CenterState Wealth Management
I. Equity Markets
A. The Stock Market’s Historic Run.
- The selling pressure in common stocks, which built during October as investors turned cautious in front of the most contentious and polarizing presidential election in recent history, spilled over into early November with the S&P 500 hitting a nine day skid — its longest losing streak in almost 36 years.
- The conventional wisdom heading into the presidential election was that a Clinton victory meant four more years of President Obama’s policies, while a Donald Trump victory would send stock prices into a swoon at the risk of the economy falling into recession if the Trump administration withdrew from trade agreements, imposed tariffs on imports inciting trade wars, and punished U.S. companies that moved jobs abroad.
- With the likelihood of a Republican sweep taking place in Washington, it became very evident late Tuesday night/early Wednesday morning that the political story, which was centered on the character flaws of the two candidates, was very quickly going to become an economic/business/financial market story based on the promise of lower taxes, lighter regulation, and higher infrastructure and military spending. Rather than going into a tailspin, the stock market went on a historic run with the major market measures hitting a series of new record highs.
- In the aftermath of the presidential election, investors have bought common stocks and sold bonds and gold betting that the full Trump economic agenda will accomplish what the investment world thrives on, policies such as tax relief, deregulation and a large fiscal stimulus, while largely dismissing the potentially damaging impacts of other campaign promises, such as much tougher stances on trade, immigration, and larger budget deficits. This stock market rally has occurred without any specific policy proposals, which we would not expect to see until late in 1Q 2017 at the earliest, and maybe not a full agenda of policies until mid-year.
- Since the presidential election, the financial markets have been all about the new policies expected from a pro-growth Trump administration, ignoring the possibility of any protectionist Trump administration policies. Since November 8, the major market measures have jumped 2.5% to 10.6%, with new record highs being hit over the past week. For the full month of November, the stock market indices rose 2.6% to 11.0%, and for the first eleven months of the year, the major market measures are higher by 6.3% to 16.4%.
B. Look for a Rate Hike on December 14.
- The Federal Reserve stayed out of the political spotlight last month by passing on raising interest rates at the November 1-2 FOMC meeting. The policy statement was little changed from the September statement, but it was augmented in two subtle ways that bolster the case for a rate hike at the December 13-14 FOMC meeting.
- First, the statement said the case for a rate hike “has continued to strengthen” and that the policymakers only needed “some” further evidence of an improving economy before raising rates again, suggesting that Federal Reserve officials believe the economy can tolerate a second increase in the federal funds rate in short order. Secondly, the committee noted that “Inflation is expected to rise to 2% over the medium term,” and dropped language it used in previous statements that it expected inflation “to remain low in the near term.”
- The minutes from the November FOMC meeting stated that the committee members were confident prior to the presidential election that the economy was strengthening enough to warrant a rate hike before year end. A large number of participants said it “could well become appropriate” to raise interest rates “relatively soon” according to the minutes. Some committee members argued a rate hike should take place at the December FOMC meeting in order to preserve the central bank’s “credibility.”
- Federal Reserve Chair Janet Yellen appeared before Congress’s Joint Economic Committee mid-month and told lawmakers that the central bank could raise interest rates “relatively soon,” following the release of a series of economic data pointing to an improving economy. Ms. Yellen warned that holding off on a rate increase for too long could force the Federal Reserve to raise rates relatively abruptly in the future to keep the economy from overheating, which would increase the risks of the economy tipping into recession.
- Taking Ms. Yellen’s Congressional testimony with the minutes of the November FOMC meeting, the futures market is currently pricing in a 100% chance of a rate hike this month and a greater than 50% chance of another rate hike by mid-year 2017. We think it is very telling that Janet Yellen’s warnings on monetary policy previously focused on the risks of moving too fast, as well as moving too slowly, to increase interest rates. Currently, her warnings only focus on the risks of moving too slowly. Look for a December rate hike.
- In one of the presidential debates, Mr. Trump called Janet Yellen “highly political” and accused her of keeping interest rates low to help Democrats in the national election. In her Congressional testimony, Ms. Yellen attempted to squash speculation that she may leave the Federal Reserve after Mr. Trump takes office.
