Third Quarter 2017

Overview

As we enter the fourth quarter, the unemployment rate stands at 4.2%, the inflation rate has not reached 2%, wage and prices appear stable, overall, businesses seem to be doing well, and the Federal Reserve did not raise the discount rate during the quarter. Adding to the good news, the government announced late in the third quarter that the growth rate for the second quarter, instead of the originally reported 2%, was 3%. This helped to fuel the stock market.

Market Review

Slow and steady seems to be the creed of the economic recovery we’ve seen since 2008. Large Cap stocks continued to do well in the third quarter of this year. The S&P 500, which began the quarter at 2423, ended at 2519. This means the average gained 96 points or about 4% in the quarter. Having begun the year at 2239, the S&P 500 is now up 12.5% for the year. Mid-Cap stocks continued to do well with the S&P Mid-Cap 400 up 3% for the quarter, for a total gain, year to date, of 8.2%. The best performing U.S. group for the quarter was small stocks, which until this quarter had been lagging. The S&P Small Cap 600 was up 5.8% for the quarter and is up 7.9% for the year. Having the best performance for the year is the DJ Global ex U.S. Index which is up a remarkable 18.7% for the year, adding an additional gain of 6% during this quarter. The 10-Year Treasury rose slightly from 2.298% to 2.328%.

As we wait for companies to report earnings, it appears likely that the various hurricanes and storms that occurred during the third quarter will have a dampening impact. It also appears that the Federal Reserve will move the discount rate up in December.

Corporate Tax Reform

Taxes charged by the U.S. Government on corporations reached 35%. When those earnings are passed along to shareholders in the form of dividends, those individuals must pay taxes too on those same earnings.

The U.S. corporate tax rate is out of line with other countries and needs to be changed. The idea of lowering the tax rate to 20% makes sense and has broad support. To go along with this alteration is the idea of eliminating the corporate deduction for interest expense on bonds. While this might not be significant to a company that is not capital intensive, such as large tech companies, it would have a negative impact on large capital intense corporations, such as the automotive industry. The result may be that large companies will issue more stock and take on less debt. This could be a financial benefit over the long term, because paying dividends is more flexible and investors are less likely to take the risk of investing in a company without a clear vision.

Individual Tax Reform

The major difficulty with tax reform is that so many special interests impact what can be done. An elected official in Washington will find it difficult, if not impossible, to take a tax break away from their constituents. On the other hand, they love to talk about “lower taxes.” Why, for example is mortgage interest deductible while other types of consumer interest are not deductible?

Good lobbying by realtors and banks! Why are state, city and property taxes deductible? The deduction lowers the cost of the actual taxes and is a great boon to heavily taxed states like New York, Connecticut, California, and others.

When Federal taxes were first imposed in 1913, no itemized deductions were available. The form was a one-page schedule that almost anyone could complete. You put down how much you earned during the year. A certain amount was excluded (at the time that was $20,000), and then scaled brackets were used for amounts over the exclusion. I don’t expect to see anything like this again.

I’m not sure the U.S. government really looks at their statistics on taxes. For those with inquiring minds, here’s my take. In 2014, the most recent information available, the government processed about 148 million income tax filings. The reported income from all filers was about $9.77 trillion, with total taxes of $1.355 trillion, or a 20.1% overall tax rate. People earning less than $20,000 accounted for 48 million of the forms filed and the amount of taxes they paid was $2 million. We should not have people earning less than $20,000 file, just like in 1913 when the system started. Here’s the rub: people earning between $50,000 and $1,000,000 pay the most taxes, collectively 66.9%. People earning over $1 million, about 409,000 filers, paid 26.8% of the taxes (that’s about $363 billion or an average of $887.5 thousand in taxes each). Together these two groups paid 93.7% of the taxes. So, who got the biggest benefit from the deductions for things like medical, taxes, charitable contributions and other deductions? Surprise: the people earning between $50,000 and $1,000,000. Don’t expect any big relief in taxes, perhaps just how they count the taxes will change for individuals in that group.

Just one more point to consider when looking at taxes: the government is still not raising enough taxes to avoid deficits, having to borrow about $500 billion to make ends meet. Also, about 63% of the budget in 2014 went for entitlement programs, a growing cost in the budget.

The Economy

The government reported that the median annual income has risen to $58,000. This is good news for two reasons. The first is that more workers are earning more money and can continue to spend at a rate to keep the economy moving forward. The second reason is that wage growth has been slow and steady, which reduces inflationary pressures.

Retail stores are feeling the pain of consumers shopping online. This has also impacted real estate related to these types of stores. Large department stores and box stores are all attempting to find a strategy that will work for them. Part of this strategy is closing stores. While online shopping has been negative to retail stores, consumer spending has picked up more than enough in new sales to offset the loss of sales at brick and mortar retail stores. In addition, if appears many of the online shopping operations are paying better wages than retail.

Conclusion

This coming quarter will be one to watch. By mid-November we will have a much better idea of how business fared with the turmoil of mother nature. If earnings are strong, then the likelihood is that U.S. growth will continue well into next year. The Fed will probably raise the discount rate. This may be a good thing, because it appears inflation may finally be raising its head. Will the markets keep performing as they have so far this year? We’ll see.

Ed Mallon

Posted October 13, 2017