CenterState Wealth Management
Investment Strategy Statement
August 1, 2018
I. Equity Markets
A. Trade Truce with the European Union.
- We mentioned in last month’s ISS that the heated trade rhetoric between the U.S. and our major trading partners, particularly China, escalated to the point that it drowned out almost all other economic issues as June drew to a close. Reflecting on July, we could repeat that statement. The Trump administration imposed tariffs of $34 billion on Chinese products on July 6 and China responded with tariffs on $34 billion of American aircraft, cars, soybeans, and other farm goods. The White House then responded by threatening to assess tariffs on further $200 billion of Chinese goods, deepening the dispute with Beijing.
- Beyond rising trade tensions, President Trump dominated the news headlines last month a she flew to Brussels for a NATO summit and jolted U.S. allies with fresh demands to boost military spending swiftly, prompting some NATO members to worry that Mr. Trump’s critical approach was undermining the alliance. Mr. Trump’s NATO appearance was followed by a summit in Helsinki with Vladimir Putin, after which he was widely faulted over his unwillingness to publicly criticize Mr. Putin. Mr. Trump spent the days following the summit attempting to soften his comments made at a news conference with the Russian leader, in which he appeared to side with Moscow over his own intelligence agencies about whether Russia interfered in the 2016 election.
- In an important and possibly ground breaking development last week, President Trump and European Commission President Jean-Claude Juncker struck a preliminary deal to ease trade tensions and avoid a full-blown trade war between the U.S. and the European Union. Both sides will work to lower industrial tariffs and the European Union agreed to import more U.S. soybeans and liquefied natural gas. The two leaders said they are working towards a goal of “zero tariffs, zero barriers, and zero subsides” on non auto industrial goods.
- The two sides will “hold off” on other tariffs while negotiations proceed, putting aside for the time being President Trump’s threats of new tariffs on cars and auto parts from the European Union. The two leaders also agreed to try to use the World Trade Organization to deal with issues of intellectual property theft, forced technology transfers, industrial subsidies, distortions created by state-owned enterprises, and overcapacity — issues that are at the heart of U.S. concerns about trade with China. President Trump also said, “We also will resolve the steel and aluminum tariff issues, and we will resolve the retaliatory tariffs.”
- The declaration of a “new phase” in the relationship between the U.S. and the European Union is an important first step toward launching ambitious, market opening negotiations between two of the world’s largest economic powers. It could also foster an environment where the U.S. and the European Union could join forces in a unified front in addressing Chinese trade practices. The tariff truce comes at the same time the Trump administration is working intently to strike a deal, possibly as soon as this month, with Canada and Mexico to modernize the North American Free Trade Agreement.
- While it is too soon to declare an end to the global trade hostilities touched off by President Trump’s imposition of new tariffs on our major trading partners, it appears progress is being made in reaching reciprocal or equal access trade agreements with some of our trading partners. In the press conference with Mr. Juncker, President Trump did not mention the
U.S. trade deficit with Europe, instead he focused on the $1 trillion in bilateral trade that flows in both directions. Mr. Trump stopped referring to the European Union as a “foe,” and instead hailed a “new phase of close friendship, of strong trade relations in which both of us will win.”
- Despite escalating trade tensions and retaliatory tariff actions early in the month, those issues were absorbed by the markets fairly easily last month. For the full month of July, the major market measures advanced 1.7% to 4.7%, with the DJIA leading the pack and the Russell 2000 Index of small company stocks bringing up the rear.
- Since the recent low on February 8, the S&P 500 and the DJIA have risen 9.1% and 6.5%, respectively, while the NASDAQ Composite is higher by 13.2% and the Russell 2000 led the way with an advance of 14.1%. For the first seven months of 2018, the DJIA has posted the smallest gain at 2.8%, followed by the S&P 500 rising 5.3%. The Russell 2000 is higher by 8.8% on the year-to-date, while the NASDAQ Composite led the way with a gain of 11.1%.
B. Growing Trade Skirmish with China vs. Strong Fundamentals.
- While there are hopeful signs of progress toward lowering trade tensions with the European Union, Canada, and Mexico, the trade skirmish with China appears to be heating up. With the Trump administration placing a 25% tariff on $34 billion of Chinese goods in early July and Beijing matching those tariffs dollar-for-dollar, the heated trade rhetoric with China has given way to an expanding trade skirmish. It is clear that the Trump administration is intent on getting China to open its markets, increase its imports, eliminate its subsidiaries to major exporting companies, and change its rules of engagement to prevent the theft of U.S. technology.
