Second Wind For Actively Managed Funds

Long-overdue corporate tax reform has finally arrived. It promises to improve the global competitiveness of U.S. corporations and boost job creation on the home front, fueling the growth of exports. For stock investors it should lead to improved earnings growth. For bond investors it makes corporate borrowing less attractive – which could reduce borrowing demand and slow the rate at which yields climb as the Fed normalizes monetary policy. Still, the upside to corporate tax reform is overshadowed by its price tag: an estimated increase in Federal debt of as much as $1.5 trillion dollars. Some investors are concerned: are we setting ourselves up for a day of reckoning? Before answering that question, let's dig a little deeper. Prior to tax reform, the Congressional Budget Office (CBO) had forecast that the Federal debt would grow from $20 trillion to $30 trillion over the next 10 years. That projected increase is due mainly to the retiring baby-boom population, which is just beginning to draw on Federal entitlements such as Social Security and Medicare. Their ranks will grow over the next 10 years. Tax Reform is expected to add up to $1.5 trillion to the Federal debt over that period, boosting the 2027 projection to as much as $32 trillion. It's a big number, of course, but a little perspective is in order. Total household net worth – everything that U.S. citizens own net of debts, including property, investments, and cash – is nearly $100 trillion today, and will likely grow to around $150 trillion by 2027. GDP, an annual measure of total U.S. economic output, is $19 trillion today and will likely grow to $28 trillion by 2027. Traditionally, the portion of the Federal debt that's held by the public (about $15 trillion today) is compared to GDP, as shown in the chart on the next page. GDP is a measure of economic output that can be taxed, so it serves as a proxy for tax revenue. Thus, a government's ability to service its debt is largely determined by the size of the economy that is generating its tax revenue. But GDP is not the only thing that gets taxed; the U.S. tax system also captures a piece of household net worth too. This is accomplished mainly by capital gains tax on property and investments, but it also includes tax on IRA distributions, gifts, and inheritance. So in reality, U.S. tax revenues are tied to both GDP and household net worth. Fortunately, after a dicey period following the Financial Crisis, both of these sources are now robust and growing. As exports ramp up and energy imports wind down, the U.S. trade balance should swing positive sometime before 2027. That would set the stage for GDP, tax receipts and household net worth to climb about 50% between now and 2027. Federal debt held by the public (as a percent of GDP) will still grow over the next 10 years, meaning it will be slightly more difficult to service than it is today. But by 2027, a much larger base of exports could boost tax revenue enough that Federal debt would plateau after that. Right after the Financial Crisis, a widely reported study claimed to have statistical evidence that government debt levels above 90% of GDP would weigh heavily on long-term growth. But that study ultimately turned out to have flaws – in reality, there is little correlation between economic growth and government debt levels. Last year, we saw a dramatic example of a heavily indebted economy bouncing back from a deflationary slump. Japan, despite an overwhelming debt load (240% of GDP), and a newly imposed 8% national consumption tax, is rebounding thanks to its quantitative easing program and a recovering global economy. Finally, it's worth noting that the U.S. "debt-to-equity" ratio is not particularly onerous. Measured against household net worth, it's roughly 20% today and seems unlikely to climb above 25% in the next decade. Most S&P 500 corporations carry significantly more debt (although their entitlement liabilities are much lighter). At a time when inflation remains well controlled thanks to technology disruption, the interest payments on the Federal debt are not likely to become a major budget item until well after the Fed has shrunk its balance sheet and the U.S. trade balance turns positive. Moving Into Trade Surplus And once the U.S. trade gap has closed, the potential for debt-related economic disruption would be sharply diminished, for several reasons: • The Federal debt would once again be held largely by U.S. citizens, because foreign governments would sell off their Treasury holdings as their trade surpluses disappear (the amount of Treasuries held by foreigners has already fallen by 50% since 2009). • The U.S. should be self-sufficient in energy, agriculture, autos, aerospace, and housing. Plus, infrastructure costs may be falling – thanks to new technologies that allow private firms to relieve the government of its obligations in transportation and energy. • A relatively small sales and services tax (below that of Canada's 5% GST) could easily generate a very large amount of tax revenue with little impact on the economy (if we need it). Even if the Federal government did get to a point where it struggled to pay its bills, chances are the dollar would still hold its own, since it would represent a robust self-sufficient economy that in aggregate throws off more capital than it consumes. Investment Implications By taking on additional debt over the next 10 years, the Federal government is making an investment in the competitiveness of the American economy. Private wealth, by definition, will grow as much as Federal debt does, with the stock market likely registering a significant share of that increase. As such, it's probably unwise to use Federal debt as an excuse to reduce stock market exposure or to hold on to an excessive amount of cash. Fourth Quarter Review Stocks surged in the fourth quarter as the global economy continued to recover, and as U.S. tax reform efforts gained traction. Also helping was the Fed's announcement that its current plan for normalizing short-term interest rates did not need revision, as tax reform is not expected to meaningfully boost inflationary pressures. The unwinding of the Fed's balance sheet had very little impact on the bond market, which was far more focused on the potential impact of tax reform. And earnings remained on a favorable trend even prior to tax reform effects. The S&P 500 gained 6.6% for the fourth quarter to finish the year with a 21.8% gain. The Barclay's U.S. Bond Index edged up 0.4% for a full-year return of 3.5%. The sector side of our stock-oriented holdings finished on par with the S&P 500 for the quarter and ahead of the index for the year, whereas our diversified stock positions finished just shy of the index for both periods. On the bond side, our emphasis on high-yield and shorter maturities didn’t provide any advantage in the fourth quarter, but we finished ahead of the Barclay's benchmark for the year. Outlook Many investors think that the stock market has become expensive, but based on operating earnings today's S&P 500 P/E ratio of 21.4 is almost exactly where it was a year ago. In effect, all of the capital appreciation we've seen has been based on improved earnings. In the coming year, we may see more of the same. The impact of tax reform has yet to be factored into 2018 earnings forecasts, which were already looking rather robust. So what can go wrong? As usual there are a lot of little things to worry about: higher interest rates, a Fed that might become more hawkish, a surge in the dollar from repatriated foreign cash, a slowdown in consumer spending from residents in high-tax states, an increase in high-yield default rates stemming from reduced tax allowances for debt-service expenses, and a growing Federal debt load (which we've already discussed). At this stage, however, all of those risks seem to be manageable. As such, we're not looking to make major portfolio changes for 2018. On the sector side, we're sticking with overweighted positions in technology and financial services, while looking for an opportunity to boost consumer discretionary exposure. Among diversified stock holdings we have reduced our small-cap positions in some portfolios, choosing instead to favor large-cap growth stocks, both domestic and foreign. Bond-wise we remain focused on corporate debt, which may see a supply reduction, and where taking on extra credit risk can help boost yields. For more than five years, Fidelity’s large-cap growth funds trailed the S&P 500. Then beginning this year, stockpicking suddenly started to work again. The change in dynamics occurred in tandem with a significant reduction in active-fund outflows. And while it hasn’t spread beyond the large-cap growth segment at this stage, it offers a cautionary tale for anyone who thinks indexing can never lead to disappointing results.

