INVESTMENT STRATEGY STATEMENT
February 1, 2017
I. Equity Markets
A. Confidence Measures Soar, Trump’s Dizzying Pace.
- Donald Trump was sworn in as the 45 president of the United States on January 20, and investors celebrated by pushing the DJIA above 20,000 for the first time three trading days later. The surge in optimism among investors, consumers, and business leaders that a more pro-business and pro-growth environment and mindset has descended upon Washington remains intact. Consider that the Conference Board survey of CEO confidence is at its highest level in six years and the National Federation of Independent Business survey of small business optimism skyrocketed in December to its highest level since 2004.
- Likewise, the Conference Board Consumer Confidence measure soared in November and December to its highest level since 2001 and the University of Michigan Consumer Sentiment Index hit a new cycle high in December. Regardless of one’s political leanings, most Americans feel as if the eight year long war against business and capitalism is finally over.
- In fact, one could make a case that part of the so-called Trump rally and surge in confidence could be attributed to Hillary Clinton. The betting markets had about an 80% probability of a Clinton victory priced in prior to the election, which would have brought more tax increases, more income redistribution, and more regulation. So not only are investors, households, and business chieftains and owners celebrating Mr. Trump’s victory, there is also a sigh of relief with the outcome of the presidential election.
- Investors tracked very closely the dizzying pace of President Trump’s first 12 days in office as they searched for insights on how the Trump economic agenda will develop. Mr. Trump turned several campaign promises into executive actions which chipped away at the Affordable Care Act, expedited the Keystone XL and Dakota Access oil pipelines, and formally withdrew from the 12 nation Trans-Pacific Partnership, a proposed trade agreement with 11 Pacific countries.
- The new president declared his intention to build a physical barrier to secure the southern border with Mexico, took steps to pare back federal regulations, and triggered a diplomatic clash and fresh fight over trade by proposing a 20% tax on imports from Mexico. President Trump is attempting to use the leverage of the vast U.S. market to extract better trade terms company-by-company and country-by-country to preserve existing jobs and create new jobs in mature U.S. industries inherently vulnerable to automation and import competition.
- The S&P 500 and the DJIA fell -0.7% and -1.1% over the past two trading days in the aftermath of President Trump’s move last Friday to restrict immigration from seven Muslim-majority countries as part of a plan to tighten national security. This executive order triggered legal challenges, congressional criticism, widespread protests, and confusion at airports across the county. This incident reminded investors that the major risk with the Trump administration is political risk, particularly as it relates to immigration, tariffs, and trade wars.
- For the month of January, the major stock market measures posted moderate gains of 0.3% to 4.3%, pushing stock prices higher by 6.5% to 13.9% since the presidential election on November 8. Since the S&P 500 reached its 2016 high on December 13, the day before the Federal Reserve raised interest rates, the S&P 500 and the NASDAQ Composite are higher by only 0.3% and 2.8%, respectively, while the DJIA and the Russell 2000 are lower by -0.2% and -0.9%, respectively. Investors have spent the past month and a half digesting the positives and negative associated with a Trump administration, including the uncertainties over the specifics of the Trump economic agenda.
B. Federal Reserve to Raise Rates Slowly and Gradually.
- The Federal Reserve will conclude a two day FOMC meeting today and we do not expect any change in policy to come from the meeting. However, investors will be watching for signs about the timing and pace of rate hikes. We expect the signs to be far and few between.
- In the minutes from the December 13-14 FOMC meeting, the Committee members concluded that it was too early to know how much stimulus will be injected into the economy from President Trump’s policy proposals, when the proposals could take effect, and how such changes might alter their economic outlook. They agreed to stick to their plan for gradual interest rate hikes this year and to monitor how the economy responds to the December rate hike.
- As we think about monetary policy over the next two to three years, it needs to be acknowledged 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. Janet Yellen has consistently stated in her recent Congressional testimonies that some assistance from fiscal policy would be very welcome and would help the central bank in its mission to raise or “normalize” the level of interest rates.
- With the federal funds rate currently targeted at 0.50% to 0.75%, it remains a good distance below the 3% longer run “normal” level that the Federal Reserve is targeting over the next couple years. Consequently, we do not see the Federal Reserve undertaking any policy actions which would place the now 90 month long economic expansion at risk anytime soon.
