INVESTMENT STRATEGY STATEMENT
February 1, 2018
I. Equity Markets
A. Common Stocks Open 2018 with a Bang!
- Up until earlier this week, the reaction of investors to Donald Trump’s election, improving economic growth across the globe, and the rebound in operating earnings over the past six quarters has been nothing short of phenomenal. Consider that from the day of the presidential election to last Friday, the S&P 500 gained a remarkable 34.3%. This included a 19.4% gain during calendar 2017. Enthusiasm about the new tax law, which reduced the corporate tax rate to 21% from 35% and moved the U.S. to a territorial tax system, bolstered investor optimism and market momentum as 2018 unfolded, sending the S&P 500 higher by another 7.5% to January 26.
- The S&P 500 pulled back -1.8% on Monday and Tuesday, as almost any sentiment, momentum, or valuation measure one wished to look at pointed to a market which had gotten a bit ahead of itself. One could point to the recent rise in bond yields, fears of a more aggressive policy response on the part of the Federal Reserve, delayed tax related selling, or valuations getting stretched as a reason for the sharp pullback earlier this week. We feel it was likely all of those things which contributed to the sharp and quick decline to Tuesday’s close. We view the pullback as very healthy and as simply an interruption in the bull market, not the actual end of the bull market.
- Despite the pullback in stock prices earlier this week, the major market measures posted very sharp gains in January, with the technology-heavy NASDAQ Composite leading the way with a gain of 7.4%. The S&P 500 and the DJIA rose 5.6% and 5.8%, respectively, while the Russell 2000 Index of small company stocks added 2.6%. The gains in stock prices since the presidential election are truly remarkable, with the major market measures higher by 31.8% to 42.7%.
B. Economy Finished 2017 on a Strong Note.
- The U.S economy grew at a 2.6% annual rate in 4Q 2017, disappointing some analysts who were hoping for the economy to grow at a rate of 3% or more for the third consecutive quarter. Had the 3% growth rate been hit last quarter, it would have marked the first time the economy had grown at a pace of 3% or more for three quarters in a row over the course of the now eight and a half year long economic expansion.
- However, there is absolutely no reason for investors to be disappointed in the economy’s performance last quarter, as the headline real GDP figure materially understated the economy’s forward momentum. Businesses built inventories at a much slower pace than in 3Q 2017, subtracting -0.7 percentage points from the 4Q 2017 growth figure. Additionally, real net exports declined in 4Q 2017 — as exports grew at a 6.9% pace, but imports advanced at a much stronger pace of 13.9% — reducing real GDP by -1.1 percentage points. If the impact from both inventories and net exports had been zero, real GDP would have grown at a 4.4% annual rate in 4Q 2017.
- The most reliable measure of the economy’s underlying growth rate, real domestic private final sales (real DPFS) — the sum of consumer spending, business capital spending, and residential construction outlays — grew at a fairly robust pace of 4.6% last quarter, considerably faster than the 2.3% pace of 3Q 2017. Real DPFS rose 3.3% over the four quarters of 2017, with all of its components posting strong gains last quarter.
- Consumer spending, roughly 67% of the domestic economy, increased at a 3.8% rate in 4Q 2017, compared to an advance of 2.2% during the previous quarter. Goods purchases were particularly strong with nondurable goods purchases growing at a 5.2% pace while durable goods purchases soared at a 14.2% rate, the fastest quarterly pace since 2009.
- Goods purchases clearly benefitted from some replacement demand following hurricanes Harvey and Irma during September and the wildfires in California which hit peak devastation during October. A concern for consumer spending going forward is that the pace of consumer spending has outpaced the growth in disposable income for the past two years, resulting in the personal savings rate falling from 6.1% in 4Q 2015 to only 2.6% in 4Q 2017.
- Residential construction outlays also benefitted from the natural disasters last quarter, surging at an 11.6% rate after contracting during four of previous six quarters. The pullback in housing outlays from 2Q 2016 to 3Q 2017 was largely confined to the multi-family sector which was overbuilt following strong demand for apartments coming out of the Great Recession.
- Builders turned their attention to building high end apartment structures as many households turned away from home ownership after the meltdown in the mortgage market and the collapse in home prices during the financial crisis. As frequently happens, the supply of apartments overtook demand and multi-family housing starts declined almost 20% from 2Q 2016 to 3Q 2017.
