Economic and market perspective
The long anticipated and debated tax reform legislation was passed on December 20th. The plan has been described as the largest set of changes to the U.S. tax code in over 30 years and includes significant changes to the corporate as well as personal tax regimes. The bill will reduce corporate tax rates from 35% to 21%, speed up deductibility of business investment and shift the U.S. from a citizenship-based system to modified territorial system. Personal marginal tax rates will be reduced across all income brackets with a variety of changes in deductions as well as changes to inheritance tax, generation skipping tax and alternative minimum taxes. Other long time Republican priorities were included in the bill, including the repeal of the “individual mandate” in Obamacare and opening the Arctic National Wildlife Refuge for oil exploration. The bill is expected to add $1.5 trillion to the deficit over 10 years.
Forecasts of the impact of the bill vary, with more aggressive analyses showing a 3-5% gain in GDP growth over 10 years and others showing almost no gain after the first few years. For next year, most projections are showing a 0.3 – 0.5% increase in GDP growth due to the implementation of the tax plan. Prior to passage of the tax plan, the National Federation of Independent Business survey showed small-business optimism hitting its highest level since 1986 and a record number (+24%) of small businesses anticipating hiring new personnel (net of those anticipating reducing their workforces).
Twice in December, Congress passed stopgap measures to avoid a government shutdown. The continuing resolutions fund government operations through mid-January. The White House also indicated that President Trump will release the principals of his long discussed infrastructure plan in January prior to the State of the Union address at the end of the month. Early indications are that the plan will call for a minimum of $200 billion in direct Federal spending to be paired with $800 billion of state, local and private spending with a focus on rebuilding transportation infrastructure.
As expected, the Federal Open Market Committee raised the Fed Funds rate range by 25 basis points to 1.25 – 1.50% when it met on December 12-13.. For the year, the Fed raised rates three times for a total of a 75 basis points of increases. These hikes were in line with the Fed’s projections at the end of 2016, the first year in this cycle when Fed projections materialized. The Fed also confirmed that it will allow the balance sheet to shrink by up to $20 billion a month of maturing assets beginning in January, in line with the announced plan to unwind the balance sheet. Fed projections call for the Fed Funds rate to end 2018 at 2.1%, 60 basis points above the current upper bound. For the end of 2019 and the long-run Fed Funds rate, the Fed projects rates of 2.7% and 2.8% respectively.
Oil prices continued to rebound in December, crossing the $60 a barrel market and ending the month at the highest level since 2014. Oil rose 12% for the year on improving global growth, declining demand/supply imbalance and agreements between OPEC (Organization of the Petroleum Exporting Countries) and non-OPEC countries to reduce output.
Outlook and conclusions
In our view, the recent modest increase in rates is healthy and appropriate given the improving U.S. economic data and the final passage of tax reform. As we had suggested for the year, rates remained range-bound with the 10 year Treasury closing 2017 within three basis points of where it ended 2016. With long rates effectively unchanged, but the Fed able to push through three rates hikes, the yield curve flattened meaningfully. This flattening was in line with our long held expectations about Fed actions, which came to fruition in 2017. With growth expectations remaining robust and the corporate landscape improving with the new tax laws, credit remains appealing though markets have priced in the positive backdrop, bringing spreads to their tightest levels in a decade. Inflation, both broad measures and wages, remains the outlier given otherwise more bullish data. With the awareness of the current levels of rates and spreads, we expect the current environment and policy changes will create winners and losers, adding to our focus on uncovering idiosyncratic security selection opportunities.