INVESTMENT STRATEGY STATEMENT
April 3, 2017
I. Equity Markets
A. Failure of Health Care Bill Pushes Stocks A Touch Lower.
- The S&P 500 declined a modest -2.3% from March 1 to March 27 as skepticism grew over whether or not the White House will be able to push through promised fiscal stimulus and tax cuts and reform in the coming months. Investor sentiment soared following the presidential election on hopes that President Trump’s pro-growth economic agenda would jumpstart the economy’s growth rate and corporate earnings. However, Republicans in the House of Representatives stumbled in their first major attempt to reshape the federal government under the Trump administration, as their long promised health care bill was pulled from the House floor just minutes before a planned vote.
- The collapse of the measure to repeal and replace the Affordable Care Act occurred when Mr. Trump and House Speaker Paul Ryan were unable to pull a group of the House of Representative’s most conservative members over the goal line to support the measure. This failure drew into question the rest of the Republican legislative agenda. This division between conservatives and centrists within the Republican party may now haunt President Trump’s next priority, overhauling the U.S. tax code. While the Republican party views a major tax bill as safer political ground, investors are concerned that they might be heading right into another political minefield.
- A chorus of Republicans have stated that redesigning the tax code should be much simpler than revamping the entire health care industry. The Republican party prides itself on ideological unity in favor of lower tax rates and a less complex tax code, issues which are much less controversial than access to health care, which touches on matters of life and death.
- However, digging a little deeper and following the intraparty fight over the health care legislation, investors are fearful that a full overhaul of the tax code is fraught with potential squabbles and difficult trade-offs. The party’s failure on health care demonstrates how difficult it is for Republicans to author complex legislation which attracts support from both their moderate and conservative wings.
- The proposed legislation must balance competing interests to cut tax rates sharply, yet slow the rise of the national debt. It will need to reconcile Mr. Trump’s priority for middle class tax cuts for individuals with the House’s proposal which is focused on promoting economic growth, even if that leads to tax cuts that favor the very top of the income scale.
- The largest hurdle could be the House’s plan for a border adjustment tax — taxing imports and exempting exports from taxation. The Trump administration has been somewhat ambivalent and sometimes critical of the idea, while Senate Republicans appear to be opposed to it. House Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady have taken the position that the border adjustment is a crucial part of the legislation as it provides about $1 trillion of additional tax revenue over ten years to offset corporate tax rate cuts and it discourages companies from shifting production and tax status abroad.
- The one tax proposal which appears to have support across the Republican party, as well as some support among Democrats, is a one-time, low repatriation tax rate on corporate earnings held overseas by U.S corporations. The more than $2 trillion in earnings trapped overseas will provide a one-time tax windfall and drive jobs growth, business capital spending, dividends, share repurchases, and debt repayment when brought home. These are all good outcomes and will boost the economy’s growth rate. We look for this proposal to pass this year.
- Investors also had to come to grips with the Federal Reserve raising interest rates last month, with expectations rising that the central bank could raise interest rates a total of three times this year. The risk for investors is that a policy timing mismatch occurs. Federal Reserve Chair Janet Yellen is moving the ball down the court while President Trump and the Congressional Republicans have not yet put the ball in play.
- The stock market rally reached its eight year anniversary on March 9, with the S&P 500 and the DJIA advancing 250% and 219%, respectively, to the anniversary date. For the full month of March, the major market measures turned in a mixed bag of results after the unraveling of the health care bill called into question how easily President Trump’s economic agenda will become law.
- The S&P 500 was basically unchanged during March and the NASDAQ Composite gained 1.5%. The DJIA and the Russel 2000 fell a modest -0.7% and -0.1%, respectively. Since the presidential election on November 8, common stock prices are still higher by a strong 10.4% to 16.0% as investors continue to focus on the pro-business and pro-growth agenda and mindset that President Trump brings to Washington.
B. Confidence in the Economy Leads Federal Reserve to Raise Interest Rates.
- The Federal Reserve raised interest rates another quarter point to 0.75% – 1.0% at the March 14-15 FOMC meeting. Chair Janet Yellen summed up the reason for the increase in the news conference following the policy meeting by stating “The simple message is the economy is doing well.” She added that “we have confidence in the robustness of the economy and its resilience to shocks.”
