INVESTMENT STRATEGY STATEMENT
March 1, 2017
I. Equity Markets
A. Better Growth, Rebounding Earnings, and Trumpian Hope Lift Common Stock Prices.
- After posting moderate increases during January, common stock prices posted further gains during February, boosted by signs of an improving economic backdrop, a continued rebound in operating earnings, and hope that better times are ahead with the economic policies that the Trump administration will implement over the next year. While the economic expansion hit a speed bump during the first half of 2016, the economy regained its footing over the past few months, without the help of any pro-growth policies being developed and deployed by President Trump’s economic team as of yet.
- Solid consumer spending, an uptick in factory production, healthy job gains, strong manufacturing surveys, and stable levels of housing starts and auto sales are pointing to a healthy start in 2017 for the economy. Global growth also appears to be on firmer footing. An index of economic activity in China is near a four year high and Japan’s economy ended 2016 on a strong note as the weakening yen boosted exports. Even Europe shows signs of shaking off its torpor, with new orders running at the fastest pace in six years, businesses hiring workers at a rate not seen since before the financial crisis, and consumer prices advancing 1.8% over the past year, the fastest pace since early 2013.
- After a seven quarter long earnings recession brought on by the collapse in oil prices and the strength in the U.S. dollar, operating earnings for the S&P 500 companies grew 12.8% in 3Q 2016 on a year-over-year basis. With over 92% of the S&P 500 companies reporting, 4Q 2016 operating earnings are higher by a strong 23% compared to a year ago. Once again, this earnings recovery is taking place without the benefit of any new policies from the White House.
- 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. A wide variety of confidence and sentiment measures, along with the rise in stock prices themselves, point to growing expectations for faster growth, tax reform, and a regulatory rollback. Animal spirits are stirring as investors, business leaders, and consumers continue to bask in the glow of the eight year long war against business and capitalism having come to an end.
- Investors looking for pullbacks to put additional money to work are frustrated by a consistent bid for common stocks. Investors are looking for further gains in earnings which will translate into higher stock prices. There also appears to be an unwillingness to sell, lest investors find themselves out of the market when constructive policy details are released. Additionally, taking gains is being pushed out in the hope of lower tax rates being part of the Trump economic agenda.
- For the month of February, the major stock market measures posted solid gains of 1.8% to 4.8%, pushing stock prices higher by 2.2% to 8.2% over the first two months of 2017. Since the presidential election on November 8, common stock prices are higher by a strong 10.5% to 16.0% as investors have focused on the pro-business agenda and mindset that President Trump has brought to Washington.
B. Federal Reserve Likely to Raise Rates at the March FOMC Meeting, Watch Wage Gains.
- The Federal Reserve held the line on interest rates at the January 31-February 1 FOMC meeting — 0.50% to 0.75% — saying it remains on track to gradually raise interest rates this year, however, the central bank offered no hint about when the next rate hike might take place. The Committee members did take note of rising confidence by offering “Measures of consumer and business sentient have improved of late.”
- The policy statement said economic activity is still expected to expand “at a moderate pace” and labor market conditions to “strengthen somewhat further.” The Federal Reserve did slightly raise its assessment of the inflation outlook by stating “inflation will rise to 2 percent over the medium term.” This is a change from recent statements which referred to expectations that inflation would rise over the medium term. We feel this change in the inflation outlook is consistent with a rate hike, possibly as soon as the March 14-15 FOMC meeting.
- Janet Yellen testified before Congress on February 14 and 15 and signaled that the central bank could consider raising short term interest rates at the March FOMC meeting if the economy continues to strengthen, pushing back against market expectations that the Federal Reserve will stand pat. Ms. Yellen stated that holding off too long on rate increases “would be unwise,” since it would force the central bank to lift rates more aggressively if inflationary pressures mounted, which would risk pushing the economy into recession.
- The Federal Reserve Chair was generally upbeat about the economy with a longer list of reasons for optimism than for worry. She stated that Federal Reserve officials generally have not factored President Trump’s fiscal stimulus proposals into their economic growth and interest rate forecasts, as they “don’t want to base current policy on speculation about what might come down the line.”
- In a bow to the more hawkish element of the FOMC Committee and possibly signaling a March rate hike, the minutes of the January 31-February 1 FOMC meeting indicated that the central bank could adopt a more aggressive course of rate hikes this year than Federal Reserve officials currently expect. The Committee members said they could raise interest rates “fairly soon” and suggested that proposed tax cuts and new spending initiatives could prompt them to lift rates further to keep a lid on inflation.
