As we head into the last quarter of the year, the major U.S. equity indices are solidly in positive territory on a year-to-date basis – most of these indices are at or near all-time highs. For many investors, this positive performance in U.S. equity markets is a bit surprising. Some investors are concerned that the bull market in U.S. equities feels like it may be getting a bit long in the tooth. The current bull market began in March 2009 and is the second longest running bull market in history – the longest ran between 1990 and 2000 and ended with the “dot.com bust.” Indeed, it has been a long time – about 102 months – since U.S. equity markets pulled back by 20% or more.
Other investors point to the many geo-political and other uncertainties that abound – North Korea’s ongoing and escalating saber-rattling, Brexit, unsettled domestic policy issues (like healthcare, taxes, and immigration), U.S. monetary policy, and natural disasters (hurricanes, floods, and earthquakes). Additionally, there are some macro events and trends percolating in the background that also have the potential to impact the U.S. economy, such as the opioid crisis, the growing divide in the U.S. between the haves and the have-nots, the changing workplace and the nascent but growing reliance upon robots and artificial intelligence, and the eventual monetary tightening in Europe, the U.K., and Japan. Despite all of this, however, U.S. equity markets continue to climb. Even more surprising, though, is that U.S. equity markets are not only weathering all this uncertainty, they are doing so while maintaining historically very low volatility levels.
North Korea: So far, U.S. and global financial markets have not demonstrated much concern about the likelihood of an armed conflict between North Korea and the U.S. Hopefully, all the heated rhetoric back and forth is nothing more than bluster and diplomatic efforts and sanctions will eventually defuse the tension and encourage a more reasonable resolution that includes limitations on North Korea’s nuclear weapons program. Given that neither country stands to gain much, if anything at all, should an armed conflict erupt and given that the U.S., China, and the UN are working together to implement sanctions and trading restrictions designed to inflict significant economic pain on North Korea, for now, it seems unlikely a nuclear war will erupt.
Brexit: In June 2016, Britain unexpectedly voted in favor of leaving the European Union (“E.U.”). The E.U. was created shortly after World War II and has evolved into an economic and political union between 28 European countries. The E.U. has its own currency – the euro – which is used by some but not all of the E.U. country members and there is free movement of people, goods, and services between the 28 member countries.
Some economists and politicians predicted dire economic consequences should Britain vote to leave the E.U. but so far these have not come to pass. At this point, the departure process is underway and should be completed by March 29, 2019. Representatives from Britain and the E.U. are meeting on a monthly basis to hammer out the many details related to unwinding Britain’s association with the E.U. The reality though is that much work remains to be done in order to facilitate a smooth exit from the E.U. and to craft viable, ongoing, and mutually beneficial economic and political relationships between Britain and the E.U. member states. As this withdrawal process has never been done before, it is likely there will be some snags, unexpected bumps, and unintended consequences along the way which could inject some uncertainty into global financial markets. For now, the Brexit process appears to be moving along smoothly but we realize this could change – especially as the March 2019 deadline approaches.
Domestic Policy Issues: There are a number of unsettled domestic policy issues primarily relating to healthcare, taxes, and immigration that has the potential to positively or negatively impact the U.S. economy and financial markets over the coming months and years. For example, many U.S. companies have liquid assets located overseas. Because of fairly oppressive U.S. corporate tax rates that approach 40%, these companies have little incentive or desire to repatriate this money. Instead, it sits overseas. To give you an idea of the magnitude of U.S. corporate “cash” assets outside the U.S., Apple’s chief financial officer, Luca Maestri, stated during Apple’s latest earnings release in early August that 94% of the company’s “cash” – or $246 billion! – is located outside the U.S. As you can imagine, Apple and all the other U.S. companies are waiting for downward revisions to the U.S. corporate tax rates before taking steps to bring home some of this money.
As you are probably well aware, the Republican leadership just released a tax proposal that includes a reduction in the corporate tax rate to 20%, and a simplified 3 tax-bracket approach (12%, 25%, and 35%) for individuals along with a higher standard deduction and child tax credit. The proposal, however, is fairly light in specific details. The Congressional tax-writing committees now have their work cut out for them as they get started on drafting proposed tax legislation.
The Republican leadership also just put off a Senate vote on their plan to repeal and replace the Affordable Care Act (“Obamacare”) due to dissension in their ranks over the proposed ACA replacement. Further complicating the health insurance picture in the U.S. is the exodus of insurers from the health exchanges – Aetna and Humana, for example, both announced this year that they will completely leave Obamacare and not participate in the exchanges in 2018. The rapidly escalating cost of health insurance and the dwindling choice of health insurers on the ACA exchanges do not bode well for the ongoing viability of Obamacare. The alternatives at this point are still unknown. Perhaps the U.S. is on the path towards a single-payer health insurance model?
U.S. Monetary Policy: At its meeting this month, the Federal Reserve left the federal funds rate at its current level (1.25%) and announced that beginning in October it will start taking baby steps towards reducing its bloated balance sheet. Both of these actions were expected and in line with what the Fed had earlier indicated it would do. Reducing the Fed’s balance sheet is the next logical step as the Fed proceeds along in its multi-year process of unwinding all the accommodative efforts it used during and after the financial crisis and Great Recession. As you can see in the chart below from the Federal Reserve’s website (https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm), the Fed’s balance sheet more than quadrupled between mid-2007 and mid-2014. During this time, the Fed employed several rounds of quantitative easing in an effort to support the U.S. economy and encourage growth while also keeping a lid on interest rates. The Fed did this by essentially printing money and then using this money to buy bonds – mostly U.S. government-backed bonds.
