INVESTMENT STRATEGY STATEMENT
December 1, 2017
I. Equity Markets
A. Earnings, Economic Growth, Governor Powell, and Tax Reform.
- Common stocks continued their push higher last month fueled by the ongoing rebound in earnings, growing signs of synchronized global growth, the nomination of Jerome Powell as the next chairman of the Federal Reserve, and hopes that comprehensive tax reform will provide a further boost to earnings, household purchasing power, and business capital spending. The now five quarter long rebound in operating earnings for the S&P 500 companies continued, with particularly strong earnings growth among technology and energy companies. With 94% of S&P 500 companies reporting, 3Q 2017 operating earnings look to have grown 10% year-over-year, after growing 18.1% over the previous four quarters.
- U.S multinational companies are benefitting from strong growth across the world as the global economy is growing at its fastest pace since 2010, with the upturn becoming increasingly synchronized across countries. In fact, all 45 countries tracked by the OECD — Organization for Economic Co-operation and Development — are poised to grow this year and next year for the first time in 50 years. This long awaited lift to global growth, supported by aggressive monetary policies by central banks across the globe, is being accompanied by solid employment gains, a moderate upturn in investment, and a pickup in trade growth.
- Investors were also encouraged by the nomination of Jerome Powell, currently a member of the Board of Governors of the Federal Reserve, to be the next chairman of the Federal Reserve. In his five years at the central bank, Mr. Powell has been a reliable ally of Janet Yellen and would likely represent no dramatic shift in monetary policy, continuing the Federal Reserve’s current gradual approach to reducing monetary accommodation.
- Finally, investors were focused on the GOP’s efforts to deliver the biggest transformation of the U.S. tax code in more than thirty years, calling for deep cuts in corporate tax rates, which would make the U.S. more competitive across the globe. In the competing bills moving through the House and the Senate, the U.S. would move to a territorial tax system which taxes income where it is earned and would also offer a low one-time repatriation tax rate on earnings currently trapped overseas.
- The proposals would also provide immediate deductibility of capital investments such as factories and machinery and lower the tax rate on “pass through” businesses. On individual taxes, the proposals would improve simplicity for millions of taxpayers, but likely raise taxes for taxpayers in high tax, expensive real estate locales by reducing selected deductions.
- In a remarkable display of broad-based strength last month, three of the four major market measures finished at new all-time highs, with the DJIA leading the way with a gain of 3.8%. The S&P 500 and the Russell 2000 index of small company stocks also reached new records, advancing 2.8% and 2.7%, respectively. The NASDAQ Composite gained 2.2%, finishing within a whisker of its all-time high which was set Tuesday. The major market measures are now higher on the year by 13.8% to 27.7% and are higher by a remarkable 23.7% to 32.4% since the presidential election on November 8.
B. President Trump Nominates Jerome Powell as Chairman of Federal Reserve.
- One uncertainty facing investors as we head into 2018 was cleared up last month as President Trump nominated Jerome Powell as the next chairman of the Federal Reserve. While we had hoped that Janet Yellen would be reappointed on the merits of the outstanding job she did during her four year term as chair — the unemployment rate is currently at a 16 year low of 4.1%, core inflation is running at 1.4%, and the economic expansion has continued uninterrupted and now ranks as the third longest expansion in U.S. history — Mr. Powell appears to be a solid choice.
- Janet Yellen’s time as chair of the Federal Reserve will end in February after just one four year term, the shortest tenure as the head of the central bank in nearly four decades and a break from precedent. All three previous Federal Reserve chairs were reappointed by presidents from the opposite political party that placed them in office. Ms. Yellen led the central bank to slowly and cautiously reverse the Federal Reserve’s extraordinary stimulus programs implemented during the financial crisis, the Great Recession, and the subsequent sluggish economic recovery.