One of the immutable rules of market-based investing is that any approach that becomes too popular for its own good will run the risk of performing worse than expected. In other words, the market has a way of disappointing the majority. If a majority of investors want to buy something, prices rise until the number of buyers and sellers are exactly matched.

Strategies that have fallen victim to excessive popularity in recent decades include the January Effect, the Dogs of the Dow, Sell in May, market timing based on moving averages (or valuations / earnings yields), and sector rotation based on the economy’s position in the business cycle.

Indexing proponents may think that they are immune to excess popularity, because their approach does not involve seasonality, timing, or valuation-based techniques. But when stock markets are dominated by large amounts of capital flowing into capitalization-weighted indexes, it has the effect of propping up value stocks, holding back growth stocks, and inflating the value of stocks held in popular indexes (relative to comparable firms that are not part of those indexes). These distortions have a way of reversing once capital flows subside, allowing savvy managers to step further out on a limb without punishment. Most likely we’re at that point today.

The Risk of Lackluster Index Results Going Forward
Much like the 5-year period that followed the indexing craze of 1996-1998, today’s active managers may benefit from a heightened range of opportunities brought on by five years of risk-aversion and valuation conformity. Consider the following:

  • There are fewer active managers still on the job, and those that remain are the cream of the crop. Today their funds are smaller and more nimble than they were five years ago.
  • We are entering an age where technology disruption (driven by powerful AI software) may benefit a relatively small number of companies at the expense of the majority. It may not be an environment that rewards index strategies. Frequently, disruptor firms are not even admitted to popular indexes until they are fairly close to realizing their full potential.
  • Third Quarter Performance Chart
  • Some stocks now have more than 30% of their float held by passive investment vehicles, making them more volatile than stocks with lower levels of passive ownership. This means they can be gamed by active investors. Should passive ownership reach excessive levels, some stocks would be prone to flash-crash like behavior. If that point is ever reached, owners of popular indexes would likely defect to active funds in order to reduce their exposure to rising volatility.
  • Many index investors are firmly convinced that a fund’s expense ratio is more important than anything else, when in fact it’s just one of many factors determining bottom-line performance. For this reason, if active funds reemerge as performance leaders, the trend is likely to be sustained for many years to come. Today’s passive investors may not budge for a decade or more, allowing active managers to remain nimble and focused even as assets grow.