- Yellen stated, “It is fully my intention to serve out that term,” when asked the possibility she might leave before her four year term as chair ends in February 2018. We hope that is true as we believe Janet Yellen remaining as the head of the Federal Reserve will provide a dose of stability to the financial markets as the transition to a Trump administration and policies takes place during 2017.
- Looking forward, the last set of rate projections released by the Federal Reserve pointed to two interest rates hikes taking place during 2017. As we will discuss more in the next section of the ISS, we anticipate that the policies of a Trump administration will boost the economy’s growth rate, lifting the number and the pace of rate hikes which the economy can tolerate without doing harm to the economy.
- Keep in mind that the Federal Reserve wants to raise interest rates because the central bank cannot lower interest rates during the inevitable next recession unless interest rates move higher prior to it. Ms. Yellen has consistently stated in her recent Congressional testimonies that some assistance from fiscal policy would be very welcome and would help the Federal Reserve in its mission to raise or “normalize” interest rates.
C. Expect Policies Which Will Boost Economic Growth.
- For now, investors are hoping that much of what Mr. Trump said during the primaries and the race to the White house was posturing and not a litany of likely policy proposals which could lead to trade wars and a foreign policy based on an isolationist posture. In our view, Mr. Trump espoused his extreme positions on many topics to get the attention of American voters and our trading partners.
- With a Republican controlled Congress and a group of seasoned business leaders and Washington veterans surrounding him as advisors and Cabinet members, we expect the President-elect to move from his extreme campaign positions to more right-of-center positions, which will lead to a full menu of pro-growth policies. Look for a transformation of candidate Trump to President Trump in the coming months.
- The extent to which stock prices have jumped since the election is a little surprising given that there are no specific policy proposals under consideration currently. In some sense, investors are reacting to a repudiation of the past eight years of a White House which fostered a hostile business environment and attempted to promote a social agenda through an overbearing regulatory framework. It seems that a rejection of President Obama’s policies was enough to get the animal spirits moving.
- While we await policy specifics, we can cite three broad themes which should characterize the next four years under a Trump administration, all of which should lead to higher common stock prices and bond yields. First we expect a pro-business environment and mindset to sweep over Washington on January 20, 2017.
- Specifically, we anticipate a rollback of much of the onerous regulatory web put in place over the past eight years, including significant changes to Obamacare, particularly those aspects which are job killers in the small business segment of the economy. Look for trade negotiations to focus on equal access, that is, whatever degree of access our trading partners have to our domestic markets, U.S businesses should have the same degree of access to those foreign markets. We do not expect a tariff war to break out.
- Corporate tax reform, which appears to have bi-partisan support, should lead to a lower statutory tax rate on corporate earnings. We also expect a one-time, low repatriation tax rate on earnings trapped overseas which should lure the money back to the U.S. where it can be spent on hiring and business capital spending, while the tax revenue generated can help fund Mr. Trump’s fiscal stimulus proposals, such as infrastructure spending. We look for a higher level of military spending and we expect president-elect Trump to promote the domestic energy industry, keeping energy costs low and moving the nation toward energy independence.
- All of these measures should lead to a faster pace of job growth, higher wages, and a boost to the economy’s growth rate, which is the second broad theme. We also look for a lowering of personal tax rates and a simplification and partial reform of the personal tax code, with some reduction, if not outright repeal, of the estate, or death tax. We look for a faster pace of growth in the economy over the next four years compared to the 2.1% annual pace over the course of the current business expansion which has been held back by our aging population and the growing regulatory burden. The question is how much faster?
- We think a directionally correct assessment is that the economy’s growth rate can accelerate to a 3.0% to 3.5% pace, with a quarter or two during which the growth rate could exceed 4%. For a more specific forecast, we will need to see the specifics of the actual policy proposals. How much of an actual reduction in the corporate and personal tax burden will occur? The elimination and/or roll back of some deductions and exemptions is likely within both the corporate and personal tax codes, raising the amount of taxable income subject to lower tax rates.