- Business capital spending rose at a 6.8% rate in 4Q 2017 compared to a gain of 4.7% during the previous quarter. Equipment spending led the way with a strong 11.4% annualized rate of growth, the third quarter in a row during which equipment purchases hit 8.8% or greater. The equipment purchases were widespread, on everything from high tech equipment to machinery and trucks. It appears the significant recovery in business confidence following the presidential election has translated into a strong commitment to boost investment, which ultimately should boost productivity growth.
- The inflation measures remained low, but did show some signs of firming last quarter. The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose at a 2.5% pace as oil prices rose about 17% during 4Q 2017. Excluding the more volatile food and energy prices, the core gross domestic purchases price index increased 1.9% compared to 1.7% during 3Q 2017.
- The Federal Reserve’s favorite measure of inflation, the core personal consumption expenditures index, also rose at a 1.9% annual rate, compared to 1.3% during 3Q 2017. However, core inflation year-on-year was higher by only 1.5%. While inflation remains low, it looks like the Federal Reserve’s 2% inflation target could finally be coming within reach over the next year or so.
C. Look for a Further Acceleration in the Economy’s Growth Rate.
- Over the course of this economic expansion, now 102 months old compared to the average length of an expansion since WWII of 58 months, the economy has grown at a 2.2% annualized rate, compared to a 3.2% long run growth rate, primarily due to an aging population and growing regulatory burdens during the Obama administration. Over the four quarters of 2017, the economy grew at a somewhat faster pace of 2.5%, led by solid gains in consumer and business capital spending as confidence measures soared.
- By all indications, the economy has responded fairly positively to President Trump’s election over the past year. Consider that the two major measures of consumer confidence — the University of Michigan Consumer Sentiment Index and the Conference Board Consumer Confidence Index — both reached 17 year highs during October.
- Likewise, the National Federation of Independent Business Index of Small Business Optimism ended 2017 just below its all-time high recorded in 1983 and the Conference Board CEO Confidence Survey is just below its pre-Great Recession high reached in 2007. Additionally, all of the purchasing manager surveys and the business surveys done by the regional Federal Reserve Banks are all consistently strong.
- As we stated in last months’ ISS, we expect the economy’s growth rate to rise to a range of 2.5% to 3% this year and next, and would not be surprised by the economy’s quarterly growth rate exceeding 3% for a quarter or two. Consumer spending will be supported by solid job growth with the decline in the corporate and pass-through tax rates, the return of corporate earnings held overseas to the U.S., and from the drumbeat of companies announcing bonuses and higher starting wages with the passage of the tax package in December.
- Business capital spending is expected to be the strongest sector of the economy this year as the decline in the corporate tax rate and the move to a territorial tax system lowers the cost of capital to Corporate America and from the provision which allows immediate expensing of capital outlays for the next five years. We believe the opportunity for companies to write off capital investments in the year in which they are made is the most economically interesting part of the tax package in the near term as it will stimulate business capital spending on equipment, providing a near term boost to aggregate demand while increasing the economy’s productive capacity over time.
- The outlook for the housing market is a bit of a mixed bag. The cap on the amount of mortgage interest that can be deducted is only a minor negative when one considers that only 5% of households have a mortgage greater than $500,000. The cap on the deduction for state and local taxes will have a significant impact on the housing market, however, creating a whole series of winners and losers across the country. It deals a blow to high tax, costly real estate regions of the country, but potentially fuels demand in low tax, less costly real estate regions of the county.
- The cap on the deduction for state and local taxes will only reinforce the recent trend of migration — largely driven by retiring baby boomers — from high cost regions of the economy to lower cost regions as a large portion of the subsidies for residing in high tax locales and owning high priced real estate has been legislated away. It will also lead businesses to be more likely to expand operations in lower cost states, as high state and local income taxes and property taxes will become even greater hurdles to doing business in high cost states.
- Of course, solid job growth and continued forward momentum in the economy will support housing outlays, while the recent modest rise in mortgage rates will hurt affordability conditions across the country. All in all, we look for little change in residential construction outlays for the economy as a whole this year, but look for vastly different impacts across the various regions of the country as homeowners sort out all of the factors impacting the economics of home ownership across this vast nation we live in.
- Before the passage of the tax package in December, the economy had solid forward momentum around 2.5% and there were no signs on the horizon of the economy falling into a recession anytime soon as policymakers have not had to address building inflationary pressures. In fact, inflation eased a touch during 2017, allowing the Federal Reserve to continue on a course of only gradually increasing interest rates. The bottom line is that the economic expansion can continue until inflationary pressures build, which will ultimately force the Federal Reserve to tighten monetary policy.
