The Training Wheels Are Off

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1 AT At MORGAN Morgan Stanley STANLEY The Training Wheels Are Off Nicholas Paget, CFP, CPM Morgan Stanley Wealth Management fa.morganstanley.com/pswm Wealth Advisor 601 Union St. tel Senior Vice President Suite 5200 fax Family Wealth Director Seattle, WA toll free NMLS: facebook.com/pugetsoundwm Since we published Time to Party Like It s 1999 in November, the S&P had risen another some 11%. It paid to take advantage of soaring stocks, until it didn t. Equity markets rapidly sold off in February, erasing the gains made in January, and have since been stuck in a trading range marked by more volatility than in quite some time. We are now well into the Q earnings season, the first to reflect the impact of the tax overhaul passed in December, and we ve reached a new phase of this economic cycle. The Fed has stopped using monetary policy to stimulate growth and now looks to control inflation, so the economy must stay on track by itself. In the process, it is contending with two dynamically opposed sets of factors: on one side deregulation, accommodative tax policy, low unemployment, growing U.S. and global economies, and heightened animal spirits represent continued growth signals. On the other side rising interest rates, unsustainable profit growth, and mounting U.S. government debt represent threats to a tiring, decade-old bull market. What does this mean for investors? Our team does not believe the current bull market is over yet but we do recognize the economy has reached a new phase, one that will require more patience and a longer-term perspective. The Impact of Tax Cuts and U.S. Equities Many investors remain bullish specifically because of the potential impact of the tax bill passed late in 2017, which amounted to the most significant tax changes in the U.S. in 30 years i. While the changes for personal taxes are too many to list and are certainly meaningful, the changes to the corporate tax code are the most dramatic. Specifically, whereas a company at the highest marginal rate would pay 35% under the old code, the new tax rate is now a 21% flat rate on all corporate profits. Think about this: a company that earned $100M in net profits in 2017, in a highly simplified example would owe $35M in taxes. Under the new code, that same company will pay $21M in taxes freeing up $14M to invest back into the company, employees, research and development, buying back stock, and much more. To say this is highly productive for corporate America would be an understatement, so shouldn t this be a huge buying opportunity? Perhaps. As we ve discussed before the stock market is a mechanism that judges current prices not on today s information but tomorrow s. Below is a chart of forward earnings estimates based on the consensus forecast. As you can see these estimates jumped vertically once the bill was passed. Translation: the tax cuts are already built into the expectations for

2 2018, PUGET and therefore SOUND anything WEALTH short of MANAGEMENT even higher targets will be looked upon as a disappointment. This chart is called the first order effect of the tax cuts because the market prices in what is already known. What is unknown for the next order effect is how companies will deploy their freed-up capital. Our opinion is over the mediumterm with the backdrop of strong U.S. and global growth, companies will pile this money back into technology, research and development, stock buybacks, and higher dividend rates; therefore the tax code will be positive for stocks. Longer-term, this type of growth is inflationary, and we see this translating into higher inflation reflected by the recent move upwards in the 10-Year Treasury yield to over 3%. Higher rates mean higher costs of capital, which will work against growth. This tango between growth and higher rates is a delicate one and the Federal Reserve will have the difficult task of balancing between managing inflation and not restricting the economy by overtightening rates. Interest Rates and Inflation As noted earlier, the yield on the 10-year Treasury note recently spiked above 3%, and it did so for the first time since Given the rate started at approximately 2.4% at the beginning of 2018, a move of some 25% in four months is quite significant.

