CenterState Wealth Management
Investment Strategy Statement
April 2, 2018
I. Equity Markets
A. Threats of Protectionist Trade Policies Undercut Stock Prices.
- The tone and tenor in the stock market has changed dramatically since new all-time highs were recorded on January 26, placing the rally in common stocks at a crossroads. The surge in optimism and confidence springing from the most significant changes to the U.S. tax code in almost two decades has been swamped by the negative reaction to President Trump’s decision to place tariffs on steel and aluminum imports.
- This announcement was followed by a proposal to place tariffs on $60 billion of Chinese imports in response to China’s increasingly predatory trade practices and behavior, including intellectual property theft and subsidies to Chinese companies focused on overtaking U.S. rivals in product segments ranging from basic materials to advanced technologies.
- Investors fear that the Trump administration’s focus on trade restrictions aimed at reducing the nation’s trade deficit could threaten the underpinnings of the strongest world-wide economic expansion in years. The incessant personnel turnover in the Trump administration also weighed on investor sentiment last month, amidst growing concerns about the outcome of the 2018 midterm elections and the likelihood of impeachment proceedings should the Democrats gain control of Congress.
- If the tariff threats lead China to end the practice of requiring U.S. companies to transfer important technologies to Chinese firms and open Chinese markets in a broader context to U.S. produced goods, then raising the specter of tariffs would be viewed as a success, fostering a movement toward fair and reciprocal trade with our largest trade partner, which ultimately would be beneficial to U.S. growth prospects over the longer term.
- It is difficult to argue that fair and equitable trade around the globe is not in every countries’ best interests, but it is the process of getting to the outcome — done in President Trump’s own unique style — which has unnerved investors. If the threat of tariffs — a truly blunt force instrument — becomes a reality and triggers retaliatory trade wars, U.S. growth will suffer and inflationary pressures could build.
- The threats of increasingly restrictive trade policies which threaten to disrupt the global economic expansion inject new uncertainties into the outlook for common stocks at the same time that volatility has returned to the stock market after a remarkable two year period of low volatility. These threats arrive at the same time that new leadership has been put in place at the Federal Reserve and the rate hiking cycle has brought the federal funds rate roughly up to the level of inflation in the economy for the first time in over nine years.
- When common stocks corrected to the February 26 low, the catalyst was a sudden jump in longer maturity Treasury yields and fears that inflationary pressures were building, likely leading to the need for the Federal Reserve to speed up the pace of rate hikes. During the most recent downdraft, with the lows being recorded on March 23, geopolitical risks and fears of trade wars have taken center stage, becoming more of a near term risk than rising interest rates and bond yields.
- The worries over the tariffs and mounting protectionist pressures weighed on investor sentiment last month, with three of the major market measures declining -2.7% to -3.7%, although the Russell 2000 Index eked out a 1.1% gain. For 1Q 2018, only the NASDAQ Composite showed a gain at 2.3%, while the other major market indices fell -0.4% to -2.5%.
B. Aggressively Pursuing Reciprocal Trade Agreements Versus Strong Earnings.
- In last month’s ISS, we asked what were the risks associated with our view that a fundamental shift in the economic outlook had taken place over the past year or so following the confidence boost from Donald Trump’s election and the heavy dose of fiscal stimulus. The economic expansion has transitioned from below average growth with lingering disinflationary/deflationary concerns which required ultra-low interest rates and bond yields to forward looking growth more in line with the economy’s long run growth rate with disinflationary/deflationary concerns and the era of ultra-low interest rates and bond yields now in the rear view mirror.
- On the outlook for inflation, we stated that only a modest build in inflationary pressures should take place, largely due to structural influences keeping a lid on inflation. As for the response of the Federal Reserve, we expect the still low rate of inflation to keep the central bank from moving to a policy stance where it needs to tighten monetary policy in an inflationary environment. While we think it is possible yields on longer maturity Treasury securities could rise a touch further this year, we expect modest inflationary pressures and strong investor demand for fixed income to cap the rise in bond yields.
- Now, we need to add tariffs and mounting protectionist pressures to the list of risks. It is our view that the Trump administration is just beginning the process of renegotiating U.S. trade agreements across the whole spectrum of product categories and trading partners. The Administration has stated it is seeking reciprocal or equal access trade agreements which eliminate the inherent disadvantage the U.S. encounters in most trade agreements currently in place.
