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The Weekly Economic & Market Recap

The Weekly Economic & Market Recap

July 14, 2017

Earnings reports for the second quarter are just beginning. It is broadly expected that earnings momentum in the second quarter will continue after a very strong first quarter of greater than 10% earnings growth. According to Zacks Investment Research, total 2Q earnings are expected to be up 5.6% versus a year ago on 4.6% revenue growth. Analysts expect earnings in energy and industrial sectors to be especially strong as they continue to recover. Technology companies should continue to post strong relative earnings as well. Given the competitive disruption caused by internet retailing and a weakening in automotive sales, earnings in the consumer discretionary sector will probably show some deterioration. Speaking broadly, domestic growth is sufficiently strong to allow for modest earnings expansion for the domestic equity market. We would not expect significant multiple expansion in a moderately rising rate environment, so solid earnings growth is extremely important to drive the equity market higher.

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July 7, 2017

Investors had the opportunity to review and digest minutes from the last Federal Reserve Open Market Committee meeting in June. Coincidentally, the European Central Bank released their minutes as well this week. The impression we were left with, both from reading the minutes and from recent comments by global central bankers, is that central bankers are becoming increasingly focused on balance sheet and rate normalization. There appears to be a shift in the mindset. The Fed has already raised rates 3 times in the past 7 months, and despite weaker than expected economic growth and eroding domestic inflation forecasts, the Fed clearly seems committed to continuing the process of normalization. The Fed believes the economic softness is transitory. They received some evidence to support this view with a relatively strong employment report on Friday. The change in sentiment regarding additional accommodation from central bankers will be a headwind to both the bond and equity markets.

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June 30, 2017

Equity and fixed income investors were both treated to favorable markets in the first half of 2017. Positive earnings surprises in the first quarter and accommodative global central banks have been the key drivers of solid returns this year. Financial markets have been accustomed to central banks providing liquidity whenever economic conditions soften or risk concerns creep into investor’s psychology. The second half of the year is likely to be more difficult as central banks are becoming less of a supportive factor. Recent rhetoric from the Bank of England, Bank of Canada, and even the ECB is suggesting a shifting attitude toward tightening. Perhaps, the central banks are finally getting concerned with potential asset inflation as reflationary forces take hold. Regardless of the reason, it is likely to be an additional challenge for both the bond and equity markets.

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June 23, 2017

Dominating the financial news this week was the Federal Reserve’s decision to raise its target on the Fed Funds rate by one quarter of a point to between 1 and 1.25 percent. The Fed also gave specifics regarding its plan to reduce the $4.3 trillion balance sheet. Notably, the yield curve continued to flatten. Over the last three months, the Treasury 2-to-10 year spread has contracted 40 basis points (bps) to 83 bps. The Fed’s three rate increases over the last six months and anticipated future rate hikes have lifted the short end of the yield curve. Declining inflation expectations and a weaker first half domestic economic environment have caused yields for longer maturities to decline. The 2-to-10 year spread that we monitor closely is a predictor of economic health. It would be disconcerting to see this indicator continue to decline, especially with implied 5-year inflation expectations at 1.50%. Indicators that have been reliable in the past may have less predictive value in the future due to the market distortion caused by global central banks.

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June 16, 2017

Dominating the financial news this week was the Federal Reserve’s decision to raise its target on the Fed Funds rate by one quarter of a point to between 1 and 1.25 percent. The Fed also gave specifics regarding its plan to reduce the $4.3 trillion balance sheet. Notably, the yield curve continued to flatten. Over the last three months, the Treasury 2-to-10 year spread has contracted 40 basis points (bps) to 83 bps. The Fed’s three rate increases over the last six months and anticipated future rate hikes have lifted the short end of the yield curve. Declining inflation expectations and a weaker first half domestic economic environment have caused yields for longer maturities to decline. The 2-to-10 year spread that we monitor closely is a predictor of economic health. It would be disconcerting to see this indicator continue to decline, especially with implied 5-year inflation expectations at 1.50%. Indicators that have been reliable in the past may have less predictive value in the future due to the market distortion caused by global central banks.