- When we initially reviewed President Trump’s first foray into resetting the trade agreements the U.S. has with our major trading partners in the April ISS, we laid out three overriding principles which needed to be kept in mind when thinking about how these trade negotiations could 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. Progress on the trade front with the European Union is consistent with these first two principles. Lastly, at some point China cannot match the U.S. with retaliatory responses because the U.S. imported more than four times the amount of goods and services from China than China imported from the U.S. last year.
- We again encourage our readers not to overreact to the back and forth trade retaliation announcements between the U.S. and China, as we are hopeful positive developments will occur, similar to the recent de-escalation of trade tensions with the European Union. It is all part of a negotiating process. The U.S. and our major trading partners will likely avoid serious trade conflicts because all countries will eventually do what is in their best economic interest, including being able to sell into the U.S. economy for our major trading partners.
- The Administration is likely asking itself, what better time to take on the unfavorable trade agreements with our global trading partners than when the domestic economy is benefitting from tax cuts, the repatriation of earnings from overseas, and the $300 billion federal spending plan passed in February. It is difficult to argue that fair and reciprocal trade across the globe is not in every countries’ best interests. Do not be surprised if the world economy is benefitting from lower trade barriers across the board in the years to come.
- While we acknowledge that the markets are being forced to digest a marked rise in trade tensions as the Trump administration attempts to reset the inherent disadvantage the U.S encounters in most trade agreements currently in place, 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.
- As second quarter earnings reports continue to be released, it is clear that operating earnings have now advanced for eight 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 26% over the four quarters of 2018.
- With the 17.2% growth in operating earnings over the four quarters of 2017, the 26.8% year-over-year gain in operating earnings reported for 1Q 2018, the 28.2% estimated advance for 2Q 2018 with 65% of companies reporting, and the moderate rise 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 20x at the end of July, below the 21.1x on the day of the presidential election.
- As always, there is no shortage of things for investors to worry about. Investors are watching to see the extent to which inflationary pressures build, assessing the risk of the Federal Reserve making a policy mistake, monitoring the nation’s political mood ahead of the mid-term elections, and looking for the extent to which rising trade tensions create a negative feedback loop on the pace of economic growth, particularly on business capital spending initiatives.
- The economy’s forward momentum remains solid and the outlook for earnings is very strong, both benefitting from the fiscal stimulus put in place earlier this year. Any signs of ebullience in the stock market, which were evident to the January 26 high, have evaporated and yields on longer-dated Treasury securities have eased from the May 17 high. While the S&P 500 and the DJIA have posted only moderate gains on the year, the past five to six months look to have been a pause in the ongoing advance in stock prices that has refreshed the outlook for stock prices.
II. Monetary Policy
A. Chairman Powell Indicates Rate Hikes Are Not on Automatic Pilot.
- Since the Federal Reserve raised rates for the seventh time during this rate hiking cycle following the June 12-13 FOMC meeting, the minutes of that meeting have been released, Chairman Jerome Powell testified before Congress, and President Trump delivered a relatively rare presidential criticism of the Federal Reserve. In the July 2 ISS, we concluded that monetary policy was roughly at neutral, where further rate increases could push policy to the side of being restrictive.
- We went on to say that the rise in interest rates is beginning to be felt in the household sector as borrowing costs rise, that clues about the stance of monetary policy will continue to be found in the Treasury market, and that the Federal Reserve was likely to raise rates one, maybe two additional times this year to push against fiscal stimulus, and then will become data dependent in 2019 with respect to any further rate increases. Our outlook on monetary policy has not changed over the past month.
- The minutes of the June 12-13 FOMC meeting signaled that the Federal Reserve could hike rates over the next year to a level that was no longer supportive of helping the economy grow. This implies that the level of the federal funds rate is currently below neutral and that three to four additional rate hikes would lead to a more restrictive policy stance. Our view is that rates are currently at, or very close to neutral, and that three to four additional rate hikes would lead to a more restrictive policy stance than the minutes seem to imply.
- In his testimony before two Congressional committees mid-month, Mr. Powell delivered an upbeat assessment of the economy, similar to his comments in the press conference following the June 12-13 FOMC meeting. He acknowledged risks to growth if escalating trade tensions resulted in permanently higher tariffs, but said that trade policy is outside of the Federal Reserve’s mandate of full employment and stable prices. In a nod to our position that monetary policy is likely already at neutral, Jerome Powell said that the FOMC Committee “believes that, for now, the best way forward is to keep gradually raising” the federal funds rate.
