Cautiously Optimistic on the Season Ahead
By Nan Wang | November 7, 2017
As holiday season approaches, U.S. equity markets continue to make new highs while experiencing historically low levels of volatility. The month of November started with several key financial events around the globe which included the release of a tax plan by House Republicans, appointment of the next FOMC chief, the Bank of England’s rate decision along with earnings announcements of multiple large cap companies.
On November 1st, The FOMC committee announced the decision to maintain the federal fund rate at 1 to 1.25 percent, as was widely expected by investors. The FOMC statement highlighted strong economic data despite the disruption of two major hurricanes, leaving a December rate hike highly likely.
The next day, Trump appointed Jerome Powell, a current Fed governor, to succeed Janet Yellen as Fed Chair in February 2018. Treasuries rallied on the news as Powell is seen as the most dovish candidate and is expected to closely follow Yellen’s gradual rate increase policy. While Powell will likely continue to normalize monetary policy and gradually reduce America’s bloated balance sheet, he will face the challenge of striking a balance between attempting to stoke inflation while restraining an asset price bubble.
Also last Thursday, the U.S. Congress revealed their long-awaited tax plan, namely the Tax Cuts and Jobs Act. The bill aims to reduce corporate tax rates from 35% to 20%, while keep the top individual tax rate at 39.6%, but doubles the standard deduction for middle class families. The plan also caps the mortgage interest deduction to principal balances of just $500,000. Also under the plan, multinational companies’ accumulated offshore corporate earnings would be taxed at as much as 12 percent. Apple and Procter & Gamble, among other big U.S. companies, would collectively be taxed on trillions of dollars in overseas profits.
U.S. stocks showed mixed reaction to the proposal as markets discerned small businesses would be helped by the tax cut while some sectors would be negatively affected. For example, homebuilders shares dropped amid concern that a lower mortgage interest deduction would slow the housing market. Trump applauded the bill’s arrival, and has called on Congress to pass it by Christmas. Nevertheless, lawmakers still have a number of obstacles to overcome and opposition by various interested parties needs to be address before the plan can get to the President’s desk.
On Thursday, the Bank of England announced the first benchmark rate hike in a decade, raising it by 25 basis points to 0.5 percent. Besides the move, policymakers showed concern over The U.K.’s economy as the 2019 Brexit approaches. The more dovish tone of the meeting minutes pushed the pound down by approximately one percent against the dollar to $1.306. Gilts rose following expectation of a slower pace of rate hikes.
On Friday, the U.S. jobs report for October came in strong with unemployment rate falling to 4.1%, the lowest since year 2000. The jump in nonfarm payrolls indicates workers affected by hurricanes have returned to post. The strong employment data strengthened the case for a December rate hike.
On the corporate side, new highs of major technology firms following earnings releases pushed the S&P 500 index up further. Alphabet rallied 4.3% and Amazon 13.2% after beating revenue projections. Apple shares gained 10% following high demand for iPhone X and Q4 2017 earnings beating estimates.
Looking ahead to the reminder of the year, we remain cautiously optimistic about the risk markets despite a relatively favorable macro environment. Low interest rates, low inflation, and potential tax reform are all positive factors for global GDP growth while improving technology continues to reduce costs and contributes to ongoing margin expansion.
Although the economic backdrop is constructive, we remain cognizant of historically high equity market valuations and the challenge this presents. While we see no obvious reason for an imminent sell off, geopolitical risks such as tensions between the U.S. and North Korea and the recent troubles in Spain highlight the potential for unexpected events which could spill over into the markets.
Furthermore, because global equity markets have not had a major correction in almost two years, a retreat is always possible. Investors should be prepared with proper diversification and risk controls while not losing sight of their longer term objectives.