2018 is here and it started with the strongest first week of a year since 1999. A dramatic revision to the tax code is now in place, the Dow moved north of 25,000, and to our pleasant surprise, the Celtics are tied with the Warriors for the most wins in the NBA. There is a palatable mix of both excitement and apprehension as we enter the 10th year of the bull market and watch how investors, politicians, and policymakers navigate the challenges and opportunities ahead. The market will not go straight up forever, but with the change in the tax code adding to underlying momentum in corporate earnings, we see strong potential for quality growth stocks to continue their advance.
2017 was a banner year for equity markets as all major US indices reached record levels and global markets joined the rally. Emerging markets led the way, surging to life after about 6 years of flat returns. For the first time, the S&P 500 had 12 positive monthly returns showcasing an incredible lack of volatility in the market and a consistent grind higher. The S&P 500’s worst intra-period decline was only 3% and it was in positive territory for the entire year. This all occurred while the US Federal Reserve raised interest rates three times, as the target overnight bank lending rate hit 1.5% for the first time since 2008. Given the market’s reactions to previous moves by the Fed, it was notable that rates could be increased as aggressively without even a temporary negative market reaction, likely showing that the Fed was trailing the market.
Markets often climb a wall of worry as it did in 2017; 2018 looks to be no different. Investors are aware of strong stock valuations, the near-record length of the rally now approaching the 9-year anniversary of the 2009 market bottom, and the near absence of volatility. The recent protests in Iran and the government crackdown in Saudi Arabia add further concerns about the stability in the already volatile Middle East. North Korea may attend the Olympics and may have military discussions with South Korea but the heated rhetoric concerning nuclear capabilities between them and the US is off-putting, to say the least. Domestically the Federal Reserve has guided to raising interest rates three more times in 2018 while allowing their bond portfolio to decline significantly. We are carefully watching these events and risks as we move into 2018 and would not be surprised to see a more volatile, but ultimately positive 2018.
Tax Reform & Jobs Act
The GOP finished 2017 with a major overhaul of the US tax code for the first time in 31 years. The US corporate tax rate was reduced from 35% to 21% which should drive a significant uptick in earnings for US companies, particularly those that pay the full rate due to having primarily domestic sales and limited deductions such as regional banks and retailers. As such, Wall Street has begun to revise their 2018 earnings expectations dramatically higher. Consensus earnings for 2018 now stand at $149/share for the S&P 500 up from $119/share in 2017, a gain of 25%. This has increased by 11% in the past 4 weeks as the impact of tax reform has begun to be incorporated into the consensus forecast. This has lowered the forward multiple on the market to 18.3 times. Estimates may climb higher still, once analysts have a chance to digest the guidance from company management during their upcoming quarterly conference calls.
The new tax code also reduces the cost to corporations that seek to repatriate cash held offshore which McKinsey & Co estimates to exceed $1 trillion. The influx is expected to be supportive of the economy and stock market whether it is used to fund growth or it is returned to shareholders in the form of dividends and share repurchases. Companies are further motivated to repatriate the cash as the tax on foreign-held earnings will be levied regardless, removing any temptation to delay repatriation to avoid the taxes.
There are two different groups of beneficiaries, those which have significant cash overseas which they can bring back to the US, and those which will benefit from the reduction in US taxes. Those with the most cash on their balance sheet overseas tend to be technology and healthcare companies such as Apple, Microsoft, and Johnson & Johnson, and they are most likely to use the capital for acquisitions, dividends, or to repurchase their stock. We would not be surprised to see an uptick in acquisitions building on some of the large deals recently announced such as the CVS/Aetna merger; the attempted purchase of Qualcomm by Broadcom; and the purchase of Fox assets by Disney.
When we select individual investments, we focus on quality companies with differentiated businesses, defensible moats, and strong balance sheets and not surprisingly, that is often what acquiring companies are looking for in potential targets. One of our newest holdings is XPO Logistics, a top ten global logistics provider which employs innovative technology in supply chain solutions, particularly in e-commerce and omnichannel delivery. We invested in the stock because of a great management team, excellent end-market growth trends, and strong profitability, all of which gave us a bright long-term outlook for the company and stock. Recently there have been rumors that Home Depot is considering acquiring XPO Logistics, potentially to fend off a similar move by Amazon, which accelerated a +36% move up in the XPO stock price by year-end from our purchase price. While we do not know if the deal will or will not happen, we believe this interest validates the opportunity ahead for XPO and the value of the company. We look at these type of moves as opportunities for us to manage our positions, such as potentially adding to our position in the name if it were to sell off on the lack of a deal materializing.
Beyond the ability to return cash to the US, the new tax code also allows companies to more quickly depreciate some capital assets through 100% bonus depreciation. This change was added with the hope that it will spur domestic investment in new plants and equipment and subsequently drive job creation. Building on the tax bill, the President, and Congress will likely focus on an infrastructure bill as their next objective. The GOP is motivated to continue pushing forward on this agenda and unlike healthcare or tax reform, it has broader support as US infrastructure is in desperate need of repair and improvement. The Republican Congress wants to add to their rather short list of legislative victories as they head toward mid-term elections and fight to keep the majority in both houses. In anticipation, many industrial stocks have moved higher which could be the beginning of another leg higher in the stock market if infrastructure spending does spur additional economic growth.
Broad-Based Global Growth
All 35 countries composing the OECD (Organization for Economic Cooperation and Development) are expected to report positive real GDP growth for 2017 showing a level of coordinated global growth for the first time since 2007. The growth was driven in part by the Emerging Markets which had a strong year, particularly China and India. Our position in India has been well rewarded with a +34% return and we remain positive on our investment as structural reforms are setting a good foundation for long-term growth. Commodity-linked countries also showed signs of life with Brazil returning +28% and Australia +13%. The recent strength in oil prices may bode well for a continuation in 2018 but we will watch for inflationary concerns which may emerge if prices move too quickly. We moved to reduce our long-standing underweight to the Energy Sector in 2017 and may add further weight as we build confidence in a more sustained recovery.
The setup for 2018 is positive and off to a solid start. With the combination of global growth, relatively low inflation, and strong growth trends we look for markets to continue moving higher. If interest rates move higher as expected it is likely that there will finally be the rotation from bonds to equities to further push markets higher. Despite all the aforementioned optimism, valuations remain above historical averages, inflation is showing signs of picking up, growth is present but not robust, and geopolitical risks remain keeping our positioning near the mid-point of asset allocation ranges. After 2017 delivered unusually low volatility and exceptional equity market returns we expect higher levels of volatility to return in 2018. We recommend clients stay invested in common stocks while protecting for volatility; be opportunistic in buying some longer-dated bonds as rates move higher; and have a degree of exposure to ex-US investments. We see this strategy as the best risk-adjusted opportunity for capital appreciation in the current environment.
Bainco Company Update
Bainco is pleased to announce the hiring of Mark Alaimo, CPA/PFS, CFP, and Nicole DellaPasqua. Mark joins our Wealth Strategies team bringing a breadth of experience delivering personalized tax and financial planning strategies. Nicole joins our Client Advisory Team, adding further depth to an already impressive group dedicated to serving our clients’ needs.