Current Market News: Fed hopes fade, but all is not lost

Think it over, think it under.” – Winnie the Pooh

On Wednesday, December 19, the Federal Reserve (“Fed”) raised short-term interest rates to a range of 2.25% to 2.5% – as expected. The Fed also lowered 2019 growth forecasts and inflation forecasts – as expected. They even modestly lowered interest rate forecasts for 2019 and beyond (Exhibit #1). The market, however, was hoping for a greater degree of rate path moderation, but directionally speaking the results were – as expected. What was not expected was a press conference performance by Chairman Powell that seemed to cast the Fed as out of touch with recent economic and market developments. An onslaught of skeptical questions came from reporters about the need to raise rates, particularly in light of low and falling inflation estimates. One after another, the crowd turned on him:

“If you haven’t achieved 2% inflation, and you don’t see an overshoot which would be implied by a symmetrical
target, what’s the point in raising rates again at all?” 

“You’re about to undershoot your inflation target for the seventh straight year . . . can you help us to understand why you would be advocating restrictive monetary policy at a time of persistent inflation undershoots?” 

“What data are you specifically looking at for you that shows when the Federal Reserve starts to become that headwind in the economy with the rates?”

“Are markets on to something that hasn’t yet showed up in the data?”

“What are the markets telling you?”

“The 10-year note yield has gone down pretty steeply . . . is it a worrisome sign for you?”

Exhibit 1: FOMC Participant Assessments of Approriate Monetary Policy (Fed Dot Plot)

Source: Federal Reserve, BMO Wealth Management

Chairman Powell’s initial responses emphasized the health of the economy, but as the barrage continued, his answers devolved into statements that included, “Some volatility probably doesn’t leave a mark on the economy,” “we’ll just have to see,” “people have disparate views,” and, “[falling rates on the 10-year T-Note] could be thought of as a signal of expectations of lower growth, but, you know, we don’t know that that will happen.” . At the beginning of the press conference, the equity market was still holding on to half of its earlier gains. By the end, a fatigued Chairman Powell seemed unable to convince himself with his responses, much less the market, and equities closed down about one and a half percent on the day.

We have believed for some time that the Fed would ease back from its earlier projections for the path of interest rates in 2019. The reasoning behind our expectation is simply that the economic realities would prove to the Fed that its projections are untenable. Indeed, based on the new estimates released at this December meeting, the median forecast of FOMC members is now for 2 hikes in 2019 rather than the previous projection of 3 hikes. That’s a start, but even after this December Fed announcement, the market is still placing the highest probability on zero rate hikes in 2019, and that expectation barely budged even after this December announcement (Exhibit #2).

Exhibit 2: Target Rate Probabilities for December 2019 Federal Reserve Meeting

Source: CME, BMO Wealth Management

In the near term, the hopes of the Fed communicating a position more supportive to equities have been pushed back to Q1 2019 at the earliest. We do expect the Fed’s tone and outlook to shift gradually and lend support to equities over the next few months and quarters. The relentless line of questioning may have also had a sufficiently visceral effect on Chairman Powell that the he will focus more on the forest rather than the trees. In the meantime, the market will have to look elsewhere for positive news that will help regain economic momentum, or at least staunch the slowdown.

With the Fed seen as the primary hope to spark a meaningful yearend rally, it is now likely that 2018 will end with losses across most major equity asset classes. Sentiment also remains excessively bleak as investors consider the U.S.-China trade war, an earnings growth slowdown, BREXIT deadlines and recession fears. Contrast this to the start of this year, where overly enthusiastic expectations reigned supreme, and it is no wonder that volatility has increased markedly these past few months. So where do we go from here? As our 2019 outlook suggests, we believe 2019 will be a slower growth year, but do not see signs of a severe contraction in business activity or excessive systemic risks. Assuming the Fed continues to walk back its projections for higher rates and there is not a material escalation in the U.S.-China trade war, perhaps the end of 2018 may be the hour “darkest before the dawn”. Indeed, global leading indicators have stabilized recently, and over 75% of manufacturing PMIs remain above 50 (indicating economic growth). The path from here will not be straight, but with valuations in-line to slightly below historical medians (Exhibit #3), corporate earnings still growing (though at levels below those seen in 2018), and interest rate pressures easing, our work suggests equities remain an attractive asset class for 2019.