- Jerome Powell is viewed as a pragmatist and a thoughtful policymaker, but will be the first chair of the Federal Reserve without a Ph.D. in economics in three decades. Mr. Powell’s views on economic and monetary policy have been aligned with Ms. Yellen’s as he never dissented from the FOMC’s policy decisions since he joined the Federal Reserve’s Board of Governors in May 2012.
- We believe the primary reason Mr. Powell was chosen over Janet Yellen was his support for a slightly lighter touch on financial regulation compared to Ms. Yellen who supported the heightened regulatory environment placed upon the financial system over the past decade. Lightening the regulatory burden on the financial system is a key pillar of President Trump’s economic agenda.
- While one uncertainty regarding the Federal Reserve and future monetary policy was resolved with Jerome Powell’s nomination, another emerged with the announcement that William Dudley, president of the New York Federal Reserve Bank, will retire next year. The New York Federal Reserve president is traditionally one of the central bank’s most influential policymakers, serving as vice chair of the FOMC committee with a permanent vote on the monetary policy deliberations of the committee.
- Dudley’s retirement caps off an unprecedented wave of turnover among the Federal Reserve’s top monetary policy and regulatory decision makers. Besides Ms. Yellen and Mr. Dudley, Vice Chairman Stanley Fischer stepped down in October, leaving three of the seven seats on the seven member Board of Governors open currently. Ms. Yellen announced last month that she will resign from the Board once Mr. Powell is confirmed as chairman, even though her term on the Board of Governors does not end until 2024, leaving four of the seven Board seats open.
- Just yesterday, President Trump nominated Marvin Goodfriend, former Director of Research at the Richmond Federal Reserve Bank, to the Board of Governors. Dr. Goodfriend, a widely respected monetary economist, has been generally supportive of the policy decisions of the Federal Reserve over the past decade, but argued that the bond buying programs should not have included purchases of mortgage-backed securities.
- Marvin Goodfriend will add some academic heft to a group of policy makers which lost a respected economist when Stanley Fischer resigned in October and will lose Ms. Yellen’s expertise when her term expires in February. It is expected that Mr. Goodfriend will be an advocate for continuing the Federal Reserve’s current approach of gradually removing the degree of policy accommodation.
- As we have stated in the past few ISS’s, investors will need to assess if the composition of the Board of Governors early next year will possess the adeptness, foresight, and cautious approach of the Board members since the financial crisis. Investors will also need to evaluate if Mr. Powell indeed follows Janet Yellen’s gradualist approach to removing policy accommodation which adhered to the theme of “doing no harm to the economic expansion” as long as inflationary pressures remained quiescent.
- Monetary policy has been the primary policy tool used to manage the economy over the past decade in the aftermath of the financial crisis. While the unprecedented leadership change at the central bank is definitely an ongoing source of uncertainty for investors as we enter 2018, we believe the institutional framework that is centered on the research staff at the Federal Reserve is likely to guide future monetary policy decisions along the gradualist path which has prevailed since the third and last bond buying program was ended during 2014.
C. Look for the Federal Reserve to Hike Rates in December.
- We expect the Federal Reserve to raise the target for the federal funds rate 25 basis points at the December 12-13 FOMC meeting to a range of 1.25% to 1.50%. The central bank has raised interest rates twice this year, the last time in June. The Federal Reserve will likely remain opportunistic in its efforts to raise interest rates as the economy’s very consistent and persistent underlying growth rate of 2% to 2.5% remains intact. The economy is also receiving an additional boost this quarter from the repair, rebuild, and restocking taking place along the Texas gulf coast and in Florida following the devastation from hurricanes Harvey and Irma.
- Consider that single-family housing starts in October reached an annual rate of 877,000 compared to a year-to-year date average through September of 837,000 as disruptions caused by the hurricanes faded and the process of replacing houses damaged by the storms began. Likewise, light motor vehicle sales averaged 18.25 million during September and October compared to a year-to-date average through August of 16.8 million.