- The in conclusion of the qualifier “for now” to Mr. Powell’s statement was a new addition, likely meant to emphasize that policy decisions are not pre-set and also signals less certainty about future rate hikes. With inflation low and appearing to be under control, the central bank does not want to run the risk of unnecessarily bringing about the next recession because it raised interest rates clearly to the side of restraint without inflation pressures building in a material manner beyond the Federal Reserve’s 2% target. The risk of recession is heightened by the intensifying trade disputes, which could hurt business confidence and roil the financial markets if they developed into full-blown trade wars.
- Finally, President Trump offered up a criticism of the Federal Reserve a little over a week ago by saying “I am not happy about it,” when asked about the Federal Reserve raising interest rates. He went on to say he was “not thrilled” because every time the economy strengthens “they want to raise rates again.” While it is rare for a president to outright criticize the central bank, the only real surprise to us is that Mr. Trump waited as long as he did to criticize the Federal Reserve. With his background as a real estate developer, Mr. Trump prefers low interest rates.
- One irony of President Trump’s criticism, however, is that Mr. Powell now has the added burden of directing monetary policy under suspicion of political influence. He could feel pressure to maintain a gradual pace of rate hikes to show the financial markets that he and the other officials at the Federal Reserve are truly independent decision makers.
- While we feel Mr. Powell, the other members of the FOMC Committee, and the research staff at the Federal Reserve will not be so easily swayed, Mr. Trump’s criticism raises the remote possibility of more rate hikes and higher interest rates as a show of independence. That would be a mistake and one we expect the Federal Reserve to avoid.
B. Watch the Yield Spread for Clues about Monetary Policy.
- It is clear that the Federal Reserve is actively trying to determine the current neutral interest rate at which monetary policy is neither stimulating nor restraining the economy’s growth rate. As we have described in previous ISS’s, trying to ascertain the current level of the neutral rate can be fairly arcane, somewhat arbitrary, and a bit of a moving target. That is why we have focused our readers on the yield spread between two-year and ten-year Treasury notes since the summer of 2015 to monitor the Treasury market’s assessment of how tight or easy monetary policy currently is.
- We have monitored the yield spread between the two-year and ten-year Treasury notes as an indicator of whether investors 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 of the yield spread — or too aggressive — which could lead to a slowdown in the economy and cause a narrowing of the yield spread.
- As a point of clarification, it is not the narrowing of the yield spread which will cause a slowdown or contraction in real economic activity, it is the tightening of monetary policy by the Federal Reserve which will bring about the slowdown or economic downturn. The narrowing yield spread is merely the “canary in the coal mine,” warning of the looming slowdown or downturn, not the cause of it.
- 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 rate hike in March, the yield spread fell to 46 basis points. After the Federal Reserve raised rates in June for the seventh time in the current rate hiking cycle, the yield spread narrowed further to only 33 basis points by the end of June. With the Federal Reserve expected to leave rates unchanged later today at the July 31-August 1 FOMC meeting, the yield spread ended July at 29 basis points.
- We continue to believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake. In the context of a neutral rate, we take the narrowing of the yield spread as a signal that the Federal Reserve is approaching that level of the federal funds rate where monetary policy could flip from being neutral to the side of restraining the economy’s forward momentum.
- We, and the market it appears, feel the real, or after inflation, neutral rate is still fairly close to zero, and with the midpoint of the range for the federal funds rate at 1.88% and core inflation at 1.9% year-on-year, the real federal funds rate is currently at zero. In our view, further rate hikes will push monetary policy to the side of being restrictive.
- It is important to note that the narrowing of the yield spread is not occurring solely from the Federal Reserve raising rates and in the process pushing the yield on the two-year Treasury note higher. It is also happening because the yield on the ten-year Treasury has declined from its recent peak of 3.11% back on May 17. We believe that the yield on the ten-year Treasury note settling in at a level just below 3% is recent weeks is an acknowledgement by investors that the rise in interest rates is beginning to be felt in the household sector as borrowing costs rise on auto loans, credit cards, home equity lines of credit, and home mortgages.
- The question is whether the new leadership at the Federal Reserve can balance its intention to raise interest rates so that the central bank has the ability to lower interest rates during the next recession with the risk of unnecessarily bringing about the next recession because it raised the neutral rate clearly to the side of restraint without inflation pressures building in a material manner beyond the Federal Reserve’s 2% target.
