Sustained Economic Growth Points to Increasing Interest Rates in 2018

2017 was a good year for most investors. December marked the fourteenth month in a row the US market saw a positive return. Volatility remained near historic lows, providing a steady growth experience in the fourth quarter and throughout the year. The passage of the Tax Cuts and Jobs Act only helped to promote investor confidence.

Developed international and emerging equity markets also performed well, posting even higher returns than the domestic market despite ongoing geopolitical issues such as Brexit and escalating tensions between the United States and North Korea.

2017 Q4 Returns

Sources: Frank Russel Company’s Russell 3000 Index, ©MSCI World ex USA Index [net div.], ©MSCI Emerging Markets Index [net div.], Standard & Poor’s S&P Global REIT Index [net div.], Bloomberg Barclays US Aggregate Bond Index, and Citigroup’s Citi WGBI ex USA 1−30 Years [Hedged to USD].

Top Factors Impacting the Markets

While current economic data points toward sustained domestic and global economic growth, there are a number of potential opportunities and risk areas to look out for as an investor—such as impacts of tax reform, increasing interest rates, and the changing landscape of the fixed income market.

Tax Reform

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA) into law. Estimated to be a $1.5 trillion tax cut, the bill represents the most significant change to the US Tax Code in three decades.

The TCJA significantly reduces the income tax rate for corporations and eliminates the corporate alternative minimum tax (AMT). It also provides a large new tax deduction for most owners of pass-through entities and significantly increases individual AMT and estate tax exemptions. It makes major changes related to the taxation of foreign income as well.

The corporate tax reduction—down to 21% from 35%— should benefit most corporate profits, and a near-term boost in earnings is expected. Low debt- and domestic income-oriented companies will benefit the most because their effective tax rate will fall the furthest.

While we do expect this legislation to impact certain asset classes differently, it's not clear how businesses will utilize these tax savings. We don’t believe it’s necessary for investors to make any significant changes to their long-term asset allocation in response to the passage of this bill.

Interest Rates

The Federal Reserve’s three main goals are maximum employment, stable prices, and moderate long-term interest rates. In the context of the current economic environment, the Fed has communicated their intention to increase the overnight lending rate in quarter-point increments as many as three to four times in 2018.

At 2.5%, wage growth is just starting to outpace inflation, which is at 2.1% as of December 31, 2017, implying the Fed anticipates more inflation gains in the near-term. Meanwhile, the unemployment rate is 4.1%, lower than the historical full-employment benchmark of 4.6%.

Despite the possible increase among short-term interest rates, the global demand for longer-term, US fixed-income investments remains strong. As most developed nations’ populations are aging, investors seek safer, income-producing investments.

US government bonds currently offer higher yields than most foreign bonds and are viewed as having little credit risk. This immense demand is already causing the shape of the US Treasury yield curve to flatten as long-term yields are bought down and the Fed raises short-term interest rates.

It’s important to consider that the current economic expansion is approaching a decade in length, and it may be closer to the end of the expansion cycle than the beginning. Given the Fed’s intention to continue modestly increasing short-term interest rates, there’s a heightened risk of a policy error if they were to raise interest rates too fast. This is especially true if they overestimate the strength of the economy or underestimate the impact of increasing interest rates, which could cause a slowdown of borrowing and consumer spending.

Fixed-Income Market

As interest rates continue to rise, bonds are beginning to compete with stocks in terms of return. Interest rates on bonds and other traditional fixed-income investments were so low over the past few years, so people were entering the stock market and other income producing investments in search for their needed return. While rising rates will result in increased yield from fixed-income investments, higher rates can have negative impacts on existing bond prices and create volatility in this space.

Looking ahead, the municipal bond market impacts are less certain. As a result of the TCJA, most individuals have lower federal tax rates, so there’s less need for the tax-free income municipal bonds provide—meaning demand for them may decrease. However, some high income-tax states such as California and New York, may see increased demand for municipal bonds, because individuals there will be looking for additional tax-free income now that the TCJA’s $10,000 cap on state and local tax deductions is in effect. 

In the high-yield market, a lower tax rate should be a credit positive for most issuers in the near-term. However, the TJCA introduced a cap on interest deductibility at 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), which could pose a risk to some particularly highly leveraged companies. Longer term, we expect this cap will likely result in companies borrowing less and, ultimately, a smaller but healthier high-yield market.

Looking Ahead

After a record fifteen straight months of positive returns, and its biggest January return since 1997, the S&P 500 has been giving back some of these returns since the start of February. After a year of historically low market volatility, this decline may seem concerning.

Whether the recent market drop is due to rising inflation and interest rate fears, some profit taking after significant gains, or just a regular market correction, this isn’t uncommon. While we can’t predict when the markets will turn, or to what degree, long-term investors have historically been rewarded for staying invested and not trying to time short-term market actions. That’s why portfolios should be designed with market downturns in mind.

With that said, global and domestic economic growth is expected to continue its steady acceleration throughout most of 2018, and potentially beyond. And while there’s no imminent risk of a recession, it’s prudent for investors to consider the potential impacts of increasing interest rates on their investments.

Investing in nontraditional income investments, such as floating rate securities—which will increase their interest rates as rates climb—will help investors diversify their portfolios and mitigate the risks of rising interest rates.

International markets continue to look attractive moving into 2018, and we believe European and emerging market equities currently represent the best long-term growth prospects due to their attractive valuations when compared to domestic equities and their positive demographic trends.

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To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams advisor.

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