The recent tax reform eliminated personal exemptions for taxable years after December 31, 2017, and before January 1, 2026. This makes your child worthless to you on your Form 1040. But there is a way to get even or, perhaps, much more than even.
Let’s set the stage first. For taxable years after December 31, 2017, and before January 1, 2026, the standard deduction for a single taxpayer begins at $12,000 in 2018 and increases every year for inflation. The 2017 standard deduction for a single taxpayer was only $6,350.
The new standard deduction means that a single taxpayer such as your child can earn up to $12,000 in W-2 wages and pay not a penny in federal taxes. As the owner of a business, you have the advantage of being able to hire your child to work in your business, and that creates tax-saving opportunities for both you and your child.
The big dollar benefits of hiring your child go to the Form 1040, Schedule C taxpayer and the husband-and-wife partnership because such businesses are exempt from FICA when they employ their children who are under age 18. The parental proprietorship and partnership hiring rules also exempt wages paid to a child under the age of 21 from unemployment taxes. Keep in mind that the single-member LLC that did not elect corporate tax treatment is taxed as a sole proprietorship for federal tax purposes.
Example. You employ your 9-, 11-, and 13-year-old children to work in your proprietorship. You pay them a fair market wage for the work they perform, and that just happens to equal $12,000 per child and total $36,000 for the year.
Children’s federal taxes. Zero! The $12,000 standard deduction zeroed each of the children out of federal income taxes for the year.
Your federal taxes. You claim the $36,000 W-2 wages deduction on your Schedule C, where it reduces both your income taxes and your self-employment taxes. If you are single with Schedule C income and taxable income of $120,000, you save at the 38.13 percent rate, for a total of $13,127. Of course, your tax rate is likely higher or lower than the example above, but you get the idea of how this works to your benefit. No taxes to the child and tax savings to you. Yes, you are having your cake and eating it, too.
S and C Corporations, Non-Spouse Partnerships, and Self-Employed Taxpayers with Children Age 18 and Over
When you hire the child under age 18, the Form 1040, Schedule C business and the partnership with only the child’s parents are exempt from Social Security, Medicare, and federal unemployment taxes. The S and C corporations and the non-spouse partnerships do not qualify for this benefit. They have to pay the payroll taxes on all employees—period. There is no parental benefit. (Similarly, the self-employed individual or the spouse-only partnership with a child age 21 or over does not qualify for any employment tax breaks.) This obviously changes the game. Let’s look at the three children above and apply the payroll taxes. Here’s how:
- $2,754 employer FICA taxes on the $36,000 in wages paid to the three children
- $2,754 employee FICA taxes extracted from the three children’s $36,000 in wages
- $1,200 in state and federal unemployment (this could be a little higher or lower depending on the employer’s experience with unemployment and the unemployment condition of the state where the business resides)
The payroll taxes above have left the pockets of either the children or the business entity. But the bottom line is that the money is now with the governments. All is not lost, and in most cases, this actually works out pretty well.
The business does get a tax deduction for its FICA and unemployment taxes. Let’s say this is your business and you operate it as an S corporation, so the net income passes to you. The tax deduction for hiring your three children is the $36,000 of wages paid, plus the $2,754 in FICA and the $1,200 in unemployment taxes, for a total of $39,954.
If you are in the 35 percent tax bracket, you save $13,984 on your $39,954 deduction. Remember, the children pay no income taxes, although they did suffer the $2,754 in FICA taxes.
Here’s the tally for the family:
Cash received from the government $13,984
Corporate cash paid out for FICA -$2,754
Corporate cash paid out for unemployment taxes -$1,200
Children’s cash paid out for FICA -$2,754
Net cash benefit to the family $7,276
You can see that payroll taxes take a toll, but they by no means kill the strategy. You, as the owner of this S corporation that hired the children, just put $7,276 in the pockets of the family. And you are going to do this for a number of years, so this one corporate strategy could be worth a lot of money to you. Of course, it’s unlikely that your savings will equal the calculation above. You might save more or less. Use the example above with your tax rates to calculate your exact savings.
If you can hire your children, the recent tax reform did you a big favor with the new $12,000 standard deduction.