- Despite our outlook for a more pro-business environment and mindset in Washington, a pickup in the economy’s 2% growth rate, and some reflation in the domestic economy from Mr. Trump winning the presidential election, the policy details are still unknown and the initiatives are not likely to directly impact the economy in a meaningful way until late 2017 and into 2018. The degree to which growth and inflation is rekindled will depend on the specifics of the policy proposals and the reactions in the financial markets — particularly bond yields and the dollar — to those proposals.
- The 1.9% rate of growth in the economy during 4Q 2016 and the 1.3% pace of inflation reported for the core personal consumption expenditure price index last week do not provide any sense of urgency for the Federal Reserve to move away from its slow and gradual pace of rate hikes. We think the Federal Reserve is still in the midst of a prolonged period of seeking the pace of rate hikes and the level of interest rates that the economic expansion can “tolerate.” That is, look for the central bank to remain data dependent — with a keen interest on the details of the Trump economic agenda — and to pursue a pace of rate hikes which will not cause the economic expansion to stall.
- While the December forecast from the Federal Reserve contained three rate hikes for 2017, the Treasury market is looking for the Federal Reserve to be able to raise rates two times this year with the two-year Treasury note yield finishing January at 1.2%. The futures market has a roughly 32% probability of two rate hikes this year and only a 25% chance of three hikes. Assuming that optimism about the Trump economic agenda impacts household spending decisions and business hiring and capital spending decisions this year in a positive manner, we can see two rate hikes in 2017, but three rate hikes still look to be a bit of a stretch at the moment. As always, stay tuned!
C. Fourth Quarter 2016 Growth, More of the Same.
- The economy posted a 1.9% growth rate in 4Q 2016, right in line with the 2.1% annual rate of growth over the course of the current business expansion, making it the weakest expansion since WWII. However, the current business expansion is also one of the longest at 90 months, compared to the average length of an expansion since WWII at 58 months. For all of 2016, the economy grew 1.6%, the slowest pace since 2011 and down from 2.6% in 2015. That marks the eleventh consecutive year that the economy has failed to reach a 3% growth rate, the longest period since the government started reporting on the economy’s growth rate in 1929.
- Consumer spending continued to grow at a solid pace, advancing at a 2.5% rate last quarter and growing 2.7% for all of 2016. Consumer spending was led by a strong 10.9% gain in durable goods outlays, with gains across the board in motor vehicles, household furnishings, and recreational goods and vehicles. A 2.3% rise in real disposable personal income and a decline in the personal savings rate from 5.8% to 5.6% supported the solid rise in consumer spending.
- Housing outlays rebounded at a 10.2% rate in 4Q 2016, after contracting in the prior two quarters. The gain in housing activity was consistent with housing starts growing at a 27.2% pace over the course of the fourth quarter, which was led by a 43.8% annualized rise in single-family housing starts. Business capital spending rose at a 2.4% rate, the third consecutive quarter of modest growth following two quarters of decline at the end of 2015 and beginning of 2016.
- Real domestic private final sales — the sum of consumer spending, housing outlays, and business capital spending — grew at a 2.8% pace in 4Q 2016 compared to 2.4% in 3Q 2016 and contributed 2.4 percentage points to the economy’s 1.9% growth rate. Business inventories rose at a $48.7 billion annual rate, adding one percentage point to the economy’s growth rate. This inventory build could be a source of weakness in the current quarter’s growth rate to the extent inventories are drawn down this quarter.
- The big drag on the economy’s growth rate last quarter was a further widening in the trade deficit, as real net exports subtracted a significant -1.7 percentage points from the economy’s growth rate. Both sides of foreign trade hurt the economy’s growth rate with exports falling at a -4.3% annual rate and imports rising at an 8.3% pace. This drag on the economy’s growth rate last quarter is just more fodder for President Trump’s focus on “unfair” trade agreements and the negative impact of production being moved out of the U.S.
- The inflation measures were relatively tame again last quarter, with the price index for gross domestic purchases, which measures prices paid by U.S. residents, rising at a 2.0% rate, largely due to rising energy prices. Excluding the more volatile food and energy prices, the core gross domestic purchases price index increased at only a 1.4% rate. The Federal Reserve’s preferred measure of inflation, the core personal consumption index, rose at a 1.3% rate and was higher by 1.7% over the four quarters of 2016.