- Following the passage of the tax package, and analyzing its impact on corporate and individual taxes, we expect that only a moderate amount of aggregate demand will be pulled forward into 2018-19. The majority of the benefits in the tax package are embodied in the corporate and small business tax reform which lowers the cost of capital to businesses and places the U.S. and U.S. companies in a more competitive position, providing very much needed benefits to the U.S. economy and U.S. businesses on a longer term basis. Individual tax relief is fairly modest, as evidenced by the adjustment in the IRS withholding tables which will provide only a 2% to 4% increase in take home pay starting this month.
- The tax package does pose some risks for the economy, in particular its impact on the outlook for inflation. Not once during the post-WWII era has the economy received a fiscal stimulus boost with the expansion eight and a half years old, the unemployment rate at 4.1%, the economy posting consistent job gains, and an improving global economy boosting U.S. exports and industrial production. While we are not looking for a material build in inflationary pressures this year, the current set of circumstances in the economy places inflation at the top of the list of risks as we enter 2018.
D. The Real Issue, the Outlook for Inflation.
- One of the most notable characteristics of the current business expansion is that despite an unemployment rate that has been at 5.0% or below since September 2015, the wage- inflation dynamic of past economic cycles has not developed. The unemployment rate is currently 4.1% and average hourly earnings are only higher by 2.5% year-on-year. While this increase in average hourly earnings is higher than the recent low of 1.7% back in December of 2014, it is materially below the historical range of increases in average hourly earnings at very low levels of unemployment.
- Related to this modest rise in wages is the Federal Reserve’s preferred measure of inflation — the core personal consumption expenditure deflator — being higher by only 1.5% on a year-over-year basis. There are several reasons, unique to current times and the current business expansion, why wages and prices have not followed their historical pattern of moving significantly higher as the expansion ages.
- First, the 4.1% unemployment rate likely understates the amount of slack in the labor market due the labor market participation rate being artificially low due to discouraged workers who have taken themselves out of the labor force and income support from a variety of welfare programs which offer an alternative to working.
- Consider the 25 to 54 year age cohort, the prime source of workers in the economy. Prior to the Great Recession, the participation rate of this age group in the labor market was 83% to 83.2%. It fell to a low of 80.5% following the recession and has only risen to 81.8% currently. As the jobs market continues to improve, this age cohort represents a source of labor available to fill job openings not included in the official statistics.
- Demographics are also keeping a lid on wage pressures. While no longer the largest segment of the population, the baby boomers are still a large and influential component of the work force. As the baby boomers reach retirement age — 10,000 baby boomers reach the age of 65 each day — on average those who retire give up a wage at the upper end of the pay scale and are replaced by workers from the millennial generation who earn a wage at the lower end of the pay scale as they do not have the benefit of years of experience. This generational churning of the employee population places downward pressure on wages.
- A hangover from the Great Recession is an unwillingness on the part of households to accept higher prices for items which they can look to substitute or do without. Related to this is the so-called “internet effect” which has greatly facilitated the search for low prices. Web-driven comparison shopping enhances consumer knowledge of prices, keeping a lid on prices that retailers can charge.
- Price competition has moved to unprecedented levels with the ability to source product from anywhere in the world. A fallout from this extreme price competition is an unwillingness on the part of employers to raise wages because they fear an inability to pass those higher wages on to higher prices for their products and services. The ecommerce revolution is a structural shift in shopping habits where low prices beget low prices.
- Notice in the table below that from the end of 2014 to the day of the presidential election, the ten-year implied forecast for inflation embodied in ten-year Treasury securities remained in a fairly tight range between 1.5% and 1.75%. Following the election, the implied inflation expectation moved fairly quickly toward 2% by the end of 2016 and remained there as 2017 came to an end. However, as investors have had an opportunity to digest the tax package signed into law at the end of last year, the implied inflation expectation has risen a touch higher, to 2.11% at the end of January.
- In our view, the key to the outlook for the economy and the financial markets will be the extent to which inflationary pressures rise this year and into 2019 following the passage of the tax bill which will inject a moderate amount of additional stimulus into a late cycle economic expansion. As we stated previously, this is the key risk to the economy and the financial markets from the tax package. A rise in core inflationary pressures will lead the Federal Reserve to shift the intent of monetary policy deliberations from a policy of gradually removing accommodation to a policy of tightening credit availability to combat rising inflationary pressures.