- 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 and/or a neutral position to an outright tightening posture. The economy’s inflation rate will determine how high the federal funds rate can rise without stalling the economy
- We will watch the two-year to ten-year Treasury yield spread for the market’s assessment of whether monetary policy has moved into the restrictive zone. We doubt the Federal Reserve will deliberately raise interest rates in such a manner that it pushes the yield on the two-year Treasury note above the yield on the ten-year Treasury note if inflationary pressures remain low. This is the primary reason we believe the proposed policy moves of two more rate hikes this year and four more in 2019-20 by the Federal Reserve are too aggressive.
- Our view remains that the Federal Reserve raises interest rates one, maybe two additional times this year to push against the fiscal stimulus, and then becomes data dependent in 2019 with respect to any further rate increases. The most important data to follow in the coming months will be the wage and inflation data. It would not surprise us if the dialogue shifts over the next 6 to 12 months from “Is the Federal Reserve behind the curve?” to “Is the Federal Reserve moving too far?” As always, stay tuned!
III. Economic Outlook
A. Strong Growth Reported for Second Quarter.
- The U.S. economy grew at a strong 4.1% annual rate in 2Q 2018, compared to a 2.2% growth rate in 1Q 2018, led by solid gains in consumer spending, business capital spending, exports, and federal government outlays. The details of the report were very positive relative to the outlook for the economy over the remainder of the year and into 2019, however, there were a couple one time events which boosted the economy’s growth rate over 4% which will not be repeated. We think a better way of evaluating the forward momentum in the economy is to look at the year-on-year growth of 2.8%, which evens out some of the one-time distortions.
- The largest sector of the economy, consumer spending, grew at a 4.0% pace last quarter compared to a paltry 0.5% advance in 1Q 2018. Consumer spending was supported by low unemployment, strong job gains, moderate wage gains, and the modest reduction in personal tax rates. However, part of the strength last quarter was due to the distortions in the pattern of consumer spending following the hurricanes last September.
- Consider that consumer spending grew at a 3.9% rate in 4Q 2017 led by durable goods outlays (including motor vehicles and household furnishings) surging at a 12.7% rate following the destruction caused by the hurricanes. Durable goods outlays declined at a -2% rate in 1Q 2018 as the inevitable payback for the fourth quarter surge occurred. Consumer spending last quarter was boosted by a 9.3% bounce back in durable goods outlays, with motor vehicles advancing at an 8.4% rate and household furnishings gaining at a 7% rate. The hurricane-related distortions in consumer spending should now be washed out of the data.
- Business capital spending advanced at a 7.3% rate, a bit slower than the 11.5% first quarter gain, but still very healthy. The strength in business investment was driven by a continued rise in capital expenditures in the energy sector, which accounted for more than 100% of the 13.3% growth in structure outlays, as the rise in the price of oil and an easing of some onerous regulations is supporting expenditures in the energy patch. Investments in equipment advanced at a 3.9% rate and in intellectual property at an 8.2% pace as the long-lived business expansion, the lower corporate tax rate, and the ability to immediately write off capital spending outlays is supporting business investment.
- Net exports contributed 1.1 percentage points of the economy’s 4.1% growth rate last quarter as imports grew at only a 0.5% rate, while exports surged at a 9.3% pace, with goods exports even stronger at a 13.3% rate of growth. The gain in goods exports was driven by a 110% jump in exports of food, feeds, and beverages — which was largely the result of a temporary spike in soybean and corn shipments which were rushed to port to beat the imposition of tariffs by China. That export surge was a one time even and will not occur this quarter, likely leading to net exports being a drag on growth this quarter.
- The $300 billion federal spending bill passed in February started to show up in the GDP data last quarter with the 3.5% gain in federal government spending, led by a 5.5% rise in national defense outlays. Two sectors of the economy were drags on growth last quarter, a drawdown in inventories and housing. Inventories subtracted one percentage point from the economy’s growth rate as goods which otherwise would have been stockpiled got shipped to China and Europe to beat the tariffs.
- The modest -1.1% drop in housing outlays last quarter likely reflected some residual effects from the hurricane-related surge in repair and rebuild spending in the housing sector in 4Q 2017 when housing construction jumped at a 11.1% rate. Housing outlays fell at a -3.4% rate in 1Q 2018 along with the modest decline last quarter, as housing activity remained at a level above the two quarters prior to the hurricane-related surge, but slightly below the peak level of activity during 4Q 2017. The modest decline in housing activity last quarter also likely reflected the rise in mortgage rates and the changes to the tax code which diminished the subsidies which encourage homeownership.
