U.S. equity market indices turned in unusually strong performances during 2017. The S&P 500, for example, returned over 19% last year while the Nasdaq bested 28% and the Dow Jones Industrial Average returned just over 25%. With the exception of the energy and telecommunication sectors, which were negative for the year, the remaining nine sectors of the U.S. economy returned between 7.17% (real estate) and 36.91% (technology). A number of major international equity indices followed suit including the Hang Seng (Hong Kong), the Nikkei (Japan), the Kospi (South Korea), the Dax (Germany), and the S&P BSE Sensex (India). Commodities, on the other hand, were much more of a mixed bag during the past year. Oil and a number of the industrial and precious metals (aluminum, copper, nickel, gold, and palladium) were standouts on the upside while corn, soybeans, cocoa, coffee, and sugar all turned in negative performances last year. As for the fixed-income markets, after years of rising prices and falling yields, the U.S. bond market experienced a slightly different environment in 2017. Thanks to three interest rate increases this year from the Federal Reserve, the yields on shorter-term bonds rose. At the same time, and mostly because of an insatiable demand for U.S. longer-term bonds from overseas, yields on longer-term bonds fell resulting in a flattening yield curve.

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The U.S. Treasury Yield Curve graph below illustrates this phenomenon. As you can see, at this time last year the yields on the shorter-term bonds were considerably below the yields on the longer-term bonds (orange line). Of course, we also began 2017 with a fed funds rate of just 50 – 75 basis points (0.50% – 0.75%).

During the past year, the Federal Reserve increased the fed funds rate three times from a range of 50 – 75 basis points to a range of 125 – 150 basis points. As the year progressed and the fed funds rate rose, yields on the longer-term maturities fell and the yield curve flattened. As you see in the graph on the previous page, the yield on the 30-year bond is considerably below where it was at this time a year ago. You may wonder why this occurred as you would expect longer-term bonds to pay correspondingly higher yields to reflect the higher amount of interest rate risk an investor takes on when they purchase a longer-term bond. In this instance, however, high demand for U.S. bonds from overseas investors seeking better yields in high-quality securities ultimately drove longer-term bond yields lower. At the same time, interest rate increases drove rates higher in the shorter end of the yield curve.

As we look back on 2017, it appears this was the year the U.S. economy began to build some momentum after many years of sluggish and fitful growth. The current U.S. economic expansion began in mid-2009 and for the most part, has struggled to turn in a 2% per year growth rate as measured by the GDP (Gross Domestic Product). This year, for the first time since 2014, the U.S. economy turned in two straight quarters of growth at an annualized rate of 3% or better and seems set to turn in a third straight quarter of 3%+ GDP growth assuming the recent holiday retail sales data is a good indicator.

Even though we are eight and a half years into the current economic expansion and this expansion is already the third longest in history, the U.S. economy appears poised to continue moving ahead in 2018 and possibly beyond. We ended the year with unemployment at a 17-year low, wages rising at a manageable pace, and consumer confidence just slightly off the 17-year high point it reached in November 2017. Holiday retail sales were the best they have been since 2011 and U.S. home prices continue to head upwards. In addition to lots of positive economic data of late suggesting U.S. GDP growth will continue at a more robust pace, the new tax bill should also help to boost growth this year. In short, the tax bill reduces the corporate tax rate from 35% to 21% and also slightly reduces the tax burden on most individual taxpayers. In the wake of the bill’s passage, some companies, like AT&T and Boeing, immediately announced bonuses or wage increases for many of their employees while others indicated they would expand their hiring and/or capital investment plans for 2018. The tax bill coupled with the promise of a reduced corporate regulatory burden should hopefully help drive corporate earnings higher and give business owners – particularly the owners of small and mid-sized businesses – the confidence and financial flexibility to expand and hire.

The timing of the tax bill and other regulatory changes is quite interesting. For years, extremely loose monetary policies helped buoy the U.S. economy, likely kept it from falling into a depression during the financial crisis and paved the way for the ensuing economic recovery. However, beginning in 2014, the Federal Reserve began to slowly and ever-so-slightly rein in all its accommodative efforts. First came the 2014 tapering of the quantitative easing programs followed by the first interest rate increase in years in December 2015. Now, quantitative easing is long over, there have been four more interest rate increases since December 2015 with a couple more probably to come this year, and the Fed is slowly and methodically reducing its balance sheet. In short, we look to be in a monetary tightening phase. But now that monetary stimulus is gone, we have entered a period of fiscal stimulus designed to encourage economic activity. Among other things, the tax bill and other ongoing regulatory efforts are supposed to encourage businesses and individuals to engage in more economic activity. The hope is that these fiscal stimuli will jump-start the U.S. economy and jolt it out of its listless growth pattern of the last many years.

