The broad-based U.S. stock market surged 19% in 2017 while the narrower Dow Jones Industrial Average was up 25%. Nearly two thirds of investors now feel like the stock market will continue to rise which is the highest measure on record. Investors are buying on even the smallest pullbacks with the expectation that corporate profits will increase under the Republican tax bill and assuming that economic growth across the U.S. will maintain itself in a low but steady gear. Across the globe, soaring stock prices added more than $9 trillion in market value, the largest rise in a decade. In the U.S., about one quarter of the increase came from the five large U.S. companies: Apple, Alphabet (formally known as Google), Amazon, Facebook and Microsoft.
Technology stocks in China have played a leading role in lifting international markets with the overall Chinese market index up 46% during 2017. Emerging-market stocks climbed almost 32% while international stocks in developed nations gained 23%, all in U.S. dollar terms. The euro zone economy looks to be expanding as are company earnings in Japan. There are almost no dark clouds on the markets’ horizons. Worldwide, inflation remains muted and, other than the possibility of extreme geopolitical events originating in places like North Korea or Iran, the political environment seems more stable than it has been for many years.
What could go wrong? U.S. stocks now trade at close to 18.5 times next year’s earnings, the highest level in 15 years. Looking backwards, companies in the broad-based S&P 500 are valued at roughly 23 times their past 12 months of earnings, which is 30% above their 10-year average. Stocks are more expensive today than at any time since the tech bubble of the late 1990s. Bonds are even more expensive than stocks and as dangerous, as even small interest rate hikes could negatively impact the values of many bond mutual funds. Strong corporate earnings in the U.S. and Europe, along with continued accommodative monetary policy, indicates that holding the course and maintaining one’s position in stock ownership is the “right” thing to do.
Short-term interest rates have started to rise due to recent Federal Reserve activity but long-term rates, those charged by banks for 10+ year loans or mortgages, have actually come down, creating what’s called a “flat yield curve.” The importance of the yield curve is that historically, as short and long-term rates converge, the probability of an economic recession increases. Many analysts feel that a recession is unlikely in 2018 but that by 2020, it is highly probable. As the Federal Reserve raises interest rates and labor becomes less abundant, inflation is likely to reappear. For the time being, however, everything is calm and as a result, interest rates paid on U.S. treasuries will probably continue to move in a slow and controlled manner. This phenomenon exists in the bond markets of most industrialized nations, indicating that central-bank coordination is alive and well.
The U.S. large technology company index, the NASDAQ 100, continued to lead the way in stock performance during 2017 with a 31.5% gain, second only to the biotech industry, which gained 37.3%. The worst-performing sectors were oil and oil service companies which were down 18%. U.S. midsize companies were up 14.5% with small companies advancing 11.7%. Usually, small-company stocks outperform large-company stocks, but this has not been the case over the last six or seven years.
Industrial and agricultural commodities gained around 10% in 2017 while gold was up close to 13.5%. Even the price of oil went up, advancing 12.5%. With the advent of fracking throughout much of the U.S., natural gas output has increased dramatically, thereby depressing its price by 21% over the course of last year. Overseas markets gained 24.6% on average with the European Union market advancing 10.1%. The Hong Kong index led the overseas pack with a 36% gain, India rose 28%, Japan was up 19% and the Shanghai composite was up a mere 6%.
The best performing segment of the domestic bond market once again was high-yield bonds with a 6.6% gain. U.S. government bonds advanced 2.5% while corporate bonds were up about 4%. The incremental interest rate that investors now receive on low-grade bonds versus high-grade bonds is negligible, a sign that the public’s appetite for risk and their desire to reach for a higher return remains unabated. This kind of disregard for risk return tradeoffs usually does not end well.
