Much like the first half of 2017, the third quarter brought solid returns for investors. All of the major asset classes we track have posted remarkably consistent returns in each of the first three quarters this year.
Volatility has been extraordinarily low. At one point in August, the ten-day rolling volatility of the S&P 500 was the lowest it had been since 1969. The S&P 500, now up 14.2% for 2017, has posted 40 new all-time-high closing values in 2017. The index has fallen by more than 1% on only four days in the first three quarters. Over the past four years, we have averaged over 17 such days through the end of September. Past bull markets have seen similar periods of calm—though not quite to this degree.
Fed takes more steps to normalize policy
At its September meeting, the Federal Reserve announced that it will begin unwinding its $4.5 trillion balance sheet in October. As it laid out in its June meeting, the Fed will not be selling bonds but instead simply will not reinvest a portion of the bonds that mature each month. Specifically, starting in October, the Fed will allow $10 billion of bonds to mature without reinvestment. This amount will gradually increase to reach $50 billion per month over the next year. At a time when other central banks are expected to continue growing their balance sheets, the US is the first to actually begin tightening monetary policy.
Unwinding means scaling back a policy that has helped support bond prices since Quantitative Easing began in 2008. The Fed has already pushed short-term interest rates higher with four federal-funds rate increases dating back to 2015, with another likely to happen later this year. Unwinding the balance sheet may begin to push longer-term interest rates higher, though at a muted pace.
The Fed is able to make these moves because the US economy has been heading in the right direction for some time, as you can see in the chart of four leading economic indicators since the market bottom in March 2009. We have even seen manufacturing start to pick up in the past year, after declining in 2015. We are likely to see a negative impact from the recent hurricanes, however.
Impact of hurricane season is personal and financial
One of the worst hurricane seasons in history has affected millions of lives and inflicted billions of dollars of damage. While stories of heartbreak poured out in the aftermath of the storms, the country’s reaction showed the strength and resilience of our nation as people from all over the country rushed to help those in need.
Hurricanes Harvey, Irma, and Maria, which all hit in quick succession, may have caused as much as $290 billion in destruction based on one estimate from Accuweather. Hurricane Katrina, the costliest US natural disaster on record, caused as much as $108 billion in damages, according to Moody’s.
The effect was seen quickly. In the week after Harvey made landfall, US weekly jobless claims spiked 26% to 298,000 people filing for unemployment benefits, up from 236,000 the week before. We saw similar increases in claims after Katrina and Sandy, but after both of those storms, jobless claims returned to pre-storm levels within two months. There is a long road ahead for rebuilding in Texas, Florida, and Puerto Rico. The money spent to rebuild will add to US GDP, but the loss in economic activity will be a drag on GDP growth for the second half of 2017.
The debt ceiling was just given a short-term extension until December 15th to ensure the funding of hurricane relief efforts. That could become an important date to mark on the calendar if disagreement over other policies leads to another standoff over the debt ceiling. We are hoping we don’t see a repeat of the debt-ceiling crises of 2011 and 2013.
Tax reform is on deck
Recent reports from Congress show that we may be nearing some of the tax reform promised by President Trump. Here are some of the proposed changes:
Overall, taxes would likely fall initially for most Americans but without details that are yet to be hammered out, it is impossible to gauge what changes people at different income levels will see. The last bullet point is more straightforward.
The US has the highest corporate tax rate among developed countries at 35% and there is actually some agreement on both sides of the aisle in Washington that the high rate discourages investment in the US. A drop to a 20% tax rate could bring a nearly 25% bump in profits overnight to those companies which pay the full tax rate. Not all companies pay the full tax rate. Some, especially large multinational corporations, pay much lower effective rates. On the whole, we would expect a significant positive impact for corporate earnings should this legislation pass.
The projected increase in earnings would likely boost economic activity in the US. Companies may be more likely to hire more employees, invest in new projects to grow revenues, pay down debt, or even return money to shareholders through share repurchases. Increased economic activity means hiring and with unemployment already low, wages may begin to rise more quickly than the sub-3% annual gains seen since the financial crisis. A lower tax rate would also diminish the incentive for tax inversions that have become so common in recent years. In an inversion, a US company acquires a foreign-based company that is located in a lower-tax jurisdiction. The acquiring company then relocates to the lower-tax jurisdiction and enjoys a lower tax bill.
Much has been made about the fact that stocks are trading at higher-than-normal valuations. The S&P 500 has a nearly 20% return since last year’s election and as mentioned earlier, the market has hit numerous new all-time highs this year. We expect some of the recent exuberance is due to the anticipated tax legislation but investors are also bullish about corporate earnings. Earnings among S&P 500 companies have already shown promising growth in 2017 and expectations are for third-quarter growth to exceed 4.2%. So far, 43 companies in the S&P 500 have raised their estimates for third-quarter earnings—the most in any quarter since 2010. It should be noted that none has increased its estimate since Hurricane Harvey made landfall. Finally, investors are hopeful that recent strong readings for consumer spending and business investment will result in accelerating economic growth, further juicing earnings. The big question is how much of the promise of tax reform, future earnings growth and accelerating economic growth is already baked into current market prices? Stay tuned.