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June 9, 2017

The equity market has been a very pleasant surprise for most investors this year. Few market pundits expected the market to be as strong as it has been in the first half of 2017. There is clearly an element of disbeliefon the part of some investors. That is partially related to the divergence within the market. Investors with a value orientation have not experienced the same ebullient market as have investors that concentrate on growth opportunities. Through May, the Russell 1000 Value index is up only 1.9% versus the Russell 1000 Growth index which has rallied 13.6%. That is a striking divergence. The difference is largely related to the strength of five large technology stocks (Facebook, Apple, Amazon, Microsoft and Alphabet). Collectively, these five stocks haveaccounted for an astounding one-third of the gain for the S&P 500 (YTD). Return clustering in a handful of names has occurred four other times in the last 20 years. We would be more comfortable to see a broader-based market advance.

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June 2, 2017

The release of the Non-Farm Payroll report was rather disappointing relative to expectations, with only 138,000 jobs created in the month of May. This number was significantly below ADP’s 253,000 projection and a consensus estimate of 185,000. In addition, the results for the prior two months were cut by a total of 66,000 jobs. The unemployment rate fell from 4.40% to 4.29% but the participation rate also declined to 62.7%. Average hourly earnings grew by .2% which met expectations but a revision to April’s data kept the year over rate of increase at 2.5% below the expected 2.6%. Upon the Bureau of Labor Statistics release, the dollar sold off and Treasury yields rallied with further curve flattening. Overall, we feel May’s employment numbers were strong enough to keep the Fed’s anticipated June rate hike on track but additional sub-par economic results could cloud the picture for the rest of this year. Several Fed officials commented this week that the Fed tightening cycle will accelerate. We will be closely listening to the commentary after the next Fed meeting to see if there is any moderation in their rate views, after the weaker job report.

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May 26, 2017

It was interesting timing that the Organization of the Petroleum Exporting Countries met in Vienna to discuss extending production cuts immediately after President Trump’s successful visit to Saudi Arabia given his outspoken desire to drive U.S. energy independence. OPEC’s efforts to moderate production, assuming members have the discipline to adhere to the cuts, have the potential to do little more than modestly impact the oil inventory cycle. OPEC’s real problems are secular.

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May 19, 2017

Volatility picked up dramatically this week as the financial markets reacted to the turmoil in Washington. Allegedly, President Trump asked FBI Director James Comey to drop a probe of his former national security advisor. That revelation ultimately prompted the Justice Department to appoint a special prosecutor to review the matter. President Trump is losing control of the political agenda as he becomes mired in political infighting with both Democrats and establishment Republicans. Given the dysfunction in Washington and the poisonous atmosphere, it appears that tax reform and fiscal stimulus could be sidelined for the time being. The financial markets have been expecting, and perhaps to some extent pricing in, a lift to earnings from tax reform. Tax reform, if done correctly, has the promise of changing the trajectory of economic growth by driving incremental capital formation and indirectly fostering innovation.

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May 12, 2017

Markets have been able to shrug off news and events that in the recent past would have rattled market participants. The dysfunction and contention in Washington had minimal negative impact on the equity markets. More significantly, it was not too long ago, investors worried that Federal policy would be too constrictive and would damage the economic recovery. This week, Kansas City President Esther George said not only should the Fed continue to raise rates gradually, but it should begin to shrink the balance sheet later this year. Both fixed income and equity markets largely ignored her comments. It seems that investors are increasingly tuning out the Fed, even as the Fed is actively withdrawing accommodation from the financial system. The market’s complacency is clearly related to the very strong first quarter earnings. With over 90% of companies in the S&P 500 having reported first quarter earnings, year-over-year earnings are up over 15%, and 74% of companies exceeded earnings expectations. The insensitivity of financial markets to central bank policy is somewhat disconcerting.

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May 5, 2017

The domestic equity markets have been trading in a relatively flat and tight trading range since the third week of February. The listless trading pattern has evolved as the expectation of an economic regime shift, due to new political leadership, has confronted the difficulty of enacting real change. This week the House Financial Services Committee voted along party lines to submit the Financial Choice Act to the full House. The bill would rollback significant elements of the Dodd-Frank law. The banking and financial services industries strongly support lifting some of the burdensome restrictions of the Dodd-Frank law. The Financial Choice Act should easily pass out of the House, but Senate approval seems problematic. This is one example of the plodding efforts under way in Washington. Many asset classes have embedded in their valuations the expectations of significant reduction in regulation and tax reform. Given the political climate, the timing and magnitude of implementation remain highly uncertain. In the meantime, we sense some market complacency creeping into investor psychology regarding international economies, especially in regard to China. If financial market volatility picks up in China as Chinese officials begin to address high debt levels and risks to their banking system, investor attention could quickly shift away from Washington.