Investment Implications
Stock indexing can still make sense where technology disruption is not a major factor, or when the index itself is heavily populated with disruptor firms. Ignored but important indexes may also enhance portfolio performance. But if today’s market continues to reward opportunistic behavior, the best bet for the large-cap growth segment is likely to be Fidelity’s actively managed funds, especially if their funds don’t add much volatility over a passive approach.

Active funds may also be the better bet for other asset classes not characterized by a large and consistent population of winners. This would include foreign stock funds, high yield funds, and investment-grade bond funds that aren’t focused on treasuries. Especially on the bond side, the risks that are mitigated by security selection can far outweigh the relatively modest expense ratios that Fidelity’s funds incur.

Finally, a word about passive ETFs. These investment vehicles have become popular because of their ability to be traded like stocks during market hours. However, that feature can come with hidden transaction costs (which are magnified when market liquidity is poor). For that reason, we favor index funds for our passive bets. Unlike ETFs they rarely trade below net asset value.

Third Quarter Review
Stocks moved higher during the third quarter, thanks to improved earnings that were helped by a weaker dollar and rising oil prices. At the same time, an increase in business spending and exports gave the economy added support.

The market’s relatively steady performance occurred against a backdrop of nail-biting news stories. A war of words between Trump and North Korea evoked memories of the Cuban Missile Crisis. The Fed made a hawkish shift and announced plans to begin unwinding its balance sheet holdings. Several powerful hurricanes tested the limits of disaster preparedness, relief efforts, and insurance company risk management. And the path to an extension on the Federal debt limit was anything but straightforward. The market’s muted response to these headline events was surprising to some, but refreshing to others. After nine years of worrying about things that had little impact on corporate earnings, the market is now worrying only about the things that do.

Our stock-oriented portfolios, which continued to emphasize technology, financial, and foreign stocks, finished slightly ahead of the S&P 500 for both the quarter and the year (during the third quarter the S&P 500 climbed 4.5%, and is up 14.2% year-to-date). The bond side of our portfolios did well too, outperforming the U.S. Bond Index (The Barclays U.S. Aggregate was up 0.8% for the quarter and returned 3.1% year-to-date.) We kept volatility similar to the Barclays by emphasizing high-yield and short-term debt, while going light on treasuries.

The Fed appears to be setting its policy around expectations that tax reform efforts will succeed in delivering a boost to the economy while pushing inflation up closer to its 2% goal. Should Congress be unable to agree on a tax package, it would come as no surprise if the Fed puts its plan on hold. This policy stance also allows for a degree of flexibility during the unwinding of the Fed’s portfolio of mortgage securities and treasuries: depending on what happens to the yield curve, plans for the Federal Funds rate can be altered to mitigate any increased risk of recession or wage inflation.

While there have been many dramatic and sensational predictions for bonds coming out of the mass media, very little has changed for income-oriented investments on a fundamental basis. We believe today’s low inflation is largely the result of technology disruption, a global force that the Fed will ultimately have to acknowledge (and consider fully) in setting policy. Because interest rates are anchored to inflation, we don’t see bond pricing being swayed by Fed actions nearly as much as it has in the past. We remain satisfied with our current bond fund positions, and at this point we’re not looking to make changes.

Corporate earnings have been enjoying a tail wind thanks to this year’s decline in the dollar (which boosts the value of profits earned abroad and makes U.S. exports more competitive).While the dollar recently strengthened in response to the Fed’s plan (and due to increased political uncertainty in Europe), we think the Greenback has additional room to fall as interest rates continue to normalize in Europe and Japan.


Jack Bowers

Jack Bowers
President & Chief Investment Officer

Bowers Wealth Management, Inc. is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Bowers Wealth Management, Inc. and its representatives are properly licensed. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Bowers Wealth Management, Inc., unless a client service agreement is in place.

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