It looks likely that fiscal stimuli will contribute to GDP growth this year and possibly next year too. Beyond that, however, is anyone’s guess. There is also some concern that the beneficial impact of the tax bill will be muted because the U.S. economy is already at or beyond full employment. In other words, there is a plethora of anecdotal evidence indicating that most employers are finding it almost impossible to find new employees since those who are ready, willing, and able to work are already doing so. If employers are already not able to find additional employees, it could be more difficult for them to expand their hiring practices and grow their businesses. Furthermore, some economists are also wondering whether these fiscal policies could help fuel inflation in the coming years. At present, the U.S. inflation rate is still not worrisome although it is noticeably higher now than it was a year or two ago. Fairly low long-term bond yields suggest inflation over the longer haul remains a non-issue for now. However, we continue to closely monitor this data point. Also, the Fed’s openly-stated intention of continuing to normalize (increase) U.S. interest rates suggest that rate increases can and will be used to manage any brewing inflationary pressures.

Outside the U.S., many developed economies – like those in Europe and Japan – continue to benefit from loose monetary policies. These economies are several years behind the U.S. economy in terms of where they stand in the economic recovery/expansion cycle because their central banks implemented monetary easing efforts several years after the Fed did. Indeed, and as you may recall, some of these economies were actually employing austerity measures rather than accommodative measures during the height of the financial crisis. As we have noted in earlier newsletters, the U.S. economy continues to benefit indirectly from the loose monetary policies overseas and from the economic recoveries now spreading across Europe and Asia.

While it appears there are many positives on the horizon suggesting that 2018 will be another decent year for the U.S. economy, we would be remiss if we did not acknowledge that, as always, there may also be some items that could challenge this positive outlook. In no particular order, these risks include:

  1. U.S. inflation increasing at a more aggressive pace this year or next
  2. The Federal Reserve increasing interest rates more quickly than originally expected
  3. A geopolitical event (either from a known hotspot like North Korea, Iran, or Russia
    or from a wholly unexpected place)
  4. A messy and contentious U.K. exit from the EU
  5. An unexpected reduction in monetary stimulus in other parts of the world
    (EU, Japan, China, etc.)
  6. Restrictive or insular trade policies or a trade war
  7. The implementation of restrictive U.S. immigration policies
  8. Rapid growth in the already out-of-control rate of opioid addiction

The reality is that one or more of the items listed above could occur in the next year or two and that other yet to be contemplated risks may also crop up along the way. The economy never
travels a smooth, straight, or predictable path!

As we look ahead to what 2018 may bring, we think it is likely U.S. equity markets will have to weather one or more periods of heightened volatility. Of course, this is something we also predicted for 2017 and it never actually occurred. We also think it is possible U.S. equities will stumble at some point during the year and perhaps even fall into correction territory (down 10% or more) – something that has not happened since early 2016 as you can see in the S&P 500 chart on page 3.

If either or both of these things should come to pass, please keep in mind that they are both usual and necessary patterns of activity that occur with some regularity and, at times, without much warning. While it can be nerve-wracking to be in the midst of a correction – especially when we have not had one for several years – it is important to stay the course and remember the correction should eventually pass. Also, a well-diversified portfolio comprised of a variety of securities from various sectors of the domestic and global economies will also help cushion the temporary sting of any downward market pressure.

As you are probably well aware, a new tax bill was signed into law at the end of 2017. Among other things, the new tax bill changed the income ranges for the various tax brackets, increased the standard deduction, and eliminated certain exemptions. Please consider touching base with your tax advisor at your earliest convenience so that you understand how these new regulations might impact you and your 2018 tax situation.

Beginning January 1, 2018, our firm will formally be known as BLB&B Advisors, LLC. We have gradually been transitioning to this name over the past year and you will now see it on all our publications and our new website (coming this quarter). Among other things, our new name reflects how our business has evolved into a full-service investment management and financial planning firm. There are many exciting things on the horizon for BLB&B Advisors and we look forward to sharing them with you!

 
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