Here we are at the mid-point of the third quarter and I think it’s safe to say that despite some headwinds and uncertainty the economy remains in good shape. A good economy generally goes hand in hand with a good stock market. Market trends follow companies’ earnings, and the most recent round of reporting showed a strong double-digit year over year growth. The effects of tax cuts should be seen in continued profits, particularly in the small and mid-sized domestic companies. That is a good news/bad news story, however. A recent guest on Bloomberg Surveillance said it best – “tax reform in the short run is political gold; in the long term it will be economic poison.” At least for now we are in the “gold” period, and there is no sign of recession through the end of this year.
Investors want to know what tax reform can be expected to do for them. In the July 14th issue of Barron’s Mr. Forsythe said it very well – and I paraphrase a bit. “While tax cuts put one foot on the accelerator, tariffs place another on the brake. Fiscal stimulus pumps up demand; trade curbs restrict supply.” And uncertainty dampens confidence which is the driver for further growth. For consumers, the good effects of the tax cuts already have been largely negated by the increase in energy and therefore gas prices. As tariffs work their way into the end products we consume inflation will further erode many of the personal benefits of tax reform. So, I expect that the real beneficiaries of tax reform will be corporations and the investors who own a piece of that wealth.
As managers of wealth, we find our greatest challenge this year is posed by the fixed income portion of your portfolios. Short term interest rates are going up as the Federal Reserve slowly but gradually tries to bring the rate they control back to a more normal range which has been absent for over ten years. As rates move up either because of Fed moves or inflationary pressure, the bonds we hold generally recede in value. We have attempted to reduce risk in the bond portion of portfolios by removing high yield and most longer dated bonds. So, you may ask, why do we hold any bonds? As some of you will remember these same questions were being asked in 2000, right before the tech bubble burst, money moved massively back into bonds, and the S&P 500 Index remained negative for almost ten years. Good wealth management requires a diversified portfolio to catch the upside potential when it presents, and to have positions which will stabilize the portfolio when negative volatility comes knocking.
Another thing about interest rates and their trend movement – they are a very good indicator of where the economy and hence the stock market is going. Long term rates, such as on the 10 year Treasury bond, tell us what kind of growth to expect over the next ten years. This bond market is telling us to expect between 2.5% to 3% growth – not too much above where the market is pricing the 2 year Treasury Note which today is giving 2.6%. We are watching the difference between these two rates carefully. When the 10 year rate slips below the 2 year rate we should assume a recession is around the corner and the stock market will react to that trend with a correction before we actually get there.
We are not there yet, but we are watching closely.
Linda P. Erickson, CFP®
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.