- It seems three overriding principles need to be kept in mind when thinking about how these trade negotiations will play out. First, no country has ever won a trade war, it is the rare confrontation where a victor has never been declared. Secondly, the U.S. market is the prize which all foreign countries wish to sell into. These realities should force negotiations to an outcome which leads to trade that is more even handed and continues to grow. Lastly, given the importance of trade in today’s global economy, we would not bet against rational people arriving at reasonable outcomes, with the goal of companies from all countries competing on a more level playing field.
- Along those lines, it is noteworthy that several of our closest allies were exempted temporarily from the steel and aluminum tariffs, leaving the brunt of the tariffs to fall on China and Russia. Additionally, there were several reports over the past week that China and the U.S. have begun behind the scenes negotiations to improve U.S. access to Chinese markets and reduce the trade deficit in response to the tariff threats. While President Trump’s bluntness can be unsettling, it is clear he believes trade threats create opportunities for serious trade negotiations.
- While we acknowledge that the markets are being forced to digest a marked rise in both political and policy uncertainty, the bottom line is that earnings have been, and should continue to be, unambiguously positive for stock prices since the earnings recovery began in 3Q 2016. Operating earnings have now advanced for six consecutive quarters and the analysts at Standard & Poor’s have revised sharply higher their earnings estimates for 2018 in light of the economy’s forward momentum and the reduction in the corporate tax rate. Current estimates are that operating earnings will grow more than 21% over the four quarters of 2018.
- With the 23.7% growth in operating earnings over the four quarters of 2017 and the modest pullback in stock prices so far in 2018, the trailing four quarter price-to-operating earnings ratio on the S&P 500 has fallen from 22.6x at year end to 21.1x at Thursday’s close, roughly its same level as on the day of the presidential election.
- We continue to view the rather swift decline in stock prices from late January to mid February and the more recent selloff since the second week of March as harbingers of more price volatility this year than in the previous 22 months. Investors are watching for a rise in inflationary pressures, assessing the risk of the Federal Reserve making a policy mistake, following the ongoing political drama that the Trump administration has brought to Washington, monitoring the nation’s political mood ahead of the mid-term elections, and hoping that the threat of tariffs is only a tactic in trade negotiations rather than a policy tool meant to shrink the nation’s trade surplus.
- There is surely no shortage of things to worry about, but we continue to expect only a modest rise in inflation and Treasury bond yields, the Federal Reserve to raise rates to a level and at a pace which the economic expansion can tolerate, and the threat of tariffs to remain a tactic rather than a policy tool. Stability, or lack thereof, in the Trump administration and the outcome of the mid-term elections are wild cards that no one can predict. Solid growth, strong earnings, and fiscal stimulus are still in place and we look for common stock prices to move higher over the remainder of the year.
C. Federal Reserve Hikes Rates and Growth Outlook.
- The Federal Reserve hiked the range for the federal funds rate 25 basis points to 1.5% to 1.75% at the March 20-21 FOMC meeting. The optimism found in the minutes of the January 30-31 FOMC meeting and in new Federal Reserve Chairman Jerome Powell’s testimony before Congress in February carried over to the policy statement, which stated that “The economic outlook has strengthened in recent months” and “labor market conditions will remain strong.” In the summary of economic projections that the FOMC releases each quarter, the 2018 real GDP forecast was raised to 2.7% from 2.5% and the 2019 forecast from 2.1% to 2.4%, however, growth is expected to cool thereafter, with the 2020 forecast holding at 2%.
- While the Federal Reserve is still looking for a total of three rate hikes during 2018, seven of the 15 members of the FOMC Committee now look for four rate hikes this year, up from four of 16 members at the December FOMC meeting. With the upgrade to the Federal Reserve’s growth forecast, three rate hikes are now predicted for 2019 compared to two in the prior set of economic projections.
- The central bank expects two more rate hikes in 2020, with the federal funds rate reaching a range of 3.25% to 3.5%, up from the previous forecast of the federal funds rate peaking at a range of 3% to 3.25% in 2020. The Federal Reserve is also looking for the unemployment rate to fall from 4.1% to 3.8% this year and to 3.6% in both 2019 and 2020.
- Despite the outlook for somewhat stronger growth and a lower unemployment rate, the FOMC Committee’s inflation outlook is little changed. The 2018 forecast remains at 1.9% for core personal consumption expenditures inflation. For 2019 and 2020, the forecast for core inflation edged only slightly higher to 2.1% from 2%. Many observers viewed the rather benign inflation outlook as somewhat surprising given that the FOMC Committee now sees unemployment running even lower over the next three years.
