creeping up, and the tax cuts are providing extra growth. Add in more stimulus from the most recent spending bill and it becomes clear that the Fed will likely be forced to raise interest rates. The trouble is, not all rates are rising as fast, causing the yield curve to flatten. (If you plot all the interest rates on a graph from short-term rates to long-term rates, the shape is called the yield curve.) The normal shape is a rising curve with short-term rates lower than long-term rates. If short-term rates rise faster than long-term rates, the curve is said to be flattening. This is fine to a point. If it flattens too much, however, or even inverts (short-term rates higher than long-term rates), the economy is in for trouble. This is because it is difficult for banks to borrow money short and lend long as they normally do. They would lose money doing so and therefore don’t do it.
Adding to the angst, Trump followed through on his campaign promises and initiated some protective tariffs in the steel and aluminum industries. He was able to do so without the consent of Congress by declaring these industries vital to national security. Clearly, during wartime, our nation could not rely on foreign steel and aluminum to support our war efforts. The trouble is, our steel and aluminum mills are not very efficient, and these tariffs will not address that problem. Plus, the retaliations that are sure to come (and, in fact, have already begun) puts us at risk of a trade war. Our economy is now inextricably interwoven into the world economy. So a trade war would be a complete disaster. While it may be true that the tariffs will save a few jobs in the steel and aluminum industries, the net effect on employment is depressingly negative. That is because there are many more value-added industries that rely on cheap steel and aluminum to compete globally. Industries like autos, home building, air travel and infrastructure all benefit from relatively cheap steel and aluminum. The job losses that will occur in those industries far outweigh the gains that will be realized in the steel and aluminum industries. Ironically, tariffs will hurt the efforts of the just-passed spending bill because infrastructure spending just got more expensive.
Cause for Optimism.
In reality, the outlook isn’t nearly as bleak as the picture I’ve painted here. The markets were due for a correction, and this quarter provided an excuse to have one. This is not unusual. The tariffs sound scary, but the dollar amounts are actually pretty small relative to the economy. China did retaliate, but thus far has done so in a controlled way. It feels like one giant first bid in a long, drawn-out negotiation. Certainly, China needs to be put in check as it is notorious for stealing our intellectual property. Yes, it is worth monitoring, but the hits to the market may be an overreaction.
The fact that long-term rates aren’t rising rapidly is a net positive as long as the Fed doesn’t overdo it on the short end. While they have provided a path that indicates up to six more increases in the next two years, I do not think they will be that aggressive if long-term rates don’t normalize, or the economy starts to cool off. Relatively low interest rates will reduce the burden of the increased debt loads to our economy. If short-term rates stay below 3% and long-term rates don’t rise above 4%, the economy should be durable enough to withstand modest hikes.
The coming mid-term elections should prove to be interesting. Nearly every first-term President’s party has lost seats in past mid-term elections. This year is unlikely to be different, despite the fact that Democrats have more seats to lose than Republicans. The most likely scenario is that the Republican Party, at the very least, loses control of the Senate. Given that both parties tend to spend like drunken sailors when they are in complete control (despite the alleged conservative platform of the Republican Party), adding a Democrat counter-weight may help fix some of the problems mentioned above. The markets seem to be acting as though the current state of affairs is permanent or will even worsen. History, however, suggests we’ll adapt and adjust. The intense nature of the rhetoric spewed by media these days and spread through social media, fueled partially by our President’s own Twitter account, skews our perception of reality.
Putting it all together, the market still has potential to rise as global economies continue their recovery. With no recession yet in sight, a major bear market is unlikely. Maintaining exposure to stocks remains prudent. Interest rates will most likely rise in the coming year. Thus, fixed income portfolios need to adjust to this new reality. Adding safer treasuries and shorter floating-rate securities will help during this adjustment period. Finally, check your pulse from time to time as the year unfolds. If you need to review your plan or just want to talk through it, please give us a call or set up an appointment. The key to success for any financial plan is to stick with it during uncertain times, and we are most certainly in the midst of uncertain times.