- So far the Treasury market is looking for inflationary pressures to move only a touch above the Federal Reserve’s 2% inflation target over the next ten years following the passage of the tax package. We believe the outlook for inflation is at a critical juncture. Will the cyclical dynamics come together, following the passage of the tax package, to flame inflation pressures, or will the structural dynamic grounded in ecommerce continue to place a lid on inflation? We expect the structural dynamic to prevail, with only a modest build in inflationary pressures. The initial clues on the outlook for inflation will be found in wages, so we encourage everyone to keep an eye on the average hourly earnings data.
E. Era of New Leadership at the Federal Reserve Begins.
- Janet Yellen attended her last FOMC meeting on January 30-31 as a board member and chair of the Federal Reserve. Ms. Yellen will likely be remembered for emphasizing the central bank’s commitment to fostering a healthy labor market over her 7+ years on the Board of Govenors as the economic expansion proceeded in fits and starts. Previous to her four year term as chair, Janet Yellen was among the strongest supporters on the Board of unprecedented policy moves, including holding short-term interest rates near zero for an extended period of time and buying government bonds to lower long-term bond yields, as the economy grew at a very lackluster pace.
- These aggressive and unconventional policies were implemented to boost hiring and support the somewhat fragile recovery in the economy from the Great Recession. During her term as chair, Ms. Yellen oversaw the end of the last bond buying program in late 2014, the first increase in interest rates for this cycle in December 2015, and the start of the Federal Reserve shrinking its $4.3 trillion investment portfolio in October of last year.
- As widely expected, the Federal Reserve left interest rates unchanged at 1.25% to 1.5% following the conclusion of the policy meeting yesterday, after raising interest rates at the December 12-13 FOMC meeting. The Committee said that “Gains in employment, household spending, and business fixed investment have been solid,” that it expected the economy to expand at a moderate pace this year, and that labor market conditions will remain strong. The most important comment in the policy statement referenced inflation, however.
- The Committee upgraded its inflation outlook by stating, “Market-based measures of inflation compensation have increased in recent months” and added that “Inflation on a 12- month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term.” According to projections released in December, the Federal Reserve expects to raise interest rates three times this year and the policy statement was supportive of that outlook. We expect the Federal Reserve to deliver its next rate increase at the March 20-21 FOMC meeting.
- It looks to us that with the forward momentum in the economy at roughly 2.5% as 2017 came to a close and with the economy’s growth rate expected to accelerate a moderate extent following the passage of the tax bill, the Federal Reserve is likely to hike rates three times this year as the current business expansion should be able to “tolerate” it.
- It seems that both the economy and the Federal Reserve are becoming more comfortable with the central bank raising interest rates. Consider that the Federal Reserve expected to raise rates four times in both 2015 and 2016, but eventually raised rates only once each year, both times at the December FOMC meeting. 2017 was the first year the Federal Reserve was able to raise rates as expected since it started to plan for interest rate increases in 2015.
- The economic conditions last year were somewhat different than the Federal Reserve expected, however, as the FOMC committee members thought that the unemployment rate would fall less than it did and that economic growth would be a touch weaker than it turned out to be. They also expected the inflation rate to make more progress on moving toward the central bank’s 2% target. In other words, the Federal Reserve expected to raise rates because inflationary pressures were building. As it turned out, rates were raised because a healthier than expected economy was able to “tolerate” the rate hikes, keeping the economic expansion moving forward, while inflationary pressures actually eased during the year.
- While we know Jerome Powell will succeed Janet Yellen as Chair of the Federal Reserve next week, four of the seven Board seats are currently open, although Marvin Goodfriend has been nominated by President Trump to fill one of the seats. Another uncertainty regarding future Federal Reserve policy deliberations is the pending retirement of William Dudley, the president of the New York Federal Reserve Bank. This position serves as vice chair of the FOMC committee and has a permanent vote on the monetary policy deliberations of the committee.
- As we have stated in the past few ISS’s, investors will need to assess if the eventual composition of the Board of Govenors this 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 2018 unfolds, 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 in late 2014. As always, stay tuned!
F. Earnings and Inflation Remain the Keys to the Economy and Stocks in 2018-19.
- Despite the pullback in stock prices earlier this week, we believe the backdrop for further gains in stock prices this year remains positive. As covered earlier in this ISS, the forward momentum in the economy is very positive as 2018 unfolds. Improved consumer and business confidence, solid jobs growth, a synchronized worldwide expansion, and a tax package that is becoming increasingly popular are expected to ramp the economy’s growth rate to a pace near 3% over the next two years compared to the 2% to 2.5% growth rate over the course of this business expansion.