- Additionally, industrial production jumped 0.9% in October, led by sharp gains in the production of chemical and petroleum products and motor vehicles and metal. The pickup in construction activity will continue into early 2018 and likely will combine with the rebound in manufacturing production and durable goods purchases to boost growth above 3% for 4Q 2017.
- Despite the core inflation rate running considerably below the Federal Reserve’s target of 2% at 1.4% year-over-year through October, we think the economy can tolerate a 25 basis point hike in interest rates this month considering the economy’s forward momentum. The far more interesting and serious question is how many times the central bank will raise interest rates during 2018. Currently, the Federal Reserve is forecasting three additional rate hikes next year which would place the federal funds rate slightly above 2%. Currently the futures market has a roughly 90% likelihood of rates being boosted by the June 2018 FOMC meeting and about a 58% chance of a second rate hike in 2018.
- We continue to believe that a 2% federal funds rate is very important, as that was the level of the federal funds rate prior to the Federal Reserve moving to an emergency level of interest rates — ultimately zero — between October and December 2008. A 2% federal funds rate would also put in place a roughly zero real, or inflation-adjusted, short-term interest rate if the Federal Reserve’s 2% inflation target were met, compared to the negative real federal funds rate that has been in place since the late fall/early winter of 2008.
- Using the midpoint of the current target range for the federal funds rate — 1.125% — and a 1.4% reading on core inflation, the real federal funds rate is slightly negative today and would approach zero, with no change in reported inflation, following the expected rate hike this month. This can be compared to an average negative real federal funds rate of approximately -1.5% over the past 9 years.
- This concept of a zero real, or inflation-adjusted short-term interest rate came into play during July in Janet Yellen’s Congressional testimonies and in a speech by Lael Brainard, a Governor of the Federal Reserve. Both Ms. Yellen and Lael Brainard stated that the Federal Reserve “may not have much more to do” in terms of rate hikes, given the level of real, or inflation-adjusted, short-term interest rates.
- In separate appearances, the Federal Reserve officials said that considering the low level of inflation — which had been reported at 1.4% year-on-year for the core personal consumption deflator at the time of their remarks — the central bank, with a 1.0% to 1.25% target for the federal funds rate, was near its effective “neutral rate” in which monetary policy is neither stimulating nor restraining the economy. Brainard explicitly stated that the neutral rate goal– the federal funds minus inflation — is currently estimated to be near zero.
- The level at which the federal funds rate ends this rate hiking cycle will be a function of the level of inflation and whether or not the economy begins to overheat which would require a tightening of policy by the Federal Reserve. If core inflation remains at or below 2%, then the federal funds rate likely will not rise materially above the 2% marker, less the central bank tip into a tightening of monetary policy. A more robust core inflation rate would support a higher federal funds rate.
D. An Update on “Too Quickly or Too Slowly.”
- Given the largely unprecedented turnover among the Federal Reserve’s top monetary policy and regulatory decision makers currently taking place, the unchartered waters the central bank has just begun to navigate in reducing the size of its $4.3 trillion securities portfolio, and the expectation for another rate hike this month, we feel it is crucially important to monitor the Treasury market’s assessment of whether the Federal Reserve is moving too quickly and aggressively to remove monetary accommodation — possibly tipping to a tightening mode, or too slowly which could lead to a build in inflationary pressures.
- We feel the answer to these questions will be unveiled in the Treasury bond market, specifically in the yield spread between two-year Treasury notes and ten-year Treasury notes. Recall that the primary determinant of the yield on longer dated Treasury securities is investor expectations for inflation, with the outlook for growth a secondary consideration.
- If the bond market believes the Federal Reserve is raising interest rates prematurely and/or at too rapid a pace, the yield curve will flatten, i.e., the yield spread between two-year Treasury notes and ten-year Treasury notes will shrink. Likewise, if investors believe the Federal Reserve is proceeding at a pace which is too slow or deliberate, the yield curve will steepen, widening the yield spread between two-year Treasury notes and ten-year Treasury notes.
