The U.S. economy finished 2017 with another strong quarter. GDP grew at an annual rate of 3.2% in the third quarter (the fourth quarter is still being tallied) and is estimated to be 2.3% for the year. That growth coupled with low inflation and stable unemployment powered the markets to even higher levels. Optimism about the impacts of the recent tax law changes also likely contributed.
For the year, the Dow Jones Industrial Average Index increased 25.08% while the more broadly-based S&P 500 increased 19.42%. Small cap stocks, as measured by the S&P 600 SmallCap index recorded an 11.73% increase and the S&P 400 MidCap Index was up 14.45%. Consistent with the last several quarters, international equities outperformed most of the U.S. Indices with the MSCI EAFE Index, which measures the performance of large and midcap stocks in 21 developed economies, gaining 22.41%.
Earnings for the S&P 500 companies increased 6.2% in Q3, a decline from the double-digit earnings growth of the last two quarters but still quite strong. The inflation rate in the fourth quarter was 2.1%, the same as for the year, and the unemployment rate was down slightly at 4.1% at year end from 4.4% at the end of Q3.
In last quarter’s Market Review, we discussed the traditional linkage of low unemployment, a growing economy and wage growth. Typically, growth in the economy and low unemployment lead to increases in wages and inflation. While wage growth ticked up slightly in Q4, it continues to lag the growth in the overall economy. The long-term impact of the disconnect in these metrics is unknown but it hasn’t dissuaded the Federal Reserve from continuing to increase interest rates. The Fed raised the benchmark Federal Funds rate to 1.5% in December and there is general agreement among the members that rates should be raised two to four times in 2018. Rate increases are normally used to control growth and inflation but with concerns mounting that the near 10-year run in economic expansion may be coming to an end, the Fed’s rate increases appear to be mostly an attempt provide room to lower rates if a slowdown materializes.
The bond market responded to the rate increase in December (and the expectation of further increases) by pulling back, as expected. For the year, the S&P 500 Muni Bond index reflected a gain of 4.95% but was essentially unchanged during the quarter. The impact of the Fed’s actions was felt more sharply by those invested in short-duration instruments, which generally saw negative returns in Q4. The Fed’s rate increases have moved short-term rates as expected but the reaction of longer-term maturities has been muted, and the yield curve has flattened as a result. The premium for tying up your money for 30 years with U.S. Treasury instruments is just 1.46% above the 30-day rate (1.28% for 30 days versus 2.74% for 30 years!). That premium stood at 2.52% at the beginning of the year. These rate movements signal that the investing community does not believe we are entering a long-term period of significantly higher interest rates.
A discussion of the quarter wouldn’t be complete without mentioning the recently passed Tax Cuts and Jobs Act. The new law took effect on January 1st and will boost corporate earnings and cash flow in 2018. Most individuals and families will see a reduction in their taxes as well. If recent history is any indication, corporations will use most of the tax savings for dividends, share buybacks, and mergers and acquisitions. All of these are positives for investors in the near-term. The long-term effects are less certain. Much of the political justification for tax cuts is the economic growth they generate and most economists agree that tax cuts provide a short-term boost. However, the correlation between tax cuts and economic growth over the long term is virtually nonexistent. And, with a Federal budget deficit of $666 billion in 2017, the tax cuts will most likely stop the trend of falling deficits since 2009 and create more uncertainty in the markets.
In conclusion: The exceptional equity returns of 2017 will not likely repeat in 2018. And the fixed income market will continue to be challenging. Focusing on quality issuers will be more important than ever. Increases in corporate earnings will provide support to the market but the large gains over the past two years will likely begin to narrow. Developed economies outside the U.S. are in earlier stages of the economic growth cycle and will likely provide some portfolio stability. However, continued interest rate increases and the prospect of ballooning Federal deficits will put downward pressure on both the equity and fixed income markets. As always, a well-diversified portfolio is key to meeting your long-term financial goals.