The Political Economy
Our prognosis for 2018 is that there will be an upturn in wages and inflation due to the flood of money that businesses will receive due to lower tax rates called for under the 2017 Tax Act. This will be followed by the Federal Reserve raising rates to at least 2% by the end of 2018. The U.S. gross national product (GNP) growth rate looks like it will come in around 2.3% for 2017, slightly above 2016. This level of growth does not justify the U.S. stock markets’ meteoric rise since the election of President Trump, though corporate profitability has increased considerably more than the “real” economy as a whole. The U.S. has, officially at least, a 4.1% unemployment rate, the lowest in a decade. Most Americans who own stock are feeling wealthier due to the increase in value of their stock market holdings, which in the aggregate was a $6 trillion gain in 2017. Consumer confidence continues to manifest itself in robust spending on automobiles, durables, and real estate.
Unfortunately, U.S. wage earner productivity growth remains moribund and even innovative companies in Silicon Valley cannot find enough high return investments for their cash. They are therefore pursuing large-scale common stock repurchases which allows them to show better earnings per share and paper profit numbers going forward.
We expect the U.S. dollar to strengthen in 2018 due to the repatriation of profits promulgated by the Tax Act. Due to growing demand for oil in the developed and emerging markets, we expect oil prices to move higher which would provide a welcome respite for the energy and oil service companies which have suffered over the last four years.
Congressional midterm elections take place this year and if they become a referendum on the Trump administration, Republicans could see setbacks in both houses. We do not see any substantive political crisis developing in either the Mideast or in East Asia, as the administration’s performance in foreign affairs has not followed the tone of the President’s bellicose public remarks.
Chinese authorities continue to try to address their rampant and long-standing credit and corruption problems while the Chinese military will, we hope, see the benefit of cooperating with the international community to contain North Korea’s expansion of their nuclear weapon and missile programs. We believe that cyberattacks originating in China, Russia and North Korea will increase in 2018 and that many business opportunities are being created in this field (see below section on bitcoin, blockchain technology, and quantum computing).
The Japanese economy is gaining traction in exports and the aggressive fiscal and monetary policy of the Bank of Japan should allow their economic recovery and recent stock market rally to become more broad-based. Growth in the euro zone will be slightly below 2% in 2018 but there is a significant risk of a continued rise in anti-European Union sentiment. The British exit from the European Union will not occur until 2019 and we expect Britain to establish bilateral trade agreements with other nations to supplant their lost revenue from being an integral part of the EU. Interest rates are still negative in most of Europe and we expect this weirdness to continue through the coming year due to the tepid rate of real economic growth.
Emerging markets had a great year in 2017, especially in countries such as Argentina and Chile where there are now pro-growth governments. Emerging Asia is the fastest-growing region on the planet and this is expected to continue through 2018, though their stock markets are at risk if the Chinese economy slows and fewer commodities are needed from the developing world. Overall, the prospects for global stock markets show a higher risk and lower return conditions on the horizon. International stock markets will probably grow at a faster pace than the U.S. in 2018, and real estate markets worldwide will reflect any deep correction in the valuation level for stocks.
The 2017 Tax Bill –What it does and doesn’t mean
The one thing that is clear about the new tax bill is that it is not simple. Americans as a whole will continue to spend about 6 billion hours a year on their taxes and most people will still need the help of a professional to prepare their returns at a total compliance cost to the country of around $200 billion per year. Nearly everyone was in favor of simplifying the tax code but that did not happen because the only way to do so is by getting rid of deductions such as the charitable deduction, mortgage interest deduction, personal exemptions, retirement contributions, and so forth. Doing this would help put less strain on the budget, now estimated to increase around $1 trillion per year due to the 2017 tax cuts.
The only major tax break that was challenged was the deduction for state and local taxes which includes both income and real estate taxes. This deduction was reduced in the final bill to a $10,000 maximum level. New mortgage loans of more than $750,000 will not be deductible but none of the other deductions were touched and so Congress appears to have missed its once in a generation chance to meaningfully simplify the tax code. Tax preparers and lawyers are delighted. From an estate planning perspective, wealthy Americans now have twice the previous death tax exemption and so, starting this year, up to $11.2 million can be gifted or left upon death to heirs free of estate tax, twice that amount for married couples. This tax benefit is scheduled to expire in eight years, in 2026, when it reverts back to 2017 levels, adjusted for inflation, so estate planning professionals will certainly be busy.