The biggest benefits accrue to the Form 1040, Schedule C business or the spouse-only partnership when such a business can hire the under-age-18 child of the parent (or parents, in the case of the partnership). Why? Because with such a business, both the business and the parents are exempt from FICA taxes.
But every business where the owner can employ his or her children likely produces a nice financial benefit for the family. Make sure to review the tax savings in this article to see how you can come out ahead.
As you likely know by now (I love assuming everyone has read the new tax bill), your travel meals continue under tax reform as tax-deductible meals subject to the 50 percent cut. And tax reform did not change the rules that apply to your other travel expense deductions.
One beauty of being in business for yourself is the ability to pick your travel destinations and also deduct your travel expenses. For example, you can travel to exotic locations using the seven-day travel rule and/or attend conventions and seminars in boondoggle areas. From these examples, you can understand why the IRS might want to see proof of your business purpose for any trips, should it examine them.
With deductions for lodging, a meal, or other travel expenses, the rules governing receipts, business reasons, and canceled checks are the same for corporations, proprietorships, individuals, and employees. The entity claiming the tax deduction must keep timely records that prove the four elements listed below:
- Amount. The amount of each expenditure for traveling away from home, such as the costs of transportation, lodging, and meals.
- Time. Your dates of departure and return, and the number of days on business.
- Place. Your travel destination described by city or town.
- Business purpose. Your business reason for the travel, or the nature of the business benefit derived or expected to be derived.
When in tax-deductible travel status, you need a receipt, a paid bill, or similar documentary evidence to prove
- every expenditure for lodging, and
- every other travel expenditure of $75 or more, except transportation, for which no receipt is required if one is not readily available.
The receipt you need is a document that establishes the amount, date, place, and essential character of the expenditure.
Hotel example. A hotel receipt is sufficient to support expenditures for business travel if the receipt contains
- the name of the hotel,
- the location of the hotel,
- the date, and
- separate amounts for charges such as lodging, meals, and telephone.
Restaurant example. A restaurant receipt is sufficient to support an expenditure for a business meal if it contains the
- name and location of the restaurant,
- date and amount of the expenditure, and
- number of people served, plus an indication of any charges for an item other than meals and beverages, if such charges were made.
You can’t simply use your credit card statement as a receipt. Like a canceled check, it proves only that you paid the money, not what you purchased. To prove the travel expenditure, you need both the receipt (proof of purchase) and the canceled check or credit card statement (proof of payment).
In a nutshell, a travel expense is an expense of getting to and from the business destination and an expense of sustaining life while at the business destination. Here are some examples from the IRS:
- Costs of traveling by airplane, train, bus, or car between your home and your overnight business destination
- Costs of traveling by ship (subject to the luxury water travel rules and cruise ship rules)
- Costs of renting a car or taking a taxi, commuter bus, or airport limo from the airport to the hotel and to work destinations, including restaurants for meals
- Costs for baggage and shipping of business items needed at your travel destination
- Costs for lodging and meals (meal costs include tips to waiters and waitresses)
- Costs for dry cleaning and laundry
- Costs for telephone, computer, Internet, fax, and other communication devices needed for business
- Tips to bellmen, maids, skycaps, and others
The travel deduction rules are the same whether you operate your business as a corporation or a proprietorship, with one important exception. When you operate as a corporation during the tax years 2018 through 2025, you must either
- have the corporation reimburse you for the expenses, or
- have the corporation pay the expenses.
Fringe benefits are usually a good thing—but there’s a catch when you own more than 2 percent of an S corporation. The good news? Federal tax law allows the cost of these fringes as deductible expenses for your S corporation. The bad news? You, the shareholder-employee who owns more than 2 percent, may suffer additional taxes on some of the benefits because the tax code requires your corporation to put selected benefits on your W-2 (sometimes favorable, sometimes not).
Here’s the ugly rule that causes this problem. Under the federal income and employment tax rules for the most popular fringe benefits, tax law treats the more than 2 percent shareholder-employee of an S corporation as a partner. And—we know you are just waiting for this—more bad news: related-party stock attribution rules apply to the S corporation. Under these rules, tax law says that your spouse, parents, children, and grandchildren own the same stock you own—and if you employ them in your S corporation, their fringe benefits suffer the same ugly fate as your fringe benefits.
