The third quarter of 2017 was a strong quarter for the markets — a continuation of what we experienced in the first and second quarters. Equity markets were strong once again, and led by emerging and developed foreign markets — again. Fixed income markets continued its slow, stable march upward.
Economic trends in the US were little changed over the summer. We learned that US GDP growth was 3.1% in the second quarter and appears to be tracking at 2.5% in the third quarter. Job growth had continued at a decent pace until Hurricanes Harvey, Irma, Jose, and Maria helped break an 83-month streak of positive job growth. Nonetheless, unemployment finished the quarter at 4.2%, a level not seen since February of 2001.
S&P 500 earnings per share grew by 10.3% in the second quarter on easy comparisons, which disappear in the third quarter — expectations are for only 2.8% growth per Factset.
The Federal Reserve (Fed) left its benchmark federal funds rate steady at 1-1.25% during the quarter, however it did announce that it would begin to bleed down its $4.4 trillion balance sheet at a rate of only $10 billion per month (less than 3% reduction per year). The Fed, along with the Bank of Japan (BoJ) and the European Central Bank (ECB), have accumulated over $11 trillion in financial assets (i.e. quantitative easing) since the onset of the 2008-2009 recession in an attempt to spur their economies by forcing down the borrowing costs of its companies and consumers. The Fed becomes the first of the big three central banks to begin to unwind years of quantitative easing, but the ECB appears to be close behind.
The investment community will be closely watching President Trump’s choice to lead the Fed once current chairperson Janet Yellen’s term ends in February 2018. Although Yellen is on Trump’s short list, it would appear that Trump will choose a chairperson who shares his goals of unwinding banking regulations, particular those that Yellen helped put in place in reaction to the 2008 global financial crisis (e.g. Dodd-Frank Act). There are concerns in some financial circles that the new chair will be aggressive in raising rates and reducing the Fed’s balance sheet, namely Stanford professor John Taylor. He developed the well known “Taylor Rule,” an equation to calculate the “optimal” benchmark federal funds rate based the divergence of actual and desired/potential levels of inflation and GDP growth. The rule currently points to a fed funds rate of over 3%, well above today’s 1-1.25% rate.
September’s hurricanes not only destroyed jobs, but also took the lives of over 100 Americans and caused between $200 and $250 billion of property damage (1.0-1.35% of US GDP), much of which was uninsured. While these hurricanes may not have been directly caused by climate change, the majority of scientists agree that their power was enhanced by it.
Although more frequent and damaging hurricanes are just one on a long list of damaging consequences of our warming environment, they serve as a poignant reminder that there are very significant costs associated with our world’s fossil-fuel dependent economy. It is out of this concern that we, as a company, are proud to partner with 1% for the Planet to address this challenge. We think our financial contributions to non-profits tackling climate change will be a great investment enjoyed by generations to come.
On the trade front, US, Mexico, and Canada are currently engaged in the fourth of seven scheduled rounds of negotiations on the North American Free Trade Agreement (NAFTA). The Trump administration has yet to make any concrete proposals, but its rhetoric thus far has been extremely protectionist and inflammatory. Meanwhile, the US Department of Commerce has raised import tariffs on a wide range of Canadian imports, including lumber, magazine paper, dairy products, and most recently, aircraft. The latter, a 300% tariff on Bombardier’s new C Series regional jets, if not removed, will scupper Delta Airlines order for 125 C Series aircraft worth $5.6 billion at list prices. Canada and the United Kingdom have threatened to retaliate by passing on future orders for American-made Boeing fighter jets and attack helicopters. We fear that more frequent and damaging breakdowns in trade between the US and its largest trading partners are possible as Trump implements his “American first” approach to foreign trade, hurting all economies, and most companies, employees, and investors involved.
Geopolitical tensions continued to deteriorate during the quarter, particularly US-North Korea and US-Iran relations. North Korea tested several medium to long-range missiles and conducted its sixth nuclear test, the US and South Korea held their annual military exercise, and Chairman Kim Jong Un and Trump traded personal insults and threats of nuclear annihilation.