- The Federal Reserve offered another reason for the rate hike decision in its policy statement which said inflation in recent quarters was “moving close” to its 2% target after undershooting that level for years. The central bank also said the inflation target remains a “symmetric” goal, meaning that the inflation rate will run above and below the 2% target at times, implying that it would not surprise the FOMC committee members if inflation moved above 2% later this year or into 2018. Ms. Yellen stated that the term “symmetric” was “a reminder 2% is not a ceiling on inflation, it is a target.”
- Janet Yellen was careful to note that the Federal Reserve had not significantly changed its forecasts for economic growth, unemployment, or inflation, but it expected gradual continued improvement in the economy. The Federal Reserve maintained its forecast of three quarter point increases in the range for the federal funds rate this year, including the one announced last month. The committee members also forecast three rate hikes in 2018, with the federal funds rate reaching its long run goal of 3% in 2019.
C. Solid Economic Backdrop and Getting Ahead of European Union Uncertainty.
- In our view, the move to raise rates last month without increasing its projected path for interest rates shows the central bank taking advantage of favorable economic and financial market conditions as opposed to an initial step toward a faster pace of rate increases. We also continue to believe that the Federal Reserve wanted to get a rate hike out of the way before the presidential election in France this spring that has raised the possibility of France withdrawing from the European Union and the euro.
- Far-right presidential candidate, Marine Le Pen, is widely expected to make it to the second round of voting in France this May. Le pen has said she would pull France, one of the European Union’s founding nations, out of the European Union and the euro. She wants to allow the French central bank to finance government deficits, currently prohibited by European Union policy, and also wants to negotiate the return of the French franc. That could mean redenominating France’s government debt, which in the view of the rating agencies could effectively trigger a default.
- The appeal of Le Pen’s policies has captured the imagination of many voters in France. If the transitional costs could be minimized — a big “if” — a return to the franc could be a boom to France. Since the euro’s introduction in 1999, Germany has benefitted from a euro that is too weak for the German economy and France — along with several other EU members – has suffered from a euro that is too strong for the French economy.
- Returning to the franc would permit a currency devaluation large enough to wipe out this currency disadvantage. Along with ramped up deficit spending, France could be looking at a significant pickup in economic activity. However, traversing the transition — including a potential capital flight from the weak franc to stronger currencies and the risk of default on French sovereign debt — would likely be an unnerving event for the global financial markets.
- Recall that at the start of last year, the Federal Reserve projected the economy would strengthen enough to allow four quarter point increases during 2016. Growth slowed early in the year amid market volatility in China, a collapse in commodity prices, and fears of the U.S. economy falling into recession. Then in June, Great Britain voted to leave the European Union, fueling market volatility and raising the risks associated with rate increases. The central bank ultimately raised rates only once last year in December, after raising rates just once in 2015.
- This year so far has been different from 2016 as the economy appears to be on solid footing with wages and inflation firming, pointing to the economy being able to “tolerate” a higher rate environment at the moment. As a result, Janet Yellen stated the process of raising rates “likely will not be as slow as it was during the past couple of years.” Raising rates last month allows the central bank to space out two more rate hikes this year as officials monitor the economic data and the looming political uncertainty in the euro zone, and France in particular. As always, stay tuned!
D. Health Care Bill Was Not a Litmus Test for Trump Economic Agenda.
- We cautioned in last month’s ISS that investor enthusiasm for common stocks could sag in the near term on skepticism about how quickly the economic agenda of President Trump would be enacted and the extent of the firepower the negotiated and compromised policies will carry. The failure to unite the House Republicans behind legislation to dismantle the Affordable Care Act exposed an inability to unite rebelling conservative and centrist Republicans.
- The failure by the Republicans to unite around a bill which fulfills their most visible pledge to their constituents to repeal and replace Obamacare raised the fear that Republicans will not be able to unite around a governing agenda. The naysayers assert that the Democrats will be emboldened in their resistance to the Republican legislative agenda, increasing the likelihood that more of President Trump’s and the House GOP’s priorities get pulled into the whirlpool.