In this article, we are going to explain the following:
- Four fringe benefits that are (a) deductible by your S corporation, (b) taxable to you as a shareholder who owns more than 2 percent, and then (c) deductible by you on your personal tax return. You can see that navigating this maze is a little crazy, and you have to do it right to make it work—which, of course, we explain how to do.
- Six stinky fringe benefits. These benefits are stinky because, first, you get nothing from them because you are a shareholder-employee who owns more than 2 percent and, worse, you pay extra taxes because the “non-benefit to you” goes on your W-2 subject to FICA.
- Three maybe (but maybe not) fringe benefits. This group of S corporation fringe benefits comes with special rules that can disqualify your eligibility for the benefits.
- Four no-problem fringe benefits.
Four Beneficial but Somewhat Crazy Fringe Benefits
The following four fringe benefits work their way through a tax code maze to eventually produce a personal benefit to the shareholder-employee who owns more than 2 percent. For example, for the more than 2 percent shareholder-employee to get any tax benefit whatsoever from health insurance, he or she needs to follow the exact road map you see in No. 1 below.
- Health Insurance
If you are a shareholder-employee who owns more than 2 percent of an S corporation and you want a tax benefit from your health insurance, you need to follow the three-step path that we lay out in Update: 2018 Health Insurance for S Corporation Owners. The three steps are described below:
- Make the S corporation pay for your insurance premiums, either directly or through reimbursement to you.
- Have the S corporation include the health insurance as wages not subject to FICA on your W-2.
- Deduct (as an individual taxpayer) the cost of the premiums, using the self-employed health insurance deduction on page 1 of your Form 1040.
Warning No. 1—No Section 125 plan. You, as a more than 2 percent S corporation shareholder-employee, can destroy the S corporation’s tax-favored Section 125 cafeteria benefit plan. If you participate in the Section 125 plan, you disqualify the plan and make it taxable to yourself and all employee participants.
Warning No. 2—Beware of employees. The S corporation can pay for or reimburse your individual owned insurance because you are a shareholder who owns more than 2 percent. But your S corporation may not pay for or directly reimburse your employees for individually owned health insurance
An S corporation that directly pays for or reimburses employees for employee-arranged health insurance premiums (as opposed to paying premiums for company-arranged group coverage) faces the Affordable Care Act penalty of $100 a day per affected employee per day ($36,500 per employee per year).
- Health Reimbursement Arrangements (HRAs)
As a shareholder-employee who owns more than 2 percent, you don’t gain any extra benefit from a Section 105 plan or other HRA. If the S corporation reimburses the more than 2 percent shareholder-employee using a health reimbursement plan or account, it simply creates W-2 treatment for the shareholder. If health insurance costs are included in the reimbursement, the shareholder treats the health insurance costs included in his or her W-2 as discussed in No. 1 above.
For medical reimbursements other than health insurance that the S corporation reports on the W-2, the shareholder itemizes those deductions on Schedule A of the Form 1040.
- Health Savings Accounts (HSAs)
The S corporation treats contributions to the more than 2 percent shareholder-employee’s health savings account (HSA) as W-2 income exempt from FICA and Medicare, and the shareholder-employee deducts the HSA on his or her Form 1040.
- Disability Insurance
The S corporation treats the premiums paid for an income replacement disability policy on a more than 2 percent shareholder-employee as wages for withholding tax purposes that are exempt from FICA and unemployment taxes. Under this requirement, the more than 2 percent shareholder-employee actually paid the disability premiums personally because of the W-2 treatment, and that means he or she collects the disability income tax-free.
Six Stinky Fringe Benefits
What makes a fringe benefit stinky? The stinky fringe benefit gives your S corporation a tax deduction for the compensation that it includes on your W-2. Effectively, this gives you a zero tax benefit from the stinky fringe benefit. The stinky fringe benefit increases the corporation’s FICA taxes on the compensation it has to add to your W-2 and the stinky fringe benefit increases your personal FICA taxes because of the compensation added to your W-2.
In summary, the stinky fringe benefit is absolutely NO benefit to you, and it increases both your and your corporation’s FICA taxes. That’s really stinky.
