Perspectives & Planning Spring 2016
April 15, 2016
Market & Economy
Despite a rocky start to 2016, we remain fairly optimistic on the outlook for both the U.S. economy and financial markets. The U.S. would appear to be in a self-sustaining phase of expansion characterized by moderate growth. Potential bubbles in the high yield bond market or energy sector have largely deflated already. After sagging over 10% from year-end levels, the S&P 500 Index rebounded sharply to post a modest 1.3% gain at quarter end. We continue to favor equities versus fixed income, given low interest rates coupled with the likelihood of yields trending gradually higher, and have not altered our overall asset allocation recommendations. While there may be some debate as to relative valuation, U.S. equities remain, in our view, more attractive on a risk adjusted basis than foreign stocks, particularly emerging markets.
After concluding 2015 on a sluggish note, U.S. economic activity has perked up in the most recent quarter. While equities swooned in response to the slowdown and investors headed for the exits, the rebound in growth was fairly predictable. Q4 2015 employment remained healthy, as did consumer spending. Disappointing GDP growth of 1.4% in the final quarter of last year seemed largely a function of inventory adjustment and timing of government spending rather than of any major underlying issues. At this juncture, growth appears likely to have improved somewhat in Q1 2016.
For the full year, we expect U.S. GDP growth in the 2.0% to 2.5% range, a pace similar to that of the past several years. Furthermore, the probability of recession appears low given solid employment growth, low energy prices, and low interest rates. Manufacturing and energy remain challenged, but consumers are in excellent shape.
Growth in consumer spending of approximately 3% should be supported by rising real disposable income, as more Americans are working and wage gains continue to exceed the rate of inflation. Labor market conditions continue to tighten. With the unemployment rate at 5%, it appears likely to drift lower towards 4.5% over time. Monthly job gains for the quarter averaged over 200,000, well above the 125,000 to 150,000 needed to absorb new entrants into the labor force. Consecutive increases in the participation rate indicate a return of discouraged workers to the job market. High frequency data, particularly the low level of weekly jobless claims, point to a continuation of these trends.
Consumer finances have also dramatically improved, with debt reduced by most measures to the lowest level in years, if not decades. Consumers have been banking more of their income as the savings rate exceeds 5%. This stands in contrast to the period of the real estate bubble when it hovered near a mere 2%. Household net worth has climbed better than 25% above the pre-recession peak. The consumer not only has the wherewithal to spend at a healthy pace, but also to take on debt for larger purchases, if desired. Hence, our forecast is that housing starts could rise at a mid-teens rate this year.
A solid increase in consumer spending is a reasonable assumption based on the above factors. If the consumer, representing almost 70% of the economy, is growing at 3%, our forecast of moderate growth of 2% or slightly better for the economy as a whole appears very achievable. A robust January 2016 retail sales report, accompanied by an upward revision to December 2015, released on February 12 was likely one of the sparks to the current rally. Despite a subsequent downward revision, “core” retail sales (i.e. excluding gasoline and autos) remain solidly above levels from a year ago. While a rising trade deficit exacerbated by falling domestic energy production will detract from GDP, higher government spending at both the federal and local level will help provide another offset.
What remains concerning are the mixed economic signals from overseas, particularly Japan, China, and other emerging markets. While the statistical impact from weakness overseas is likely to remain muted on U.S. GDP, the effect on earnings growth for the highly internationalized S&P 500 Index may well be magnified. Since the end of last year, as estimates for global GDP have slipped from 3.4% to 3.0%, consensus 2016 earnings estimates for the S&P 500 Index have dropped from $128 to slightly under $120. Another major reason for the declining forecasts is that plunging oil prices have wiped out energy sector profits.
Declining earnings prospects make equity valuations more challenging, but recent market developments provide hope that the continual slide in estimates may have run its course. The price of oil may have hit a low of $26 per barrel in February 2016, but has since climbed 40% to $38. While this is a huge move, oil is still $10 cheaper than a year ago. Oil supply is still more than ample but U.S. production is falling. U.S. Production peaked in 2015 at an average 9.4 million barrels per day.