Against the recommendations of the international community, Secretary of State Rex W. Tillerson, and Defense Secretary Jim Mattis, Trump will “decertify” the international nuclear deal that restricted Iran’s nuclear enrichment program through 2030, if numerous White House insiders are to be believed. Such a step would trigger a 60-day congressional review period to consider the next steps for the US, which could include pulling out of the deal. With all other signatories indicating that they will not reopen negotiations over Iran’s nuclear program, it would appear that Trump hopes that threats of US sanctions and/or military attack will convince Iran not to advance its nuclear weapon and missile programs, and to stop aiding US adversaries in Syria, Lebanon, Iraq, and Yemen.
Angela Merkel won her fourth term as chancellor of Germany, however it was the strong showing of the far-right AfD party (13% of the votes) that made headlines. Merkel and her CDU party are trying to form a government with FPD and the Greens, a coalition that has never existed before in German politics — leading to concerns over the stability and effectiveness of the coalition.
As with the previous two quarters this year, AlphaGlider Strategies performed well on an absolute basis, but notched only 75-80% of that of its benchmarks. This is not surprising as our strategies were conservatively positioned to protect our downside risk. We held large cash and cash proxy positions, underweight equities, and short on duration in our fixed income investments — reflective of our concern about high equity valuations in the US, low interest rates in a time of Fed tightening (albeit very slowly), and rising geopolitical tensions.
As in the first half of the year, the best performing fund throughout all of our strategies during the third quarter was our emerging market fund2 (Vanguard FTSE Emerging Markets, VWO), up 6.7%. Our US information technology fund (Vanguard Information Technology, VGT), which we hold in our more aggressive strategies, was up 7.9%. However, our overall underweight in US equities was large enough to cause all of our strategies to be underweight this well performing sector.
Within our US equity allocation, we were hurt by our exposure to the conservative consumer staples sector (Vanguard Consumer Staples, VDC) — our fund was down -1.7%. And as we mentioned earlier, our skew to short duration in our fixed income allocation detracted from our performance. Our corporate and aggregate short term bond funds (Vanguard Short-Term Corporate Bond, VCSH, and
Vanguard Short-Term Bond, BSV), were up only +0.3% and 0.0%, respectively. Our biggest sin of omission (the asset we wished we had owned, but didn’t) during the quarter, was commodities.
OUTLOOK & STRATEGY POSITIONING
In the past I have always written about investments in this section, but this quarter I’m going to discuss another topic — taxes. Like investments and their returns, taxes have a major impact on how much you are able to save for life’s major expenditures. At AlphaGlider, we do all that we can to minimize, or defer, taxes on our clients’ investments through tax-sensitive asset location, tax loss harvesting, and infrequent trading. But that’s not the topic today. Instead, I will dive into the tax code reform effort that the Trump administration and Republican leadership commenced in late September, with a focus on what I believe to be the most relevant points for most of my clients and readership, which tend to be upper middle class professional individuals and families living on the West Coast and in Texas.
Although light on details, the Republican’s nine-page (including the cover page) framework document provides tax policy wonks enough nuggets to make some projections with the aid of reasonable assumptions. The Tax Policy Center (TPC) was the first well respected, non-partisan group to publish an analysis of the Republican tax framework, so I will be using their numbers from here on, unless otherwise stated.
The first conclusion is that this tax reform effort really isn’t about you and me directly, but about businesses. As the table on the left shows, the framework’s new individual tax provisions look to raise an additional $0.23 trillion over the next 10 years, or $0.47 trillion if you exclude the repeal of estate, gift, and generation-skipping transfer taxes which only apply to the wealthiest 0.2% of Americans. But businesses (including the owners of pass-through entities such as S-corps, LLCs, partnerships, and sole proprietorships) look to see a whopping $2.65 trillion tax cut over this time period.
The chart below shows the annual magnitude and timing of these individual and business tax provision changes. The benefits to business (orange bars) are front loaded due to a proposal to allow the immediate expensing of capital expenditures over the coming five years — but then resort back to standard depreciation expense practices.
But businesses are ultimately owned by individuals, so the TPC analysis goes on to map the business provisions to households, which leads to the second conclusion: this tax reform effort is fairly insignificant to the lower 95% of American households by income, but quite lucrative for the top 5% (the 95th percentile household income is approximately $300,000). For the lower 95%, after-tax income will be affected by 1.2% or less, regardless of being in the lower, middle, or upper end of this large group of taxpayers. However, the after-tax income for the top 1% of households will improve significantly, nearly 9% on average. In absolute terms, that’s $129,000 in additional after-tax income next year for the average top 1% income household. So if you’re fortunate enough to be in this elite group (households with $732,800 or more in annual income), then congratulations, this tax reform effort is about you.
