CenterState Wealth Management
Investment Strategy Statement
June 1, 2018
I. Equity Markets
A. Strong Earnings, Trade Tensions, and Euro Zone Uncertainty.
- After trading slightly lower over the first four months of 2018, common stocks advanced across the board during May — particularly so for technology and small company stocks — primarily on the back of a remarkable acceleration in earnings growth during 1Q 2018. After growing 17.2% over the four quarters of 2017, operating earnings on the S&P 500 advanced 26.1% in 1Q 2018 compared to 1Q 2017. The earnings gain was led by continued solid growth in the economy, strong consumer and business confidence, a healthy jobs market, and the reduction in the corporate tax rate to 21% from 35% in late December.
- Depending upon the latest headline from the ongoing trade negotiations with China, Canada, Mexico, and the European Union, optimism about an easing of trade war tensions rose or fell on any given day last month. The most positive news on the trade front during May was that the U.S. and China were “putting the trade war on hold” according to Treasury Secretary Mnuchin, after two days of talks in Washington produced meaningful progress. The U.S. agreed to suspend its efforts to apply new tariffs to $150 billion of Chinese imports, while China is doing likewise to $50 billion of U.S. imports and agreed to purchase more energy and agricultural products from the U.S. China also agreed to lower existing tariffs on imported cars and auto parts, making good on a promise China President Xi made in a major speech in early April.
- We stressed in the last two ISS’s that the threats of tariffs by President Trump were likely a tactic in trade negotiations rather than a viable policy tool meant to reduce the nation’s trade surplus. The reality is no country has ever won a trade war and the U.S. market is the prize which all foreign countries wish to sell into. Consider that Chinese companies exported almost four times the dollar amount of product into the U.S. than U.S. companies exported into China during 2017.
- Our conclusion was that given the importance of trade in today’s global economy, we would not bet against rational people arriving at reasonable outcomes, leading to the eventual negotiation of new trade agreements which eliminate the inherent disadvantage the U.S. encounters in most trade agreements currently in place. While last month’s developments do not mean the risk of tariffs and protectionist policies on trade with China are completely behind us, they do support Mr. Trump’s position that tariff threats can create opportunities for serious trade negotiations.
- However, just yesterday the Trump administration announced it will place tariffs of 25% on steel imports and 10% on aluminum imports from Canada, Mexico, and the European Union. The U.S. had previously given these allies a reprieve from those duties, first announced in March, but with the negotiations on revising the North American Free Trade Agreement stalled and no progress on winning trade concessions from our European Union counterparts, the Administration decided to move ahead with tariffs. Time will tell if this announcement is a viable negotiating tactic with some of our key allies, a minor trade skirmish, or a serious step toward a trade war.
- Geopolitical events dominated the financial markets over the past week. Last week President Trump cancelled a meeting with North Korean leader Kim Jong Un scheduled for later this month at which the two leaders were expected to discuss ending North Korea’s nuclear program in return for rolling back economic sanctions which have crippled its economy. While U.S. stocks initially fell on the news, they recovered by the end of the day as investors concluded that cancelling the proposed summit would have no real impact on the U.S. economy. Treasury yields fell and gold prices rose, however, as some investors sought safe haven assets.
- As a telltale sign of how significantly the economic sanctions are hurting the North Korean economy, the day after cancelling the summit President Trump sounded a more optimistic tone, saying the two countries had resumed talking and a June summit could take place. This was followed by a hastily arranged meeting of the South and North Korean leaders last weekend aimed at reviving the meeting between President Trump and the North Korean leader. As of this writing, we are waiting on official confirmation of the summit taking place.
- In addition to the North Korea situation, the financial markets were once again rattled late in the month by uncertainty over the future of the euro zone and the viability of the euro. This time, Italy’s political crisis was the issue. Italy, the third largest economy in the euro zone, has been without a functioning government since an inconclusive election vote in early March. Italy’s power struggle between euroskeptic populists and pro-European Union establishment lawmakers has investors fearful that the looming prospect of fresh elections could be fought over the country’s role in the European Union and the euro zone.
- Despite these trade and geopolitical worries, stock prices rose during May. Supported by the best earnings reports since the economy was in the early stages of emerging from the depths of the Great Recession, the four major stock market measures all posted gains last month, led by the technology – heavy NASDAQ Composite gaining 5.3% and the Russell 2000 Index of small company stocks rising 6%. The S&P 500 and the DJIA posted smaller advances of 2.2% and 1%, respectively. On the year, only the DJIA is negative at -1.2%, while the S&P 500 has eked out a small gain of 1.2%. The NASDAQ Composite and the Russell 2000 have risen 7.8% and 6.4%, respectively, so far in 2018.