With the number of operating drilling rigs plunging by two-thirds, U.S. production is expected drop to 8.7 million barrels per day this year and then fall to 8.2 million barrels in 2017. The official Energy Information Administration forecast is for the price of oil to average $34 per barrel this year and $40 in 2017.
The price of oil has been inversely linked to dollar strength in recent years. The dollar index appreciated roughly 20% over the course of 2014 and 2015 as the price of oil plummeted. The consensus view which we also embraced was that the dollar would continue to strengthen in 2016 given the divergence in monetary policy as the Federal Reserve tightened while other major central banks eased. Contrary to expectations, the greenback has lost ground this year not only against the Euro and the Yen but against a host of other currencies as well. Astonishingly, even after the European Central Bank fired its proverbial “bazooka” of monetary stimulus at its March 2016 meeting by cutting deposit rates deeper into negative territory and announcing an even more expansive quantitative easing program, the dollar failed to rally.
While currency traders (and central bankers for that matter) are likely confounded by the recent action, stabilization or even some weakness in the dollar is a significant positive in several respects. The bouts of market volatility experienced last August and in January 2016 coincided with modest devaluations of Chinese Yuan. Given recent dollar weakness, China has allowed the Yuan to strengthen rather than depreciate. A drop in the dollar accompanied by a rally in energy and other commodity prices is certainly good news for many emerging market economies. It is also reassuring to investors fretting over the health of the financial system due to bank exposure to energy and mining companies. Finally, a softer dollar will tend to boost U.S. companies’ overseas earnings, all else being equal.
Interest Rates & Financial Markets
Using what we hope is a conservative 2016 earnings estimate of $120, the S&P 500 Index is currently valued at a Price/Earnings ratio of 17x, which we view as reasonable. However, earnings are not the only factor to consider when estimating future earnings. Interest rates are also a critical factor and are just as important.
While we still expect interest rates and bond yields to rise over the course of 2016, the path is likely to have moderated. Initially, our expectation was for the Federal Reserve to hike rates two or three times this year. At this point, two rate hikes at most seem to be on the table. While the orientation of Fed policy is exclusively domestic in theory, the Fed has no choice but to be sensitive to international conditions. As major central banks flood markets with liquidity to avert deflation and stimulate their economies, the Fed is constrained from tightening too rapidly, undercutting their efforts and causing a further spike in the dollar. Furthermore, the Fed monitors financial market conditions carefully. A Fed governor recently compared current financial market turmoil to the equivalent of a ¾% rate hike.
Similarly, bond yields are likely to rise at a more gradual pace. With yields in the Eurozone and Japan negative across much of the yield curve and likely to stay that way, there appears to be a ceiling on U.S. interest rates. With a 10-year German bund yielding under 0.20%, a 10-year U.S. Treasury note at 1.8% appears to be a bargain. As such, we trimmed our forecast for the yield on a 10-year Treasury to a range of 2.25% - 2.50% from our previous range of 2.50% - 2.75%. From an equity market perspective, lower rates and yields tend to support higher valuations, and it is possible that the stock market multiple could rise this year. This would support our forecast for 2016 domestic equity returns in the mid to high single digits.
With rates and yields likely to remain lower, fixed income investment continues to be a challenge. As we continue to find equities relatively attractive versus bonds, we are mindful of risk and have attempted to counterbalance our above average equity exposure with a conservative fixed income approach emphasizing quality and liquidity across the credit spectrum. With the turmoil in markets, there may be some opportunity to take advantage of wider credit spreads in the corporate bond market.
While the market volatility has been stomach churning and the corrections daunting, our sense is that the recent recovery in the equity market is not without foundation and could continue to grind higher. Economic and geopolitical risks overseas remain high but Europe continues its tepid recovery and China seems to be managing its challenging transition to a more balanced, consumer oriented economy. In response to an extended period of subpar economic performance, political risk has escalated across the globe including here at home as politicians, right and left, spout unproven economic theories as quick fixes in an appeal to a populist tide. In the U.S., however, fundamentals would indicate that the economy, for now at least, is heading in the right direction. Thankfully, from the perspective of constructing a market forecast, it is still premature to obsess over the impact of the election, never mind the outlook for 2017.