- The yield spread ended 2015 at 122 basis points and ended 2016 at 125 basis points, compared to a reading of 75 basis points on July 8, 2016 at the peak of investor concerns over the vote in Great Britain to leave the European Union. Following the recent June 13 – 14 FOMC meeting where the Federal Reserve stepped up its proposed moves to reduce monetary accommodation, the yield spread fell to 78 basis points, nearly reaching its level on July 8, 2016. With a modest backup in yields at the end of June, the yield spread ended the month at 92 basis points, and finished July at 94 basis points.
- With the growing consensus that the Federal Reserve would announce at the September FOMC meeting that it would begin to reduce the size of its securities portfolio in October, the yield spread narrowed again during August to 79 basis points. Following the actual announcement by the Federal Reserve to start the gradual runoff of a portion of its bond portfolio during October, the yield spread ended September at 85 basis points. With the growing likelihood of the central bank raising interest rates again this month, the yield spread fell to 57 basis points last month, its lowest level since late 2007 just prior to the Great Recession, before ending November at 63 basis points.
- In our view, the Treasury market has been, and continues to send a fairly clear message to the Federal Reserve that it needs to be careful in its ongoing effort to reduce the degree of monetary accommodation in the U.S. financial system. It appears to us that the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake as it continues along the current path of raising interest rates.
- Guiding 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. The tax proposal also raises the possibility of the Federal Reserve needing to shift its policy approach toward a tightening of monetary policy rather than gradually removing accommodation. The larger, more stimulative, and more deficit financed the tax legislation turns out to be, the greater the likelihood that inflationary pressures could build, ultimately forcing the hand of the Federal Reserve.
- Following the expected rate hike this month, we expect the Federal Reserve to take some time to assess the economic data, particularly the inflation data which continues to run below the central bank’s target. The Federal Reserve will also need to assess the expected impacted from the tax proposal, if in fact tax legislation is signed into law, before returning to the rate hiking cycle sometime in the spring. As always, stay tuned.
E. Is Longevity Necessarily a Bad Thing?
- Consider the following, rather remarkable facts about the current business expansion. As of November, the business expansion has now lasted 101 months, making it the third longest expansion on record since WWII. We continue to expect the expansion to challenge the record 120 month expansion during the 1990’s. Through October, the economy has generated 85 straight months of jobs gains. Jobs growth is the most reliable economic series, as it is much easier to count the number of employees in the economy compared to the aggregate value of their output.
- While the economy has only grown at the lackluster pace of 2.2% over the course of this expansion, growth has been very durable, persistent, and consistent. Consider that over the seven calendar years of this business expansion, the annual growth rates have been between 1.6% and 2.6%, not too hot, not too cold. We originally took the position in the May 2013 ISS that the moderate growth rate of the economic recovery would translate into a long business expansion which would very slowly build momentum over time. We expected better jobs growth to be the key to the expansion becoming self-reinforcing and self- sustaining.
- Hardly a day passes that we do not hear an economic pundit assert that a recession is right around the corner given the age of the current business expansion. We counter that assertion by reminding our readers that economic expansions do not die of old age. Every recession since WWII was preceded by a tightening of monetary policy by the Federal Reserve to address building inflationary pressures in the economy.
- That is why we focus on wage growth — most recent reading on average hourly earnings is 2.4% year-on-year — and on inflation — 1.4% year-on-year reading on core personal consumption expenditures deflator for October — to get a read on whether the Federal Reserve needs to shift its monetary policy approach from removing policy accommodation to a tightening of policy.
- A key result of the long, moderately paced economic expansion has been a long and steady recovery in earnings, which included a seven quarter long interruption largely due to the collapse in oil prices from mid-2014 to early 2016. The recovery in operating earnings began in 4Q 2009 following the trough in stock prices in March 2009 and the start of the economic recovery in 3Q 2009. The rise in earnings continued through 3Q 2014, until the collapse in oil prices caused a seven quarter long earnings recession to 2Q 2016.
