Perspectives & Planning: Spring 2017
April 17, 2017
- Slight reduction in full-year growth outlook to a level of 2.5%1, with modest risk to the downside
- Q1 GDP soft but expect pickup in consumption, given strengthening consumer finances and confidence
- Reduced expectations for fiscal stimulus in 2017
- Global economic outlook is improved, but political risk remains high due to French election
- Despite “surprise” March rate hike, Fed still likely to raise rates a total of three times in 20171
- 10-yr Treasury note yield to rise to 2.75% by year-end on better growth and slightly higher inflation1
- Maintain preference for equities, although bargains are scarce across asset classes
MARKET & ECONOMY
Despite a preponderance of encouraging economic data, Q1 GDP appears likely to be lackluster and in the vicinity of 1.5%1. A weak winter quarter has been more or less the norm in recent years with weather providing a convenient excuse2. However, this year’s mild winter leaves us somewhat perplexed. After powering the economy in the back half of 2016 shoppers took a break, as consumer spending has been virtually stagnant in the early months of 20172.
Our expectation is that consumption will rebound as the year progresses. Given strong job gains, as well as wage and income growth, the consumer appears in excellent shape and has the ability to spend. In fact, employment data has been surprisingly robust and our 2017 forecast of an average of 150,000 new jobs created per month could be low. Consumers’ finances are also solid. Americans added to savings during the first quarter of 2017 as income growth exceeded spending2. Household net worth also continues to climb as stocks surged and homes appreciated in value. With March’s consumer confidence jumping to its highest level in 16 years, it seems unwise to bet against the American consumer3.
While consumer spending was soft and investors fretted over peaking auto sales, housing continued to flourish during the quarter and our outlook may need to be upgraded. While data has been somewhat erratic, momentum appears to be building in the key single-family segment. In many markets, sales appear to be constrained by tight supply. Unlike automobile sales, the housing cycle has considerable room to run, based on demographics, higher household formation, and a prolonged period of underbuilding.
Capital spending should also provide a boost to growth this year. Rising oil prices will play a major role, encouraging drillers to boost production. This increase should not be limited to the energy sector and business investment in structures more broadly should strengthen. Durable goods orders have been solid, although aircraft orders may have played an outsized role. The most recent ISM Manufacturing Survey is also hovering near a two year high, with particular strength in export orders3. Better growth is not confined to the U.S. as a number of major economies (including China and the Eurozone) appear to be improving. One concern we have, however, is that a lack of clarity on tax policy could result in businesses delaying new projects.
Understanding the direction of economic policy more generally has become a challenge for investors. Prospects for President Trump’s plan to inject major fiscal stimulus into the economy have slipped. After the failure of the Republican healthcare plan a more modest program is anticipated and its impact may not be felt before 2018.
On one hand, the lack of action and toning down of rhetoric on international trade has likely been reassuring. Given the complexity of global supply chains, an indiscriminate imposition of duties on imports could certainly backfire in the effort to support American manufacturing. On the other hand, major pro-business, investor friendly proposals for tax reform (i.e. tax cuts) and infrastructure spending are now in abeyance. As such, we have removed the effect of fiscal stimulus from our current year forecast but retain the view that the U.S. economy began the year in a sweet spot in which it remains firmly ensconced.
The Federal Reserve “surprised” investors by hiking the Fed Funds rate by 0.25% in mid-March on the back of stronger than expected employment data. At the beginning of the year, following a December rate increase, most observers believed that the Fed would wait until late spring or early summer before acting again. Despite a more hawkish Fed, the bond market was well behaved during the quarter and generated modest gains, as the yield on the 10-year Treasury note fell by 0.06% to 2.39%. Investors seem to be reassured by both the Fed’s continued projections of a total of three rate hikes in 2017 and disarray on the policy front concerning fiscal stimulus. The yield curve flattened modestly as the two-year yield rose by 0.06% in response to the rate hike.
We retain our view that the yield on the 10-year Treasury note will conclude the year somewhat higher, in the neighborhood of 2.75%. While bond market sentiment has improved markedly, our expectation is that stronger U.S. GDP accompanied by better global growth will ultimately result in gradually rising yields. Furthermore, we believe the Fed is likely to achieve its 2% inflation target by year-end and investors will require some compensation. (On a technical note, while CPI is running above 2% already, the Fed’s preferred inflation measure related to Personal Consumption Expenditures has yet to clear this hurdle.)