Stinky No. 1: Group Term Life Insurance
Your S corporation treats the cost of any company-provided group term life insurance coverage as wages to you SUBJECT TO FICA. You, the shareholder-employee, have no tax code section that allows you to deduct the group term life insurance on your personal tax return.
To see how good or bad the idea of having the group health insurance cover a more than 2 percent shareholder-employee is, you need to compare the cost savings (if any) of the group insurance with the additional FICA taxes paid by both you and your S corporation. For your S corporation’s regular employees, you can provide up to $50,000 of group term life insurance tax-free.
Stinky No. 2: Qualified Moving Expense Reimbursements
For tax years beginning January 1, 2018, and before January 1, 2026, tax reform eliminates both the fringe benefits and tax deductions for moving expenses. This applies both to employees and to shareholder-employees who own more than 2 percent. If your S corporation provides moving expense reimbursements to a more than 2 percent shareholder-employee, the corporation treats the reimbursement as wages subject to FICA. Having your S corporation reimburse you, the more than 2 percent shareholder-employee, for moving expenses was and is a bad idea because both your S corporation and you, the employee, pay FICA taxes on the amounts included on your W-2.
Planning tip. Pay the moving expenses yourself. That way you save the corporation its FICA, which increases the S corporation income that flows through to you. And second, you save yourself the FICA taxes that apply to you, the W-2 employee.
Stinky No. 3: Qualified Transportation Fringe Benefits
Your S corporation has to treat as wages subject to FICA and FUTA any qualified transportation fringe benefits it pays to you, the more than 2 percent shareholder-employee. As you’ve seen, the inclusion of the monies on your W-2 does more than just eliminate the benefit—it makes you and your corporation pay additional FICA taxes. So, forget this fringe benefit for the shareholders who own more than 2 percent.
Instead, and especially if you are the sole owner of the S corporation, follow a strategy that allows your S corporation to deduct your cost of transportation and more without creating wages for you, as detailed in S Corporation? Office in the Home? Learn How to Escape Taxes.
Rank and file. Note that tax reform has made transportation fringe benefits granted to employees a less attractive offering from the employer perspective.
Stinky No. 4: Meals and Lodging
Meals and/or lodging that are provided by the company to a more than 2 percent shareholder-employee for the company’s convenience (for example, because the shareholder-employee must be on the company premises for overnight duty) are treated as wages subject to FICA. The amounts included in the shareholder-employee’s income are not deductible by the shareholder-employee on his or her personal tax return.
Rank and file. The S corporation may provide lodging and meals for the convenience of the employer to employees who are not shareholders who own more than 2 percent.
Stinky No. 5: Qualified Employee Achievement Program
Your S corporation treats the cost of a qualified employee achievement award given to a more than 2 percent shareholder-employee as wages subject to FICA at both the corporate and employee levels. The more than 2 percent shareholder-employee may not deduct the value of an employee achievement award on his or her Form 1040.
Rank and file. The S corporation may deduct the cost of qualified achievement awards given tax-free to employees other than shareholder-employees who own more than 2 percent.
Stinky No. 6: Qualified Adoption Assistance
If your S corporation pays you, the more than 2 percent shareholder-employee, the adoption assistance fringe benefit, the corporation has to put that payment on your W-2 as wages subject to FICA. You may, of course, claim the adoption tax credit allowed by the tax code on your personal tax return (your IRS Form 1040).
Planning tip. Pay the adoption expenses yourself. Don’t let your S corporation pay the monies and then put those monies on your W-2. By paying the monies yourself, you save both the corporation and yourself the FICA taxes.
Rank and file. Your S corporation may establish an adoption assistance fringe benefit that’s tax-free to employees who are not shareholders who own more than 2 percent.
Three Maybe (but Maybe Not) Fringe Benefits
The three fringe benefits in this section face special tax code disallowance rules that often take these benefits away from the S corporation shareholder-employee who owns more than 2 percent.
Maybe No. 1: Qualified Educational Assistance Program
The qualified educational assistance program fails as a qualified program and is not tax favored for ANY employee when more than 5 percent of the benefits are provided to shareholder-employees who own more than 2 percent or their spouses or dependents.
