Bronfman Rothschild 2017 3rd Quarter Review: “The Next Correction”
So, when is the next market correction coming? It is probably the single most asked question from clients over the past year. There has not been a ten percent drop in the markets (the common definition of a correction) since early 2016. Even then, stocks recovered quickly. This year, we have all enjoyed consistent and nearly uninterrupted gains.
Not surprisingly, the debate for what comes next is heating up. For those perma-bulls out there (the clear minority, at least vocally), global economic growth is accelerating, inflation is modest to non-existent, investor optimism is high, and consumer and business confidence is accelerating, all of which are powerful drivers of positive equity returns.
For the perma-bears out there (pretty much everyone else), the risks to the status quo include policy mistakes (imprudent tax and regulatory changes, the Fed miscalculating the impact of shrinking its balance sheet, etc.), historically high US equity valuations (based upon almost any measure), excessive indebtedness, entitlements, health care, and simply time. The global economy came out of a painful recession in 2009, and now that we are more than eight years into our current recovery (with the post WWII average recovery lasting just under six years), how much longer can the party last?
The easy answer is: we do not know. Putting a finer point on it, both the sloth (bears) camp and the herd (bulls) camp are probably correct (eventually). In the short-term, global economic expansion coupled with (or caused by) low interest rates and inflation can take stock prices even higher. This has long been hailed The Most Hated Stock Rally in History, and markets can climb the now cliché Wall of Worry for a while longer. Longer-term, the combination of factors above could limit stock market performance to low single digits above inflation for the next decade or so.
The conclusion? Stay open-minded about how markets might behave. Absorb the argument for subdued returns for years to come, be prepared for some bad stretches, and allow for a pleasant surprise if markets turn out to be more generous than expected.
Wind, Rain, and Municipal Bonds
As a firm, Bronfman Rothschild clients have roughly $400 million* in municipal bonds spread across the country. As an effective diversifier to stocks, they combine a high level of liquidity with low volatility (compared to stocks), while also adding interest income that is exempt from Federal taxation (and potentially state taxation if you happen to live in the state of the bond issuer). These features make them an important asset to consider for taxable investors.
Those features also open investors to state specific risk. In contrast to recent years, this hurricane season has been noteworthy. For the first time that I can remember, two different Category 4 storms (Harvey and Irma) struck the US mainland in the same year. With the area around Houston, Texas, as well as parts of Florida seeing significant damage, many municipal bondholders may be concerned about how this could impact the creditworthiness of their holdings. If the past is any indicator of the future (which we always warn against considering, then do it anyway), these fears may not be warranted.
Per Moody’s US Municipal Bond Defaults and Recoveries, 1970—2016 (June 2017), natural disasters have not caused a single default by a rated municipal borrower, ever. Investment grade issuers (like Texas, which is one of a few states with a AAA rating, and Florida, which is rated AAA by one credit agency and AA by another) generally have the financial flexibility to overcome short-term revenue disruptions. In this example, Houston’s gross domestic product (GDP) is roughly the same size as the entire state of Virginia, with both being roughly equivalent to Sweden’s economy (as an FYI, the GDP of Texas is roughly equivalent to Canada). Florida’s economy is roughly the size of Indonesia (Sources: Bureau of Economic Analysis and International Monetary Fund). Even after Hurricane Katrina, which caused over $120 billion in damage, New Orleans, which has a smaller economic footprint, did not default on its debt obligations.
Affected areas normally receive substantial disaster relief from the Federal government. Federal Emergency Management Agency (FEMA) aid (which often equates to over 60% of disaster-related expenses) and other insurances go a long way to mitigating the financial impact to municipalities.
Although it is a bit early to know whether we will see any credit downgrades in the wake of recent storms, significant changes appear unlikely.
What is UFFOBTC?