3 Considering this already significant move, where will the yield go from here? Morgan Stanley s Global Fixed Income Team led by Jim Caron thinks the move to 3% was a catch-up to economic fundamentals, not a sign of coming inflation, and rates could settle in the % range in 2018 ii. This is positive for the market because it means they are naturally lifting to neutral (that is rates not suppressed by QE) and not to levels that would excessively tighten financial conditions. He goes on to say while the move from 2.4% to 3% was upsetting to the equity markets, yields settling into a new range could result in a potential rebound in equity prices. That being said, Caron and his team see two risks to rates breaking out higher than the predicted range: 1) inflation accelerating faster than anticipated, which could be driven by wage growth, and/or 2) a global revaluation of U.S. Treasury assets from foreign purchasers potentially due to a credit downgrade or anticipation of even higher U.S. deficits. Either way, for now the impact on the bond market is the price appreciation bondholders have grown accustomed to over the last decade may be a thing of the past. The good news is higher rates mean higher coupon payments for newly issued bonds, which is especially important for savers. The bad news is existing bonds, especially those that traded at premiums during a lower rate environment, may trend lower as rates normalize. U.S. Debt It is important to start with the fact that discussions of U.S. debt and borrowing are very complicated and entail numerous economic ideas. My goal here is to frame the current environment and point out our concerns long-term, not to give a detailed description of every facet of our economy.

4 A quick refresher on debt and the deficit: outside of a brief period in the late 90 s, over the last 130 years the U.S. has spent more money each year than it has taken in. In order to finance this deficit, the U.S. primarily issues Treasury bonds. Because the U.S. has historically had a strong and growing economy, the federal government can finance future growth at a relatively low cost. As long as the U.S. continues to grow, the government will roll over its debt and repeat the cycle. The three key areas of importance when having a context for the magnitude of U.S. debt are 1) total public debt, 2) the budget deficit (spending in a given year in excess of income received), and 3) these levels relative to the GDP of the country. As of Tuesday, April 24th total public debt outstanding was $21.06 trillion and for fiscal year 2018 the federal government in its latest budget estimated that the budget deficit will be $833 billion, compared to $665B in 2017, $585B in 2016, and $438B in 2015 iii. To bring this into perspective, current total debt outstanding is 104.2% of GDP, meaning our total debt outstanding is approximately 4% greater than the value of goods and services the U.S. produces in one year. The highest this ratio has been in history was just after the end of WWII when the federal debt was 119% of GDP. Likewise, the federal budget deficit of $665B in 2017 was some 3.4% of GDP. The highest ratio this has been in history was again at the end of WWII when the budget deficit was 29% of GDP iv. For right now two of the three credit rating agencies, Fitch & Moody s, maintain a AAA rating for U.S. debt (the third, S&P, downgraded the U.S. rating to AA+ in 2011 based on long-term debt concerns). This reflects their belief that the overall size of the U.S. economy, high per capita income, and a dynamic business environment give the U.S. sufficient buffers to withstand debt pressures v. However with the recent tax cuts there are growing concerns that borrowing is getting out of control with Fitch warning that total debt to GDP could hit 129%, higher than post World War II levels. The current administration believes the tax overhaul will restart the U.S. economic growth engine, which will lead to higher tax revenue and thereby shrink the estimated deficit. For the last decade, we ve been stuck in what many refer to as a sluggish economy posting on average 2.2% growth compared to the long-term average of 3% vi. Not judging by Q1 economic data, which tends to be seasonally slow, so far they may be right. However, economies are cyclical and there are appropriate times to borrow and appropriate times to pay back. Dairy farmers for example borrow when the price of milk is low, and pay back when the price of milk is high. They use debt strategically to bridge the gap from one period to the next, and though the farmer will always carry debt, he will be mindful of how he is using it. The U.S. economy is now in a strong position and in my opinion ideally should be paying down debt in anticipation of the next slowdown. Higher debt loads put greater pressure on our economy, especially as rates rise. Furthermore, if we don t get the growth we are anticipating, the situation could grow worse and the next time we face a crisis we ll have fewer tools at our disposal to jumpstart the economy again. When clients ask me if there is one thing that keeps me up at night (for the record I sleep soundly), my answer is our growing reliance on debt in the U.S. and throughout the world, and what this will mean for our children. Volatility During and in the years following the Great Recession, investors learned to live with market volatility. But then in 2017 it seemed to simply stop. Judging by the Chicago Board Options Exchange Volatility Index (VIX), a gauge that shows the market s expectation of 30-day volatility, from the time Donald Trump was elected until November 2017 the markets experienced one of the most profound and prolonged declines in market volatility on record. In fact at one point, the market went 44 straight trading days without even a half-percent drop the longest streak since 1968 vii.