- We continue to believe the low in domestic inflation for this cycle likely occurred in 2015, prior to the pace of gains in average hourly earnings turning up over the past 18 months. The wage gains set the stage for inflation to rise modestly over the next year, before any impact from the still unknown Trump economic agenda takes effect later this year and into 2018. We are looking for the economy to reflate a touch over the next two years, reaching the Federal Reserve’s 2% target. However, the rise in inflation will be capped by a commensurate rise in bond yields, the dollar, and potential policy moves from the Federal Reserve.
D. Business Expansion to continue at Moderate Pace for Now.
- The consensus among investors, consumers and business leaders is that the economy’s growth rate is poised to accelerate from President Trump overhauling the corporate and individual tax codes, boosting military and infrastructure spending, rolling back federal regulations, and negotiating new trade deals which will narrow the foreign trade deficit. However, until the Trump economic agenda is defined and ready to be implemented, we see the current economic expansion rolling on at a pace near 2%. We see no signs of the economy slipping into recession any time soon, nor do we see any evidence that a significant pickup in the economy’s growth is about to take place, absent the anticipated policy proposals.
- We stated in the November ISS that a faster pace of growth would likely require pro-growth fiscal policies centered on business capital spending initiatives, tax reform which contained household and business incentives, and high payback infrastructure spending. Add in some regulatory rollbacks and that sounds like the general thrust of the still undefined Trump economic agenda.
- President Trump has the opportunity to improve on the 2.1% growth rate of the current expansion and the key to a faster pace of growth with the expansion being 90 months old is business investment. With the population aging, we do not look for much of a ramp in consumer spending. This means faster growth and productivity will have to come from liberating the trillions of dollars in capital that have been waiting for the political, tax, and regulatory climate to change. The promise of the Trump-Republican proposals on tax reform and deregulation have lifted confidence, optimism, stock prices, and bond yields and if they are implemented, could unlock a burst of business capital spending and risk taking.
- We look for the economy to start benefitting from the President’s economic agenda in 2018. For 2017, the boost to confidence could add to the economy’s growth rate through a modest acceleration in household and business capital spending, potentially pushing the economy’s growth rate a touch above the 2.1% pace seen over the course of this expansion. A growth rate closer to 3% will require a full menu of pro-growth policies and initiatives. Stay tuned as the Trump economic agenda is developed and negotiated with Congress over the next 3 to 6 months.
E. So Far, So Good on the Earnings Front.
- We stated in last month’s ISS that 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 S&P 500 growing 12.8% in 3Q 2016 on a year-over-year basis, ending a seven quarter long earnings recession brought on by the plunge in oil prices and the surge in the dollar. Investors are looking for the earnings recovery to benefit from the implementation of the Trump economic agenda, but that is not expected to impact the economy and earnings until later this year and into 2018.
- What about 2017? Will the earnings recovery continue, lowering the price-to-operating earnings ratio in a positive manner, with the gain in earnings exceeding the gain in prices? With almost 43% of the S&P 500 companies reporting fourth quarter earnings so far, operating earnings look to be higher by more than 30% over 4Q 2015.
- A good portion of that is an expected rebound in oil company profits, but even ex-energy, 4Q 2016 operating earnings look to be higher by about 15% year-on-year. If the expected earnings gain for the fourth quarter holds to the end of the earnings season, the trailing four quarter P/E ratio on the S&P 500 would drop from 22.1x at year end to 21.0x
F. Growth and Earnings vs. Inflation, Interest Rates, and Bond Yields.
- We continue to look for moderately higher common stock prices this year, with a growing earnings stream being an absolute necessity. The modest reflation we expect over the next two years with the Trump economic agenda spurring a faster growth rate will initially be good for earnings. This can be thought of as good reflation. History suggests, however, that good reflation can transition to bad reflation should it lead to more significant increases in interest rates and bond yields.
- Should inflationary pressures shoot above 2% and begin to approach 3%, the resulting levels of interest rates and bond yields run the risk of a decline in valuations — the market’s price-to-operating earnings ratio — which could more than offset the rise in earnings from the stronger pace of growth. The result would be lower stock prices arising from the rise in interest rates and bond yields due to the building inflationary pressures.