Many details remain to be worked out but it is clear that the Tax Act of 2017 creates a huge window of opportunity for large corporations as well as for wealthy families. The corporate tax rate will decrease by a whopping 45%, from a top bracket of 35% down to 21%; while the average tax rate on individuals and couples will decline 10%, from a top bracket of close to 40% to approximately 36% so the benefits of the Tax Act are allocated about 80% to businesses and 20% to individuals.
The guiding theory of the Tax Act is that companies will use their tax savings to reinvest in America – thereby creating jobs. Most corporations will use some of their increased profits to improve their facilities and in some cases, raise wages, but the bulk of it will be used to return profits to shareholders. Realtors appear to lose the most under the new tax code because of new limitations on deducting state and local taxes as well as a limit to the mortgage interest deduction. It will be a particularly harsh blow to homeowners in expensive markets that have high state income tax brackets like New York, New Jersey and California. The traditional advantage of owning one’s home will diminish and it is expected that within 18 months, U.S. home prices will be about 4% lower than they would have been if the tax bill was not passed. In high state income tax locales, residential prices could fall as much as 10%.
The 2017 tax bill will be a boon to large retailers, pharmaceutical and energy companies – both in terms of better write-offs and lower tax rates. The largest corporate holders of overseas cash, which previously was not returned to the United States for reinvestment because of high tax rates, are expected to bring back a flood of money into the U.S. Wall Street expects most of those companies will pay a very low tax rate on repatriated funds and then use most of the excess after tax cash to buy out rivals, purchase back their own shares and in general do things that benefit company executives and large shareholders.
Republicans presented the tax bill as a way of encouraging global manufacturers to move production back to the U.S. This may turn out to be the case as the new law allows companies to immediately write off the costs of equipment purchases. The compromise tax plan imposes a new limit on interest expense deductions, which will hurt highly leveraged companies. The airline industry will see a benefit from lower tax rates as will the defense industry because the drop-in tax rates as outlined above far outweighs any loss of credits to them for research spending. Restaurant companies and fast food firms are expected to reinvest their savings from the much lower tax rates into improving their food quality and to remodel restaurants, but many analysts feel that companies are much more likely to reduce their debt loads, buy back their own shares and increase dividend payouts. We really won’t know which way things are going until at least 12 months down the road. We do know that large companies will benefit more than small companies and that is why a special lower tax rate on pass-through income from activities such as owning real estate and making loans did make its way into the final tax bill.
It is unclear whether working professionals such as doctors and lawyers will be able to take advantage of the new law. We believe there is a high probability that investors in our private investment projects will be some of the prime beneficiaries of the new tax law. Also, worthy of note is a “let the good times roll” provision in the tax bill that cuts Federal excise taxes on alcohol. This is the first cut in tax rates for alcohol makers since the Civil War. Skeptics say that the economic harm from excessive alcohol consumption costs the nation about a quarter of a trillion dollars annually, including 88,000 deaths, untold amounts of domestic violence, chronic illness and lost productivity.
The Tax Act will, unless the U.S. economy grows at a 4% or greater level over the next 5 to 10 years, leave the federal government with an inadequate revenue base to cover its expenses. The bipartisan Simpson Bowles commission concluded that the Fed government needs a revenue base equal to 21% of gross domestic product. It appears, upon initial analysis, that under the Tax Act of 2017 the federal government will end up with a revenue basis of 17%, a difference of $1 trillion a year. The Tax Act was motivated by the conviction that by borrowing and building, the U.S. economy will be revitalized. Let’s hope so!
Cryptocurrencies, Blockchains and Quantum Computers: A Brave New World
Bitcoin, one of the largest and earliest innovations made possible by the blockchain technology described below, was priced around $1,000 per coin at the beginning of 2017 and rose to nearly $20,000 by December, a gain of approximately 2,000%. This meteoric rise was punctuated by five selloffs of at least 30% each, so clearly, it is not an investment for the fainthearted! What does the future look like for cryptocurrencies and is Bitcoin here to stay? Will it become a viable substitute for the “fiat” money (not backed by gold or other hard assets) that has been created and maintained by pretty much every modern sovereign nation?
