(Since it’s the most pressing and biggest topic right now, I’m going to flip the script and start with updates on taxes and legislation out of DC).
Tax & Legislative Updates
On Friday December 22 President Trump signed the new Republican tax bill, making significant changes to both personal and corporate income taxes for 2018 and following years. Changes affect how taxpayers will take deductions from their income, tax rates that will be paid and treatment of business income. I’ll do my best to summarize how these changes will affect most tax payers.
- Tax code will retain 7 tax brackets with new rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%.
- The Standard Deduction will nearly double to $24,000 for married filers and $12,000 for single filers. This is paired with the elimination of personal exemptions, formerly $4,050 per individual.
- Itemized deduction of state and local income and property taxes will be capped at a combined $10,000 limit.
- Home mortgage interest deduction limited to $750,000 of debt for purchase only for new mortgages. Home equity financing will no longer be deductible.
- All miscellaneous itemized deductions, including payment of tax preparation and investment advisory fees, are eliminated.
- The Alternative Minimum Tax impact is reduced, with a higher exemption limit ($109,400 from $86,200 for married filers) and a higher phaseout. AMT will impact a much smaller populace than in prior years, especially with more limited deductions of state and local taxes (a large use of which often triggered AMT).
- The Child Tax Credit is expanded from $1,000 to $2,000 per child under 17, and the phaseout level is increased from $110,000 to $400,000 for married couples. A new $500 credit will be available for non-qualifying dependents, including children over 17 or dependent adults.
- 529 College Savings Plans can now make qualifying distributions for the use of primary and secondary schools, including private schools. Especially in Colorado and other states with large deduction allowances, this makes 529 plans significantly more attractive for parents of children attending private school.
- Pass-through business entities, including sole proprietors, will be able to deduct 20% of their business income from taxable income, subject to some restrictions. There are significant complications related to W-2 wage amounts and service businesses that should be discussed with a tax professional as it may relate to your personal situation.
- Taxable business entities (C-Corporations) will see a large reduction in tax rate to 21%.
- Estate and Gift tax exemptions are doubled up to $11.2M per individual after 12/31/17.
- The individual health insurance mandate and accompanying penalty as part of the Affordable Care Act is repealed effective 2019.
The primary impact of these changes is that many taxpayers will no longer itemize deductions, given the increased standard deduction and limit on the deduction of state and local taxes. Most taxpayers will see an effective reduction in income taxes, though the changes are complex enough that is can be dangerous to paint with a broad brush. Planning opportunities will change in 2018, including the timing and use of charitable giving, college planning and business structure. Right now, most tax professionals and attorneys have had barely enough time to begin to understand all of the complexities, incentives and impacts that will come out of these changes, and we’ll be learning a great deal over the next several months.
In short, 2017 was an fantastic year for stock investors. Throw a dart and most equity asset classes are up double digits. Large caps, small caps, tech, developed international, emerging markets, the list goes on. For the first time on record, the S&P 500 was positive for every month during the year, one in which we had practically no volatility. The VIX, a measure of market volatility derived from options traders’ expectations, has been sitting at unusually low levels nearly all year. We haven’t seen a 3% correction since November of 2016!
Here’s a look at how major assets fared.
As I mentioned, large cap US stocks had a remarkably good year with gains of 21.83% in 2017. Small caps also gained, but did not keep pace, up 14.65%. International stocks, boosted for US investors by a weakening Dollar, finished the year up 25.03% and emerging markets had a tremendous year, up 34.35%, the best performing of major asset classes. Even bonds fared reasonably well, as the Barclay’s Aggregate gained 3.54%, enough to stay ahead of inflation. The bond bears were wrong for yet another year, and while bonds hardly added to the performance of a diversified portfolio, allegedly impending bond market carnage was not to be found.
We could spend hours discussing the current state of the markets. We can debate whether or not stocks “should” have gained so much this year, as if it’s something to decide we deserve or not. We can choose to worry about valuations and stay up all night fretting over the impact of CAPE ratios. You can sweat missing out on huge tech returns because you had a well diversified portfolio or a reasonable exposure to bonds.
Or, you could be happy, satisfied, pleased with a better-than-average year, and know that when years like this come, we take them. We don’t take it for granted, but we take it. And the consequences are pretty straightforward. If a great year like this one leaves your portfolio out of balance, you rebalance. After a year like this, you do what you said you were going to do after a year like this. Instead of fretting, instead of trying to guess if the rally will continue or when the inevitable correction will come, do what you said you were going to do. That’s the only way this works. Not changing your mind, not going with your gut instinct or making a move based on what you think the President will tweet next. Having a plan is the beginning. Having the discipline to stick to that plan is the other 95%.
Nearly all measures of economic growth and activity remained solid during 2017, and the fourth quarter showed little change in that pattern. Housing, employment, GDP, industry and consumer sentiment all point to a very solid year for 2017, as we’ll see below.
American consumers are in fantastic shape, and remain in a considerably better position than before the 2008 financial crisis. Household net worth continues to make all-time highs:
And personal debt, both as level relative to GDP and cash flow servicing as a percentage of disposable income, remains very low. American households are less leveraged than before the crisis and are spending less of their free cash flow servicing debt, in part thanks to the continued low interest rate environment.
Consumer spending growth has been very steady, leading to a reasonably slow economic expansion but also indicating a lack of over-exuberance and borrowing.
Related, Real GDP growth remains steady but unexciting. Economic activity is robust but hardly the boom often associated with blow-off-top bubbles we have seen twice in the last 20 years.
Housing in the United States is robust by most any measure. National home prices have risen steadily since the financial crisis.
This is certainly not unrelated to the fact that supply remains limited relative to pre-crisis levels. Housing starts are growing, but at a much lower level than the early to mid 2000’s.
Partially as a result, home buyers have faced a market of limited supply that has essentially remained unchanged since the washout after the crisis.
As with most economic factors, these above are linked. Reduced supply and constrained new construction contributes to increasing home prices nationwide. What may be more interesting is that recovering home values have not led to increasing consumer debt loads as we saw in the previous runup in home values from 2000-2007. Perhaps (a big perhaps) consumers learned some lessons about the dangerous of being too leveraged and are steering away from the house-as-ATM phenomenon we saw a decade ago.
Economic confidence is strong across both consumers and industry. University of Michigan Consumer Sentiment remains very high with the last reading at 95.9 in December 2017. The long term post-crisis trend is upwards.
The Institute for Supply Management’s Purchasing Manager’s Index is a reliable indicator for the health and expansion of the US manufacturing sector based on orders, inventories and other factors. A level above 50 indicates expansion, and the most recent data was a reading of 58.2
Of course all of this data is current or backward-looking. We can’t predict what happens next and most of the above should be mentally categorized as (maybe) interesting but probably not actionable.