- This makes watching the scale and scope of the actual tax cuts and reform, the size of the increase in military and infrastructure spending, the extent of any regulatory roll backs, the actual impact on trade and immigration, and the resulting burden on the federal budget deficit to be extremely important. We remain optimistic about the general tone of the likely proposals to come from a Trump administration, but the net impact from everything mentioned above on earnings and inflation will determine if investors will be rewarded from the new, but still undefined, economic proposals and initiatives.
- As investors digest the positives and negatives associated with a Trump administration and the new policy dynamics it generates, the Trump rally could be held in check for a while longer, as has been the case since mid-December, despite the DJIA hitting 20,000 last month. However, we look forward to a positive, pro-growth economic agenda and believe the experienced business leaders who are advising the President and have been nominated and/or confirmed for Cabinet posts will largely thread the needle and propose policies which will boost growth and earnings, while limiting the rise in inflation, interest rates, bond yields, and the budget deficit.
- As such, we recommend that investors buy any -3% to -5% pullbacks in stock prices early this year to position their portfolios for 2017. We look for the Trump economic agenda to leave the 2.1% growth rate of the past seven and a half years in the rear view mirror. Once fully implemented in 2018, we expect the economy’s growth rate to accelerate to a 3.0% pace, with a quarter or two during which the growth rate could exceed 3.5% to 4%. As the economy and earnings pick up over the next couple years, we look for common stocks to grind higher.
- The new hurdle possibly facing stock prices is the era of ultra-low interest rates and bond yields fading into the background. We expect the economy to be able to tolerate somewhat higher interest rates from the Federal Reserve as pro-growth policies boost the economy’s growth rate and inflationary pressures rise a modest amount, reaching 2%, but remaining under control. This scenario will also result in bond yields rising modestly over the next year. Volatility should return to the stock market this year with a push-pull taking place as signs of faster growth and stronger earnings face off with bouts of higher interest rates and bond yields and a stronger dollar.
II. Treasury Market
A. Interest Rates and Bond Yields Little Changed in January.
- After rising sharply following the presidential election to the end of 2016, interest rates and bond yields were little changed during January. Consider that the yields on three-month and one-year Treasury bills rose 8 and 17 basis points, respectively, from November 8 to the end of 2016. The 25 basis point increase in the range for the federal funds rate announced by the Federal Reserve on December 14 lifted yields at the short end of the Treasury yield curve. Yields on three-month and one-year Treasury bills rose one basis point and fell -5 basis points, respectively during January.
- Treasury yields rose to a much greater extent from two years to thirty years from November 8 to the end of 2016, on the order of 34 to 61 basis points. During January, yields on Treasury securities from two years to thirty years fell -2 basis points to rising one basis point. The Treasury market, just like the equity market, repriced for a faster pace of growth with wages and prices firming in anticipation of a pro-growth Trump economic agenda.
- The yield on the ten-year Treasury note rose from 1.86% on November 8 to 2.44% at year end 2016. During January, the ten-year Treasury yield traded between 2.33% and 2.52%, before ending the month at 2.45%. We have been looking for the yield on the ten-year Treasury note to trade between 2.35% and 2.75% for the next couple months and see no reason to change that outlook at the present time.
B. Treasury Market Expecting Modest Rise in Growth & Inflation.
- The fixed income market is looking for 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 that the yield on ten-year TIP’s fell into negative territory following the vote in Great Britain to exit the European Union as investors feared that global growth could suffer in its aftermath. That growth scare and negative TIP yields quickly passed, however, 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 as investors pushed out to late 2017 before the economy will be impacted by the Trump economic agenda. We should note, however, that the TIP yield is below its level at the end of 2015. The market is likely expecting that the downward pressure on growth from the aging U.S. population and the burdensome size of the national debt are headwinds that the Trump economic agenda will confront.
- 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 fairly sharply from its low on July 8 at 1.27% to over 2% currently. This placed the market’s ten year inflation outlook over 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.
- It appears the Treasury market is focused on the secular forces holding back growth and the timing of the pro-growth policy initiatives expected from the Trump administration with the expansion 90 months old, slack in the labor market waning, and wage pressures building. One potential inference is that the Treasury market is wary the Trump policy initiatives could hasten the end of the business expansion to the extent inflationary pressures rise, leading to the Federal Reserve tightening monetary policy and bond yields rising. Lots of uncertainty, lots of analysis ahead of us
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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