INVESTMENT STRATEGY STATEMENT
January 3, 2017
I. Equity Markets
A. Optimism Reigns! Stocks Climb a Wall of Hope.
- Following a brutal start to 2016 with the major stock market measures dropping -10.1% to -16.0% to the lows on February 11, all of the stock market indices surged to new highs last month. The yearlong rebound in stock prices and the strength of the rally since the presidential election defied the recession fears early in the year and the doomsday forecasts which preceded events such as the vote in Great Britain last summer to leave the European Union and the stunning victory in the presidential election by Donald Trump.
- Common stock prices have rallied sharply since the presidential election as investors increasingly concluded that President-elect Donald Trump will bring an economic agenda to Washington which will be good for business and the economy. Investors are embracing the prospect of both corporate and personal income tax cuts and reform, corporate earnings trapped overseas being repatriated, regulatory rollbacks, and ramped up military and infrastructure spending under Republican leadership in Washington.
- This optimistic outlook has lifted stock prices, bond yields, and the dollar. The sense of euphoria which has swept over the stock market, the consumer confidence measures, and investor sentiment are an expression of hope that the eight year long war against business and capitalism is finally over. The market has climbed a wall of hope since the election, rather than the typical refrain of climbing a wall of worry.
- The DJIA finished above 19,000 for the first time ever on November 22 and investors hoped to end 2016 with a bang, with the DJIA closing above 20,000. However, since December 13, the day before the Federal Reserve raised interest rates, the stock rally lost its forward momentum, with the DJIA falling -0.7% to year end. The DJIA backed away from the big number milestone after edging within 13 points on an intraday basis on December 20.
- Investors and the financial press gave so much attention to the DJIA hitting the never-reachedbefore-mark that the notoriety likely began to serve as a barrier to piercing through the level. Tax loss selling, particularly in Nike and Coca-Cola, also likely played a role in holding the DJIA below the 20,000 milestone.
- Since November 8, the major stock market measures jumped 3.7% to 13.6%, with new record highs being recorded last month across the board. For the month of December, the stock market indices rose 1.1% to 3.4%, and for all of 2016, the major market measures are higher by 7.5% to 19.5%, with the bulk of the gains coming during the second half of the year. Since the lows on February 11, stock prices soared a remarkable 22.4% to 42.3%, a pretty impressive accomplishment following the worst ever five day start to a year last January for the DJIA.
B. Confidence in the Economy Leads Federal Reserve to Raise Interest Rates.
- After passing at the past seven FOMC meetings due to recurrent worries over slow growth and low inflation, China’s economic slowdown, volatile markets, and Great Britain’s Brexit vote, the Federal Reserve raised the federal funds rate 25 basis points, from 0.25% to 0.50% to 0.50% to 0.75% at the December 13-14 FOMC meeting. Last month’s interest rate hike was just the second since 2006 despite an unemployment rate that has tumbled from 10% in 2009 to 4.6% currently. The Federal Reserve has nursed along a sluggishly growing economy with massive bond buying programs and near zero interest rates since the recession ended in mid- 2009.
- In its policy statement, the Federal Reserve painted a generally optimistic picture of the economy, saying “the labor market has continued to strengthen” and “economic activity has been expanding at a moderate pace since midyear.” It added that “job gains have been solid in recent months” and household spending has risen moderately, but investment spending has been “soft”.
- Perhaps more significantly, the central bank said market-based measures of inflation, such as
those contained in Treasury securities, “have moved up considerably but still are low,”
reinforcing the Committee’s expectation that inflation will reach two percent over the medium
term. Janet Yellen stated that the rate hike reflected the confidence the Committee had in the
progress the economy has made and its judgement that it will continue.
- While the rate increase was widely expected, the financial markets focused their attention on the expected pace of future rate hikes. For 2017, the Federal Reserve had forecast two rate hikes at the September FOMC meeting, but increased that to three rate hikes for 2017 at the December meeting. The policy statement contained no mention of the Trump administration’s plans to cut corporate and personal income tax rates, boost military and infrastructure spending, and lighten the regulatory burden on the business sector.
- The inference is that the slightly faster pace of rate hikes expected in 2017 reflects the cumulative and expected progress made in the economy against the Federal Reserve’s mandate of full employment and a 2% inflation target, with little consideration given to the potential impact from a package of stimulative fiscal policy proposals anticipated this year.
- Janet Yellen emphasized in the press conference following the FOMC meeting that the Federal Reserve was not prejudging the likely course of fiscal policy or other economic policies which could be proposed this year. Ms. Yellen declined several times to comment on the merits of Mr. Trump’s plans or to predict their consequences for the economy. “We are operating under a cloud of uncertainty at the moment,” the chair of the Federal Reserve said.
C. Good Chance of Two Rate Hikes this Year.
- In last month’s ISS, we said to look for a more pro-business environment and mindset in Washington starting on January 20, a faster pace of growth, and some reflation in the domestic economy as a result of Mr. Trump winning the presidential election. It is important to keep in mind, however, that the degree to which growth and inflation is rekindled will depend on the specifics of the policy proposals, the reactions in the financial markets to those proposals, and the manner in which the Federal Reserve reacts. Of course, how the central bank reacts will depend on the scope of the policy proposals and the reactions in the financial markets.
