The Return of Volatility

After a 2017 market that will go down in the history books as a year with among the lowest levels of volatility on record, 2018 markets seem to set out to revert to long-term average volatility levels. The first few weeks hinted at a repeat of 2017, only to have the market take a steep dive amid a myriad of negative headlines. U.S. “saber-rattling” with North Korea as they tested their new intercontinental ballistic missiles, tariff/trade-war rhetoric and posturing with China and the world, and massive private information leaks by Facebook and negative spill-over to other leading social media companies, taken together, were too much for a market that was nearing the end of digesting the good news of the recently-passed tax reform legislation. The market reaction was sudden, decisive and violent, quickly reaching and then testing important technical support levels. We expect additional volatility as the market attempts to establish a new trajectory.

The Return of Volatility

After a 2017 market that will go down in the history books as a year with among the lowest levels of volatility on record, 2018 markets seem to set out to revert to long-term average volatility levels. The first few weeks hinted at a repeat of 2017, only to have the market take a steep dive amid a myriad of negative headlines. U.S. “saber-rattling” with North Korea as they tested their new intercontinental ballistic missiles, tariff/trade-war rhetoric and posturing with China and the world, and massive private information leaks by Facebook and negative spill-over to other leading social media companies, taken together, were too much for a market that was nearing the end of digesting the good news of the recently-passed tax reform legislation. The market reaction was sudden, decisive and violent, quickly reaching and then testing important technical support levels. We expect additional volatility as the market attempts to establish a new trajectory.

The Economy

The U.S. economy continued on its upward trajectory, with overall growth and employment posting solid gains. The Bureau of Economic Analysis reported its third estimate of fourth quarter 2017 gross domestic product (GDP) of 2.9%, up slightly from the prior estimate, but somewhat lower than the third quarter’s 3.2% reading. The employment situation also made gains, with an average of approximately 242,000 jobs added each month. At the same time, the unemployment rate remained steady at 4.1%. The Federal Open Market Committee (FOMC) modified its interest rate policy by raising the federal funds rate target 25 basis points to a range of 1.50% to 1.75%. Economists expect as many as three additional increases in 2018 as inflation picks up and wage pressures accelerate.

The global economic environment continues to benefit from a rebound in demand and generally accommodative monetary policies. The Eurozone economy grew at a 2.7% annual rate in the fourth quarter, well above trend. Growth in the region has been driven by ultra-accommodative monetary policy, a firming labor market, and robust domestic demand. Japan is expected to maintain its strong momentum into 2018, driven in part by revived external demand. China continued its strong growth from 2017, and experienced its first year-over-year acceleration since 2010. The country’s 6.8% fourth quarter annualized GDP growth was higher than the 6.5% target, even as policymakers are implementing deleveraging designed to limit debt-driven growth. However, economists believe that the focus on deleveraging will inhibit China’s growth somewhat in 2018. (Sources: Bloomberg & Yahoo Finance)

Highlights and Perspectives

Gross Domestic Product (GDP)
The Bureau of Economic Analysis released the third estimate of the fourth-quarter 2017 real GDP, a seasonally adjusted annualized rate of 2.9%, down from the third quarter’s 3.2% annualized growth, but up slightly from the 2.5% prior estimate. Economists generally believe it will be difficult to maintain this level of growth while the economy is at full employment, meaning that the expansion may be in its latter stages. Consumer spending continued to drive growth during the quarter. Inflation showed signs of accelerating in the quarter, with the personal consumption expenditures (PCE) index of prices rising 2.7%, following a 1.5% advance in the prior quarter. Corporate profits fell by 0.1% (not annualized) during the quarter. Confidence among businesses and consumers is high, but economists caution that sustaining current levels of growth will be difficult. (Source: Bureau of Economic Analysis)

Housing
The housing segment remains robust, and analysts continue to have a positive outlook for 2018. Existing home sales for February (the latest monthly data available) grew at an annualized rate of 5.5 million units, an increase of about 3% from January, and up about 11% from year-ago levels. The inventory of existing homes was slightly more than three months of supply, down marginally from the prior year. Existing home prices in February were up 0.4% from January, and have increased 5.9% from February 2017. In the new-home segment, the NAHB Housing Market Index, a measure of homebuilding activity, ended the quarter at 70, slightly lower than the previous month. Nevertheless, analysts cite strong homebuilder confidence in maintaining a positive outlook for housing over the coming months. (Source: NAHB)

Employment
The employment situation continued to be very robust in February. Employers added 313,000 jobs during the month, far exceeding the consensus expectations of 200,000 new jobs, and outpacing the prior month’s gain of 239,000. The three-month moving average also jumped, coming in at 242,000. The unemployment rate in February remained at 4.1%, unchanged since October 2017. Average hourly earnings increased by a modest 0.1% in the month, with expectations that wages will rise in coming months. (Source: Department of Labor)

Federal Reserve Policy
The Federal Open Market Committee (FOMC) ended its recent March meeting by announcing an increase of 25 basis points in the federal funds rate target from 1.50% to 1.75%. While the rate increase was expected, the FOMC also revised upward its economic and interest rate projections. The FOMC increased its GDP growth estimate for 2018 from 2.5% to 2.7%, and also expects growth to be 2.4% in 2019, higher than its previous estimate of 2.1%. The FOMC also lowered its estimates for unemployment for this year and going forward. The FOMC is becoming somewhat more hawkish in its interest rate stance, and may become increasingly so in coming quarters as inflation begins to rise. (Source: FOMC)

Interest Rates
Fixed income securities’ prices and yields were affected by a variety of factors, including the FOMC’s decision to raise short-term interest rates once again at its recent March meeting; the Trump administration’s new tariff policies on aluminum and steel imports; solid improvement in economic data; and volatility in stock prices. The administration’s new tariffs on certain imported goods were a fulfillment of one of President Trump’s campaign promises, but created concern among analysts that the gains from the recently enacted tax reform package would be undone. The economy continues to post strong gains, and the FOMC is likely to become increasing hawkish under new Federal Reserve (Fed) Chairman Jay Powell. The FOMC expects to raise short-term rates at least three more times in 2018.

