Monthly Market Insights – Is Tax Reform a New Reason to Cheer?

December 5, 2017 – Recent headlines have been dominated by the prospect of tax reform which is now in its final stages. While the tax reform bills are largely uniform between the House and the Senate, there are still some significant differences that need to be ironed out – including how the bills treat the taxation of flow-through entities, whether alternative minimum tax will be eliminated or preserved, and whether the estate tax will be repealed.Some market pundits have suggested that tax reform will give the stock market a “shot in the arm” and send domestic stocks higher. Investors are cheering the progress that’s been made and are not waiting for the tax bill to take its final shape.  Over the last week, we’ve seen a rotation out of the technology sector and into cheaper, undervalued stocks which have been laggards for much of the year. Sectors such as banks, retailers, energy, and transportation are expected to benefit from a stronger economy, higher interest rates, and lower taxes. Domestically-oriented small cap stocks are showing relative strength for the same reasons and are once again outpacing their large-capitalization counterparts.

While tax reform creates opportunities at the sector and company level (which is great for active managers like ourselves),the tax bill’s fiscal stimulus will likely have a more muted effect on the broader economy.  It is important to note that when it comes to tax cuts, not all sectors are created equal.  While the headline corporate tax rate in the United States currently stands at 35%, the rate that S&P 500 companies actually pay (the effective corporate tax rate) is only 25.6%, and significant dispersion exists across sectors when it comes to effective tax rates. For example, telecommunications companies have the highest effective tax rates and stand to benefit greatly from reform, but real estate investment trusts (REITs) do not pay taxes at the corporate level and technology companies already have operations set up around the world in an effort to pay the lowest taxes possible. Because the tax cuts will not benefit all sectors in the same manner, the flow-through effect to employee wages, hiring, and investment spending will likely not be broad-based, and it will take time to assess the overall impact on the economy. That being said, there are legitimate reasons for optimism among investors. In the U.S., the unemployment rate is sitting at its lowest level in 17 years, economic growth hit a three-year high of 3.3% in the third quarter, and, for the first time in years, we are witnessing a backdrop of robust and broad-based global GDP and corporate profit growth.

I noted in last month’s commentary that bonds were trading with very tight credit spreads – leaving investors in high yield bonds with heightened risk and little room for capital appreciation. In November, there was a notable selloff in high yield bond spreads mid-month as some companies lowered revenue guidance and investors had jitters over the deductibility of interest in the new tax bill.  By month-end, the underperformance of high yield was partly mitigated by strength in the oil sector. The Morningstar® US High Yield Bond Fund Category Average lost 0.27% in November. Global government bond yields were broadly flat in November. We continue to expect a very gradual pace of policy tightening in the U.S. and elsewhere and a trend toward higher levels. 

On the equity side, world markets suffered a bit of a selloff in mid-November as investors took profits but rebounded to close out the month. The S&P 500 Index gained 3.07% in November while the international MSCI EAFE Index gained 1.05%. A strengthening euro and sterling versus the U.S. dollar caused much of the lag in international versus domestic stocks. Overall, we remain constructive on international stocks, especially in Europe, as November business survey data reaffirmed the euro area’s position as the major economy growing most above trend. 

Year-to-date, the Russell 3000 Index, a broad measure of domestic stocks, is up a stunning 19.93% while the Barclays Aggregate Bond Index is up a mere 3.07%. Unless a dramatic reversal takes place in December, stocks will outperform bonds for the seventh consecutive year in 2017. Stocks have only outperformed bonds for seven consecutive years on three occasions in the past 220 years, the last of which was in 1928. Apart from the Roaring ‘20s and the Golden ‘50s, it has seldom been the case that equities, bonds and credit have been similarly expensive at the same time. History shows us that elevated valuations often signal that investment returns over the medium- and long-term will be lower. At this juncture, a lowering of return expectations heading into 2018 is prudent. As part of our process, we are continually looking for managers and investment opportunities that can further diversify portfolio risk and will incorporate them into our portfolios as appropriate.

We appreciate your continued confidence.Please reach out to us with any questions you may have and have a blessed Christmas.

-Hillary Sunderland, CFA

Chief Investment Officer for Beacon Wealth Consultants, Inc.

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