FINANCIAL MARKET PERFORMANCE - 1Q 2017*
Source: FactSet; Index Performance is provided
*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. (1) The MSCI Emerging Markets Index consists of 23 countries representing 10% of world market capitalization. (2) The MSCI EAFE Index is a widely recognized benchmark of the world’s stock markets that typically includes 80% of index securities and select derivative instruments in Europe, Australasia and the Far East; (3) The S&P 500 is a widely followed benchmark of large firms’ stock performance which includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks; (4) The Dow Jones Industrial Average is the price weighted average of 30 stocks traded on the New York Stock Exchange; (5) The S&P 400 Midcap is a barometer of U.S. mid-cap equities; (6) The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization; (7) Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market; (8) The Barclays Capital U.S. Intermediate Government/Credit Bond Index is an unmanaged index of intermediate and long-term government securities and investment grade corporate debt securities.
Corporate debt continued to outperform Treasuries during the quarter as credit spreads narrowed further. High-yield (below investment grade) bonds were strong performers yet again. With the near-term probability of recession low, investors remain comfortable taking on credit risk. Municipal bonds also performed well, as the fear of a major tax overhaul lessened. With credit spreads tight, we would likely focus on higher quality investments, including callable government Agencies, bank CDs, and municipal bonds. As conventional fixed rate bonds will be subject to price erosion if yields rise, some exposure to floating rate bank loans and inflation protected securities should provide a worthwhile hedge.
Equities continued their post-election surge as the S&P 500 Index returned 6.1% during the quarter ended March 31, 2017. Smaller cap stocks provided positive returns but did not keep pace with the S&P 500 Index. U.S. equities have emerged from a prolonged earnings recession. Earnings growth likely approached 10% last quarter and high single digit gains for the full year are expected. However, after the S&P 500 Index returned 17% in the past year, U.S. stocks may not be overvalued but are trading at valuations above their historical averages. The S&P 500 Index currently trades at a P/E of 18.2x versus its 15.7x average4. As a result returns for the balance of this year may be somewhat limited if corporate tax reform does not move forward.
U.S. GDP Growth
March 31, 2017
Source: BEA, WMRI
U.S TREASURY TEN-YEAR YIELDS
High-Low Range & Year-End Close
Source: BEA, WMRI
Although it may seem counterintuitive, stocks could actually be helped by a modest increase in the rate of inflation. Historically, equities have enjoyed their highest valuation when inflation is in the range of 2% to 3%. After years of very low inflation, inflation may finally return to what is viewed as a more optimal level. This would indicate that companies are regaining pricing power and have the ability to sustain profit growth.
International stocks were helped in Q1 by a softer dollar and outperformed domestic equities. Emerging markets jumped 11.5%, while developed markets advanced 7.5%4. While valuations are at more reasonable levels overseas, the dollar could resume its uptrend, given a tighter Federal Reserve as compared to foreign central banks. Additionally, political risk remains high. While the populist tide appears to ebbing, a win by the National Front in the French election could throw the Eurozone into disarray given their desire to exit the monetary union. We prefer to remain on the sidelines until after the election in early May.
Risks to our forecast have not changed substantially since our last report. Geopolitical risk remains high with turmoil in the Middle East and saber rattling in East Asia always present. As stated above, an adverse outcome in the French election would create major shock waves in the financial system due to the implications for the Euro.
The Chinese economy has performed quite well of late but a curtailment of economic stimulus could result in weak growth late this year. Should the dollar resume its rise, trade tensions between the U.S. and China could reemerge as a hot button issue. Emerging market economies with large foreign debt would also suffer. Tighter monetary policy in the U.S. may well exacerbate this potential problem and we remain on the lookout for any signs that the pace of Fed rate increases could accelerate.
Finally, there appears to be something of a vacuum in terms of economic policy from the executive branch, including the Treasury department and other agencies. There are already several vacancies on the Federal Reserve Board and the Chair and Vice Chair’s terms will expire in the first half of 2018. Insight is limited on the Administration’s views on monetary policy or who President Trump may nominate to fill these positions. The importance of these appointments cannot be overemphasized. The Fed’s response to the financial crisis was essential in fostering recovery and restoring our financial system to health. By contrast, the European Central Bank was far less effective and continues to grapple with many of these same issues to this day.
Help For a Beneficiary Inheriting Your IRA Through a Trusteed IRA
Individual Retirement Accounts (“IRAs”) are popular investment tools designed to hold retirement savings for as long as possible with the intent of achieving long-term growth on a tax-deferred basis. Your IRA can be a major portion of your estate, requiring special attention to estate planning options to pass your wealth to your beneficiaries. However, since not all beneficiaries may understand the value of spreading out IRA distributions over the maximum period of time allowed by law, there is an easy solution, called the Trusteed IRA, to ensure the money is not quickly squandered.
What is a Trusteed IRA?