- While the S&P 500 price index largely flatlined during the seven quarter long earnings downdraft, stock prices did not decline because the moderate decline in operating earnings was localized in the energy sector. With the rebound in oil prices and continued growth in the economy, earnings have now rebounded for five consecutive quarters and stock prices have moved sharply higher.
- Additionally, hardly a day goes by that we do not hear an investment strategy pundit assert that a bear market in stocks is right around the corner. The principal reason cited is the age of this bull market — currently 104 months — compared to the 109 month average length of a bull market since WWII. While one never knows about stock prices due to the influence of investor sentiment, given our outlook for the economy to continue to grow, we would see any near term downdraft in stock prices as a major buying opportunity.
- Earnings continue to carry the day for common stocks, which makes sense as earnings are the primary source of value for common stocks. The transition from a low interest rate driven bull market to an earnings driven bull market over the past year continues. U.S. multinational companies are being supported by strong global growth. Inflation, interest rates, and bond yields are still low and confidence measures across households, and small and large businesses are strong.
- The bottom line is we remain positive on the outlook for common stocks due to the outlook for the economy and earnings. We continue to view the majority of the advance in stock prices since the presidential election as supported by the persistence of the economic expansion, the sharp rebound in operating earnings, and the fact that no new taxes were enacted and no further ramp up in growth inhibiting regulations occurred this year because Hillary Clinton was not elected president.
F. Do the Tax Proposals Contain Risks to the Economy and the Stock Market?
- We see two risks to the economy and the stock market from the current effort in Washington to pass tax legislation late this year or early in 2018. First, it does appear that some probability of tax reform, particularly corporate tax reform, has been priced into stock prices over the past three months as the push from the White House and Congress has gathered momentum. The S&P 500 has advanced another 7.1% since the end of August and we think that represents a reasonable amount of downside risk to stock prices should the effort to rewrite the tax code fail.
- The other risk from the push for tax reform lies in the composition of the package that is passed. We believe investors are clearly hoping for corporate tax reform with a lower statutory tax rate on earnings which will improve the attractiveness of the U.S. on the global stage. Additionally, a move to a territorial tax system — including 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 spend on jobs, business capital spending projects, dividends, and share repurchases — would be well received.
- The tax proposal risk is a major stimulus package which includes a large tax cut for high income taxpayers which results in much larger budget deficits which will ultimately place upward pressure on Treasury yields at a time when the Federal Reserve is shrinking the size of its investment portfolio of Treasury securities, agency, and mortgage-backed securities.
- A major stimulus package could also pull growth forward, boost wages, flame inflationary pressures, and move the Federal Reserve to leave the term “gradual” behind and more aggressively raise interest rates, beginning the tightening phase which will eventually lead to the next recession. The bottom line is the larger the tax cuts turns out to be and the larger the resulting budget deficits turn out to be, the more likely it is that the tax proposal will hasten the end of the current business expansion.
- We need to keep in mind that the current movement toward a tax proposal is coming with an economic expansion that is over eight years removed from the Great Recession. The expansion is now the third longest on record and the economy is posting consistent gains in the jobs market, consumer spending, and business capital spending on equipment. Add in that the nation’s unemployment rate is at a 16 year low at 4.1% and an improving global economy is boosting U.S. exports, industrial production, and capacity utilization.
- The major tax cuts under Presidents Reagan and Bush came with the economy in recession or just beginning to rebound. It would be very unusual to advance a major stimulus plan financed by massive budget deficits at this point in the economic cycle. Corporate tax reform is appropriate; a significant deficit financed stimulus plan is not. The last thing the economy needs right now is to inject a one or two year sugar high into the expansion, only to have the economy either fall into recession or return to its current trend growth rate, with a significant increase in the national debt. As always, stay tuned!
