December 08, 2017

Stocks rallied yesterday as the volatility of recent sessions faded. Bonds rose and yields fell.

This week, in looking ahead to 2018, I noted that the key variable was interest rates. Over the past couple of weeks, as volatility increased and the pace of rotation escalated, some investors began to fear the dreaded 10% correction, that killer of stock valuations that has kept some out of the market as prices continue to rise. They figured non-taxed institutions were selling off the year’s big winners in front of taxable investors trying to hold out until after January 1 to avoid paying Uncle Sam anything more than they had to.

Indeed, some of the hottest stocks, notably within the semiconductor space, did sell off by 10% or more. But temporary tax selling doesn’t create major corrections. If you remember back to the last major correction, stocks fell as oil prices collapsed and fears rose that growth in China would decelerate rapidly. Once oil prices found a bottom and China stabilized, the correction not only ended, but rapidly reversed. Today, there are no concerns of that size. That is not to say they can’t happen tomorrow. The problem for stocks certainly isn’t the earnings outlook. If anything, growth around the world is accelerating. Christmas season seems to be getting off to a strong start and inventories are lean. Oil prices are back near $60 per barrel. Today’s employment report should show a continuation of recent trends. The biggest problem companies are having today is finding qualified workers. A Wall Street Journal story earlier this week noted that trucking firms are paying $10,000 signing bonuses for truckers who might earn $1,000 per week.

An overheated economy (and we aren’t there yet) would probably bring with it rising inflation expectations. As I noted in my 2018 outlook, interest rates, not earnings, are going to be the key variable to watch this year, in my opinion. But as stocks calmed down yesterday, and it appears more calm will come this morning barring an outlier of an employment report, long-term bond yields remain within a very narrow range. If real inflation expectations were rising, it should be reflected in the bond market. Fears of what might happen are different than reaction to what actually is happening. The key number in today’s employment report probably isn’t the number of jobs created. Rather, forward-looking economists will be closely watching the average hourly wage number for any sign of inflation escalation. For months that number has hung right around 2.5%. Even if it jumps a bit this month, one monthly number doesn’t make a trend, but all trends have to start somewhere.

The pending tax bill is designed to help accelerate economic growth. Time will tell whether it will. Increased corporate investment spending and some trickle down from investors receiving higher dividends could add a couple of tenths to our GDP growth rate. However, for most individuals, they won’t really know the impact of this bill until sometime in 2019 when they file their 2018 taxes. That will be particularly true if Congress keeps the alternative minimum tax (AMT). In fact, the way the Senate version of the bill is written, quite a few married couples with simple returns, who might be eligible to use the doubled standard deduction will end up getting caught in the AMT for the first time. These unintended consequences (at least I think they were unintended) are a result of rushing a bill through Congress without proper due process and consideration. A bill of complexity will have its flaws that require subsequent fixes. Hopefully, the Congressional conference committee will be able to spot and repair some. But back to my point about growth, most of the benefits of this bill go to businesses, and they are not going to be heavy spenders until they see increases in demand. The nation’s consumers aren’t about to accelerate spending if they don’t have more income to spend. Thus, a lot depends on how Congress restructures brackets, and how withholding changes for the average worker, if at all. Without a significant reduction in taxes withheld and a commensurate increase in take home pay, it is unlikely that there will be a significant increase in spending patterns. Yes, today’s investment spending may lead to benefits over time. But it would appear, to the extent there are significant benefits from this tax bill, they are not likely to be felt until 2019 or later.

One thing that isn’t in doubt, however, is that whatever passes is going to increase the deficit. The deficit is rising today, before the bill passes, as growth in entitlements more than offsets the growth in revenues from higher tax receipts. That could change in coming years as investors begin to realize significant capital gains, but one can’t build budget expectations around the notion of a stock market rising 20% per year.

One big fiscal initiative that has been missing so far in the Trump presidency has been anything related to infrastructure spending. Reports today suggest that the next big initiative will indeed be infrastructure. They say the program will be built around $200 billion of government infrastructure spending, combined with $800 billion of private investment. What is left vague is how the $200 billion in government spending is going to be funded. Mr. Trump’s private business success was built on heavy use of debt financing. The government doesn’t work the same way. Add the rising deficits, the additional impact of tax reform, and monies to fund infrastructure spending, and you have the makings of a debt service burden that could be overwhelming in just a few years if interest rates rise simply to historic norms.

But I don’t want to ruin the Christmas party. A strong employment report this morning, a good economy, and normal year-end momentum has us in good spirits for now. There are few signs the party is about to end. The biggest possible storm cloud, rising inflation fears, isn’t visible just yet, but bears watching out for. Until then, the best thing you can do is look at your portfolio, weed out the companies persistently coming up short versus expectations, and enjoy the holidays.

Today, Nicki Minaj is 35. Teri Hatcher is 53.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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