Although not offered by all financial institutions, with a Trusteed IRA the financial institution serves in a fiduciary capacity, meaning it’s obligated to act in your best interests and those of your beneficiaries. The account is structured like a trust, but without the need to hire an attorney, create a lengthy irrevocable trust document or undergo the process of funding an irrevocable trust. The Trusteed IRA allows you to combine some of your retirement planning goals and your estate planning in a simpler format.
Unlike traditional IRAs where beneficiaries take control at your death with full withdrawal rights at any time, a Trusteed IRA allows you to dictate payout terms for your beneficiaries beyond required mandatory minimum distributions (RMDs), while still providing potential tax deferred growth for your beneficiaries. Distributions beyond the required minimums may be controlled and timed for when you feel the beneficiaries will be ready to handle the IRA assets responsibly.
Potential Benefits of a Trusteed IRA
In effect, a Trusteed IRA provides many of the estate planning benefits of an irrevocable trust, but without the complexities or expense of creating a separate trust. Potential advantages include the following:
1. Post-Death Distribution Terms are Determined by the Owner. Trusteed IRAs can be designed to give the trustee – a financial institution qualified to offer and administer such plans – discretion to make payments as needed to provide for your beneficiary’s health, support, welfare, and education.
2. Addressing Different Needs of Multiple Beneficiaries. Trusteed IRAs offer greater flexibility than traditional IRAs when multiple beneficiaries are involved. With traditional IRAs, distributions are made to all beneficiaries based on the age of the oldest heir. Trusteed IRAs allow the creation of separate accounts for each beneficiary, with minimum distributions based on each person’s life expectancy. Younger beneficiaries benefit from paying taxes on their distributions more slowly and retaining more growth potential within their account.
3. Complex Family Dynamics. A Trusteed IRA offers the steady guidance of a professional Trustee to help the next generation navigate complex financial and estate planning decisions.
4. Family Wealth Transfer. In second marriage situations, a Trusteed IRA offers important advantages over traditional IRAs. The surviving second spouse is able to enjoy income from the IRA during his or her life, and then the assets can pass on to the children of the first marriage. And if the second spouse remarries, you can ensure that his or her new spouse will not become a beneficiary of the IRA assets.
5. Planning for Incapacity. With a Trusteed IRA, you are protected from the expense and delays of guardianship proceedings in the event of incapacity. In such an event, the trustee may make distributions on your behalf. Additionally, you are able to plan for the inheritance of the IRA by a beneficiary who is, or may become, disabled.
6. Estate Tax Planning. Estate tax savings are still available with structuring the Trusteed IRA to qualify for a marital deduction for estate tax purposes after your death when the assets will continue to be held for your spouse. This further simplifies estate tax planning.
7. Streamlined Estate Administration. If the bulk of your estate assets are in a Trusteed IRA, your estate may be able to settle quickly without the need for probate. The Trusteed IRA assets should transfer according to the terms of the Trusteed IRA outside of the court process.
Who Should Consider a Trusteed IRA?
Transferring wealth from one generation to the next requires careful planning to ensure that the best interests of you and your beneficiaries are served. A Trusteed IRA can give you peace of mind that assets will be passed in accordance with your wishes, while potentially protecting family wealth for heirs and even further generations. However, Trusteed IRAs are not for everybody. Generally the minimum balance to establish a trusteed IRA, and the fees charged, are higher than those of other IRAs, making trusteed IRAs most appropriate for large IRA accounts. You may also incur attorney's fees and other costs. They can be particularly useful in cases where minor or special needs children are involved, or if you are not comfortable with ceding total control of retirement assets after death based on a beneficiary’s money management skills or experience. Other approaches might be more appropriate. For example, it may be possible to "stretch" the mandatory distribution from you IRA after your death by instead naming a trust as the beneficiary of your IRA.” If specific IRS rules are followed, RMDs can be calculated using your trust beneficiary's life expectancy (this is commonly called a "see-through" trust). See-through trusts are generally more expensive, and more complicated, than trusteed IRAs. It's important that you consult an estate planning professional who can explain your options and make sure you choose the right vehicle for your particular situation.
If you’d like to discuss any of the information contained in this newsletter, please call your relationship team or 800-582-1076. You can also read past editions of our publications by visiting our website, www.washtrustwealth.com. 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. Weston Financial Group, Inc. and Halsey Associates are subsidiaries of The Washington Trust Company, of Westerly and a part of Washington Trust Wealth Management
Sources: (1) Washington Trust Wealth Management; (2) U.S. Bureau of Economic Analysis; (3) Bloomberg; (4) CFRA/Standard & Poors Investing entails risk, including the possible loss of principal. Past performance does not guarantee future results. This information does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. 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. 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. 04/18/17