Bitcoin, like the other cryptocurrencies, relies on blockchain algorithms that use up a great deal of computer power and electricity. To act as a functioning currency, a certain threshold of acceptance needs to be achieved amongst the public at large and by governments in particular. U.S. dollars, in their various paper and electronic formats, are legal tender for all debts, public and private which is another way of saying the government has mandated that everyone must accept dollar bills as payment. The government doesn’t say we cannot accept other things as well, hogs or horses for example, so long as you and your counterparty agree on the value in the trade. However, you still must report taxable gains of your trading in non-money based transactions and then pay your taxes in regular U.S. dollars. The government has the power to define money based on how it requires people to pay their taxes. Businesses must use the government dictated currency as their accounting units and so most people will, for practical purposes, use the same currency for their personal spending, business investment and speculation.
Bitcoin was developed by people who wanted to keep their information away from the prying eyes and taxation authority of governments. It has also been used for criminal transactions and for avoiding government restrictions on moving capital from country to country. Some governments, such as Tunisia, have created their own electronic currency but someone there must stand ready to provide a backup if the system goes down. Bitcoin is, in our opinion, is on a collision course with the central banks of the world, whose mandate is to influence the money supply, so they can help stabilize their domestic economy. Generally, sovereign powers do not give up their “power of the purse” without a fight, which we are only now, in the last several months, starting to see.
We think it is likely that governments will move in to regulate independent cryptocurrencies like Bitcoin and then they will move on to create their own digital currencies, making Bitcoin superfluous. If this happens, rogue or non-government sponsored currencies will see their value diminish quickly as people rush to exit everything but the government sponsored vehicles. Bitcoin’s creators and early users, libertarian and idealistic persons from around the world, have shown that there is value in decentralized processing and independent verification of data which is the definition of blockchain technology. Financial institutions worldwide are developing their own blockchain applications because it is faster, more secure and adaptable than the current modes of processing information over the Internet.
Without getting too technical, blockchain technology is a way of maintaining a continuously growing list of ordered records and decentralizing the processing of making changes to those records while providing a method of verification of the records based on unique numbers. These factors combined allow for huge advantages in the timeliness and secureness of processing. Currently, Bitcoin relies on using vast amounts of electricity and massive duplication of effort. When the new blockchain technology is fully developed, it should allow for a massive lowering of transaction costs which will mean that the innovations of companies such as Amazon, Google, and Facebook will happen again, perhaps through other, as yet unknown companies, but in much greater magnitude. E-commerce, which has been around for less than 20 years, will be upended by blockchain technology in ways that we cannot imagine. Think of all the documents in the world that provide the basis for our society: deeds, contracts, photographic images, financial and medical records, libraries, research papers, entertainment and then imagine them all digitized – able to be called up, transferred, manipulated electronically with proper authorization, then reproduced and verified in real time. Sounds like the USS Enterprise from Star Trek just went into permanent orbit around planet Earth! It’s hard to imagine what this change would mean for many of the jobs that exist today. The financial service sector is going to be one of the first to use blockchain technology and it will obviate the need for many middlemen and transform the way that finances are carried on around the globe.
Blockchain technology is developing at the same time as a new type of hardware computing technology, called quantum computers, is starting to emerge on the forefront of physics and materials sciences. Companies like Google, IBM and several nations are racing to develop quantum computers which use elementary particles, protons and electrons, to simultaneously store multiple pieces of information in superfast motion as opposed to the binary one and zero alternating signals of current computers.
Quantum computing will likely rely on The Cloud for its distribution because the physical conditions under which it can take place are extremely radical and expensive to maintain. The successful development of quantum computers will determine who wins the technology race of the 21st Century. Quantum computers will make current encryption coding and security systems obsolete almost immediately. Like blockchain technology, quantum computing is not something that will happen overnight, both for technical and social reasons. It is likely that governmental agencies will control the use of quantum computers and that private companies, while they may be taking the lead now, will find themselves restricted to support roles because of the inherent power of quantum computing to disrupt, control, manipulate and steal.