II. Treasury Market
A. Treasury Yields Rose Across the Yield Curve Again Last Month.
- For the third month in a row, Treasury yields rose across the yield curve last month. Against a backdrop of solid economic growth, still low inflationary pressures, and the Republican – led Congress and the White House pushing for a major tax proposal, investors responded to the growing likelihood that the Federal Reserve would increase the range for the federal funds rate 25 basis points to 1.25% to 1.5% at the December 12-13 FOMC meeting.
- Yields on Treasury securities with maturities between three months and two years rose 13 to 19 basis points last month following a gain of 9 to 13 basis points during October. Since the end of August, the two-year Treasury note yield has increased 45 basis points from 1.33% to 1.78%.
- Yields at the longer end of the Treasury yield curve are being impacted by two things. First is the Federal Reserve beginning to shrink the size of its investment portfolio during October. The central bank did not reinvest $10 billion of maturing securities in both October and November and will follow suit in December. The central bank will raise the monthly runoff amount by $10 billion in each of the next four quarters until the monthly runoff reaches $50 billion per month in October 2018.
- Investors are also responding to the growing likelihood that our elected officials in Washington will pass a package of tax reform/cuts sometime later this year or in early 2018. While the exact composition of the proposal is still being negotiated, the package is expected to include some near term stimulus and larger budget deficits, which should support some upward pressure on wages and prices, lending support to continued gradual hikes in interest rates by the Federal Reserve and some additional upward pressure on longer term bond yields.
- Yields on Treasury securities with maturities between five to thirty years rose 3 to 12 basis points last month following a gain of 2 to 8 basis points during October. Since the end of August, the ten-year Treasury note yield has increased 29 basis points from 2.12% to 2.41%.
- Despite the recent increases in yields across the Treasury curve, the ten-year Treasury yield at 2.41% remains slightly below the 2.44% yield at the end of 2016 when the markets were encouraged that Donald Trump would bring an economic agenda to Washington which would have been good for business, households, and the economy, in general. With the major push on a tax package by the GOP over the past three months, it is not surprising Treasury yields have approached the levels that prevailed from December through March when hopes were high that major tax legislation would move forward over the summer months.
B. Tax Legislation Could Push Treasury Yields Higher.
- As the yield on the ten-year Treasury note has risen over the past three months, notice in the table below that both the real, or TIP, yield and the implied inflation expectation have risen. While the start of Federal Reserve shrinking its investment portfolio likely had some impact on the ten-year Treasury yield, we think the vast majority of the rise in the real yield and the inflation premium has been caused by the anticipation of the tax reform/cut package becoming law in the not too distant future. It is interesting to note, however, that while the implied inflation expectation has moved modestly higher over the past three months, it is still below the expected inflation rate over the next ten years recorded at year end.
- Where Treasury yields go from here over the next quarter or two will be materially impacted by the scale, scope, and timing of the tax proposal, including whether or not the GOP can corral its somewhat disparate factions to back the passage of a bill at all. For the time being with the solid 2.0% to 2.5% forward momentum in the economy, some near term hurricane- related pick-up in demand, modest inflationary pressures, and with the uncertainty of a tax proposal of some unknown economic punch becoming law sometime in early 2018, we continue to look for a trading range of 2.25% to 2.75% for the ten-year Treasury note to remain in place in the near term.
- Should a tax proposal which contains a significant amount of deficit financed stimulus pass Congress over the next couple months, the yield on the ten-year Treasury could take a run at 3%, a level we have not seen since late December 2013. The more stimulative and deficit financed the proposed tax rewrite turns out to be, the possibility exists that the entire Treasury yield curve could shift even higher.
- Not only would Treasury yields need to adjust to a faster growth rate in the economy and the likelihood of additional rate hikes by the Federal Reserve, but also to a potential increase in the federal budget deficit at a time that the Federal Reserve is shrinking its holdings of government bonds and the cost of servicing the national debt is rising with the rise in Treasury yields. As always, stay tuned!
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.