Market & Economy

The U.S. economy roared back in the second quarter of 2018 with GDP growth likely in excess of 3.5%, a sharp improvement from the 2.0% Q1 advance¹. The rebound is not surprising. Job creation remained robust with the addition of an average 214,500 new hires per month throughout the first half of the year². Given rising incomes and consumer confidence, our expectation for stronger consumer spending was well founded and has come to fruition.

The outlook for the labor market continues to be healthy. Weekly jobless claims are hovering near an all-time low and there are more jobs available than job seekers¹. Furthermore, the moderate pace of wage gains would imply there is still some slack in the labor market despite an unprecedented 93 consecutive months of employment growth¹. Our hope is that the labor participation rate will edge back towards pre-recession levels as folks on the sidelines re-enter the job market. In any event, it is apparent that our initial forecast of a 1.8 million increase in payrolls will be shy of the mark. A much higher 2.2 million job gain appears achievable³.

While the consumer is in excellent shape, the segment of the economy that has turned in the greatest performance thus far in 2018 has been business investment or capital spending. In the first quarter capital expenditures jumped 10.4% and may well increase in the high single digits in Q2². While a large percentage of the increase has been driven by rising oil prices and investments in energy, the very size of the gain indicates a broad-based recovery. Stronger global demand as well as rising corporate profits should help sustain this trend.

Financial conditions in the U.S. also remain supportive of the economy. While the Fed has raised interest rates by 0.25% in three successive quarters, inflation has also been rising gently. With the Fed’s preferred inflation indicator, the core PCE index, finally hitting its 2% target and the Fed Funds rate in a 1.75% to 2.0% range³, real interest rates (interest rates adjusted for inflation) are still below 0% as the expansion enters its 10th year¹. Longer-term interest rates have only risen modestly with the 10-year Treasury yielding 2.85% versus 2.41% at the beginning of year⁴.

The narrow differential between short- and long-term yields can be viewed as a bearish indicator of weak future growth. Nonetheless, the resultant low mortgage rates continue to support the housing market. Credit, in general, is readily available. The housing sector has strengthened markedly. May housing starts were 20% above year ago levels, yet supply remains constrained. There is concern, however, that further improvement may be limited due to a shortage of construction workers. Increased government spending is also a positive. Combined with the tax cuts, the Federal budget deficit is widening quickly, providing additional fiscal stimulus to an already solid economy.

The elephant in the room is the trade war. What we had viewed last quarter as a low probability event is now a reality. Absent the worsening trade picture, we would likely raise our 2018 GDP forecast from the current 2.5% - 3.0% range³. Ironically, U.S. exports have been performing well with May exports up 12% versus May of last year. Higher U.S. tariffs will be borne by the consumer, while retaliatory tariffs overseas will curb U.S. exports.

The net result will reduce GDP and cost jobs. The tariffs on Chinese products are surprisingly focused on capital goods and intermediate goods used by American manufacturers as inputs to production. Further, alternate sources for these goods are largely available only from other countries with which we are also embroiled in a trade dispute such as Germany, Canada, or Mexico⁵. The pro-free trade Peterson Institute estimates that the initial U.S. salvo in a trade war could cost up to 195,000 jobs; a full blown conflict with retaliation could result in a 624,000 job loss⁶. Of course, this must be kept in the context of a labor force that has 149 million people currently employed. Given the strength of our economy versus overseas, it can be argued that the U.S. now has the upper hand, but it is a truism that the winner of a trade war is who loses least.

Markets have generally been stable despite the handwringing. The Federal Reserve continues to tighten gradually and we maintain our view for two more 0.25% rate increases in 2018, although the market is probably pricing in a single hike due to recent developments on trade. The yield on the 10-year Treasury rose a modest .11% to 2.85% during Q2⁴, despite the acceleration in growth, and a return to the 3% level or slightly higher still seems probable. However, low bond yields abroad continue to encourage capital to migrate to the U.S. and suppress yields here.

U.S. equities enjoyed a solid second quarter as the S&P 500 Index advanced 3.4%4, erasing earlier losses. Smaller capitalization stocks outperformed, probably due in large measure to their more domestic orientation as the dollar rallied. With earnings growth for the S&P 500 Index likely to be in the vicinity of 20% this year, we remain optimistic on U.S. equities despite rising interest rates. However, while cash may not be king, the argument that “there is no alternative to stocks” appears out of date. A risk-free 3-year CD at 3% also is a sensible alternative. As investors turn their attention to 2019, the growth outlook is bound to moderate as the boost from this year’s tax cuts anniversaries and earnings growth is more dependent on underlying fundamentals.