- We do not look for the anticipated policy initiatives to directly impact the economy in a meaningful manner until 2018. Optimism about the proposals could impact household spending decisions and business hiring and capital spending decisions this year in a positive manner, however. We continue to look for Paul Ryan and the House Ways and Means Committee to play a significant role in the development of the new tax and spending policies.
- The active participation of the House Committee responsible for all legislation concerning taxation will keep the impact of lower tax rates and ramped up spending plans on the budget deficit 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, but immediately rose after the election results, trading above 2.5% for 10 days in December, before closing 2016 at 2.44%. This represents a tightening of financial conditions, particularly in the housing market where mortgage rates have risen about a half percentage point since the election, making housing more expensive and lessening the likelihood of households refinancing outstanding mortgage obligations.
- 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 benefitted, 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.
- During 2016, the dollar fell about -7% from January to August, only to rebound a little more than 8% to the end of December, 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 this year as a continued rise in the dollar will further tighten financial conditions, offsetting to some extent the stimulative impact of the new economic agenda.
- It is very significant that the fiscal stimulus plans that everyone expects from the Trump administration will be delivered with a 4.6% unemployment rate, wages and inflation firming, and the business expansion at 90 months compared to an average length since WWII of 58 months. Typically a stimulus plan on the order talked about by Mr. Trump would be delivered with the economy in recession and shedding jobs. That is a key reason we anticipate that the economy is poised to reflate a touch, leaving the era of ultra-low interest rates and bond yields in the rear view mirror. We look for the nation’s core inflation rate to hit 2% in the next 12 to 18 months, but not much more.
- 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.
- With the federal funds rate still a good distance below the 3% longer run “normal” level that the central bank is targeting over the next couple years, we still do not see the Federal Reserve undertaking any policy actions which would place the economic expansion at risk any time soon. Despite the expectation of growth-oriented fiscal policies being proposed in Washington this year, we still think the Federal Reserve is 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 and to pursue a gradual pace of rate hikes which will not cause the economic expansion to stall.
- However, 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 stated in last month’s ISS that we expected the Federal Reserve to be able to increase the federal funds rate at least two times during 2017, which was the central bank’s previous forecast.
- We still hold that the response of the U.S. dollar to the specific Trump economic proposals will be key to the outlook for the economy, inflation, bond yields, and Federal Reserve policy over the next two years. The Treasury market is looking for the Federal Reserve to be able to raise rates two times in 2017, with the two-year Treasury yield closing out 2016 at 1.19%. Three rate hikes this year looks to be a bit of a stretch to us at the moment, but, as always, stay tuned!
D. Common Stocks Need Earnings Growth to Move Higher.
- As we all await policy details on the Trump economic platform, which will likely be released over the first three to six months of 2017, we have put forward three big picture themes to guide us until the specific policy proposals are hammered out between Congress and Mr. Trump’s team. We expect a more pro-business environment and mindset in Washington, a faster pace of growth, and some reflation in the domestic economy. In general, we have been looking for higher common stock prices and bond yields in the quarters ahead.
- While we still hold that outlook, we need to acknowledge that the major stock market measures have already advanced 3.7% to 13.6% since the election and the yield on the ten-year Treasury note has increased from 1.86% on November 8 to 2.44% as 2016 came to a close. Investors’ expectations of growth, corporate profits, and inflation are at multi-year highs and stock prices are likely running ahead of the fundamentals as we enter 2017. Consider that the price-totrailing operating earnings ratio on the S&P 500 has risen from 21.1x on November 8 to 22.1x at year end 2016.
- As January unfolds, our concern is that the stock market could to stumble a bit as it comes off its post-election adrenaline rush given the size of the gains since the election. It is possible that some investors were reluctant to take gains during December, preferring to push the tax liability into the 2017 tax year rather than the 2016 tax year. Additionally, there is some chance that the capital gains tax rate could be reduced, effective in 2017, as a new personal income tax policy is negotiated between the Trump administration and Congress. Do not be surprised by some selling pressure early in 2017 as investors take some gains.
- Among other factors which could undercut stock prices this year is a dose of reality colliding with the euphoria that has swept over the stock market. Investors could be disappointed by the actual structure of the proposed tax cuts, the amount of infrastructure spending put forward, or the pace and extent to which the regulatory burden is reduced.
- Will strains on the federal budget deficit limit the size of the tax cuts and the boost in spending on the military and infrastructure, or will the proposals lead to trillion dollar budget deficits similar to the early years of the Obama presidency? Will rising inflationary pressures lead to a material further rise in bond yields and prompt the Federal Reserve to tighten monetary policy in a more aggressive fashion?
- Could the unknown policies on immigration and trade result in higher inflation and actually reign in the economy’s forward momentum? These are important questions which we will not know the answer to until Mr. Trump takes office and his legislative agenda moves forward.
