THE PRUDENT PALADIN THE PALADIN GROUP AT MORGAN STANLEY

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1 THE PRUDENT PALADIN THE PALADIN GROUP AT MORGAN STANLEY NOTHING IS CERTAIN 4 th quarter, 2017 Taxes, taxes, and more taxes. We are certain this is not the first thing you have read about the new tax plan and how it may affect you, but we do hope to share some insights in a way that is nonpartisan, economically focused, and from a group whose only agenda is to keep clients happy. Much has been said about the new tax plan. One side claims it can cause US economic growth to accelerate to as high as 4%, others are more skeptical. For reference, since the financial crisis ended in March of 2009, US real GDP growth has not exceeded 2.73% on an annual basis i. The United States is an advanced, productive, and mature economy with full employment. It is also massive, and despite the growth of China and the recovery of Europe, it remains the world s largest economy by all estimates ii. Big things cannot maneuver easily. Like a container ship trying to do a U-turn, it s not easy to move big things quickly. Furthermore, the United States is, by most measures, at full employment. As we ve mentioned before, because employment gains are one of the main ways an economy expands, policymakers tend to focus on improving employment figures when economic growth is the IN THIS WORLD NOTHING CAN BE SAID TO BE CERTAIN EXCEPT DEATH & TAXES. BENJAMIN FRANKLIN goal. In our their opinion, efforts misguided. point want are This is a we to reiterate as we re certain you ve heard from various media outlets that people cannot find jobs. True enough, there will always be some unemployed people, and as always, those with less education have a more difficult time finding jobs than their more educated contemporaries, all else being equal. However, when you look at the trends for all of these data points (unemployment at various ages & education levels), they are all trending down, meaning as a country many more people have jobs now than they did at any other time this decade. For reference, the unemployment rate touched 10% October It is currently 4.1%; we have come a long way indeed. iii Now, onto the tax plan. Benjamin Franklin said it best, death & taxes are the only certainties in life. While our group is keenly focused on minimizing taxes within the confines of the law, we do not want to make recommendations that may be beneficial from a tax standpoint but harmful from an investment standpoint. We view taxes as necessary and inevitable, so while you can optimize your finances to not overpay, payments themselves are not a question of if, but when. As you all know, the Tax Cuts and Jobs Act of 2017 (herein, Tax Act ) was passed on December 22 nd, While it is very long and complex, there are only a few pieces of it that have the potential to impact the economy in meaningful ways. The most impactful change is the corporate tax reform. The corporate tax rate is reduced to 21% and there is also a one-time tax holiday designed to get

2 T H E P A L A D I N G R O U P A T M O R G A N S T A N L E Y companies to bring accumulated profits overseas back to the US. The rationale is that if companies bring money back to the US, those dollars will benefit the US economy, possibly through expanding research & development efforts, hiring more employees, building more offices, acquiring another company, raising wages, or any number of other things. Thankfully, we have some guidance about these effects, because we ve been here before. In 2009, the National Bureau of Economic Research sponsored a study which looked at the 2004 corporate tax holiday; they did this in order to ascertain where companies might spend their dollars if allowed to bring them back to the US at a lower tax rate. What they found pleases us as shareholders, but may make you a bit perturbed otherwise. The study found that 94% of every dollar brought back was spent on share repurchases and dividends (79% on share repurchases 15% on dividends). In other words, the vast majority of the money was used primarily to increase shareholder value, not to improve the American economy as a whole. Our guess is that nothing much will change when we see the effects of repatriation this time around. iv So, if Corporate America is going to spend the money boosting their stock price (while this is great for stocks, it is neutral to economic output), where will the anticipated economic growth come from? One option is stimulus (or when the government simply spends money for the direct purpose of economic growth), but we believe that any proposal for stimulus will be difficult to pass into law. Since the Tax Act is already expanding the federal deficit and increasing the national debt, we are of the opinion that policymakers will be very hesitant to increase these further, especially ahead of 2018 elections. Hearing this may make you feel cynical and cause you to wonder why Corporate America isn t a bit more altruistic. However, as investors, we believe that since this spending pattern is likely to recur, stocks could very well continue their run upwards to even higher highs. Let s consider the impact of the Tax Act on individuals. While we are not tax accountants, we are willing to speculate that for the typical middle class family, the Tax Act will likely reduce their tax bill, through a combination of reduction in marginal rates, the doubling of the standard deduction, and doubling of the child tax credit. If many American families have more dollars in their pockets (via lower taxes owed), the government hopes that all of those dollars will be spent or invested. If this happens, economic growth could see a bit of a spike due to increased consumer spending (remember, this makes up around 2/3 of US GDP). This could be very good, but we are doubtful that consumers will spend 100% of this money. We all remember the financial crisis and still carry some scar tissue from it, and we believe consumers do too. Back in 2015, after oil prices plummeted and many economists saw this as a boost to consumers (less money spent on gas means more money spent on other things, called the cheap gas dividend ). However, this boost did not materialize. Instead of spending the money and helping boost the American economy, most consumers did the responsible thing and paid down debts or put the money into savings. We view a recurrence of this as very possible, so we are taking a wait and see approach to see how much the average family saves on taxes. With our belief that the U.S. economy is in the later stages of the business cycle, we are also going to temper our excitement about economic growth with our concerns about higher inflation and interest rates. Other aspects of the Tax Act are getting plenty of headlines, but likely will not impact the economy very much. For example, the mortgage interest deduction changes only affect newly purchased homes with a mortgage over $750,000, and while this affects many of our clients, this is a relatively small portion of the overall mortgage market. The changes to State