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April 28, 2017

It is not unusual for a barrage of headline news to grab the attention of equity investors. In the past few months, concerns about future Fed rate hikes, geopolitical tensions in Syria/North Korea, French elections and the Trump agenda have had an impact on investor sentiment. This is a legitimate reaction as any one of these events could have significant economic implications. What seems to have been under-reported, however, are more fundamental factors that dictate the valuation of individual companies and the market as a whole. Currently, about 287 companies have reported their 1st Quarter results. Earnings for the group are up 15.6% with revenues advancing by 7.9% over the same period last year. Approximately 80% of the reports have beaten analyst expectations and 65% have exceeded top-line expectations. Factoring in the estimates for the companies yet to report, S&P 500 earnings growth for the quarter could be 9.7% with revenues 5.9% higher than last year. Importantly, these results are broad based with multiple sectors contributing to the uptrend. Also, this is not a one quarter phenomenon as the trajectory began in last year’s 3rd Quarter and could continue over the balance of 2017. Obviously, it is necessary to incorporate both internal and external factors in any investment evaluation.

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April 21, 2017

First quarter GDP expectations continue to drift lower as economic releases indicate the U.S. economy softened at the beginning of the year. The Atlanta Fed has an econometric model they update as economic statistics are released. That model suggests the economy grew a negligible 0.45% in the first quarter. There are also a number of indexes we track that examine economic surprises and have some predictive value for future economic releases. These surprise indexes point toward continuing weakness into the current quarter. Despite the tepid beginning to 2017, the Fed appears to be committed to at least two more rate hikes this year. Fed officials speaking at public events have been consistent and firm in their intention to raise rates. It would be difficult for them to reverse course without eroding credibility. Investors remain skeptical as “Fed funds” futures suggest that there is only one more increase likely in 2017. The Fed has a history of not delivering on rate hikes due to economic weakness and financial market instability. We expect them to deliver on at least another hike given the recent resilience of the financial markets and better economic strength in Europe. In the meantime, the markets will be focused on the French election this weekend that could spark some near-term volatility.

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April 14, 2017

Tax season comes mercifully to an end on Monday. Through last week, tax receipts are running ahead by 5.5% as compared to last year. The growth rate of tax receipts in 2016 was 3.0%. Tax receipts are tightly correlated with the growth rate of nominal income and that has been growing at a 4% annualized rate since the last recession. Nominal income is largely driven by employment, wages and hours worked. Strong tax receipts are indicative of a healthy employment situation. Despite the generally positive jobs environment, we have noted an increase in the number of consumer defaults. Subprime auto loan defaults have risen dramatically and there is some evidence that default rates are edging higher in other consumer loans. During the middle-to-late portion of the business cycle the relationship between consumer spending and delinquencies is tenuous. Our concern would be heightened with the emergence of credit tightening. Currently, available credit is not an issue, but it bears watching since consumer spending is such a large component of the economy.

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April 7, 2017

Despite a bevy of interesting and meaningful news items this week, financial markets were generally quiet. Equities drifted slightly lower with some volatility around the release of the minutes from the Federal Reserve’s March meeting. Insight into the current thinking of Fed officials was arguably the most significant news event. FOMC minutes indicated that a number of Fed officials believe the process of normalizing the Fed’s $4.5 trillion balance sheet should begin later this year. After the financial crisis the Fed aggressively purchased MBS and Treasuries to provide support for the recovery, causing their balance sheet to dramatically expand. Whenever they do begin unwinding the unusual stimulus, the Fed will likely take up to five years to reduce the balance sheet down to a level they feel is optimal. An elongated approach will minimize the impact on the long end of the yield curve. As global growth trends slightly higher, the Fed should have room to continue to gradually increase rates at the short end of the curve. Given the overall tepid economic growth and the approach we anticipate the Fed will pursue, we expect the yield curve to moderately flatten as the year progresses.