Over the course of several rounds of quantitative easing, the Fed’s balance sheet grew from around $800 billion to about $4.5 trillion. Many of the government bonds purchased by the Fed had relatively short maturities and along the way, as they matured the Fed used these bond proceeds to purchase more bonds. As you can see in the graph on the left, the Fed’s balance sheet has not grown since early 2014. By October 2014, the Fed was no longer using newly created money to purchase bonds and was only reinvesting the bond proceeds it received on maturing bonds into more bond purchases. This practice kept the balance sheet fairly flat but still allowed the Fed to reinject money into the U.S. economy. Now, the Fed is taking the next step as it moves towards a more normal operating environment. Beginning in October, the Fed will let $10 billion of the maturing bond proceeds it receives each month not be reinvested in more bonds. This $10 billion figure will gradually increase to $50 billion/month by October 2018. Although it will likely take years, the Fed’s goal is to dramatically ratchet back its balance sheet.
Because the Fed has done a good job of explaining what it intends to do and why, and because the Fed is patient, recognizes the benefit of taking a slow and steady course, and thankfully has had the luxury of doing so because of low inflation, the tightening efforts of the last several years have been mostly pain free to the U.S. economy. Hopefully, the Fed can continue this slow, steady, and predictable approach. It is important to note, though, that quantitative easing overseas by the E.U., Bank of Japan, and Bank of England has also helped to cushion the economic blow of Fed tightening efforts underway in the U.S. At some point – possibly in 2018 – the Bank of England and possibly also the E.U. could start tightening as well.
Natural Disasters: Unfortunately, a number of natural disasters in the U.S. and beyond occurred this quarter – most notably the hurricanes that hit Texas and Louisiana, Florida, and Puerto Rico. It is likely the economic impact of these hurricanes will appear in the U.S. 3Q17 GDP figure. Economic interruptions due to these hurricanes were numerous and are expected to shave possibly 0.5% off of GDP for the 3rd quarter. Thankfully, most of these economic interruptions will probably just be temporary and a rebound in economic activity in the 4th quarter is expected as citizens of these areas begin to rebuild and recover.
Miscellaneous: As noted in the second paragraph of this article, there are a number of other macro events and trends that can or will impact the U.S. economy in the coming months and years. One of the most prominent is the recent explosion in opioid addiction and drug-related deaths. Another is the growing divide between those Americans who live in prosperous communities with rising home prices, solid school districts, and vibrant business environments and those who live in declining areas where jobs are scarce, educational offerings are poor, and businesses are closing. There is a similar gaping divide between Americans who participated in the country’s economic recovery over the last 8 years and those who did not. There is probably some relationship between rising pockets of opioid addiction and the economically depressed areas of the country. Add to this a workforce that is increasingly stratified by academic achievement, a workplace that is increasingly using robots, computers, and/or artificial intelligence to take the place of lower-level jobs, and numerous sub-par urban public school systems churning out unqualified job applicants for the modern workplace and you have a recipe for looming trouble if allowed to continue unchecked. While these issues will not be cured anytime soon, we continue to monitor developments as they could resonate throughout the U.S. economy.
As we look ahead to the remainder of the year and into 2018, there are a number of positive signs that suggest U.S. economic activity will continue to grow at a steady and manageable pace and that global growth will continue to benefit from the accommodative monetary policies in the U.K., the E.U., and Japan. A number of emerging market economies are also starting exhibit strength after years of sluggish growth. Here at home, corporate earnings are strong and U.S. multinationals are benefitting from the recent pullback in the U.S. dollar as U.S. goods and services are now more affordable to those outside the U.S. Consumer confidence took a hit in the wake of the recent hurricanes but has otherwise been strong and is expected to recover. U.S. consumer spending is also strong – a good sign given that consumer activity is responsible for about 2/3s of U.S. economic activity. We look forward to what will hopefully be a positive 4th quarter in U.S. and global financial markets and a successful start to 2018
FAFSA Application Window Now Open!
On October 1, 2017, the application window for the FAFSA (Free Application for Federal Student Aid) opened for the 2018 – 19 school year. If you have a child who will attend college during the next school year, you should make every effort to submit a completed FAFSA application as soon after October 1st as possible. Many colleges distribute financial aid packages on a first-come-first-served basis so applying for aid as soon as possible generally works in your student’s best interest.
Also, many colleges use the FAFSA as a way to determine a student’s eligibility for other scholarships like merit-based aid. Thus, even if you do not think your child will be eligible for need-based aid, it can still be worth submitting the FAFSA as your child may end up receiving some merit-based financial assistance for college. Additionally, because your family’s eligibility for financial aid is based on numerous factors and not just your income level, you should not assume that your income alone renders your child ineligible for federal financial aid. There is no income cut-off limit to qualify for financial aid.
You can obtain and submit the FAFSA form here: https://fafsa.ed.gov/index.htm. Please keep in mind that completing and filing the FAFSA is a free process – you do not need to pay any application or filing fee in order to submit the FAFSA. Be wary of any FAFSA service that charges a fee to file the FAFSA on your behalf and/or may appear to be affiliated with the U.S. government. There are no fee-for-service FAFSA filing companies that are legitimately affiliated with or endorsed by the U.S. Department of Education. Rather, the website noted above contains all the resources and information you need to complete and file the FAFSA.