- We look for Paul Ryan and the House Ways and Means Committee to play a significant role in the development of new tax policies, which will keep the impact on the budget deficit of lower tax rates and fiscal stimulus plans as part of the negotiations surrounding the development of a complete Trump economic platform. Keep in mind that the federal debt currently stands at around 77% of nominal GDP, compared to 25% in 1981 (Reagan tax cut) and 31% in 2001 (Bush tax cut).
- Remember also that these policy proposals will not take place in a vacuum. There will be, and already have been, reactions in the financial markets. The yield on the ten-year Treasury note was 1.86% on November 8, up from the all-time low of 1.36% on July 8, but closed November at 2.37%. This represents a tightening of financial conditions, particularly in the housing market where mortgage rates have risen, making housing more expensive and lessening the likelihood of households refinancing outstanding mortgage obligations.
- It is very significant that the fiscal stimulus plan that everyone expects will be delivered with a 4.9% unemployment rate, wages and inflation firming, and the business expansion at 89 months compared to an average length since WWII of 58 months. Typically a stimulus plan of this type and magnitude would be delivered with the economy in recession and shedding jobs. This leads to our third broad theme, that the economy is poised to reflate, leaving the era of ultra-low interest rates and bond yields in the rear view mirror.
- For inflation to move higher, workers need to become scarce enough to boost wages. We believe there is more slack in the labor force than the 4.9% unemployment rate represents due to the decline in the participation rate, but the key will be to watch the year-over-year change in average hourly earnings contained in the monthly employment data. The average hourly earnings figure has risen 2.8% over the past year, compared to an annual gain of 1.8% recorded some 18 to 20 months ago and 2.1% to 2.2% over the summer months.
- Employers will need to pass the higher wage costs on to consumers in terms of higher prices and then consumers need to be willing to pay the higher prices, something that has not happened in almost two decades. We look for the nation’s inflation rate to warm up, but it is not likely to bellow into a flame.
- An environment with a faster growth rate and an upward tilt to inflation will increase the economy’s ability to tolerate higher levels of short-term interest rates. As such, we expect the Federal Reserve to be able to increase the federal funds rate at least two times during 2017, which is the central bank’s current forecast. The response of the U.S. dollar to the Trump economic proposals will be key to the outlook for the economy, inflation, bond yields, and Federal Reserve policy, however.
- In response to the Federal Reserve ending its most recent bond buying program in November 2014 and turning its attention to rate increases, the dollar rose roughly 25% from the summer of 2014 to January 2016. U.S. exports suffered, imports benefited, oil prices crashed, goods inflation turned to deflation, and the manufacturing sector suffered through a mild recession with industrial production falling -3.1% between November 2014 and March 2016.
- So far in 2016, the dollar fell about -6% from January to August of this year, only to rebound almost 7% to the end of November, returning to its January level, tightening financial conditions once again. It will be important to watch the reaction of the dollar to the rollout of the new policy proposals next year as a rise in the dollar will tighten financial conditions, offsetting to some extent the stimulative impact of the new economic agenda.
- So, we expect a more pro-business environment and mindset in Washington, a faster pace of growth, and some reflation in the domestic economy as a result of Mr. Trump winning the presidential election. The degree to which growth and inflation is rekindled will depend on the specifics of the policy proposals, the reactions in the financial markets, and the Federal Reserve. In general, we look for higher stock prices and bond yields in the quarters ahead. D. Valuation, Interest Rate, and Bond Yield Concerns Versus Pro-Growth Policies.
- The stock market is transitioning from a low interest rate driven bull market to an earnings driven bull market. The transition started before the presidential election with operating earnings on the S&P 500 growing 13.8% in 3Q 2016 on a year-over-year basis, ending a seven quarter long earnings recession brought about by the plunge in oil prices and the surge in the dollar. With the stunning victory by Donald Trump in the election, investors are now looking for the earnings rebound to continue, with the economy anticipated to benefit from a future that holds lower taxes, less regulation, and a heavy dose of fiscal stimulus. That is the good news.