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March 31, 2017

Although returns were unevenly distributed, global equity markets generally had a robust first quarter. The fixed income markets offered modestly positive returns as well. Looking ahead to the second quarter, clearly political uncertainty has risen in both Europe and the United States since the beginning of the year. The political environment in Europe is clouded due to concern over election outcomes and the long, slow breakup of the European Union and the United Kingdom. Despite these concerns, latest investment flows out of domestic equities into European equities has been quite strong. The macro economic news has been steadily improving in Europe and the general perception is that European equities are undervalued compared to U.S. equities. European equities outperformed U.S. equity markets by slightly less than 300 basis points in March. With a more hawkish Federal Reserve and an uncertain hand-off from monetary and fiscal policies domestically, we would expect more capital flows into European equities assuming the French election resolves itself favorably.

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March 24, 2017

The financial markets have been keenly focused on the progress of the Obamacare replacement bill constructed by Speaker Paul Ryan, and championed by President Trump, that has struggled to find enough support to pass a predominantly Republican House. The difficulty that the Republicans have had on repealing and replacing Obamacare has made many observers question their ability to accomplish tax reform in a reasonable timeframe. While this has the potential to have meaningful short-term market implications, we are also watching China’s reaction to last week’s Fed rate hike. Rate increases by the Federal Reserve put pressure on China to also increase rates to support the yuan. The yuan has been eroding against the dollar since the middle of 2014. The Chinese have spent roughly 1 trillion dollars in foreign reserves in an attempt to support the yuan. Additionally, as China cuts back on infrastructure spending in an effort to transition toward a more consumer-led economy, it is counting on the private sector to ameliorate the economic slowdown. Rising rates would be an impediment to private sector growth. Although the Chinese have raised some secondary rates after the Fed hike, they have left the benchmark 1-year lending rate unchanged. We think China’s reaction to rising short rates in the U.S. has very important implications for financial markets.

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March 17, 2017

Monetary policy was in the headlines this week with the FOMC announcing a 25 basis point (bp) rate increase in the Fed funds rate on Wednesday afternoon. Markets had accurately priced in the 25 bp increase, but were surprised by the lack of a hawkish tone. The FOMC reiterated their guidance of two more 25 bp rate hikes in 2017 even though headline inflation has moved close to the Fed’s target. The Fed pays considerable attention to core Personal Consumption Expenditures (PCE) and according to their numbers, core PCE was little changed since they last met and is still running slightly below their two percent target. The FOMC predicts that GDP will grow by 2.1% in 2017 and if global economic conditions continue to strengthen, volatility remains low and core inflation does not increase much, we believe the Fed funds rate should end the year up an additional 50 bps.

The rise in populism took a pause with the Dutch voters not showing much support for Geert Wilders and the Freedom Party. With the Netherlands being one of the EU’s six founding members, the election showed the EU still has unity at its core. That unity will be tested in April and May when France goes to the polls and again in September with the German elections. However, we feel that the French and German voters will follow the Netherland’s lead and populism should remain contained in both countries.

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March 10, 2017

Market participants are looking for the Fed to hike the Fed Funds rate at their March 15th meeting. According to the Reuters poll of more than 100 economists, the economic data is strong enough to support this rate hike. The Bloomberg implied probability of a rate hike next week is now at 100% after a number of hawkish comments last week. If the Fed is able to orchestrate three rate hikes this year at 25 basis points each, the Fed Funds target rate would be 1.25%-1.50% by year-end. The commentary from the meeting and the update to the Fed’s economic forecast will be closely watched and compared to what was released at December’s meeting. Mario Draghi announced on Thursday that the European Central Bank is maintaining its benchmark rate and will continue with the monthly asset purchase program at a reduced level. The tone was more positive on the Eurozone economy and gave a lift to the European banking sector. The rise in U. S. interest rates and change in policy is a break from the coordinated global stimulus since the 2008 financial crisis. The Fed will be closely watching and balancing interest rate normalization with economic growth and financial stability. We expect that there will be increasing volatility in both the fixed income and equity markets as the Fed embarks on this new course.