Market Outlook

• Earnings growth of approximately 20% for S&P 500 Index in 2018 appears achievable as tax reform boosts after tax earnings³
• Corporate tax reform to add approximately 7% to S&P 500 Index earnings³
• U.S. equity market valuation less challenging after pause in rally
• Potential modest or slightly negative fixed income returns as interest rates and bond yields rise
• Corporate and municipal bonds appear richly valued as spreads remain narrow; Treasuries, Government Agencies, and CD’s continue to be attractive
• TIPS (Treasury inflation-protected securities) have some appeal as an inflation hedge
• Foreign central banks likely to curtail quantitative easing in latter part of year, removing some liquidity
• Return to normal volatility as rates rise and liquidity reduced (end of financial repression)
• Dollar relatively steady after weak 2017 as Fed tightens and European recovery discounted

Downside Risks:

• U.S. political risk, especially concerning trade policy
• Geopolitical risk high around the Globe; Europe, Middle East & East Asia are all vulnerable
• Wage gains accelerate toward 4% resulting in even faster pace of rate hikes
• Synchronization of monetary policy; foreign central banks become more restrictive
• Return of market volatility harms consumer confidence and consumption slows
• Increasing supply of U.S. Treasury debt disruptive to fixed income market

Upside Risks:

• Notable improvement in productivity allows for non-inflationary wage growth and higher profit margins
• Greater political stability in Europe
• Steadier exchange rates and commodity prices
• Trade issues recede on better growth

PLANNING

It’s a Small, Small World ... Managing Conflicts of Interest for Nonprofits

They say the world is getting smaller, but that has always been true in New England. In tightly knit regions, connections simply can’t be avoided. Nonprofits naturally want to take advantage of those connections: securing Board members and vendors who support the cause and provide expertise, experience - and maybe even free advice, contributions/ sponsorships, or discounts! But the IRS has ramped up investigation into conflicts of interest, assessing millions in penalties and even revoking exempt status in egregious cases. Nonprofits also have fiduciary duties to avoid conflicts of interest under state nonprofit laws and other applicable regulations. Clearly, it’s important for the individuals who manage and govern nonprofits to recognize and take appropriate steps to manage conflicts of interest.

What is a Conflict of Interest?

A conflict of interest generally exists when a director, officer, or other key individual has a material personal or financial interest in a proposed transaction with the nonprofit. For example, if a Board member is an employee of a company and the nonprofit is a customer of that company, there could be a conflict if the Board member approves transactions that could impact his/her personal compensation (through a commission or bonus).

Are Conflicts of Interest Per Se Prohibited?

Absolutely not. Nothing could get done – especially in a small state – if all potential conflicts of interests were inherently illegal or unethical. In fact, a contract or transaction that is fair and reasonable is explicitly permitted in some states, even when a conflict exists. But any appearance of a conflict of interest should be scrutinized and vetted.

How can Nonprofits Manage Conflicts of Interest?

One of the best ways for an NPO to manage conflicts is to adopt, follow, and document compliance with a written conflict of interest policy. The policy should:

• Apply whenever there is an appearance of a conflict, not just when there is an actual conflict;
• Require affirmative disclosure all actual and possible direct or indirect conflicts and relevant facts;
• Require a comprehensive, transparent process and documentation of any decision involving a conflict of interest;
• Require decisions based on the fairness of the transaction and the best interests of the nonprofit;
• Be reviewed and updated periodically;
• Require annual certification from key individuals that they reviewed, understand, and will comply with the policy;
• Since penalties increase if a nonprofit corporation does not timely correct a conflict; perhaps include a duty to respond to allegations of wrongdoing.

Are There Any Guarantees to Protect Against Conflicts?

As with anything involving the IRS, there are no guarantees! But the IRS does provide a safe harbor for some conflicts of interest (known as “excess benefit” transactions), the most common of which is compensation for the nonprofit’s executives. This “safe harbor”, when applicable and done correctly, puts the burden on the IRS to prove that a conflict exists, rather than the other way around. Generally, the “safe harbor” requires: (1) Board approval, (2) reliance on appropriate comparable information, and (3) adequate contemporaneous documentation (e.g. meeting minutes).

So don’t shy away from conflicts – it’s a small, small world, even for nonprofits! Instead, identify them, use and document your conflicts policy, and seek guidance of independent parties, such as attorneys, tax professionals and financial advisors.

If you’d like to discuss any of the information contained in this newsletter, please call your relationship team or 800-582-1076. You can also read past editions of our publications by visiting our website, www.washtrustwealth.com. Weston Securities Corporation is a Broker/Dealer, Member FINRA/SIPC. Securities are offered through Weston Securities Corporation, which is a sister company of The Washington Trust Company, of Westerly and Washington Trust Wealth Management is a division of The Washington Trust Company, of Westerly. Weston Financial Group, Inc. and Halsey Associates are subsidiaries of The Washington Trust Company, of Westerly and a part of Washington Trust Wealth Management.

Sources: (1) U.S. Bureau of Economic Analysis (BEA); (2) U.S. Bureau of Labor Statistics; (3) Washington Trust Wealth Management; (4) Bloomberg; (5) Empirical Research Partners, LLC (6) The New York Times. The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opin-ions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.