The practical applications of quantum computing may not be to produce consumer devices like super-fast mobile handheld personal devices but more likely would allow for a totally new way of developing both physical and intellectual resources. Biotechnology, clean energy, transportation, and almost every other technical research field could be greatly affected.
Rob: We had a quiet holiday season here in New Mexico after hosting several family members for Thanksgiving. With the almost total lack of precipitation, snowshoeing and cross-country skiing have been out of the question so far this winter but hope springs eternal! With the advent of the new year, several private projects are taking form which will take me to California, Colorado, and the East Coast over the next several months. The painting for the bowling alley is almost finished and the “chapel” series of paintings will be installed in a church in Asheville during late February of this year.
Kyle: My family and I had a great 2017. Towards the end of the year, I started playing a lot of squash and really enjoy the game and its unique form of close quarters competition. The cardio challenge is a great change up from my weight lifting routine. Hopefully, there are some clients that will join me for a squash game this coming year. My sons turned eight in December and I am enjoying them grow in both size and as personalities. They are both very witty and active – keeping us on our toes as parents. My wife is moving into the more hands-on phase of her nurse practitioner program which will soon send her to Carlsbad, NM, in the extreme southeastern part of the state, for periodic work in a clinic. Hope everyone is off to a great 2018!
Jeff: My wife and I spent the week of Thanksgiving in San Miguel de Allende, México. Some of our close friends offered us the use of their condo for that week and we greatly appreciated the chance to be there and the opportunity to practice speaking Spanish each day. It had been over 30 years since I last visited San Miguel as it is a popular artistic and cultural place located about 170 miles northwest of Mexico City. It was very easy for us to take public buses to and from the downtown area at a cost of 35 cents. The beautiful and well-preserved historic downtown center dates back to the 17th Century. Our clients who are fortunate to live in San Miguel generously showed us some of the many beautiful sights of the town.
Anthony: The Holidays have come and gone and they were especially enjoyable for my family. We started by hosting our first Thanksgiving in our new home. It was a lot of work but it was a great feeling to share our home with family and give the day off to our parents by taking over the stress of preparing and cleaning up from the Holiday festivities. Christmas was also great, with it being the first year our daughter understood the concept of Santa and gift giving. We were able to start new Christmas traditions as a family while also passing on some that we had experienced as children growing up here in Santa Fe. The excitement in her eyes as she visited Santa and opened gifts Christmas Day made it all something to look forward to again as well. With the new year upon us, cheers to everyone’s health and happiness!
Patrick: These past few months have been full of fun family time as I was able to make it down to the hot springs community in the Mimbres Valley of Southern New Mexico on which I was raised for several long weekends: Thanksgiving, Christmas, and New Year’s. My sister visited from Portland Oregon with her husband and two young boys. It was great to put in some uncle duty time and we had a blast together. As is our family tradition, we ate a lot of delicious food and soaked in the hot springs under the stars and we all feel truly blessed that our family and community members have such close ties.
Contessa: 2017 seems to have flown by in a blink of the eye. With the start of the New Year, I took some much-needed time to step back and think about all the opportunities and blessings my family experienced last year. The holidays were an extremely busy time for us as we visited with family and friends and hosted Christmas for the first time. The kids were more excited about Christmas this year than in years’ past and even tried to set up a trap under the fireplace to see if they could catch a glimpse of Santa. It feels good to get back into a routine now that the holiday festivities have concluded. With a drought in progress here in New Mexico, I am crossing my fingers that Santa Fe gets some snow before the end of the winter. Here’s to a great 2018!
Please join us for our quarterly gathering to discuss economic and market related events. It will be held at 2218 Old Arroyo Chamiso in Santa Fe on Wednesday, March 14 at 3:30 p.m. (MT). We generally go until 5:00 p.m. The open mike conference call, available to out-of-town clients and friends, will occur on Thursday, March 15 from 3:30 to 4:30 p.m. (MT). The call-in number is 719.234.7872, after which you will be prompted to enter the code: 470070#.