- While it is plausible to argue that a cyclical build in wages and inflationary pressures will accompany the expected decline in the unemployment rate, we, and it appears the Federal Reserve, look for inflationary pressures to remain muted, driven largely by structural changes — think worldwide sourcing of goods and comparative price shopping facilitated by ecommerce and the internet. The result is more muted inflationary pressures as the unemployment rate declines toward record low levels.
D. Proposed Policy Moves by the Federal Reserve Likely Too Aggressive.
- It was interesting that Jerome Powell downplayed the importance of the median forecasts which the Federal Reserve releases each quarter. In response to a question at the press conference following the FOMC meeting, he highlighted that the only decision the FOMC made at that meeting was to increase the target for the federal funds rate by 25 basis points, nothing more, nothing less. He also said the median forecasts were interesting, but not the whole story. Mr. Powell dismissed the accuracy of the rate hike forecasts in the summary of economic projections, saying the FOMC could do more or less if the outlook changes.
- We stated in the February ISS that the pickup in the economy’s forward momentum following Donald Trump’s election and the passage of the tax package and the $300 billion spending bill made it likely the economy could tolerate three rate hikes this year. While we still expect that to be the most likely outcome for 2018, the recent escalation in trade tensions and the pickup in volatility in the stock market lead us to question the ability of the economy to “tolerate” two additional rate hikes this year. To the extent lingering concerns over protectionist trade practices weigh on the economy and business and consumer confidence, the Federal Reserve will be hard pressed to raise rates more than one more time this year.
- Beyond 2018, we feel there is little ability for the economy to tolerate another five rate hikes in 2019 and 2020, which would bring the federal funds rate to a range of 3.25% to 3.5%. First, consider that the yield on the ten year Treasury note has consistently traded between 2.74% and 2.94% since mid-February, which seems inconsistent with a doubling of the federal funds rate by the end of 2020.
- Secondly, remember that last summer chair Janet Yellen and Govenor Lael Brainard indicated that with the low level of inflation — which had been reported at 1.4% year-onyear for the core personal consumption deflation at the time of their remarks — the central bank was near its effective “neutral rate” at which monetary policy was neither stimulating nor restraining the economy. Brainard stated that the real neutral rate — the federal funds rate minus inflation — was thought to be near zero.
- With the most recent reading on the core personal consumption deflator at 1.6%, the new 1.5% to 1.75% range for the federal funds rate puts in place a real neutral rate of roughly zero. With two more rate hikes this year, the real neutral rate would turn slightly positive, or could remain at zero if core inflation rises to the Federal Reserve’s 2% target. Assuming the core inflation rate does not rise much above 2%, five additional rate hikes in 2019 and 2020 would nudge monetary policy solidly on the side of restraining the economy’s forward
- Since the summer of 2015, before the Federal Reserve began raising interest rates, we have monitored the yield spread between two-year and ten-year Treasury notes as an indicator of whether the Treasury market viewed the pace of rate hikes by the Federal Reserve as too slow or deliberate — which could lead to a build in inflationary pressures and cause a widening in the yield spread — or too aggressive — which could lead to a slowdown in the economy and cause a narrowing of the yield spread.
- The yield spread dropped to 53 basis points at the end of 2017 after the Federal Reserve hiked rates three times last year from 122 basis points and 125 basis points at the end of 2015 and 2016, respectively. Following the most recent rate hike last month, representing the sixth hike in total, the yield spread has fallen to 47 basis points, its lowest level since late 2007. We believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake, particularly in light of the emergence of threats of protectionist trade policies and the marked rise in stock market volatility.
- As we have stated many times since the Federal Reserve started raising interest rates in December 2015, rate hike decisions over the next couple years will be a dynamic process requiring a great deal of judgment by the Federal Reserve as to what level of short-term interest rates the economic expansion can tolerate and whether policy needs to shift from becoming less accommodative to an outright tightening posture. The economy’s inflation rate will determine how high the federal funds rate can rise without stalling the economy, unless that becomes a goal of the Federal Reserve to contain building inflationary pressures. As always, stay tuned!
II. Treasury Market
A. Longer Dated Treasury Yields Fall.
- After rising for six consecutive months, yields at the longer end of the Treasury yield curve fell last month, with the yield on the ten-year Treasury note ending March at 2.74% compared to 2.86% at the end of February. This represents a fairly healthy decline from the 2.94% high close for the yield on the ten-year Treasury note during February, as the inflation scare from early February continues to fade.