B. With Strong Earnings, Look for Modestly Higher Stock Prices.
- The S&P 500 and the DJIA both recorded a double bottom this year, first on February 8 following an inflation scare, and again on April 2 following the tariff/trade war threats. Since the April 2 low, the S&P 500 and the DJIA have recovered 4.8% and 3.3%, respectively. A number of positive factors have supported the rebound in stock prices. The yield on the ten-year Treasury note appears to have settled into a range of 2.8% to 3.1% over the past few weeks, after rising steadily this year from 2.41% at year-end 2017.
- Volatility in the stock market has fallen significantly from exaggerated levels in early February and again in early April. The recent inflation data has stopped accelerating from the lows reached late last year. Share repurchases have surged, rising by 49% year-on-year in 1Q 2018 according to Standard & Poor’s. Forward momentum in the economy remains very healthy and earnings have been unambiguously positive for stock prices and are forecast to grow nearly 25% over the four quarters of 2018. Lastly, the combination of lower stock prices and strong earnings have led to an improved level of stock valuations.
- While these positive fundamentals have provided a lift to stock prices since the recent April 2 low, investors continue to have a number of concerns. While recent inflation readings have been steady, fears of a cyclical ramp in inflationary pressures persist. Given the late cycle fiscal stimulus that Congress has been passed since the end of 2017, concerns have grown that the Federal Reserve could make a policy mistake, tightening policy to the extent the economy stalls or falls into recession without a build in inflationary pressures beyond the Federal Reserve’s 2% target.
- Fears persist that the Trump Administration will use tariffs as a blunt policy tool to shrink the nation’s trade surplus rather than as a tactic meant to create opportunities for serious trade negotiations. The ongoing political drama which the Trump Administration has brought to Washington is a lingering concern and the focus on monitoring the nation’s political mood ahead of the mid-terms elections has intensified.
- Our view remains that the positives outweigh the negatives, with the big positive of the acceleration in earnings growth in 1Q 2018 and the outlook for further strong gains in earnings carrying the day. While not looking for outsized gains in common stock prices this year, mid to high single digit gains appear reasonable with no recession currently on the horizon. Valuations are expected to continue to improve with earnings growing at a pace faster than the expected rise in stock prices.
C. Look for Another Rate Hike in June.
- The minutes of the May 1-2 FOMC meeting were released last week and pointed to another rate hike at the June 12-13 FOMC meeting. The minutes stated that if the economy performs as expected, “it would likely soon be appropriate for the committee to take another step” in raising rates. The committee’s outlook is for above trend near term growth, citing “a strong labor market, federal tax and spending policies, high levels of household and business confidence, favorable financial conditions, and strong economic growth abroad.”
- In the policy statement released after the May FOMC meeting, the committee noted that it sees inflation running “near” the “symmetric 2 percent objective” over the medium term. The minutes clarified that the term “symmetric” implied that allowing inflation to run “modestly above” its 2% target temporarily “could be helpful” in setting longer run inflation expectations closer to the 2% target after persistently running below the target for the better part of the past decade. In other words, do not expect an extreme reaction by the central bank to raise interest rates if inflation runs slightly above target for a period of time.
- A good portion of the minutes was devoted to a discussion of how much further the Federal Reserve will need to raise interest rates in the coming years. A number of the committee members noted that if the central bank continued gradually raising interest rates, “before too long” the federal funds rate would be at or above a neutral level which is neither stimulating nor restraining the economy’s growth rate.
- As a guide to future rate increases, the discussion focused on two key questions. First, the committee needs to determine the level of the real, or inflation-adjusted, neutral rate in light of the Federal Reserve’s expectation that the economy is poised to grow in the near term at a pace which is faster than is sustainable over the longer term as a result of the fiscal stimulus which has been delivered to the economy. Following that, the committee members need to determine how high to push interest rates above the neutral rate to slow the economy and prevent an unwanted build in inflationary pressures.
- We have discussed the notion of the real neutral rate since last summer when both Chair Janet Yellen and Govenor Lael Brainard asserted that the real neutral rate was close to zero. With the most recent reading on the core personal consumption deflator at 1.8% year-on- year, the anticipated 1.75%-2.0% target range for the federal funds rate following this month’s FOMC meeting would put in place a real neutral rate, using the midpoint of 1.88%, that is essentially zero.
- If the real neutral rate has risen above zero in the wake of the fiscal stimulus, then one or two more rate hikes should place the federal funds rate at, or very close to neutral. Then there is the issue of how much above neutral the Federal Reserve needs to raise the federal funds rate to keep the economy from overheating. We admit this analysis can be fairly arcane, somewhat arbitrary, and a bit of a moving target. That is why we have focused our readers on the yield spread between two-year and ten-year Treasury notes since the summer of 2015 to monitor the Treasury market’s assessment of how tight or easy monetary policy currently is.
- As a reminder, we have monitored the yield spread between the two-year and ten-year Treasury notes as an indicator of whether investors viewed the pace of rate hikes by the Federal Reserve as too slow or deliberate — which could lead to a build in inflationary pressures and cause a widening of the yield spread — or too aggressive — which could lead to a slowdown in the economy and cause a narrowing of the yield spread.
