Fourth Quarter 2017 Update

January 26, 2018

Key Points

• The US economy remains quite strong, with its upward trend intact
• The Eurozone economy grew at a 2.6% annual rate in the third quarter, continuing a positive trend begun early in the year
• Although wage growth pressure has not been an issue so far, that may change with the impact of the tax changes
• Despite the lack of obvious bubbles, most market watchers expect stock prices to be more volatile in 2018 than in 2017

The Global Economy

The US economy remains quite strong, with its upward trend intact. As various headwinds in the form of political infighting and geopolitical tensions continue to be obstacles, economic data in many segments remains on a solid trajectory. The Bureau of Economic Analysis reported its third estimate of third-quarter 2017 gross domestic product (GDP) of 3.2%, down slightly from the prior estimate, but a notch higher than the second quarter’s 3.1% reading. The employment situation also made gains, with an average of approximately 170,000 jobs added each month. At the same time, the unemployment rate remained steady at 4.1%. The Federal Open Market Committee (FOMC) modified its interest rate policy by raising the federal funds rate target by 25 basis points to a range of 1.25% – 1.50%. Economists expect multiple increases in 2018 as the economy encounters wage pressures.

The global economic environment has benefited from increased demand as well as accommodative monetary policies. The Eurozone economy grew at a 2.6% annual rate in the third quarter, continuing a positive trend begun early in the year. One of the key drivers in the Eurozone was solid domestic demand. Japan is among the Asian economies faring well, posting a seventh consecutive quarterly expansion, its longest streak since 2001.China continues to balance instituting economic reforms with maintaining robust growth, with economists expecting the country’s growth to decelerate to about 6.5% in 2018 from 6.8% in 2017.

Below, we’ve highlighted broader market returns for the 4th quarter and year-to-date time periods:

Source: Thomson Reuters

Fixed Income

Fixed income securities’ prices and yields were affected by a variety of factors, including the FOMC’s decision to raise short-term interest rates at its recent December meeting; Congress’ passage of tax reform; solid improvement in economic data; and a continued rise in stock prices. The tax reform package was perhaps the headline event of the quarter, with many economists predicting that the reduction in corporate and individual tax rates will give a meaningful boost to the economy over the short and intermediate horizons. However, one implication of the tax cut is that the economy could be in greater peril of overheating, meaning the FOMC will likely exercise greater vigilance when evaluating future rate increases. If wage pressure materializes relatively soon, as many expect, the FOMC will react quickly to raise rates. It is within this context that yields generally rose during the quarter.

The Treasury yield curve’s shape flattened again in the quarter, with yields on short- to intermediate-term maturities climbing, while those on long-term issues declined. By the end of the quarter, the yield on the benchmark 10-year U.S. Treasury Note was modestly higher, ending the quarter at 2.41%, compared to 2.33% on September 30.

Equities

Equity markets racked up another quarter of solid gains, benefiting from anticipation of the tax reform package, an uptick in corporate profitability, and a steadily growing economy. Against this backdrop, the S&P 500 Index finished the quarter with a gain of 6.6%, and advanced 21.8% for the full year. The S&P 500 has now posted positive returns in every quarter except one in the past five years. The last negative return in a calendar quarter occurred in the third quarter of 2015.

International stocks performed well on an absolute basis, but generally lagged behind US equities. European economies continue to accelerate, as domestic demand has picked up and monetary policy has remained extremely accommodative. China continues on pace with structural reforms, which will have the effect of lowering GDP growth, but also help deleverage the economy. With that as a backdrop, international stock indices were almost universally higher for the quarter.

Summary

The consensus among economists is that the recently passed tax reform package is likely to provide a significant short- to intermediate-term boost to the economy. The $1.5 trillion, 10-year tax cut will benefit corporations significantly, which will see a permanent reduction in their tax rate. Individual tax cuts will expire in 10 years (unless Congress eventually makes them permanent), reducing the long-term impact of the changes. Economists expect the tax cuts to act like fiscal stimulus, increasing GDP growth by as much as 0.5% per year. A fear among analysts is that annual growth increasing to 3% at a time when the economy is at or very near full employment may result in overheating. Although wage growth pressure has not been an issue so far, that may change with the impact of the tax changes, and the Fed may be forced to raise rates more quickly than it had previously anticipated. Market analysts have been raising estimates for corporate earnings for 2018, but it is quite possible that the market has already discounted higher earnings. Housing prices are likely to suffer with the tax changes, as caps on deduction of mortgage interest and property taxes are estimated to have a 4% negative impact on home prices.

The risks to the generally positive economic outlook continue to include geopolitical tensions with North Korea and Iran, as well as the potential for monetary policy missteps by the Fed. In addition, despite the lack of obvious bubbles, most market watchers expect stock prices to be more volatile in 2018 than in 2017, as valuations are more extended, and volatility remains near multiyear lows.

Information provided is for informational purposes only and should not be construed as investment advice. The views expressed are current only as of the publication date, are based on information that St. Clair Advisors believes to be accurate, and subject to change without notice. All investment decisions must be evaluated as to whether they are consistent with your investment objectives, risk tolerance and financial situation. St. Clair disclaims any liability for any direct or incidental loss incurred by applying any of the information in this publication. Indexes are unmanaged and one cannot invest directly in an index. Past performance is no guarantee of future results.

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