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Archvest Advantage Q2 2018 Newsletter 

Eric Lai & John Wenzel | Archvest Wealth Advisors | Jul 17th, 2018
Category: Archvest in the News

Market Review

Don’t look now but we’ve officially made it halfway through 2018!  The year started off with strong upside momentum, but quickly became rather volatile post the State of the Union address. Stocks sold off in a big way, turning negative for the first quarter. We headed into the second quarter with the stock market continuing to be volatile with headlines of the tariffs as well as the Federal Reserve rate hikes driving the pressure on stock prices. 

Remember the Economic Stimulus Act of 2008 which gave each taxpayer $300?  It had virtually no effect on the economy. The 2018 Tax Reform Bill is shaping up similarly as well, except this one carried a much larger deficit bill. President Trump and Congress argued that the cut in corporate taxes will provide an incentive for companies to bring corporate profits back to the US and reinvest it in the US. Unfortunately, it’s not working as planned. Many companies are holding off on reinvesting, rather they are taking this newfound cash to fund stock buybacks. As we explained in our last newsletter, stock buyback is a form of financial engineering. As a result of stock buybacks, we have seen a small rally in US stocks with the S&P 500 ending the quarter up 3.4% and the Dow up 1.2%. International stocks ended down 1.2% for the period due to concerns about the tariff and rising US dollar. Bonds were also effectively flat, endingdown .1%.

Tariffs (continued)

It has begun. On July 6th, the US levied a tariff on $34B of Chinese goods. As expected, China responded in kind, levying tariffs on $34B of US goods. In the grand scheme of world trade, $34B only represents a small sliver of goods but this gives us a potential indication of things to come. Instead of thinking about the tariff in terms of dollars, we will focus this segment on the strategy of tariffs itself.

Trade between the US and China is a two player game and can be analyzed using an economic concept called game theory. Game theory is a mathematical study of strategy, allowing conflict and cooperation to be mathematically modeled. Each player is incentivized to maximize its own payoff. 

It’s important to remember that trade is not a zero-sum game. Meaning that if one player wins, it is not at the expense of the other player. Over the years, as part of globalization, the US “exported” its manufacturing base to China. US companies were incentivized to do so to take advantage of the low labor costs in China. In return, US consumers were able to enjoy cheap manufactured products at the cost of US manufacturers. This gain in cheap manufactured products is called consumer surplus and the loss to US manufacturing is lesser producer surplus. Overall, the sum of the gains in consumer surplus and the losses in producer surplus is still positive meaning that the US economy as a whole gained as a result of globalization. Furthermore, we believe that China’s growth has acted as a heat sink for the global economy which kept inflation low across the world over the last 30 years. The benefits of trade are not one-sided as our President would suggest. 

China’s response to the tariffs was predictable because it’s employing a strategy in game theory known as “tic for tat.”  Tic for tat means equivalent retaliation, first choosing to cooperate and then replicate the opponent’s previous action.  This is a highly effective strategy (if not most effective strategy) in a competitive game because it signals to the other player (US) how it will respond before the first player makes a move. Thus incentivizing the first player to act cooperatively. 

We strongly believe that the current course of action on tariffs will be detrimental to the global economy. Thus far, the impact has been small because the tariff has been limited to a small portion of goods. However, if the US levies additional tariffs (potentially on another $200B of goods by the fall), it is clear to us that the other countries will respond in kind, tic for tat. De-escalation can only come from the US. Other countries like China will not be the first to lower tariffs.

Bond Anomaly

Since the start of the year, we have seen an anomaly forming in the bond market: the yield relationship between taxable bonds and municipal (muni) bonds. Historically, taxable bonds offer a higher rate of income relative to their muni counterpart because the income from a taxable bond is taxable. The muni counterpart is not, so higher taxed individuals are inclined to accept a lower non-taxable yield because the after-tax yield on taxable bonds is lower than the non-taxable muni yield. 

With the new tax law change, companies are funneling extra money into their pension funds to take advantage of an additional tax break. Pension funds typically invest in low-risk assets like Treasury bonds. This has created somewhat of a boom in the longer-dated Treasuries, driving the rate down on long-term debt. Despite the Fed’s move to increase interest rates; the long-term debt rates are relatively unchanged due to the incentive created by the tax law change. 

Lastly, under the tax law, prefunded bonds will no longer be issued in the muni bond market. The demand for muni bonds has not shifted, but without the issuance of new prefunded bonds, the muni supply has decreased. This has resulted in better pricing for muni bonds versus taxable bonds; muni bond prices have held firm despite two rate increases this year. Thus, we are planning a tactical shift to move from taxable strategies to muni strategies across all risk spectrums to take advantage of this bond market anomaly.

Continued Thanks

As we come up to the month of August, it will mark the four-year anniversary for Archvest Wealth Advisors, Inc. As such, we want to take this time to thank you for support as a client of our firm. We are here to serve you and we hope to have the privilege of working alongside you for many years to come!

As always, we appreciate the confidence you have placed in us to work alongside you regarding your planning needs. Be sure to follow us on Facebook, LinkedIn and Twitter as well as our RSS feed to stay up to date on what we’re reading and thinking.

Eric Lai and John Wenzel

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