Tax Planning
As we close out the 2017 tax filing season, we are focusing on the implications of the new Tax Cuts & Jobs Act (TCJA) become more clear. While we expect to identify various changes that may impact you, we wanted to share some initial insights that might help guide your tax strategies going forward. Of course, we’d be happy to discuss them and how they could affect you with you directly.

At the time of writing this newsletter, the new tax law and related interpretations continue to evolve. As is true with many new tax laws, more questions arise than answers when trying to apply the new law. One important aspect is that California and many other states may not comply with the new tax law. California law conforms to the federal tax law as it read on January 1, 2015. As a result, most of the changes enacted as part of TCJA will not apply for California purposes unless California specifically enacts legislation to conform.

The big take away is that each taxpayer will need to keep more detailed accounting records since what can be non-deductible for federal purposes might be deductible for state (California) tax purposes. A great example of this is moving expenses and employee business expenses which have been disallowed for federal purposes and are still fully deductible for California purposes. Clarity will take months to obtain. Please review your accounting for the first part of tax year 2018 to make sure you have recorded all of your expenses properly even if you don’t think the expense is deductible for Federal purposes. Moving forward, create categories to assist with the added detail needed for the Meals, see below discussion.

• Entertainment Expenses & Business Meals– If you are self-employed or have been historically been able to deduct your employee business expenses, this change increases the cost of an important business development expense for many. Entertainment expenses have been eliminated for Federal purposes with respect to an activity generally considered to constitute entertainment, amusement, recreation including the facility used in connection with such activity. An exception exists for business office parties or picnics for the benefit of employees.Since entertainment expenses are no longer deductible, one small but not immaterial strategy you can employ as an alternative is the use of Business Gifts, which are limited to $25/person per year. Buying gift cards in bulk and giving them to your clients, centers of influence and prospects can provide additional tax write-off. Business gifts are fully (100%) deductible on the $25 limit, unlike allowable meals that are only deductible at 50%. Therefore, a $25 business gift card for a restaurant has the same amount of write-off as a meal purchased for $50 that was formerly deductible as entertainment. Documentation is critical; therefore, a log or detailed records should be maintained to comply with IRS rules.
• Business Meals can be a complicated area. Travel meals away from home and employee meals for the benefit of the employer (food brought into the office to keep your employees working) are clearly 50% deductible. What is somewhat unclear are business meals with clients. Although I see little IRS guidance at the time of writing, it is my interpretation that these meals directly related to a business meeting will be 50% deductible.
• Increased Standard Deduction – The standard deduction is nearly doubling in 2018 from 2017. As such, millions of taxpayers who previously itemized deductions on Schedule A are expected to take the standard deduction instead of itemizing this year. Since many taxpayers might just miss itemizing their deductions by a few hundred dollars, the strategy of grouping your deductions in one calendar year can provide additional tax savings. This strategy takes advantage of grouping and paying your charity deductions, property taxes, DMV registration fees and state tax payments in one calendar year than spreading them out over two calendar years. The standard deduction amounts for calendar/tax year 2018 are as follows:

	Single     Individuals	Joint Return / Surviving Spouses	Head of Households	Married Filing Separately
Basic	$12,000	$24,000	$18,000	$12,000
Over 65	$13,600	$25,300 (one) $26,300 (both)	$19,600	$13,300

 

• Charitable Gifts Out of Your Required Minimum Distributions (RMDs) – When you turn age 70 ½ and are forced to take RMDs from your pre-tax retirement accounts, employ this tax strategy (called a Qualified Charitable Distribution) if you are making charitable contributions. When processing your RMD from your IRA or retirement account, direct all or part of the RMD distribution to your charity or charities of choice. By doing this, the amount distribute is NOT taxable income to you and will not be reported as income on your tax return. More importantly, the contribution amount is not limited to your RMD, in fact, you can direct up to $100,000 annually per individual. This approach reduces your Adjusted Gross Income (AGI) which is helpful in reducing taxation on your return and can potentially reduce the Medicare premium increases due to higher AGIs. It should be noted that by not recognizing the income, you obviously are not deducting the charity donation as an itemized deduction. As was noted above, many individuals will be taking the standard deduction and will no longer be itemizing charity donations anyway. Be sure to contact Ashley Graban in my office who can assist you with proper processing on your RMDs and IRA distributions if you want to make this tax strategy a reality.

Peter D Prescott

The opinions expressed are those of Prescott Tax and Wealth Management as of January 13, 2017 and are subject to change. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Investing in foreign markets involves currency and political risks. Information and opinions are derived from proprietary and non-proprietary sources.  Please note that investing in the stock market involves risk and no strategy can mitigate the risk completely.  S&P 500 is a registered trademark of The McGraw-Hill Companies, Inc. Prescott Tax and Wealth Management is a Registered Representative offering Securities and Advisory Services through Independent Financial Group LLC, a Registered Broker-Dealer and Investment Advisor. Member FINRA and SIPC. Prescott Tax and Wealth Management and IFG are not affiliated.