- The inflation measures eased a bit last quarter, indicating that price pressures remain under control. The price index for grow domestic purchases, which measures prices paid by U.S. residents, rose at a 2.3% rate compared to a gain of 2.5% pace in 1Q 2018. Consumer prices rose at a 1.8% rate after rising at a 2.5% pace in 1Q 2018. The Federal Reserve’s preferred measure of inflation, the core personal consumption index, rose at a 2% rate compared to 2.2% in 1Q 2018. The core measure of inflation in the consumer sector rose 1.9% over the past four quarters.
B. Solid Forward Momentum in the Economy, Close to 3% for Now.
- While a number of one-time factors helped to push the economy’s growth rate over 4% last quarter, the economy’s growth rate has definitely risen above the 2.2% pace of growth from the beginning of the expansion to 4Q 2017. Growth is benefitting from the surge in business and consumer confidence since Mr. Trump’s election, the lower regulatory burdens, and the fiscal stimulus placed into law earlier this year. The economy’s growth rate is likely to approach 3% for 2018, run between 2.5% and 3% for 2019 and ease to 2.3% to 2.5% for 2020 as the effects of the fiscal stimulus begin to wane.
- In the annual revisions to the GDP data, a major positive was a significant upward revision in wages and salaries, which flowed through to a sharp upward revision to the personal saving rate. The savings rate had been reported as falling over the past three years, dipping all the way to a recent low of 2.7% in 4Q 2017, which presented a headwind to consumer spending in coming quarters. The revised savings rate jumped to 6.7% from 3.4% for all of 2017 and averaged 7% in the first half of this year. We no longer look at the savings rate as a headwind to consumer spending and with continued job gains, consumer spending should continue to grow at a pace near 3%, helping to keep the expansion rolling.
- The primary long run benefit to the economy from the tax reform passed in December is the incentives for business capital spending, which is the foundation for higher productivity gains and faster growth in real wages. The bottom line is, the economy is much healthier today than it was 20 to 21 months ago prior to President Trump being elected. We just caution against extrapolating last quarter’s 4.1% growth rate over the remainder of the year and into 2019. The aging of the workforce and slower population growth are fundamental factors which will keep the economy’s growth rate under 3% on a sustained basis.
IV. Treasury Market
A. Modest Rise in Treasury Yields during July.
- Treasury yields rose a modest 9 to 14 basis points across the yield curve last month on the back of some easing of trade tensions with the European Union following the meeting between President Trump and European Commission President Jean-Claude Juncker. Messrs. Trump and Juncker agreed to cease further trade hostilities and attempt to work out a permanent trade agreement which is based on the principles of free and fair trade. The very solid 4.1% growth rate for the economy in 2Q 2018 also contributed to the modest rise in Treasury yields.
- A very slight further flattening of the Treasury yield curve took place last month as the two-year Treasury yield rose 14 basis points while the yield on the ten-year Treasury rose 10 basis points. As a result, the yield spread between two-year and ten-year Treasury notes declined to 29 bp from 33 bp at the end of June.
- As we have mentioned in previous ISS’s, as the yield on the ten-year Treasury note rose from the recent low recorded last year on September 5, both the real, or TIP, yield and the implied inflation expectation embodied in the nominal ten-year Treasury have risen, as shown in the table below. However, since the recent high ten-year Treasury note yield on May 17, the 15 basis point decline in the ten-year Treasury yield has been driven by an 11 basis point drop in the TIP yield — reflective of a slight softening in the market’s outlook for economic growth — along with a modest 4 basis point decline in the market’s inflation outlook.
- The fundamental factors which have pushed yields on longer dated Treasury securities higher on the year — the acceleration in the economy’s growth rate, a firming in the nation’s core inflation rate to the Federal Reserve’s 2% target in 2Q 2018, larger federal budget deficits, and the Federal Reserve shrinking its holding of government bonds — will continue to place a floor on ten-year Treasury yields.
- Keeping a lid on ten-year Treasury yields is the Federal Reserve’s effort to raise short-term interest rates which is increasing borrowing costs and the Trump administration’s aim to seek reciprocal or equal access trade agreements with our major trading partners — of which rising trade tensions is a natural result of the process. Based on the near term strength in the economy flowing from the fiscal stimulus passed earlier this year, we have slightly raised the near term trading range for the ten-year Treasury note to 2.85% to 3.20%.
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.