- The yield spread dropped to 53 basis points at the end of 2017 after the Federal Reserve hiked rates three times last year from 122 basis points and 125 basis points at the end of 2015 and 2016, respectively. Following the most recent rate hike in March, representing the sixth hike in total, the yield spread fell to 46 basis points, its lowest level since late 2007. At the end of May, roughly two weeks before the Federal Reserve is likely to raise rates again, the yield spread remains very tight at 43 basis points. We continue to believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake.
- In the context of a real neutral rate, we take the narrowing of the yield spread as a signal that the Federal Reserve is approaching that level of the federal funds rate where monetary policy could flip from becoming less accommodative to the side of restraining the economy’s forward momentum. We, and the market it appears, feel the Federal Reserve currently is closer to the real neutral rate than the central bank believes it is given its forecast of five additional rate hikes in 2019 and 2020. A second thought is that we and the market do not foresee a marked rise in inflationary pressures which would call for the Federal Reserve to move to a clearly restrictive policy stance over the 2019-2020 timeframe.
- The question is whether the new leadership at the Federal Reserve can balance its intention to raise interest rates so that it has the ability to lower interest rates during the next recession with the risk of unnecessarily bringing about the next recession because it raised the real neutral rate clearly to the side of restraint without inflation pressures building in a material manner beyond the Federal Reserve’s 2% target.
- As we have stated many times since the Federal Reserve started raising interest rates in December 2015, rate hike decisions over the next couple years will be a dynamic process requiring a great deal of judgement by the Federal Reserve as to what level of short-term interest rates the economic expansion can tolerate and whether policy needs to shift from becoming less accommodative to an outright tightening posture. The economy’s inflation rate will determine how high the federal funds rate can rise without stalling the economy
- We will watch the two-year to ten-year Treasury yield spread for the market’s assessment of whether monetary policy has moved into the recession danger zone. We doubt the Federal Reserve will deliberately move interest rates above longer dated Treasury yields if inflationary pressures remain low. This is the primary reason we believe the proposed policy moves by the Federal Reserve to the end of 2020 are too aggressive.
- Our view remains that the Federal Reserve raises interest rates two additional times this year and then becomes data dependent in 2019 with respect to any further rate increases. The most important data to follow will be the wage and inflation data. As always, stay tuned!
II. Treasury Market
A. Following Sharp Rise, Strong Flight-to-Safety Pushes Treasury Yields Lower.
- After rising to its highest level since 2011, the yield on the ten-year Treasury note fell from 3.11% on May 17 to 2.86% at month end. The upward pressure on yields to mid-month was the result of improving economic growth, modest upward pressure on inflation, projections of the federal budget deficit widening significantly over the next few years, and the Federal Reserve continuing to shrink the size of its investment portfolio on a monthly basis.
- A number of factors pulled Treasury yields lower over the past two weeks. From a fundamental perspective, the rise in the yield on the ten-year Treasury note over 3% pushed the thirty-year mortgage rate above 4.5% for the first time since early 2014. Rising mortgage rates hurt housing affordability, which has led to a modest softening in housing starts and new and existing home sales.
- It appears the major reason behind the drop in Treasury yields, however, was a surge in demand for safe haven assets. As mentioned previously in this ISS, the ongoing trade tensions followed by the cancellation of the meeting between President Trump and North Korea’s Kim Jong Un started the rush into Treasury securities.
- However, it was the political crisis in Italy — which brought into question, once again, the viability of the euro and the European Union as it is currently constituted — which accelerated the flight into Treasury securities this week. In fact, the yield on the ten-year Treasury experienced its biggest one day decline on Tuesday — 16 basis points — since the aftermath of the Brexit vote in June 2016.
- We sense the flight-to-safety into Treasury securities may be a bit overdone at this point, and that the fundamentals of growth and inflation and rising Treasury supply will again drive Treasury yields a touch higher over time. As we have mentioned in previous ISS’s, as the yield on the ten-year Treasury note rose from the recent low recorded on September 5, both the real, or TIP, yield and the implied inflation expectation embodied in the nominal ten-year Treasury have risen, as shown in the table below.
- It is interesting to note that of the 9 basis point decline in the yield on the ten-year Treasury note over the month of May, there was no change in the real, or TIP, yield, with all of the 9 basis point decline coming from a drop in the implied inflation expectation over the next ten years. While the roughly -7% drop in oil prices over the past two weeks and the roughly 5% rise in the U.S. dollar since mid-April have likely eased inflation concerns, it appears a general easing of inflation concerns was priced into the Treasury market last month.
- Once the flight-to-safety eases, the fundamental factors which have pushed Treasury yields higher this year will come back into play. We expect that a pickup in growth, inflation trending toward the Federal Reserve’s 2% target, larger federal budget deficits, and the Federal Reserve shrinking its holdings of government bonds will combine to place some renewed upward pressure on Treasury yields. We continue to look for a trading range of 2.85% to 3.10% for the ten-year Treasury note over the next couple months.
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.