In ten years time, as the chart to the right shows, well over 90% of the Republican’s tax cuts will accrue to the top 5% of households, and most of this (80% of the total tax cuts) to the top 1% income households.
The other highlight of this chart is the third conclusion, that the upper middle class, those in the 80th to 95th percentile in household income (approximately $150,000 to $300,000) will, on average, pay more tax over the next ten years due to this tax policy change. The TPC analysis shows one in three households in this upper middle class bracket paying more in taxes next year, and 60% paying more in 10 years.
The pain for this group of households, which I suspect you may be a part of, comes from the framework’s elimination of personal exemptions and many deductible expenses, notably state and local taxes (including property and sales taxes).
The fourth conclusion is that the Republican’s plan will likely change significantly before it gets approved by Congress. And it is far from guaranteed that it will even be approved — as the Affordable Care Act (ACA) repeal and replace process demonstrated. Tax policy reform invariably creates winners and losers, and right now there are many powerful groups in the losers column that will fight hard to overturn some of the proposals. The biggest fight is likely to come from Republican Congressmen representing high tax districts where the repeal of state and local tax deductibility will be especially painful, and I believe they will be successful. As the previous table on revenue effects of the proposal shows, elimination of state and local tax deductibility generates $1.3 trillion in additional tax revenue over the next 10 years.
The TPC believes that the framework, as currently written, will increase the national debt by $2.42 trillion over the coming 10 years (the deficit currently sits at just over $20 trillion). Assuming state and local tax deductibility is preserved, national debt increases by $3.72 trillion over the decade as a direct result of the tax plan. Such a bill would have no chance of getting through the Senate, as the Democrats would undoubtedly filibuster any vote on it. However, Republicans could pass a tax bill with 50 votes under budget reconciliation rules (there are 52 Republicans in the Senate), but this would require the bill to expand the national debt by no more than $1.5 trillion.
Finding $2.22 trillion in additional net tax revenue over next 10 years to get down to the $1.5 trillion deficit threshold requires significant changes to the current tax plan. Continuing the “what if” nature of this analysis, I suspect that Republicans will choose to add back the estate, gift, and generation-skipping transfer taxes ($0.24 trillion) and the immediate expensing of capital equipment ($0.19 trillion), create an individual income tax bracket above the current 35%, and raise the currently proposed 20% top business and the 25% pass-through entity tax rates (70% of pass-through income is earned by the top 1% income households, most of which are currently paying 39.6% on this income).
The Republicans could also raise net tax revenue through a process called “Rothification” — the forced conversion of some or all of Americans’ pre-tax IRAs and 401(k)s into their post-tax Roth counterparts, triggering a massive 1-off taxable event at marginal tax rates. There have been numerous reports over the summer that Republicans had been considering this option to fund business tax cuts.
I also suspect that we could also see the Republicans revive their attempt to repeal and replace Obamacare. Their previous, but failed, attempts would have raised approximately $1 trillion in net tax revenue over the coming 10 years.
As an extension from my first conclusion that most of the tax cuts will be enjoyed by businesses (and pass through entities), my fifth conclusion is that the value of US businesses, especially those with large portions of their profits generated in the US, should benefit. However, and this is a big however, it appears that the market has already priced in a decent benefit from lower taxes going forward. David Kostin, an analyst at Goldman Sachs, calculates that for every one percentage point cut in the headline business tax rate, the S&P 500’s earnings per share (EPS) increase by $1 — so the proposed 10 percentage point tax cut (from 35% to 20%) would add a one-time $15 boost (+11.5%) to earnings per share. Add to this the 10% growth in earnings since the election, one gets to just above the 20% increase in the value of the S&P 500 since before the election. If the new business tax rate comes in above 20% as I’ve suggested is likely, or doesn’t come through at all, then we could see the US market sell down. Prediction markets, such as PredictIt, are currently only pricing in a 30% chance of a business tax cut passing this year.