5 There are arguably many different reasons why this occurred but for the most part the world experienced an unusual degree of harmonious measured growth. In fact, all 35 countries in the Organization for Economic Co-Operation and Development (OECD) were growing and the difference between their growth rates was the narrowest in 50 years. The trend continued through the end of January, until the 1-2 punch of a Labor Department report showing a jump in average hourly earnings and the Federal Reserve indicating a subtly more aggressive stance on interest rate hikes. In a flash volatility rushed back into the system. Source: ThomsonOne, Post-Election through April 26 th, 2018 The chart above shows the volatility spike in late January reflected in the movement of the VIX. As you can see, although markets have calmed down since then they have not gone back to pre-february calm levels. Three hundred-plus point days in the Dow are now a common occurrence, which creates anxiety for investors. But should it? As unsettling as these times are for investors the fact is over the long run market swings are much more commonplace than many think. Since 1945, the S&P 500 has experienced 77 market corrections between 5-10%, and another 27 corrections between 10-20%. Of the 27 corrections between 10-20%, most came during a bull market viii. Bottom line for investors: volatility has not increased, it has simply reemerged from a longer than normal slumber, and this does not necessarily mark the end of the bull market but a new phase of the current cycle. And though large up or down swings warrant attention, they shouldn t elicit the need to take action, which can result in making the wrong decision at the wrong time. Conclusion Morgan Stanley and our team remain bullish on stocks. Despite the volatility, which we view as a normal function of the later stages of a healthy market, we think the underpinnings of a growing economy buoyed by strong profit growth and a healthy consumer will continue to chug along. The euphoria one usually sees at this stage of a recovery was tempered by the nervousness in February, resetting equity valuations to more reasonable levels.

6 As stated earlier, we see a ceiling to rates in 2018 of around 3.25%. Given where rates started this means the pain felt by most bondholders is probably at least half over, but we would expect one last push towards the exits. Investment grade bonds (those of BBB rating or better) provide the ballast necessary in times of equity market dislocation regardless of interest rate expectations, so we would not advise selling or changing one s investment allocation. If anything, shorten duration but again we think at least most of that move is done. In the midst of the Great Recession, the U.S. government and others around the world used monetary policy tools to both prevent the world economies from falling into a depression and to try to reignite the fire of growth. As a result, this created artificially low global interest rates which allowed consumers, businesses, and governments alike to borrow cheaply and stoked the stock market fire that has seen the Dow Jones more than quadruple from the lows made in March Now as stocks have rebounded and hit new highs, unemployment has fallen, and the global economy has grown, we are in a new age one that reflects a more normal economy without the support of government accommodation. This new normal will feel different. It will entail greater volatility, higher interest rates, and more cyclicality. The training wheels we ve grown accustomed to over the last decade are off so we will truly need pro-growth policies, thoughtful leadership, and a crafty Fed to keep the cycle on track. i Campbell, Todd. Tax Reform Is Done: Here's How It Matters to You. USA Today, Gannett Satellite Information Network, 21 Dec. 2017, ii Caron, Jim. U.S. 10-Year Yield Rises above 3%: Slowly Catching up to Economic Fundamentals. Fixed Income - Global Fixed Income Team - Market Pulse, 25 Apr iii Federal Deficit Analysis. US Federal Deficit by Year - plus Charts and Analysis, 30 Apr. 2018, federal_deficit_chart.html. iv Federal Deficit Analysis. US Federal Deficit by Year - plus Charts and Analysis, 30 Apr. 2018, federal_deficit_chart.html. v Cox, Jeff. With Debt at $21 Trillion and Growing, Ratings Agencies Still Give US Highest Marks. CNBC, CNBC, 26 Apr. 2018, vi Chart Book: The Legacy of the Great Recession. Center on Budget and Policy Priorities, 27 Apr. 2018, -the-legacy-of-the-great-recession. vii Santoli, Michael. The Lack of Volatility in the Markets One Year after Trump's Election Is the Trade No One Saw Coming. CNBC, CNBC, 8 Nov. 2017, viii Putting Pullbacks in Perspective. Putting Market Pullbacks in Perspective Guggenheim Investments, Guggenheim, 5 Feb. 2018, This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Morgan Stanley Smith Barney LLC. Member SIPC. CRC # /2018