We held our first quarter investment strategy meeting on December 20, 2017. As you know, at these meetings we discuss and analyze factors that affect our investment outlook and holdings in your portfolios. The primary outcome of the deliberations resulted in an increased weighting in small and mid-cap equities and a slight reduction in our macro allocation to bonds. There were no significant changes in the securities we are using for sector representation except for REITs in which we added two securities, a medical REIT and an industrial REIT, in order to further reduce exposure to the shopping mall category.
With respect to macro issues, we think the main drivers of the stock market remain positive looking into 2018. The U.S. economy, which is currently strong, appears poised for another strong year of growth. Employment and consumer spending remain strong. The consumer sector represents about 70% of the economy. The corporate sector is also in a strong position relative to both earnings and cash flow. We expect another strong year of corporate earnings growth in 2018 with potential for an acceleration in capital spending, which would add additional fuel to the economy. These factors are the positive underpinnings for stock prices. Continued low to moderate inflation, transparency of central bank policies, and a synchronized global recovery are also factors that support the positive outlook for stocks.
Despite these positives, there are some concerns or risks in our outlook. First, is the risk for an acceleration in inflation. As of now, we expect inflation could rise modestly in 2018 to potentially to 2.5% from less than 2% currently. We believe if we are wrong and inflation accelerates to the area of 3% or more, this could result in several problematic events: the Fed could accelerate its pace of interest rate increases; inflation concerns among investors could result in a decline in valuations for financial assets; and both of these events could precipitate a market correction. In addition, stock valuations are elevated: at about 18.5x forward earnings, the S&P 500 valuation is now about 23% above its long-term average valuation of about 15x. We would not be surprised to see some increased volatility in stocks in 2018 but as of now, we still expect stocks can continue to rise in 2018. We continue to believe returns for bonds will be below average due to rising interest rates.
Of course the new tax bill was a major topic of discussion at our meeting. I will not go into a detailed review of the bill but suffice to say that the bill does appear to be a net positive for both the consumer and corporate sectors. Most consumers should see some net benefit from the tax bill as all tax brackets were reduced by about 10%.There will certainly be situations where individuals have a tax configuration in which they do not benefit, but we think this will prove to be a relatively small portion. From the corporate side there are several features that are particularly positive in our opinion: a 40% reduction in the tax rate, elimination of the corporate AMT, and allowance of immediate expensing of capital expenditures. Not all of this benefit will be immediate. It will take a couple of years for the tax law changes to be fully felt; but net net, the new law should release material new capital into both the stock market and the economy which should be positive for growth. The downside to the bill, of course, is the potential risk of rising federal deficits. The two most recent examples of tax rate overhauls were in the Kennedy and Reagan administrations. In both cases, the several years following the tax overhauls resulted in strong economic growth, a rising stock market, and reduced federal deficits. Time will tell if this tax overhaul results in a similar outcome.
Robert Toomey, CFA/CFPVice President, Research