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March 3, 2017

Once again, the market’s focus has been drawn back to watching the Federal Reserve. Since the election the equity markets have rallied on expectations of fiscal stimulus, and the underlying fundamentals for both the economy and earnings have modestly improved. Market participants, despite the Fed rate increase in December, have been heavily focused on the Trump Administration and less on the Fed. This week, Multiple Federal Reserve officials have signaled in speeches that the Fed will be raising rates at their March meeting. A March increase opens the door to perhaps as many as three increases in 2017. Is the Fed feeling pressure to raise rates? Using CPI as the inflation gauge, the real yield on the 10-year Treasury bond is currently barely positive. The effective Fed funds rate is 0.63% and with inflation north of 2.0%, real rates are negative at the short end of the curve and have been for a long time. These low rates have driven equity valuations, as future equity cash flows are being discounted back at very low discount rates. Given today’s low rate structure, the next few rate increases will not materially impact valuations. At some point, it will matter to the markets and they will be very focused on the Fed.

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February 24, 2017

We are all aware that the U.S. Equity markets have been on fire with the S&P 500 increasing by 5.25% year to date. Less apparent is the fact that the 10-Year Treasury has also advanced in value with its yield declining from 2.45% to 2.31% over the same period. This is somewhat unusual as these two asset classes tend to be negatively correlated. We think the current relationship may be routed in a difference in the timing of current market expectations. Since last November’s presidential election, stock investors have been focused on the prospects of a dramatic increase in GDP and corporate earnings growth resulting from fiscal spending policies, tax reform and the relaxation of various business regulations. The bond market is not totally discounting these potential growth catalysts as rates overall have risen since Trump was elected President, although signaling it may take longer than expected to become reality. This week, Treasury Secretary Mnuchin acknowledged that his goal for significant tax reform by August was ambitious. Furthermore, Arios Media cited Republican sources saying infrastructure could fall into 2018 because of prioritization of healthcare changes, immigration policies and regulatory reform.

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February 17, 2017

Corporate share buybacks have been an important component to equity market performance over the last five years. Since 2011, companies in the S&P 500 have repurchased more than $2.7 trillion of their own stock. During that same time period, both individual and institutional investors have been net sellers. The share repurchase programs, in many cases, have used borrowed money for the repurchases. The end result is a modestly higher per share earnings at the cost of a risky capital structure. Operational performance, as measured by aggregate operating earnings, has not been good over the last five years; operating earnings on an annualized basis are only marginally higher. At current equity valuations, it is harder for corporate boards to justify continuing to purchase stock. Back in 2011, the S&P 500 was trading around 1100 and was trading at a price-to-earnings multiple of roughly 13x trailing earnings. Today, the S&P 500 is trading at 2,340 with a trailing P/E of 23.9. Over the next few weeks, we expect to hear some details emerging regarding tax reform. We would hope to see an investment tax credit to incentivize companies to invest capital in their businesses rather than using excess cash flow to repurchase shares. In the long run, by making investments that enhance their productivity, companies will be strengthening their growth potential – which is a far more productive use of capital.

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February 10, 2017

The current financial market environment is fraught with uncertainty and seems to be overly responsive to marginal news. Many asset classes have been oscillating due to poor visibility for their potential outcomes. Emerging markets clearly have been subject to this volatility. The EM asset class sold off post election largely as interest rates adjusted higher on expectations of U.S. fiscal stimulus. As rates have stabilized, emerging markets have reversed and are approaching pre-election levels. Emerging market equities rose 11.2% last year, but remain inexpensive after a multi-year bear market. With confidence for improved global growth, especially with respect to the United States, it seems logical that emerging market equities should tangentially benefit. We believe investors should opportunistically add to emerging market equities on weakness. Exogenous risks, such as rising protectionism and Chinese structural changes, remain a concern that could cause corrections in this asset class. Overall, we see value in emerging market equities, and adding exposure will allow portfolios to become more diversified.

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February 3, 2017

Equity markets in developed countries have moved sideways since the second week in December. Despite a noisy and contentious start of the Trump presidency, implied volatility of equity indexes fell to very low levels. Does this calm indifference by the financial markets indicate too much complacency on the part of investors? We think muted market action perhaps reflects current valuations and a dearth of concrete proposals that will have a meaningful impact on the macro environment. The caustic relationship developing between President Trump and the Democrats in Congress could potentially damage or delay the chances of a major fiscal stimulus program. With the domestic economy already exhibiting some acceleration off a tepid level of growth, a delay in fiscal stimulus could negatively impact business confidence. An element in Mr. Trump’s control however is regulation. On Friday, at a White House meeting with corporate leaders, Mr. Trump promised major reductions in financial regulations. The Dodd-Frank and the creation of the Consumer Financial Protection Bureau have been often cited by opponents as government overreach. Lowering financial regulation should allow capital to flow more freely and increase economic activity.

