Tax cuts had a positive effect on the economy in the second quarter. U.S. stocks rose, bouncing back from losses earlier in the year. International stocks declined due to tariff concerns and a stronger dollar. Bond returns were mixed. Taxable bonds were down slightly while a lack of tax-free bond supply nudged municipal prices higher.
1. What Effect Have Tax Cuts Had on Consumers & Businesses This Year?
The positive effect of tax cuts became evident in the second quarter. For consumers, this played out in two ways: increased spending and strong confidence readings. Early estimates indicate retail sales rose by almost 6 percent in the second quarter, as tax cuts boosted disposable income. The Consumer Confidence Index hovered near 17-year highs, reflecting consumers’ upbeat view of their present financial situation. Solid job growth and gradually rising wages should cause consumer spending to remain strong the rest of the year.
Businesses also benefited from the tax break. First quarter operating earnings for S&P 500 companies rose 26 percent, the strongest since 2010. The reduction in taxes accounted for roughly 7 to 8 percent of the earnings growth. Announced stock buybacks for 2018 are the highest ever. Many companies have chosen to deploy extra cash from tax savings in this way. Stock buybacks increase per share earnings and generally are good for investors.
The tax cuts helped accelerate U.S. economic growth to an estimated 3.5 to 4 percent in the second quarter—the fastest pace since 2014!
2. Profit Growth Has Been Exceptional in 2018 – Why Haven’t Stock Returns Been Stronger?
There are two primary reasons stock returns have been lackluster despite strong earnings growth. The first is that stocks rose through the end of 2017 in anticipation of tax cuts. Therefore, some of the expected benefits of lower tax rates were reflected in share prices entering 2018.
The second reason is that investors have been distracted by other issues. The possibility of a trade war between the U.S. and China has become a major concern. If tensions escalate, our economy could suffer. Federal Reserve rate hikes have been another source of angst. While the Fed’s approach has been clear and deliberate, rising interest rates have the potential to stall economic growth. In the short run, these and other concerns have overshadowed the strength in corporate earnings.
3. Why Are International Stocks Posting Losses?
International stocks have been affected by many of the same issues weighing on the U.S. market. However, foreign stocks, especially those in the emerging markets (EM), were impacted by other factors as well. The biggest issue has been the increase in the value of the U.S. dollar. A strong dollar reduces foreign stock returns for U.S. investors. The dollar has appreciated due to improvement in the U.S. economy and the increase in U.S. interest rates. Trade concerns also have prompted investors to buy the dollar for safety.
In spite of negative recent returns, we maintain a positive long-term view of international stocks. EM stocks in particular offer cheaper valuations and better long-run growth prospects. Emerging economies are better positioned to deal with higher rates and dollar values than they were just a few years ago. Structural changes have been made, and most of these economies are stronger today. While foreign stocks have had a tough time this year, we advise patience and a long-term view.
4. With Inflation Rising, Will Interest Rates Spike Higher?
The Fed’s preferred measure of inflation (core personal consumption expenditures) recently reached the 2 percent target for the first time since 2012. But unlike 2012, the current unemployment rate is below 4 percent. While the Fed has met its goal of full employment, wage growth has remained modest. This has helped contain the rise in overall inflation.
Core inflation should gradually trend higher, allowing the Fed to continue the approach of lifting rates at a slow and steady pace. Core inflation would probably have to reach a sustained level above 2.5 percent to cause the Fed to raise rates faster.
With that in mind, interest rates are more likely to slowly drift higher than to spike. The Fed is widely expected to increase short-term interest rates two more times in 2018. A continued rise in interest rates would cause below-average returns for bonds. However, returns did show some improvement in the second quarter as interest rates stabilized at higher levels.
5. Diversified Portfolio Returns Are Flat in 2018 – Should Investors Expect This Trend to Continue?
Some economists have begun predicting the next recession. However, current data shows an acceleration in growth, not a contraction. While future recessions are a certainty, leading economic indicators suggest a downturn is unlikely within the next 12 to 18 months.
The factors limiting investment returns could persist for a while. However, improving economic and profit growth increases the odds of better performance. For all of 2018, corporate earnings are expected to grow by 20 percent. Flat stock prices combined with rising earnings translates into more attractive valuations. Better valuations set the plate for healthier expected returns going forward.
Improving economic and earnings fundamentals also reduce risk during periods of market volatility. The first quarter of this year provided a good example. The “overdue” correction in February was limited to a 12 percent market decline. Rising economic activity and strong profits supported the market and led to a quick recovery.
As we transition to the third quarter, investor concerns remain. The upcoming midterm election season may cause additional worries, but our expectation is the underlying strengths will win out, allowing investment returns to improve in the second half of the year.
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.