3 T H E P A L A D I N G R O U P A T M O R G A N S T A N L E Y and Local Tax deductions (capping them at $10,000) affects high-tax jurisdiction residents, and while it may cause some of them to move to a lower tax area or lobby their local governments to lower tax rates, we do not see any meaningful investment implications from this. The takeaways are as follows: much of the potential benefits will be dependent upon behavior by companies and families, so we can use the recent past as a guide, but we must wait to see how this plays out. If consumers and businesses end up putting money they otherwise would ve spent on taxes or health insurance back into the economy (via spending, wage growth, investment, etc.), then this tax plan could be a boost to the economy, though not likely of the magnitude Washington hopes that it will be. However, it is our group s gut feeling that aside from a temporary boost in stock prices, many of us will look back at this Tax Act in 5-10 years and say that nothing much has changed for our economy and the markets. In closing, despite our concerns about being towards the end of the business cycle, we see no immediate risks of a recession and no reason why asset prices cannot go up in early However, we would be very surprised if 2018 was as good of a year for investors as 2017 was. For the year, the S&P 500 finished up 21.8%, led by the information technology sector (up 38.8%). Globally, European stocks finished up 26.3%, led by the Netherlands, France & Germany. Elsewhere abroad, Emerging Markets stocks did remarkably well, up 37.5% led by India & China. Finally, for all of the negative economic data that seems to always surround them, our friends in the Land of the Rising Sun had quite a good year, as Japanese stocks finished up 24.5%. Bonds also had a decent year. US Bonds were up 3.8% and non US bonds were up 10.1%. However, despite the Federal Reserve raising short term interest rates, long term interest rates have not moved much. The 10 year US Treasury yielded 2.44% at the end of As of this writing, it yields 2.41%. v

4 THE PALADIN GROUP AT MORGAN STANLEY BARTENDER, GET ME A BLOCKCHAIN ON THE ROCKS! We will spare you another section of the newsletter entirely dedicated to bitcoin. Instead, we want to point out some silliness we ve seen as of late. In December 2017, perhaps intending on capitalizing on the enthusiasm surrounding cryptocurrencies like bitcoin, litecoin, ethereum, and the blockchain technology which backs them, several companies have legally changed their names to include terms like crypto, blockchain, and more to garner more attention from investors. An iced tea manufacturer recently changed its name to include the word blockchain and saw its stock immediately soar 289%. This story has been recurring this quarter from companies that once made sports bras, electronic cigarettes, and companies that are so obscure that we can t quite decipher what they actually do, yet that has not stopped their stock prices from soaring over optimism about cryptocurrencies and blockchain. We mention this phenomenon because in years like 2017 when it was easier than usual to make money, investors often forget what their ownership of stocks or bonds actually means. Investing in a stock or bond is not simply a bet on a new technology, it is a legal claim of ownership on a series of cash flows. For stock investors, this means you are a part owner of the company, and you own a share of their profits, a vote for their board of directors, and a share of the dividends they distribute. The goal of stock investing is that the company s cash flow grows so your investment will yield much more than it cost you to invest, therefore turning a profit. If you are a bond investor, you are a lender to the company or government which issued the bond. You have a legal claim on cash flows and to be paid back your investment in full when the bond matures. Since all forms of investment are simply claims on a stream of cash flows, it is intuitive that one ought to evaluate potential investments in terms of their potential future cash flows, not on hype. While this may have led to a nice chuckle (the thought of a sports bra company becoming a blockchain company), we see the potential of this being the source of an asset bubble. Just because blockchain is a good technology does not mean that anything remotely related to it will be a good investment. We feel that this craze will lead to many investors losing substantial sums after watching hyped investments make eye-popping gains. While the temptation of the home run investment can be alluring, the risks typically involved run counter to our nature as Prudent Paladins. vi Sincerely yours, The Paladin Group at Morgan Stanley

5 THE PALADIN GROUP AT MORGAN STANLEY Randy Hartley, CFP Vann Russell Robert Randolph William Nave Financial Advisor Financial Advisor Financial Advisor Financial Advisor Glenwood Ave Suite 320 Raleigh NC toll free fax i Source: US Bureau of Economic Analysis ii Sources: IMF, World Bank & United Nations Nominal GDP figures iii Source: JPMorgan Guide to the Markets, Q iv Source: Dharmapala, Foley & Forbes, National Bureau of Economic Research v Source: Morgan Stanley Capital Markets vi Source: Bloomberg.com 12/20/2017 & 12/21/2017

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