Portability: An Important Tool, But Perhaps Not the Be All and End All for Most Married Couples
A comprehensive financial plan tailored to one’s individualized circumstances helps to achieve planning and life goals. An essential part of an effective financial plan is the assessment of potential estate taxation and implementation of strategies to minimize those tax liabilities to preserve and protect assets for intended beneficiaries. Estate tax laws have changed significantly during the last decade. For 2016, the federal estate tax exemption is worth $5.45 million per person. This exemption may be utilized by making lifetime gifts. Since 2012, married couples are also afforded the benefit of portability of their estate tax exemptions allowing a surviving spouse to utilize a deceased spouse’s unused estate tax exemption. Portability can be a powerful tool in planning to minimize estate taxes but it is not without its limitations.
What does portability mean in the context of federal estate taxation?
With portability, any unused estate tax exemption at the death of the first spouse is available (or “portable”) to the surviving spouse, allowing a married couple to shelter up to $10.9 million from estate taxation. To illustrate, if a spouse dies leaving all of the assets to the surviving spouse, there is no estate tax due to the unlimited marital deduction so the deceased spouse has not used any of the $5.45 million exemption available. If portability has been properly elected, the surviving spouse can use both exemptions at the surviving spouse’s death for estimated federal estate tax savings of approximately $2.18 million calculated at a rate of 40%.
1. Portability is not automatic. Portability of a deceased spouse’s unused exemption amount is not automatic and requires an election. The election is made by timely filing an estate tax return in the estate of the first spouse to die, which is due within nine (9) months of the date of death. The estate tax return must be filed to preserve portability, even if no estate tax will be due.
2. State estate taxation may require further planning. States like Connecticut, Massachusetts, New York and Rhode Island have estate tax systems that are separate from the federal system and do not allow portability of exemptions.
Massachusetts falls in the category of U.S. states with one of the lowest estate tax exemptions, currently at $1 Million per person in 2016. Residents in these jurisdictions with a state estate tax and no portability may require the traditional credit shelter and marital trust techniques to ensure the use of both spouses’ estate tax exemptions.
3. No portability for the federal GST tax exemption. The generation-skipping transfer (GST) tax is a separate federal tax from the estate tax and applies to transfers from one generation to beneficiaries who are two or more generations removed, such as a transfer from grandparent to grandchild. The federal GST exemption is worth $5.45 million per person in 2016, and it is not portable between spouses. Planning for the use of GST exemptions of both spouses requires careful planning.
What does portability not address?
Where there is concern about minimizing estate taxes on appreciated estates or creditor protection, portability is not as effective as trusts to hold assets passing from a decedent for the benefit of family members. For a married couple who wish to rely on portability, the assets held by the surviving spouse after the first death may continue to grow in the surviving spouse’s estate. The appreciation would result in estate taxes at the second death if the assets exceed the combined unused exemption amounts of both spouses. Alternatively, that same couple could execute estate planning documents that provide for a portion or all of the first deceased spouse’s assets to be transferred to a credit shelter trust for the benefit of surviving spouse. The taxation for estate tax purposes of the credit shelter trust assets at the second death could be completely avoided, while still giving the surviving spouse the benefit of distributions from the credit shelter trust during the surviving spouse’s lifetime.
When married couples rely on portability, the surviving spouse becomes the owner of all of the assets after the first death, subjecting all of the assets to claims of creditors of the surviving spouse. Creditor protections that may have been available through joint ownership of assets known as tenants by the entirety are lost at the first death.
There are many considerations when you factor in your personal financial and life goals when constructing an overall estate plan, and portability should be one of them. Consult with your advisor and tax professionals to discuss portability at greater length.
If you’d like to discuss any of the information contained in this newsletter, please call your relationship team or (800) 582-1076.
Weston Securities Corporation is a Broker/Dealer, Member FINRA/SIPC. Securities are offered through Weston Securities Corporation, which is a sister company of The Washington Trust Company, of Westerly and Washington Trust Wealth Management is a division of The Washington Trust Company, of Westerly.
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.