- We do not agree with those pundits who argue that failing to replace the Affordable Care Act with the American Health Care Act was a litmus test for the rest of the Trump and House GOP legislative agenda. Health care reform is complicated by the conflicting goals of lowering health care costs versus expanding coverage. An ideological position on either side of the argument makes finding common ground very difficult. The ideological positions on infrastructure spending and tax cuts and reform do not seem as extreme and we look for the Republican party to move a tax overhaul bill forward, although the most optimistic views on tax reform have deteriorated and timing has likely been delayed into late 2017/early 2018.
E. Stock Prices Rising on Improved Outlook for Growth and Earnings.
- This raises the question of whether common stock valuations can be supported if the Trump economic agenda gets diluted and delayed into 2018. The bottom line is if common stock prices rise because the economy and earnings are improving, the rally makes sense and is supportable. The economy and earnings were starting to improve prior to the presidential election with solid job gains and firming wages and prices. A surge in optimism by investors, consumers, and business leaders over the past four months only served to reinforce the economy’s forward momentum.
- Looking back to the timing of the presidential election in early November, the financial markets have been reacting to synchronized world growth for the first time over the course of this expansion, with signs of an improving economic backdrop in China, Japan, and Europe, along with the U.S., as 2016 drew to a close. The better economic momentum looks to have carried over into 2017 and the Bank of England, the European Central Bank, and the Bank of Japan are still pursing very accommodative monetary policies.
- With the Republicans gaining control of the Congress and the White House, investors and businesses have reacted positively to the fact that no new growth inhibiting regulations were on the horizon, with the exciting notion of regulatory rollbacks a distinct possibility. Additionally, the tax increases which were on the horizon should Hillary Clinton have been elected president, were suddenly no longer an issue.
- With a more hopeful outlook on the regulatory and tax fronts, the animal spirits of investors was unleased, with optimism and improved confidence washing over business leaders, households, and investors. In combination with the domestic economy already gathering some momentum as 2016 came to a close, there was, and continues to be, very little downside for the economy. Toss in some tax cuts and reform, repatriation of corporate earnings held overseas, and some infrastructure spending and there was, and is, nothing in the way of the economy gathering some steam over the next couple years.
- It looks to us that the business expansion can continue to advance until inflationary pressures begin to build to the extent that the Federal Reserve needs to alter its monetary policy stance from becoming less accommodative to the first tightening of monetary policy since 2005-06. In that regard and given the current moderate forward momentum in the economy, a dilution and delaying of President Trump’s economic agenda can be viewed in a positive manner as it pushes out the time frame when inflationary pressures are likely to begin building in the economy to the extent that they become a threat to the expansion.
- We continue to look for common stock prices to grind higher this year, with a growing earnings stream being an absolute necessity. Operating earnings for the companies in the S&P 500 grew 12.8% and 21% on a year-on-year basis during 3Q2016 and 4Q2016, respectively, and are expected to advance close to 20% during 2017 according to the analysts at Standard and Poor’s. Solid earnings growth should lead to higher common stock prices.
- We continue to appreciate the pro-growth and pro-business mindset that the Trump administration has brought to Washington. We also expect the Trump economic team to thread the needle and propose a reasonable set of policies which will add a moderate amount of fuel to the economy’s growth rate and earnings, while limiting the rise in inflation, interest rates, bond yields, and the budget deficit.
- As such, we continue to recommend that investors buy any -3% to -5% pullback in stock prices this year to position their portfolios for better growth and earnings. We took advantage of the modest -2.3% drop in the S&P 500 from March 1 to March 27 in the aftermath of the failure to pass the health care bill to place some money being averaged into the market to work and to put portfolio cash flows to work in lagging sectors.
- The very modest dip in stock prices last month seems at odds with the hand wringing that showed up on the business networks and in the market commentaries in the press. Investors looking for pullbacks to put additional money to work have been frustrated by a consistent bid for common stocks, even during the failed effort to repeal and replace Obamacare.