Although I think that a 20% marginal tax rate for businesses is unfeasible given the country’s budget realities, I do think that it should be lowered from its current 35% marginal rate which is high relative to the US’s trading partners. I also applaud the Republican’s proposed move from a global to a territorial based tax system for businesses, which nearly all of the US’s trading partners use. These two changes would remove much of the incentive for US companies to play transfer pricing games and to strand profit overseas. I am also encouraged that Republicans are considering rolling back some interest expense deductions for companies, which if implemented should incentivize US companies to lower their debt levels, and in turn, their overall risk level — more focus on operational excellence and less on financial engineering would improve true value creation within the economy.
However, there is also much to be concerned about with the Republican’s proposed tax framework. The first is the negative impact it will have on the national debt over the next 10 years. With the national debt already exceeding 100% of GDP (it was only 60% 10 years ago), social security and Medicare payments rising rapidly as the population ages, and eight plus years into an economic expansion and only 4.2% unemployment, now would be the time to get the America’s budget house in order.
I fear that increasing the country’s structural deficit in order to fund tax cuts, 90%+ of which will accrue to the wealthiest 5% of Americans, will only stoke more economic inequality and populism, and risk destabilizing the country even more than it is today. I fear for our children and grandchildren who will be saddled with higher levels of debt caused by this proposed tax framework, requiring them to pay more in taxes and/or receive less in government services. I fear that higher levels of debt will leave the government and the Fed with less leeway to react to future recessions. Balanced budgets had been a hallmark priority for the Republican Party during the previous eight years, but now in control of the Congress and Presidency, they have taken a distant back seat to tax cuts for the wealthiest 5% of Americans.
Republicans claim that their plan’s tax cuts will boost an economy that they believe is running well below its potential, so much so that the cuts will pay for themselves. The idea being that businesses will reinvest their tax savings in their operations. Factories will be built and expanded, new workers will be hired, more stuff will be sold, profits will increase, and in turn, and tax revenue will stable despite lower tax rates. But most economists and I are skeptical of this, at least in this late stage of an economic expansion running at full employment, with low borrowing costs, and substantial business free cashflow generation (see the logarithmic scale chart below; corporate cash flow is 50% higher today than 10 years ago).
Instead, we think that the bulk of the tax savings will be passed down to shareholders in the form of higher dividends, share buybacks, and to the owners of pass-through entities — the majority of which go to the wealthiest 5% of Americans. And while some of this will be spent of higher consumption, the large majority will not. We’ve seen this movie several times before, back in the late 1980s with President Ronald Reagan’s second major tax cut, in the 2000s with George W. Bush’s tax cuts, and again this decade in Kansas under the leadership of Governor Sam Brownback — unfunded tax cuts do much more to expand deficits than to create growth.
But if I and many economists are wrong, and trickle-down economics do rule the day, then I fear the economy could overheat and risk bringing forward, and make worse, the next recession. Why? In its ninth year of economic expansion (3rd longest in post-war history), the US is at full employment, so most companies looking to grow will need to lure high quality workers from other companies with the promise of higher wages and benefits — stoking inflation and with it, interest rates. So while companies may see a boost to their net margins from the tax cuts, they could get pinched by higher wage expense and borrowing costs. One only needs to look back to the most recent major tax cut to take place during the mature stages of an economic expansion — President Reagan’s reduction of the top individual tax rate from 38.5% to 28% in 1988 (but lowered the income at which it kicked in, from $90,000 to $29,750), in the sixth year of an economic expansion. Within two years, the US economy entered recession. Graduating from university in 1991, I remember that recession all too well.
So in simple terms, the Republican’s tax reform proposal, as currently written, strongly benefits the country’s wealthiest 5% at the expense of the remaining 95%. Although absolute taxes paid by the bottom 95% may not change much over the coming 10 years, the national debt would grow substantially, and with it the obligation for all Americans to pay it back in the future through higher taxes and/or lower government spending.
However, the tax reform proposal needs to morph considerably if it stands a chance of passing through the Senate due to the budget reconciliation’s maximum $1.5 trillion 10-year deficit threshold. What is known with less certainty is if the coming changes skew to reigning in the benefits to the top 5% (e.g. maintaining estate taxes, raising business and high bracket tax rates), or to adding to the bottom 95%’s burden (e.g. ACA repeal and replace, Rothification). Or if the Republican’s tax reform efforts go the way of their ACA repeal and replace attempts — coming up short of the necessary 50 votes in the Senate.
P.S. If you haven’t done so already, I highly recommend that you freeze your credit files with the four credit bureaus. I wrote a blog post last month with recommendations on how to deal with the massive Equifax hacking events.