- The bad, or not so good, news are current stock valuations and the likely trajectory for interest rates and bond yields. We have been writing since the end of 2014 that common stocks were no longer cheap. The price-to-operating earnings ratio on the S&P 500 rose from 13.3x at the end of 2011, to 14.6x at the end of 2012, and to 18.1x and 18.0x by the end of 2013 and 2014, respectively, thanks to the aggressive bond buying program of the Federal Reserve. With stock prices supported by low interest rates and bond yields, but operating earnings falling into recession, the P/E ratio rose to 19.6x at the end of 2015 and to 22.1x at the end of 3Q 2016.
- Currently, the P/E ratio is 21.6x on the back of earnings rebounding last quarter and stock prices advancing in the post-election euphoria, but with the advance in earnings outpacing the gain in stock prices. We stated in the last two ISS’s that the elevated earnings multiple on the S&P 500 could be corrected by a significant drop in stock prices or by a return to positive earnings momentum, a much preferred path.
- The rebound in earnings last quarter and the pro-growth policies expected from a Trump administration point to the preferred path having a reasonable chance of supporting current P/E ratios, possibly even lowering them a touch if the pace of the rise in earnings exceeds the advance in stock prices.
- The new hurdle possibly facing stock prices is the era of ultra-low interest rates and bond yields fading into the background. As stated above, we expect the economy to be able to tolerate higher interest rates from the Federal Reserve as the economic outlook improves and inflation warms a touch. This scenario will also result in bond yields rising over the next year. We look for higher common stock prices, with a growing earnings stream being an absolute necessity, with only a moderate rise in inflationary pressures also necessary to restrain the inevitable rise in interest rates and bond yields.
II. Treasury Market
A. Look for Treasury Yields to Rise.
- Since the Federal Reserve ended its bond buying program in November 2014, we have consistently stated that the fundamental reasons that the yield on the ten-year Treasury note remained at historically low levels were low inflation and the slow pace of growth over the course of this business expansion. We stated that it would take some serious, pro-growth fiscal policy initiatives to push the economy’s growth rate materially higher on a consistent basis to put the era of ultra-low interest rates and bond yields in the rear view mirror.
- Well, guess what? While policy details are lacking, from all indications coming out of New York from the Trump transition team and from the big picture policy initiatives Mr. Trump espoused on the campaign trail, the U.S. is on the verge of receiving some serious, pro-growth fiscal policy initiatives during the first year of a Trump administration. With the business expansion currently at 89 months, no serious threats of recession on the horizon, and inflation and wages firming a touch, we see higher interest rates and bond yields on the horizon.
- In a note we released the morning after the presidential election, we looked for the yield on the ten-year Treasury note to move toward a 2.0% to 2.5% trading range in short order. The ten-year Treasury note closed November 9 at 2.07% and has traded between 2.30% and 2.37% over the past eight trading days, ending November at 2.37%.
- We expect the 2.0% to 2.5% trading range to remain in place for a while. Once the details of Mr. Trump’s complete economic agenda are unveiled and businesses begin to align themselves for a faster pace of economic growth, we would not be surprised to see the yield on the ten-year Treasury head toward 3.0%, a level we have not seen since late December 2013. Not knowing the exact details of the policy proposals and the pace at which the details will be released makes forecasting the timing of the next move higher in Treasury yields a little difficult.
- However, one thing we have learned in following the bond market for more than three decades is that the market tends to price in future events faster rather than slower. While we acknowledge that massive bond buying programs are still in place at the Bank of Japan, the Bank of England, and the European Central Bank, we believe they are closer to ending rather than ramping up as we look for policymakers around the globe to follow Mr. Trump’s lead and turn to fiscal policies to revive growth and reflate their economies.
- While we obviously do not know the actual impact on the federal budget deficit from the still to come policy proposals, we feel it is safe to say that the deficit will grow, at least for the better part of Mr. Trump’s first term. We also look for the Treasury Department to lengthen the average maturity of the nation’s debt and it would not surprise us if the Federal Reserve began to shrink its holding of government securities by stopping the reinvestment of interest payments and maturing securities. Depending on how all this plays out, including the actual impact on the pace of economic activity and inflation, the yield on the ten-year Treasury could easily pass 3% sometime in 2017, setting its sights on 4%, a level we have not seen since October 2008. As always, stay tuned for the details!
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.
CenterState Bank of Florida 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.