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January 27, 2017

The U.S. Bureau of Economic Analysis released GDP statistics for the fourth quarter of 2016 on Friday. GDP growth was modestly below expectations growing at an annualized rate of 1.9 percent despite solid consumer and investment spending. The disappointment stemmed from a 4.3 percent annualized decline in exports that reversed a 10 percent increase in the third quarter. Net exports is a relatively small contributor to the overall domestic economy, but the GDP release does highlight the importance of the trade environment. Obviously, the global trade system is complex with many influences. Generally, goods should be produced to provide the product at the lowest possible cost. It raises everyone’s standard of living. The Trump administration’s desire to forge mutually beneficial bilateral trade agreements would be very helpful in constructing a healthy trade environment. Punitive border-adjusted tax levies have the potential to be incendiary and could lead to retaliatory trade action. The result of a trade war would be higher-priced products for everyone and a lower standard of living. The real driver of secular growth would be a more competitive corporate (and personal) tax structure. It will be a much more demanding lift given the various fractions in Washington and the current animosity. We would prefer the new administration to focus their efforts on tax reform.

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January 20, 2017

As the new Trump Administration grabs hold of the levers of power in Washington, financial markets wait for clarity regarding economic and regulatory policy to emerge. For over a month many financial pundits, us included, have tried to assess the potential global impact of the various proposals that have been suggested. We would expect the process of sweeping overhauls to the U.S. tax code and broad and invasive laws, such as the Affordable Care Act, to be messy. Given the toxic and contentious tone in Washington, we expect it will take awhile for Congress and the Administration to converge on workable legislation. Investors should expect heightened headline risk and potentially greater volatility in the months ahead. Trade policy is an area where we could see relatively quick action. New trade agreements require congressional approval, but modifying or undoing existing commitments does not. We still have few details on Mr. Trump’s intentions regarding specific trade policy, but would expect him to renegotiate components of NAFTA (rules of origin) and undo the Trans-Pacific Partnership almost immediately.

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January 13, 2017

Aspects of the Trump rally seem to be unravelling to some degree. The dollar has been very strong since the election. The U.S. Dollar Index (DYX) rallied from 97 in early November to over 103 in early January, but weakened to around 101 this week. Dollar selling was more pronounced after Presidential-elect Donald Trump’s press conference on Tuesday. To a large measure, the financial market’s post-election reaction has been predicated on the expectation of tax reform and infrastructure spending. Mr. Trump’s first press conference since being elected president focused on Russia and “fake news”, as opposed to the anticipated economic and tax policy changes. Another sign of reversal has been in the Treasury market. After a selloff that took the 10-year Treasury to a 2.65% yield, Treasuries reversed and the 10-year settled at 2.40% as the week closed. The equity market sectors and industries that have been strong post election have begun to see some consolidation (such as banks). It would not be surprising to see a broader price adjustment as the new administration takes office and confronts the hard work ahead. Often expectations get ahead of reality and financial markets are susceptible to this human behavior.

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January 6, 2017

Expect Tax Reform in 2017

Tax reform has been a frequent topic of discussion in Washington over the last decade. Many members of Congress, both Republicans and Democrats, recognize that the U.S. current corporate tax code places domestic corporations at a competitive disadvantage globally. The combined U.S. federal and state corporate tax rate is over 39% versus roughly a 25% average for other developed nations. Both the Bush (Economic Growth and Tax Relief Reconciliation Act of 2001) and Clinton (Taxpayer Relief Act of 1997) tax cuts were proposed, went through Congressional committee, and were signed into law by summer. Both of these laws were also passed by the controversial budget reconciliation that requires only a 50% majority approval. Given the Republican control of both the Senate and the House, we expect to see a sweeping tax law approved by August. We expect a meaningful reduction in the corporate tax rate (very good for earnings) and perhaps a provision allowing for the immediate expensing of capital equipment (very beneficial for technology companies). The Trump Administration may attempt to affect trade policy through the tax code by creating different levels of deductibility depending on the location of production inputs. This would be very contentious and would delay the process.

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