- The renewed strength in the U.S. dollar, which is currently at its highest level is nearly 15 years, stands to have long-lived economic consequences, potentially hampering the recent recovery in U.S. earnings with imports becoming more competitive at the expense of exports. The stronger dollar will also hurt overseas earnings as they are translated into dollars and will make the trillions of dollar-denominated debt around the globe more expensive and difficult to pay back, particularly in emerging market countries.
- 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. However, we look forward to a positive, pro-growth economic agenda and believe the experienced business leaders who are advising the President elect and have been nominated 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, and bond yields.
- 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% to 3.5% pace, with a quarter or two during which the growth rate could exceed 4%. As the economy and earnings pick up over the next couple years, we look for common stocks to grind higher.
- 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 12.8% 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. Investors are now looking for the earnings rebound to continue with the economy expected to benefit from a future which includes repatriated profits currently held overseas,
lower taxes, less regulation, and a heavy dose of military and infrastructure spending.
- 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.
- We look for moderately higher common stock prices this year, with a growing earnings stream being an absolute necessity, with no more than a modest rise in inflationary pressures also a requirement in order to restrain the inevitable rise in interest rates and bond yields. 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.
E. The Major Risk to Common Stocks and the Economy this Year.
- We believe the major risk to the equity market and the economy this year lies in a potential breakup of the euro zone. A series of elections in Europe this year will test whether a growing public conviction that the European Union is not working will carry the day against mainstream politicians in the European Union’s founding nations. A political revolt against Europe’s status quo could eventually, if not immediately, determine the fate of the European Union, with its open borders and common currency.
- The populist movements in Europe want a return to national currencies and control over domestic fiscal policy and immigration, and an end to bailing out bankrupt nations — such as Greece, Ireland, and Portugal. The end of the euro as a common currency would likely be an unnerving event for the financial markets.
- Weak post-euro currencies would likely require capital controls to prevent destabilizing outflows of capital and fragile banking systems could fail or require nationalization. While not forecasting an unraveling of the European Union and the euro, it needs to be mentioned as a major risk to stock prices and the economy and a good reason to maintain positions in defensive stock holdings and fixed income securities as we enter 2017.
II. Treasury Market
A. Treasury Yields Move Well Ahead of the Policy Details.
- Donald Trump’s stunning victory in the presidential election helped end a record breaking rally in the bond market which had pushed yields across developed economies to fresh lows over the summer. The yield on the ten-year Treasury note fell to an historic low of 1.36% on July 8 and the yield on the ten-year German bund reached a somewhat unbelievable low of -0.19%. Investors are anticipating that working with a Republican-controlled Congress, President-elect Trump will be able to deliver tax cuts and reform, greater military and infrastructure spending, and a rollback of onerous regulations which will energize the economy.
- The main risk with the Trump economic agenda is that the labor market is approaching full employment after a 90 month long expansion, with wages and inflation firming, increasing the likelihood of inflationary pressures building further during 2017. The question is how hot will inflation run? 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 4.6% unemployment rate represents due to the decline in the labor market participation rate since the Great Recession.
- The key indicator of tightness in the labor market is the year-over-year change in average hourly earnings contained in the monthly employment data. The average hourly earnings figure has risen 2.5% over the past year, compared to an annual gain of 1.8% recorded some 19 to 21 months ago and 2.1% to 2.2% over the summer months. Higher interest rates, bond yields, and the dollar will all work to keep a lid on inflation, along with ongoing deflationary influences on goods produced across the globe. We look for inflationary pressures to rise a modest amount, likely hitting the Federal Reserve’s goal of 2% in the next 12 to 18 months.
- As we stated in a note released the morning after the presidential election, the U.S. is on the verge of receiving some serious, pro-growth fiscal policy initiatives aimed at pushing the economy’s growth rate higher. We expect these policy initiatives to put the era of ultra-low interest rates and bond yields in the rear view mirror. We were looking for the yield on the tenyear Treasury note to trade in a 2.0%-2.5% range for a while, up from the 1.86% yield on November 8.
- The yield on the ten-year Treasury note broke above 2.5% on December 14, reached an intraday high of 2.66% two days later. The ten-year Treasury yield stayed above the 2.5% level for the next seven trading days, before moving lower over the last two days of the month, ending December at 2.44% compared to 2.27% at year-end 2015. Look for the yield on the ten-year Treasury note to trade between 2.35% and 2.75% for the next couple months.
- Once the details of Mr. Trump’s complete economic agenda are negotiated and set into policy, we expect to see the yield on the ten-year Treasury take a run at 3%, a level we have not seen since late December 2013. Beside the bottom line fundamentals of the outlooks for growth and inflation determining the level of longer dated Treasury yields, investors need to keep an eye on a number of other factors which will contribute to the level of Treasury yields.
- While 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 policy makers 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 budget 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 sometime in the next year or two. Depending on how all this plays out, including the actual impact on the pace of economic activity and inflation from the Trump economic agenda, Treasury yields are likely to rise on the order of 25 to 50 basis points this year. 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.
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