You may, however, be able to provide this benefit to your child if he or she is an employee and certain other conditions are met. For more on this, see Business Tax Deductions with Section 127 Plan for Child’s College.
Rank and file. The qualified educational assistance program is relatively easy to implement when all the benefits are going to employees who are not shareholder-employees who own more than 2 percent of the S corporation.
Maybe No. 2: Qualified Dependent Care Assistance Program
Your S corporation can implement a qualified dependent care assistance program, but if more than 25 percent of benefits paid for dependent care assistance during the year are provided to those who own more than 5 percent, the program fails as a tax-favored program and the benefits are taxable for all participants.
Maybe No. 3: Working Condition Fringe Benefits
Your S corporation’s ability to provide a working condition fringe benefit to all employees—including you, the more than 2 percent shareholder-employee—is found in tax code Section 132(d), which states:
For purposes of this section, the term “working condition fringe” means any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162 or 167.
Tax reform adds a fly to the ointment because it does not allow miscellaneous itemized deductions (where you claim employee business expenses) for any taxable year beginning after December 31, 2017, and before January 1, 2026. Does this mean that working condition fringe benefits are not deductible by your S corporation during this period because of tax reform? Maybe, but maybe not.
Planning tip. We think you should proceed as if the working condition fringe benefit requirements were unchanged by tax reform. To us, sloppy drafting of the Tax Cuts and Jobs Act inadvertently overlooked IRC Section 132(d) when disallowing employee business expenses, and we expect that oversight to be corrected.
Working condition fringes that your S corporation can provide to you, the more than 2 percent shareholder-employee, and/or your employees include:
- Use of the corporate-owned car for business purposes
- A smartphone, when provided for non-compensatory reasons
- Job-related education
Four No-Problem Fringe Benefits
Your S corporation can provide you, as a shareholder-employee who owns more than 2 percent, and its other employees with the following fringe benefits, which are tax-free to the employees and deductible by the S corporation:
- De minimis fringe benefits. De minimis fringe benefits include occasional use of the company copy machine, holiday and birthday gifts with a low value, occasional parties and picnics for employees and their guests, and occasional tickets to the theater or sporting events.
- No-additional-cost services. No-additional-cost services are excess capacity services, such as airline, bus, or train tickets; hotel rooms; or telephone services provided free, at a reduced price, or through a cash rebate to employees working in those lines of business.
- Qualified employee discounts. This exclusion applies to a price reduction you give your employee on property or services you offer to customers in the ordinary course of the line of business in which the employee performs substantial services. The employee discounts can be up to 20 percent on services and the gross profit percentage on merchandise.
- On-premises athletic facilities. Your S corporation can exclude the value of an employee’s use of an on-premises gym or other athletic facility from the employee’s wages if substantially all use of the facility during the calendar year is by the corporation’s employees, their spouses, and their dependent children.
As you have learned, you need to pay attention when it comes to the fringe benefits that your S corporation is going to offer you, the shareholder-employee who owns more than 2 percent. And of course, you have to pay attention when your S corporation offers fringe benefits to rank-and-file employees, too.
In “Four Beneficial but Somewhat Crazy Fringe Benefits,” you learned that the corporation puts the fringe benefit on your W-2 free of FICA taxes so that you can obtain a tax deduction on your personal income return.
In “Six Stinky Fringe Benefits,” you learned how to make both yourself and your S corporation pay extra FICA taxes on non-benefits to you. You can think of this as shooting yourself in the foot. It’s unnecessary and painful.
In “Three Maybe (but Maybe Not) Fringe Benefits,” you learned how special benefit rules can (and likely do) rob you of both the educational assistance and the dependent care assistance programs. With the working condition fringe benefits, you found a fly in the ointment caused by the recent tax reform—and why we think you can ignore it.
In the final section, you finally got to smile as you learned about the four no-problem fringe benefits that your S corporation can give tax-free to you and all your corporation’s employees. That’s really what a fringe benefit is supposed to be—a tax-free benefit.