On Wednesday, September 27, 2017, the GOP released the “Unified Framework for Fixing Our Broken Tax Code.” The plan is more of a framework of the administration’s priorities, with details still to be determined. Without discussing the merits of any part of the plan, here are the basics:
- Consolidate the current seven tax brackets into just three: 12%, 25% and 35%
- Double the standard deduction for individuals to $12,000, for married filing jointly to $24,000, and eliminate personal exemptions
- Eliminate most itemized deductions other than the mortgage interest and charitable contribution deductions
- Repeal the Alternative Minimum Tax (AMT)
- Increase the child care credits
- Eliminate most other deductions, credits, and exemptions
- Repeal the estate tax and the generation skipping transfer tax (although the gift tax is not mentioned specifically)
- Limit the tax rate for small business (sole proprietors, partnerships, and S-corporations) income to a maximum of 25%
- Limit the C-corporation tax rate to 20%
- Allow for the immediate expensing of depreciable assets (other than structures) by businesses
- Limit the deduction for interest expense for C-corporations
- Replace the current worldwide income taxation system in the US with an exemption for dividends from foreign subsidiaries, and provide transition rules to treat foreign earnings that have been accumulated overseas as being repatriated (and taxed, but at a lower rate)
We will keep you posted on these developments as more information is made available.
Equity and fixed income markets overcame global geopolitical uncertainty in Q3 to broadly finish in the black. In the US, the trend of growth beating value and low dividend yield beating high continued. Countering the trend, energy and small cap stocks rebounded to offset some of the year-to-date weakness. US dollar weakness supported non-US assets, although the trend reversed slightly toward the end of the quarter.
US large company stocks (represented by the S&P 500 Index) appreciated 4.5% for the quarter. US small-mid company stocks (represented by the Russell 2500 Index) rose 4.7%. International stocks (represented by the MSCI ACWI ex US IMI Index) bettered domestic at 6.3% and Emerging Market stocks (represented by the MSCI EM IMI Index) rose 7.6%. At the country level, Italy, China, Brazil, and Russia all topped 13% for the quarter. No major developed nation fell more than 2%.
The US Bond markets delivered coupons during the quarter with marginal shifts along the yield curve not materially impacting returns. Earlier in the quarter, expectations for another rate hike in the US fell, only to rebound in September after the markets digested the latest comments from the Fed. The Barclays Capital US Aggregate Bond Index rose 0.9% in Q3, bringing YTD returns to 3.1%. The yield on the 10-Year Treasury began and finished at around 2.3% in Q3, despite falling to nearly 2.0% in late August. Municipal bonds returned 0.7% for the quarter. The more credit-oriented areas of the market continued to perform well, with high-yield bonds returning 2.0% in the third quarter.
There were no major standouts within alternatives in Q3. Multi-strategy funds (represented by the HFRI FoF Diversified Index) rose 2.3% for the quarter. Hedged equity managers (represented by the HFRX Equity Hedge Index) rose 3.2%. REITs in the US finished up 0.9%, but abroad they rose more than 5.0%. Global Infrastructure returned 3.3%, thanks to strong performance in Europe and Japan, though a negative return in US energy infrastructure was a headwind. Commodities posted a positive 2.7%, thanks to strong performance from industrial metals and select petroleum derivatives.
- The S&P 500 index peaked on October 9, 2007 before beginning a 17-month bear market that saw the index fall 57% before bottoming on March 9, 2009. An investment in the S&P 500 index on October 9, 2007 (i.e., at the market’s top and before the fall) is up 100% (total return) as of the close of trading on Friday, September 22, 2017 (i.e., nearly 10 years later), an annualized return of 7.2% per year. (source: BTN Research)
- The total return of the S&P 500 index over the last 7 calendar years (2010-2016) was 132.8% (cumulative). The best 18 trading days during the seven years (i.e., 18 days out of 1,762 trading days) produced an 83.1% gain. Thus, 1% of the trading days over the last seven years were responsible for 63% of the index’s total return. (source: BTN Research)
- Damage caused by Harvey and Irma is estimated to be $290 billion. Harvey’s damage estimate of $190 billion would make it the costliest weather disaster in US history. As mentioned above, Harvey and Irma were the first Category 4 or higher hurricanes to strike the US mainland in the same year. (source: AccuWeather)
- For every $1 spent for wages and salaries in the private sector, employers spend an additional 44 cents on benefits. Average compensation is $23.15 per hour while the cost of benefits averages an additional $10.11 per hour. (source: Bureau of Labor Statistics)
- It took $170,500 of household income to rank in the top 10% of earners in calendar year 2016. (source: Census Bureau)
- As of last week, our country’s national debt was $20.2 trillion. Ten years ago, our national debt was only $9.0 trillion. (source: Treasury Department)