|10-yr Treas. yield||2.40%||2.33%||+0.07%||2.45%||-0.05%||-0.05%|
|Fed funds rate||1.25% – 1.5%||1.0% -1.25%||+0.25%||0.5% – 0.75%||+0.75%||+0.75%|
(stock indices are before dividends; yield and rate changes are absolute changes)
This quarter’s returns resemble last quarter’s except they are mostly better. The only area that dipped a bit was international stocks but they still posted a very strong year. The benchmark 10-year Treasury yield continued its climb from its low in early September but overall rates are still low and manageable for borrowers and savers are actually seeing some earnings from cash accounts. Oil prices rallied strongly, up 32% from the mid-year low and up 16% for the year. Holiday retail sales increased at the best rate since 2011 at nearly 5% excluding autos.
Employment was strong with 2.1 million jobs added in 2017, the seventh straight year above 2 million and the 87th month with expanded employment. Unemployment declined to 4.1%, which is considered close to full employment, but underemployment ticked up a bit to 8.1%. The percentage of 25-54 year olds with a job hit 79%, a new high since the recession. Average hourly earnings began to show growth, at 2.5% over the prior year; anemic wage growth has been considered a drag on overall economic growth. As reported in the Arizona Daily Star, Tucson’s average wages have grown only 1% per year since the recession and are well above El Paso, on par with Las Vegas, Albuquerque and San Antonio and 7% below Phoenix.
As expected, the Fed increased short-term interest rates in December for the third time in 2017, making the rate target 1.25 – 1.50%. Change in market rates was concentrated in short-term rates, particularly the 2-year Treasury, making the yield curve (the line of short to long-term rates) more flat. The Fed’s forecast for GDP growth in 2018 came in at 2.5% even though final GDP growth for the third quarter was revised upward to 3.3% on increased exports and business spending. Aside from frenzied attempts to figure out how various taxpayers would be affected, the tax package passed in late December mostly led to concerns about the effect of potential increased deficits and complaints about cuts for the wealthy.
Housing remains a good news/bad news story as prices strengthen but more areas are becoming less affordable and lack of supply of both new and existing homes for sale is also pushing prices up. Even with new home construction growing at nearly 9% in 2017 inventory is lagging behind and existing homes for sale are down over 6% for the year. Prices nationwide increased 6.2% this year (Tucson increased over 12%), and are now 6% above the previous 2006 peak, with the rate of increase double the rate of wage growth.
Consumer spending continued to expand faster than wage growth, forcing the savings rate down to 2.9%, its lowest in 10 years. Consumer confidence dipped slightly in December from a 17-year high in November but its average over the full year was the highest since 2000. Manufacturing growth hit a 13-year high in September and continued its string of 16 months of expansion. Productivity growth hit 3% for the third quarter, the best in three years, and labor cost increases were moderate. Core producer inflation was higher at 2.4% than for consumers at only 1.7%, still well below the 2% Fed target.
Internationally, Chinese President Xi was elevated to a similar political status as Mao, centralizing his control and incorporating his ideology in the Communist party charter. Upheaval in the EU has not subsided as Great Britain struggles with the practical implications of Brexit and the parliament in the prosperous province of Catalonia voted to secede from Spain, prompting the Madrid government to take control and nearly 1,000 companies to leave the province.
Last quarter we discussed some of the possible implications of the proposed tax overhaul. Now that the plan has passed, here a few other angles that could play out, with our SWAG (sophisticated wild ass guess) as to what will happen. Only time will tell, of course.
• Housing prices? – The housing lobby is crying that the triple changes of limits on deductible state and local taxes (which includes real estate taxes),the reduction in the size of mortgages for which interest is deductible and the higher standard deduction will cause housing prices to drop by as much as 10%. But the reduction in mortgage was relatively small (from $1 million to $750,000), deductions for second homes were retained and the value of deductions related to homes went overwhelmingly to higher income taxpayers. While housing prices can certainly be volatile, the impact of the tax bill will be localized, as is usually the case with most real estate. The impact in Tucson will be negligible.
• Incentive for jobs to “redistribute” to lower cost locales? – The concentration of jobs in high-cost coastal cities would probably have started to collapse under its own weight at some point but the tax bill could help hasten the change. Unlike housing prices the combination of lower cost of living coupled with tax differences will likely begin to distribute jobs to other areas, but it could be a long, slow process.
• What will corporations do with lower tax savings? – The reduction in the statutory corporate tax rate from 35% to 21% is a huge change (there are, unfortunately, even more loopholes and “carve-outs” for specific industries than before which will lower taxes even further). A couple of companies have announced they plan to increase wages or bonuses but history is pretty clear – the benefits of lower corporate taxes will accrue primarily to company owners through stock buybacks and dividends.