Many couples face an uphill battle when one spouse has a catastrophic health crisis and needs long-term care. Most people are uninsured for the risk of the Medicaid spenddown and often the healthy spouse is faced with sticker shock when the nursing home bills start coming in. There are four rules that – when used together – can help the community spouse avoid financial devastation.
RULE 1: THE 5-YEAR LOOKBACK
In every state but California, Medicaid uses a 60-month lookback rule on the transfer of assets. When a nursing home patient applies for Medicaid, the state will look at five years of bank and account statements. As part of the eligibility review process, the state makes the applicant account for any gifted funds or any assets transferred without receiving full consideration. For instance, a gift of $50,000 would trigger a transfer penalty for the full amount. But if the applicant sold a $150,000 house to his granddaughter for $100,000 they would treat that the same as gifting the $50,000 in cash.
Penalties are prospective from the date of application. Assuming the average cost of care is $10,000 a month. Medicaid determines the penalty by dividing the average cost of care into the total gift. The applicant who gave away $50,000 would be ineligible for nursing home care for five months after the application was filed with the department. What confuses a lot of people is the idea that there is no way to help the healthy spouse protect assets because it would have had to have been done prior to the 5-year lookback window. That’s simply not true. Most asset protection techniques are designed to work AFTER the patient enters the nursing home.
RULE 2: THE SNAPSHOT DATE
When a married couple has one spouse in the nursing home and another spouse living at home (called the “community spouse” by Medicaid), the amount of money they are required to spend down is governed by a formula. States either use the one-half deduction formula or the straight deduction formula, both of which are confusing to the average community spouse. In 2018, the maximum a community spouse can keep is $123,600. This is known as the Community Spouse Resource Allowance (“CSRA”).
The CSRA is determined based upon the value of the assets on the snapshot date. The snapshot date is typically tied to the date of institutionalization that proceeds the first thirty days of care. Some states make it the actual date in time and others make it the first of the month when that occurs. Countable assets (i.e., assets which count towards the spenddown) are added up on the snapshot to determine how much the community spouse can keep and what amount must be spent to achieve Medicaid eligibility. Many nursing homes DO NOT disclose this to the nursing home patients or their spouses because there is hope that they will private pay longer than is required.
A married couple with $400,000 in countable assets would only be able to keep the CSRA of $123,600 and would be on track to have to spend down $276,400 before Medicaid eligibility can be established. That amount represents the couple’s total exposure to the spenddown. Given the high cost of care, this couple is likely to spend down three-fourths of their retirement savings on the cost of care in slightly over two years. When determining the assets available on the snapshot date, Medicaid counts assets owned by both spouses and does not care if there is a prenuptial agreement in place.
RULE 3: THE ASSET-TO-INCOME RULE
Excess recourses can be converted into income. This is known as the “asset-to-income rule” although it’s not called such in the Medicaid statutes. Medicaid has specific rules on the use of promissory notes and certain Single Premium Immediate Annuities (SPIAs) that it deems to be compliant with strict rules on payout and revocability. These annuities are known as the Medicaid safe harbor annuities because of the safe harbor language protecting these annuities written right into the federal Medicaid statute in 2006. The purchase of a Medicaid safe harbor annuity converts countable assets into income. These are typically purchased on behalf of the community spouse who is not required to contribute her income towards the cost of her husband’s care in the nursing home once he’s on Medicaid. As long as the annuity meets all safe harbor rules, the purchase is NOT considered a transfer for less than fair market value and the five-year lookback rule does not come into effect.
Because there is typically a desire to maximize the amount of money a community spouse can keep liquid, the purchase of the annuity often takes place after the patient goes into the nursing home in states that use the one-half deduction formula. This way the community spouse can have all of the countable resources available on the snapshot date to maximize the CSRA. Then the excess resources are placed into the Medicaid safe harbor annuity and the couple applies for Medicaid. The purchase of the annuity brings the couple’s countable assets below the resource limit IMMEDIATELY!