- It appears investors are looking for further gains in earnings which will translate into higher stock prices. There also appears to be an unwillingness to sell, lest investors find themselves out of the market should any constructive policy details be released. Additionally, taking gains is being pushed out in the hope of lower tax rates being part of the Trump economic agenda.
II. Treasury Market
A. Further Flattening of the Treasury Yield Curve.
- The Treasury yield curve flattened a bit further during March after flattening a touch during February. Treasury yields rose 6 to 9 basis points from three months out to two years during February, as investors began to price in a March rate hike by the Federal Reserve. However, yields on longer dated Treasury securities declined -3 to -6 basis points during February, flattening the yield curve.
- This flattening trend continued during March, as Treasury yields rose 15 and 20 basis points on three-month and one-year Treasury securities, respectively, in the aftermath of the Federal Reserve boosting the range for the federal funds rate at the March 14-15 FOMC meeting. Yields on longer dated Treasury instruments were unchanged to one basis point higher.
- We offer two thoughts about longer dated yields falling slightly over the past two months while short-term yields have risen. First, investors are likely dialing back the timing and impact of the Trump economic agenda, particularly following the failure to pass the health care bill last month. As covered earlier in this ISS, we look for the Republican party to move a tax overhaul bill forward, although it likely will be compromised somewhat in its scale and scope and delayed into late 2017/early 2018.
- The other factor likely supporting prices of longer dated Treasury securities is the looming political uncertainty in the euro zone, and France in particular, where far-right presidential candidate, Marine Le Pen is widely expected to make it to the second round of voting this May. As covered previously in this ISS, Le Pen has said she would pull France, one of the European Union’s founding nations, out of the euro, proposing to spend the first six months in office negotiating the return of the French franc.
- That could mean redenominating France’s government debt, which in the view of the rating agencies could effectively trigger a default. It has been our expectation that just as the pending vote in Great Britain to leave the European Union triggered a flight to safety in Treasury securities last June, the political uncertainty in France would keep Treasury securities well bid during March and over the next few weeks.
B. Treasury Market Still Expecting Only a Modest Rise in Growth & Inflation.
- The fixed income market is looking for only a modest rise in real growth and inflation. The after-inflation, or real, yield on inflation-protected ten-year Treasury (TIP) securities is a proxy for expected real growth in the economy. Notice in the table on the next page that the yield on ten-year TIP’s fell into negative territory following the vote in Great Britain last summer to exit the European Union as investors feared that global growth could suffer in its aftermath. While that growth scare and negative TIP yields passed fairly quickly, the ten-year TIP yield was still low at 12 basis points on November 8, but at least it was positive.
- The ten-year TIP yield rose fairly sharply after the election, peaking at 0.71% on December 16 as expectations for growth rose. The TIP yield declined to 0.40% by the end of January and was unchanged to the end of March as investors pushed out to late 2017/early 2018 before the economy will be impacted by the Trump economic agenda, and likely in a fairly moderate manner.
- We should also note that the ten-year TIP yield is below its level at the end of 2015. The market is likely expecting that the growth headwinds from the aging U.S. population and the burdensome size of the national debt are speed bumps that the Trump economic agenda will confront as the economy rolls into 2018.
- However, the Treasury market’s implied inflation expectation for the next ten years – the difference in yield on the nominal ten-year Treasury note and the yield on the ten-year TIP — rose a touch from a range of roughly 1.5% to 1.75% from the end of 2014 to election day, to close to 2% since the end of January. This placed the market’s ten year inflation outlook near 2% for the first time since 2014.
- So while we are all dealing with the lack of specifics regarding the policy proposals that the Trump administration will eventually implement, the Treasury market is looking for only a modest improvement in the economy’s growth rate and a rise in inflationary pressures which does not push above 2% in any material manner.
- The yield on the ten-year Treasury note ended February at 2.36%, traded as high as 2.61% on March 13, but trended lower over the rest of the month after the Federal Reserve raised interest rates and the health care bill failed, ending March at 2.39%. With the impact from the Trump economic agenda being delayed and the political uncertainty in the euro zone, we expect the yield on the ten-year Treasury note to continue to trade in a 2.25% to 2.65% range for the near term.
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 of Florida, 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.
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