• Big one – is the next step really a full assault on entitlement programs? – Most of the tax cuts for individuals are scheduled to phase out by 2025 unless they are renewed by Congress. Those rollbacks could reduce the projected additional deficit form $1.5 trillion to $1.0 trillion. Still, many observers expect the administration to launch attacks on core entitlement programs like welfare, Medicaid and perhaps even Social Security in further attempts to close the deficit gap. While it’s always fair to ask how government is spending the money they do have in the face of lower revenues, any proposed changes to these programs will spark bitter fights so there will likely be plenty of compromises if there are any changes at all.
A large part of our investment management process involves ongoing monitoring of the funds in the portfolios to confirm that they continue to serve the purpose for which they were chosen. Performance in the particular market segment is important, of course, but we are also focused on consistency in fund management and how the overall portfolio performs as the sum of its parts. This process does not often result in a change in funds but it is extremely valuable in helping clients weather market volatility and meet their goals, even if they never actually see our efforts reflected in portfolio changes. Besides, frequent portfolio changes are a well-proven path to confusion and likely poor performance.
One of our actively-managed fixed income funds had caused us concern for a while. It was not poor performance; in fact, performance had been relatively strong. But as an actively-managed fund, its expenses, though moderate, were still higher than some other funds. The fund’s investments were heavily concentrated in a particular area of the bond market and it had not faced a rising interest rate environment in many years, so there was some uncertainty about the fund being able to adjust to those interest rate changes. Finally, and this is an inexact science, the fund manager had become increasingly high-profile, often weighing in on subjects that were far removed from the management of the fund.
A new fund could be easily evaluated regarding performance, expense, and risk and return both separately and in combination with other funds on our portfolios. The deciding factors were the interest rate uncertainty and particularly the distractions of the fund manager; when other managers have become high-profile in the past, it usually did not end well for fund investors.
Our conclusion was that by replacing the fund with an index fund the overall fixed income allocation would have lower expenses and a slightly improved risk/return profile. Only time will tell how the old fund will fare but it’s often better to make a change early rather than late. It was a relatively low-risk adjustment that reduced uncertainty going forward without compromising the fixed income allocation’s role in balancing the risk of equities in the portfolio.
Have to Say Something About It
“It” is, of course, bitcoin. Interest in and developments surrounding bitcoin and other “crypto-currencies” are moving so fast that any commentary is stale as soon as it is finished but consider some of these circumstances surrounding bitcoin.
• Bitcoin was up nearly 2,000% for the year at one point before ending the year up 1,375%, but along the way there were five selloffs of 30% or more. (Other crypto-currencies were up even more, with ethereum up nearly 5,000%.)
• The entire crypto-currency transaction process (the blockchain) was established as an “open source” system which is technically free. But to establish a more accessible “wallet” for your bitcoin or to have transactions validated more quickly involve increasing fees.
• At least two tiny companies which have nothing to do with crypto-currencies changed their names to include the word “blockchain” and their stocks shot up overnight.
• Some early bitcoin owners who use the original ownership method that required very complex passcodes have lost those pass codes, making valuable bitcoins inaccessible.
• There have been several hacks and digital errors involving digital currencies, with one code mistake leaving $280 million in ethereum inaccessible.
• One company raised $700 million for “digital tokens” even though their offering states the tokens “do not have any rights, uses, purpose, attributes, functionalities or features”.
• And my favorite – bitcoin mining, or the calculations needed to create more bitcoins, is currently using more electricity than the entire country of Serbia. Projections show that by July 2019 the bitcoin network would use as much electricity as the United States and by November 2020 it would use more electricity than the entire world does today.
It appears that digital currencies and their underlying transaction system are here to stay but it appears equally likely that the recent frenzy is unsustainable.
Another wild card is simple supply and demand. If the current amount of bitcoin were all that would ever be available then its increase in value might make some sense. And bitcoin does have a limit to its supply. There are, however, other forms of digital currency and the high demand will certainly create a burgeoning supply. Once the supply of digital currency overtakes the growth of transaction volume the price of the currency will surely drop. Companies looking to create initial coin offerings raised a further $4 billion last year and the supply is coming.
Bitcoin may turn out to be the most valuable of the digital currencies and hold more of its value. Some pundits have declared that bitcoin will replace gold as a way to store value, in which case bitcoin’s value would be astronomically higher than it is now. But our guess is that much of the value in bitcoin is pure speculation and, like most speculations, it will end badly.