RULE 4: ONLY ONE MARITAL SPENDDOWN
Many people – advisors included – falsely think that the CSRA is an ongoing asset limit for the healthy spouse. However, the last rule to note here is that there is only ever one spenddown for a married couple when the CSRA is set. Once the assets have fallen below the CSRA, the couple applies for Medicaid for the institutional spouse. On the first Medicaid application they look at both spouse’s assets held individually or jointly to determine if the couple has spent down below the resource limit. Once the Medicaid department determines that they have, Medicaid is approved for the spouse in the nursing home. On subsequent redeterminations, Medicaid no longer inquiries about the community spouse’s assets except to make sure that assets held jointly were given exclusively to the community spouse. Those assets can no longer be held in the name of the institutional spouse whose assets will be limited to the state’s individual countable resource allowance (usually $2,000 or thereabout depending on the state).
The community spouse can re-accumulate funds from the annuity or promissory note and re-invest those funds. Because the community spouse’s countable assets do not factor into future eligibility for the nursing home spouse, she does not need to keep her countable assets below the resource limit.
I’m confused. We’re enjoying a highly unusual financial “cocktail” these days that combines one part low inflation, one part low unemployment, one part strong earnings and one part low interest rates. We should be happier – share prices should be moving up – but they’re not. Do you share my concerns?
First quarter real GDP growth came in at a respectable 2.3%, easing slightly from the robust growth experienced throughout 2017. Markets have experienced heightened volatility so far in 2018 compared to 2017. Geopolitical headlines continue to play a significant role in perceived risk, with particular focus on tariff negotiations with China and tensions in Syria. Coupled with uncertainty over the role of Iran in the international community, oil prices rose 7% over the month. As a result, commodities were the top performing asset class (up 2.2% YTD and 2.6% in April). The oil price rallied. The International Energy Agency announced that the excess oil inventories that had kept prices low have now disappeared thanks to the production cuts put in place by the Organization of the Petroleum Exporting Countries (OPEC) and the strength of global oil demand. According to consensus estimates the oil price could rise further, also boosted by the prospect of sanctions on Iran.
Despite market volatility, economic readings continue to support a healthy expansion (According to Bloomberg, 180 companies in the S&P 500 Index that have reported first-quarter earnings have seen their effective tax rate drop by an average of 6%). The consumer remains confident with the US consumer confidence reading exceeding analysts expectations in April, rebounding from a slight decline in March. The Department of Labor’s initial jobless claims report came in at 209,000, marking the longest sub-300,000 recording since 1967. Meanwhile, the unemployment rate held steady at 4.1% for the sixth consecutive month. The manufacturing side of the economy continues to perform well.
The S&P 500® Index followed two consecutive months of losses with a slim gain of 0.22% in April. While most of the 11 sectors of the S&P 500 had modest gains or losses, the Energy sector enjoyed one of its largest monthly gains in years. Energy was up 9.36% in April, as oil prices continued to stage a strong recovery. Investor fervor for “growth” stocks appears intact, as the technology-laden NASDAQ Index remains by far the best performing domestic index year-to-date. Investors also appear to be favoring companies less exposed to geopolitical concerns and tariff issues. As such, small-capitalization stocks (Russell 2000) posted a relatively strong April, while the Dow Jones Industrial Average is trailing year-to-date. Internationally, worries of a Eurozone economic slowdown eased in April, resulting in a rebound in the MSCI EAFE Index.
With the U.S. 10-year yield pushing past 3% and reaching its highest level since January 2014 investors are wondering why are yields rising now? As I highlight in the below chart for the last few years two anchohave been weighing down on the back-end of the yield curve: demand from international investors for U.S. fixed income and a lack of inflationary pressure. In 2018 both of these anchors have begun to lighten.
Rising hedging costs have eroded the relative attractiveness of U.S. fixed income to overseas investors. Falling demand from overseas has pushed U.S. bond prices down and forced yields higher. Inflationary pressure is driven higher by the falling U.S. dollar, which increases to the price of imports into the U.S. and oil prices moving higher. With inflation now back on investor’s radar, bond yields have begun to grind higher. The takeaway for investors is that higher bond yields are likely here to stay as both anchors continue to lighten in 2018. We encourage investors to remain flexible when managing duration, sectors and geographies during this tough time for fixed income markets.
Despite some risks related to trade restrictions, geopolitical noise and expectations of tighter monetary policy, markets remain on track thanks to signs that the global economy continues to expand, inflation is only rising gradually and earnings growth is healthy.