Exhibit 3: S&P 500 Price/Earnings History – Trailing 20-year daily data as of December 19, 2018

Source: Bloomberg, BMO Wealth Management

10 Facts You Should Know About The Tax Act

Virtually all taxpayers will be impacted in some way by the recent tax law changes. Here are 10 facts to help you determine how the tax act may affect you. Keep in mind, the tax changes will affect people differently, so we encourage you to speak with your financial professionals and tax advisor before you take any action.

  1. Tax brackets are lower. Municipal bonds may not be as tax efficient as they were before. Review your fixed income investment strategy, especially if you were previously in the 28% or 33% tax brackets.
  2. The standard deduction is raised to $12,000 (individual) and $24,000 (married filing jointly). Combined with limits on itemized deductions, this may make itemizing more difficult for you.
  3. Miscellaneous itemized deductions subject to the 2% floor are eliminated. This includes investment advisory fees, so you’ll no longer be able to take a deduction if you pay them from a taxable account. However, paying them from a tax-deferred account means you’ll have less money growing tax-deferred. You’ll need to weigh the pros and cons.
  4. State and local income tax, sales tax and property tax deductions are capped at $10,000. If you’ve been thinking about relocating, now may be the time to consider a more tax-efficient state.
  5. The deduction for charitable contributions is expanded to 60% of your adjusted gross income.  However, this only reduces your taxes if all your itemized deductions exceed the new standard deduction. To bolster your ability to itemize in one year, you could consider lumping several years of donations into a donor-advised fund. Then make all of your charitable contributions from the fund in subsequent years.
  6. Mortgage interest deduction limits are lower. For mortgages taken out on or after Dec. 15, 2017, you can only deduct interest on mortgage debt totaling up to $750,000 (or $375,000 for married couples filing separately). Also, you can no longer deduct interest on a home equity line of credit unless you use it to acquire or substantially improve your home.
  7. You can now use 529 plans to fund K-12 private school expenses. Consider taking distributions of up to $10,000 per student per year for public, private and religious school expenses for grades K-12.
  8. The unified gift, estate and generation-skipping transfer exemption amounts are increased (until 2026).  With the estate tax exemption now at $11.2 million per person, your estate may no longer be taxable. Review your estate plan to ensure it allows flexibility to maximize tax elections. Consider lifetime gifting or asset shifting to take advantage of higher exemption amounts.
  9. Pass-through entity owners may take a 20% qualified business income deduction. If you operate a sole proprietorship, LLC, S Corp., or partnership, you can deduct up to 20% of your qualified business income (subject to a few limitations).
  10. The top corporate tax rate is now 21%. Therefore, if you operate a pass-through entity and your tax rate is above 21%, converting to a C Corp. may offer greater benefits than the 20% qualified business income deduction. Of course, a C Corp. is subject to double taxation, which could eliminate the benefit. A tax preparer can help you decide.

For additional details about the tax act and how it might affect you, speak with your financial professionals. As with all tax-related decisions, be sure to consult your tax advisor before making any changes to your estate plan, financial plan or business structure.

Current Market News – Reversal of Fortune?

What happened?

Global stocks continued their rapid descent Monday during a turbulent trading session. In the U.S., the S&P 500 and Dow Jones Industrial Average (DJIA) indexes fell 4.10% and 4.60%, respectively; their largest percentage drops since mid-2011 when the U.S. sovereign debt was downgraded by Standard & Poor’s. International equity markets also suffered, with early indications suggesting 4%+ down moves there as well. Equity selling pressure began last week with investor concern around rising inflation and a corresponding ascent in bond yields. While these concerns remain, the 10-year Treasury yield fell yesterday on flight to safety positioning. Download the document below to read more.