- Earnings have been unambiguously positive for stock prices since the earnings recovery began in 3Q 2016. Operating earnings on the S&P 500 have now advanced for six consecutive quarters and with 34% of companies reporting for 4Q 2017, operating earnings look to have grown 17% over the four quarters of 2017. The analysts at Standard and Poor’s have been sharply revising their earnings estimates for 2018 higher in light of the economy’s forward momentum and the cut in the corporate tax rate. Current estimates are that operating earnings will advance close to 22% over the four quarters of 2018.
- That leaves inflation as the remaining variable for the outlook for common stocks, and as stated earlier in this ISS, we look for only a modest build in inflationary pressures. This will postpone the day that the Federal Reserve will need to leave the team “gradual” behind and more aggressively raise interest rates, which would begin the tightening phase which will eventually lead to the next recession. It should also moderate the rise in bond yields, although we do expect a confluence of events to push bond yields a touch higher during 2018.
- No one knows if the selling pressure evident earlier this week will resume in the near term, but we would view an orderly pullback, which is long overdue, as an opportunity, not as anything to worry about. We do view the rather swift decline in stock prices earlier this week as a harbinger of more price volatility this year than in 2017, however, as investors will likely need to digest three rate hikes this year by the Federal Reserve, with a fourth rate hike more than a remote possibility. Investors should look to put money to work on any pullback which approaches -3% to -5% with the economy and earnings looking up and inflationary pressures still low.
II. Treasury Market
A. Longer Dated Treasury Yields Rise for Fifth Straight Month.
- After falling to a low on September 5 of last year, yields on the longer end of the Treasury yield curve have risen for five straight months, while yields at the shorter end of the yield curve have risen consistently since the presidential election as the Federal Reserve has raised rates four times over the past 15 months. Yields on three-month to two-year Treasury securities have risen 104 to 130 basis points from November 8, 2016 to the end of January. In particular, the yield on the two-year Treasury note has risen from 0.85% on the day of the presidential election to 2.15% at yesterday’s close.
- At the longer end of the yield curve, yields on five-year to thirty-year Treasury securities have risen 26 to 88 basis points from the September 5 low in longer dated yields last year to the end of January. In particular, the yield on the ten-year Treasury note has risen from 2.06% on September 5 to 2.71% at last night’s close.
- 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 during each of the months during the fourth quarter and raised the monthly runoff to $20 billion during January. The Federal Reserve will continue to raise the monthly runoff amount by $10 billion each quarter until the monthly runoff reaches $50 billion per month in October 2018.
- Investors are also responding to the forward momentum in the economy, the expected acceleration in the economy’s growth rate from the passage of the tax package, and the projected increase in the federal budget deficit. We expect some modest upward pressure on wages and prices, lending support to continued gradual rate hikes by the Federal Reserve and some additional upward pressure on longer term bond yields. For the month of January, yields at the shorter end of the yield curve rose 8 to 27 basis points, while yields on securities five years and longer rose 20 to 32 basis points.
B. Look for Further, Modest Upward Pressure on Longer Dated Treasury Securities.
- As stated previously in this ISS, the key to the outlook for the economy and the markets will be the extent to which inflationary pressures rise this year and into 2019. While not looking for a significant move higher in inflation this year, we expect some modest upward pressure which should take the current 1.5% year-over-year rise in the core personal consumption expenditures index closer to 2% over the next 24 months.
- Other factors impacting yields at the long end of the Treasury yield curve this year will be the extent to which there is any pullback in the massive bond buying programs still in place at the Bank of Japan, the Bank of England, and the European Central Bank. With the rebound in global growth over the past 12 to 18 months, it is fairly easy to say that those policymakers are closer to ending rather than ramping up their bond buying programs.
- We expect global policymakers to follow the lead of the United States and begin the shift from expansionary monetary policies to fiscal policies to maintain the forward momentum in the global economy and continue the process of reflating their economies. Given the forward momentum in the economy as 2017 drew to a close and the expected moderate acceleration from the tax package, we have raised the trading range for the ten-year Treasury note to 2.5% to 3% for the next few months.
- As we mentioned in last month’s ISS, we expect the ten-year Treasury yield to take a run at 3%, a level we have not seen since late December 2013, as the tax package accelerates the economy’s growth rate a moderate amount and inflationary pressures rise modestly over the next two years. The expected increase in the federal budget deficit at a time that the Federal Reserve is shrinking its holdings of government bonds will also contribute to upward pressure on 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.
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