Fourth-Quarter Market Update & Outlook

U.S. stocks were very strong in the fourth quarter as economic growth continued to improve. Wide-ranging tax reform was enacted, adding fuel to the rally. International stocks also gained and were the year’s top-performing asset class. Bonds also contributed, posting mid-single-digit returns.

How Will Tax Reform Affect Investors?

The Tax Cuts and Jobs Act signed into law in December is considered positive for the economy and markets. Here are a few important provisions for investors:

• The corporate tax rate was lowered from 35 percent to 21 percent.
• The top individual tax rate was reduced from 39.6 percent to 37 percent.
• The estate tax exemption was doubled to roughly $11 million for individuals and $22 million for couples.
• Up to $10,000 per year from 529 college savings accounts can now be used to fund K-12 tuition.

The corporate tax rate reduction may be the most significant for investors. This change will boost profits in 2018 and beyond and is a key factor fueling the current rise in stock prices. If companies use tax savings to increase hiring and investment, this economic expansion could be extended.

The new tax law is lengthy and complex. For some families, the benefit of lower tax rates may be offset by the elimination of certain deductions, credits and exemptions. Investors should contact their tax advisors for details about how the law will affect their specific circumstances.

Inflation Has Been Tame for Several Years—Will This Continue?

Inflation has been low and stable for the last several years. This could change in the new year for a range of reasons, including:

• Unemployment figures are at 4.1 percent, which may cause wage pressures to build.
• Energy prices are rising.
• Recent tax cuts may boost growth and inflation.
• The dollar has weakened, increasing the cost of imports.

A gradual rise in inflation is the most likely scenario for 2018. If inflation rises, so too should bond yields. This could create a near-term headwind for bond returns, but increases longer-term income potential. Modest inflation can be good for stocks, as companies are better able to raise prices. However, any unexpected spike in costs would likely cause a market correction.

What Should Investors Expect in 2018?

Recession is unlikely in the near term, as most economic data is improving. Positive economic and corporate profit trends should support investment returns in 2018. However, U.S. stocks aren’t cheap, so be prepared for more modest gains. Valuation levels are more attractive in most foreign markets. Therefore, international stocks may have more room to run.

Below are three important factors for investors to consider as 2018 progresses:

• Federal Reserve policy – Three more Fed rate hikes are expected in 2018 and could become a headwind for both stocks and bonds.
• The return of “normal” volatility – Volatility is a natural feature of the stock market, and downside moves often occur when least expected.
• Above-average valuation levels – When stocks are more expensive than normal, returns over the following five to 10 years tend to be below average.

The investment environment remains positive but continues to evolve. Investors should enjoy this period of strong gains and market calm. Keep in mind, however, that future corrections are a certainty—it’s not if, but when. Fortunately, most downturns aren’t as severe as the last one. Rest assured that maintaining diversification and investment discipline can help you effectively navigate changing market conditions and reach a successful outcome.

Jeffrey A. Layman, CFA®
Chief Investment Officer