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Third Quarter 2017

We are now three-quarters of the way through 2017 and capital markets continue to impress us—in both good and bad ways. US stock markets posted multiple record highs over the course of the quarter with the S&P 500 returning 4.48%. Global equities, as measured by the MSCI ACWI Index, were up 5.18%. Both the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays Global Aggregate Bond Index posted positive returns for the quarter, up 0.85% and 1.76%, respectively.

These strong quarterly numbers are right in-line with the indices’ year-to-date performances.  Since the beginning of the year, the S&P 500 Index has returned 14.2% while global equities have returned 17.2%. The two bond indices previously mentioned have posted total returns of 3.14% and 6.25%.  With another full quarter left in the year, there may be more record highs on the horizon for equities—although there are a number of factors that could derail the bull market before year-end: tightening monetary policy, gridlock in Congress, uncertainty in Europe and rising debt in China.

The Federal Reserve will proceed with its balance sheet reduction program, shrinking asset holdings acquired in unprecedented fashion following the financial crisis. The winding down of the balance sheet will be gradual, however it too will be unprecedented.  Any unexpected effects could disrupt equity markets and potentially put near-term rate hikes on hold. At the Fed’s most recent meeting, policymakers provided guidance for December with the intention, as of now, to raise the Fed Funds rate another 0.25%. It would be the third rate hike of 2017, matching the Fed’s year-end 2016 forecast (there will be multiple inflation and jobs data reports between now and the December meeting, which could of course force the Fed to alter its plans).  President Trump will also likely name Janet Yellen’s successor, if he does in fact replace her, by the end of the quarter. A reappointment of Yellen would provide a sense of stability and continuity to markets. While a reappointment of Yellen is possible, Trump may want someone that is both dovish and in favor of some financial deregulation such as Jerome Powell. Other potential candidates include former Fed governor Kevin Warsh, Stanford economist John Taylor and the Director of the National Economic Council Gary Cohn.

Over the course of the quarter, multiple attempts were made to repeal the Affordable Care Act, with the most recent attempt, the Graham-Cassidy bill, failing to come to an official vote.  While some Republican Senators want to keep the focus on health care, the majority are ready to turn to tax reform and revisit health care at a later date. Trying to pair both tax reform and health care into a potential 2018 reconciliation bill (in order to take advantage of the easier-to-clear hurdle of a simple majority to pass legislation) would not only be complex and messy but, it could also significantly hamper the reform of the tax system that many have called for.

Concerns about a rushed legislative process and lack of bipartisanship on healthcare, combined with President Trump’s eagerness to be a dealmaker, raise the possibility that tax reform could be more successful than ACA repeal efforts.  Highly ambitious and in control of both houses of Congress and the White House, Republicans are looking to revamp not only individual tax brackets and deductions but also the corporate tax code. A major tax overhaul will be challenging: the last one happened under President Reagan. Nevertheless we remain optimistic that some tax legislation will be formalized by year-end that encourages investment and puts more money back in the American consumer’s pocket.

There was no shortage of major global developments over the last three months. Angela Merkel won reelection in Germany, although it will likely be much tougher for her to govern than in the past.  Traditional parties, including Merkel’s Christian Democratic Union, were weakened significantly while the rise of the AfD party demonstrates a changing tide in European politics. Although anti-Euro and anti-immigration parties did not win control of the governments in France or Germany this year, they are gaining influence: AfD received enough of the vote to have representation in the Bundestag. What does all this mean for the greater global economy? It means that Europe as a bright spot of growth this year may not last if Merkel’s power is stifled and the continent’s growth engine is slowed. Furthermore, France’s Emmanuel Macron has set ambitious goals both for his country and the European Union, the success of which may determine the trajectory and stability of the bloc.

Much like policymakers at the Fed are increasingly wary about weak inflation in the US, the European Central Bank’s policymakers are also dealing with inflation below target levels. The US has already begun the process of paring back the monetary stimulus provided in response to the financial crisis while Europe’s monetary easing continues.  Changes to ECB monetary policy may be on the horizon though as unemployment falls and confidence rises. ECB policymakers will decide later this month whether or not to scale back bond purchases in 2018.  Any pullback in stimulus raises the risk of choking off inflation and growth too early—something ECB officials are keenly aware of after prematurely raising rates in 2011.

Standard & Poor’s downgraded China’s credit rating from AA- to A+ in September, citing increased financial risks in the country. The debt-fueled growth in China is nothing new, but it continues to reach new heights. According to the Institute of International Finance (IIF), China’s household debt-to-GDP ratio hit a record high of 45%+ in the first quarter of this year. More recently, in August, the International Monetary Fund (IMF) warned that China’s rapid debt growth could lead to another financial crisis. There have been stretches where the Chinese government has sought to rein in credit growth but the spigot of liquidity can only stay closed for so long: officials are continually trying to strike a fine balance between reducing leverage and maintaining a certain level of economic growth.

In last quarter’s letter we mentioned North Korea’s ICBM launch in early July.  The rogue nation continued its belligerent behavior in the third quarter and the markets’ reaction was fairly muted. There were a few trading sessions where equities moved lower, haven assets rallied and volatility spiked—all of which were short-lived. Once again, the complacency conundrum in financial markets continues.  This complacency, in conjunction with the lack of market volatility in 2017, reaffirms our belief in building diversified portfolios with a focus on downside protection.  Our downside protection across various strategies may mean we leave some return on the table in the short run. However, we are prepared to increase risk exposures following a market dislocation, assuming we see more compelling valuations and fundamentals. 

Carl Hall, CFA
Chief Investment Officer

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