- The one-two punch of escalating trade tensions and personnel turnover at the White House, combined with renewed selling pressure in the stock market, contributed to solid demand for Treasury securities last month. Investors typically respond to policy, political, and economic uncertainty by lightening up on stock positions and adding to Treasury positions, and last month was no exception to those long held tendencies.
- The forces placing upward pressure on longer dated Treasury yields are still in place, they are just taking a back seat to the uncertainty that investors are facing currently. The forward momentum in the economy is still expected to ramp a bit during 2018 following the late cycle fiscal stimulus which has been passed into law since late December, a modest build in wage and inflation pressures is expected to take place over the next 24 months, the Federal government is on the verge of issuing its biggest wave of new debt obligations since the
financial crisis to finance tax cuts and a sharp increase in spending, and the Federal Reserve is still in the early stages of shrinking the size of its investment portfolio.
B. In the Near Term, Little Upward Pressure Expected on Longer Dated Treasury Yields.
- As the yield on the ten-year Treasury note has risen from 1.74% on the day of the presidential election to 2.74% at the end of March, both the real, or TIP, yield and the implied inflation expectation embodied in the nominal ten-year Treasury yield have risen, as shown in the table below. While the Federal Reserve kicking off its effort to shrink its investment portfolio during 4Q 2017 likely had some impact on the ten-year Treasury yield, we think the majority of the rise in the real yield and the inflation premium has been caused by the fundamental change in the economic outlook following the boost in consumer and business confidence since the presidential election and the late cycle fiscal stimulus measures passed by Congress since late December.
- Also notice that following the presidential election, the implied inflation expectation moved fairly consistently toward 2%, the Federal Reserve’s inflation target. The rise in the inflation outlook at the end of 2016 was fueled by the anticipation of a tax package and the actual passage of the tax package kept inflation expectations close to the 2% level as 2017 drew to a close.
- Now, as investors assess the impact on the economy from the tax package and the federal spending bill, inflation expectations have moved slightly above 2% as of the end of February and March. While not looking for a significant move higher in inflation this year, we expect some modest upward pressure which should take the current 1.6% year-over-year rise in the core personal consumption expenditures index closer to 2% over the next 24 months.
- We stated in the January ISS that given our view that a fundamental change in the outlook for the economy had taken place, we expected the ten-year Treasury yield to take a run at 3%. That is still our position, but we think the yield on the ten-year Treasury will not take a run at 3% for some time, and would not be surprised if the 2.94% high yield on the ten-year Treasury note recorded on February 21 is not challenged for some time.
- There are three primary reasons behind our view. First, the 1Q 2018 real GDP data — to be released on April 27 — is likely to show the economy growing at a pace of 2% or slightly lower. Slower consumer spending, following the decline in the personal savings rate to only 2.7% in 4Q 2017, and a pullback in residential construction outlays following the hurricane related surge in 4Q 2017, are likely to have held back the economy’s growth rate last quarter.
- Secondly, ongoing concerns over the recent escalation of trade tensions and threats of tariffs which could develop into a full-blown global trade war, combined with the pickup in volatility in stock prices, should maintain a strong bid for Treasury securities in the near term. Third is the forecast by the Federal Reserve of two more rate hikes this year, and five more in 2019 and 2020, which would move the central bank to a restrictive policy stance. Based on this view, we are looking for a slightly lower trading range of 2.5% to 3% for the yield on the ten-year Treasury note over the next couple months.
- If the economy builds momentum over the course of the year on the back of the fiscal stimulus, with the threat of tariffs turning out to be a tactic in trade negotiations rather than a policy tool, investors’ risk appetite should return, pushing both stock prices and longer dated Treasury yields higher. Until that happens, however, a 3% level for the yield on the ten-year Treasury looks like a stretch.
Joseph T. Keating
Chief Investment Officer
The opinions and ideas expressed in the commentary are those of the individual making them and not necessarily those of CenterState Bank, N.A. The statistical information contained herein is obtained from sources deemed reliable, but the accuracy of such information cannot be guaranteed. Past performance is not predictive of future results.
CenterState Bank, N.A. offers Investments through NBC Securities, Inc. (NBCS”). NBCS is a broker/dealer and a member FINRA and SIPC. Investment products offered through NBCS (1) are not FDIC insured, (2) are not obligations of or guaranteed by any bank, and (3) involve investment risk and could result in the possible loss of principal.