- Between the policy statement that accompanied last month’s FOMC meeting, Janet Yellen’s Congressional testimony, and the minutes from the FOMC meeting, the Federal Reserve has done a masterful job of maintaining flexibility to raise interest rates again at any one of the March, May, or June FOMC meetings. While Janet Yellen attempted to place the March FOMC meeting “in play” during her Congressional testimony last month, the futures market only assigned about a 34% probability of a rate hike this month following her prepared remarks and the question and answer sessions with the House and Senate Committees.
- This week the futures market raised the probability of a rate hike at the March FOMC meeting to slightly above 50%, and this morning the probability is greater than 75%. Given the improving economic backdrop over the past few months, the subtle change in the inflation outlook contained in the February 1 FOMC statement, and the upbeat tone of Ms. Yellen’s comments before Congress last month, we now come down on the side of a March rate hike.
- We feel the key to what happens at the March FOMC meeting will be the year-on-year rise in average hourly earnings contained in the March 10 employment report. If average hourly earnings increase at least 2.5% — the pace reported for January — it is very likely the Federal Reserve will hike the range for the federal funds rate by 25 basis points at the March 14-15 FOMC meeting.
- An increase in the range for the federal funds rate to 0.75% to 1.0% in March would also get a rate hike out of the way before the presidential election in France this spring that has raised questions about the country’s continued use of the euro — more on this later in this ISS. The market is strongly suggesting that rates will be raised at one of the March, May, or June FOMC meetings. We do not think the exact timing is the most important thing, the path of rates is the key to Federal Reserve policy. As always, stay tuned and watch the wage data!
C. Growth and Earnings vs. Inflation, Interest Rates, and Bond Yields.
- The transition from a low interest rate driven bull market to an earnings driven bull market continues. As mentioned earlier in this ISS, operating earnings on the S&P 500 companies look to have grown a strong 23% on a year-over-year basis in 4Q 2016, following up on the 12.8% year-on-year gain in 3Q 2016. Investors have responded very positively to the end of the seven quarter long earnings recession, pushing the S&P 500 higher by 18.2% since the Brexit-related low on June 27, which roughly coincided with the record low on the ten-year Treasury yield on July 8 at 1.36%.
- A pickup in earnings allows stock prices to advance without further stretching the market’s price-to-operating earnings ratio. Consider that the S&P 500 has advance 5.6% so far in 2017, however, the market’s P/E ratio is unchanged at 22.1x from year end 2016 due to the strong year-on-year advance in operating earnings in 4Q 2016 announced during the first two months of this year.
- We continue to look for further gains in 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 increase 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 an extremely important exercise. 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 the negatives associated with a Trump administration and the new policy dynamics it generates, and on the heels of the 5.6% gain in the S&P 500 over the first two months of the year, enthusiasm for common stocks could sag in the near term on skepticism about how quickly these new policies can be enacted and the extent of the firepower the negotiated and compromised policies will carry.
- However, we continued to look forward to a positive, pro-growth economic agenda and believe the Trump economic team will largely thread the needle and propose a reasonable set of policies which will boost growth and earnings, while limiting the rise in inflation, interest rates, bond yields, and the budget deficit.
- As such, we continue to 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. 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. Do not be surprised if volatility picks up over the course of the 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. Treasury Yield Curve Flattens During February.
- We are all well aware of the rise in interest rates and bond yields following the presidential election to the end of 2016. Yields on three-month and one-year Treasury bills rose 8 and 17 basis points, respectively, from November 8 to December 30. 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.
- Treasury yields rose to a much greater extent from two years to thirty years from November 8 to the end of 2016, however, on the order of 34 to 61 basis points. 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.
- Investors took some time during January to digest Donald Trump’s victory and the likely timing of his administration’s policies and proposals gaining Congressional approval and the ultimate size and impact of the Trump economic agenda. Yields on three-month and one-year Treasury bills rose one basis point and fell -5 basis points, respectively, during January. Moving out the yield curve, yields on Treasury securities from two years to thirty years fell -2 basis points to rising one basis point during January.
- Treasury yields rose 6 to 9 basis points from three-months out to two-years during February, as investors increasingly priced in a March rate hike by the Federal Reserve, however yields on longer dated Treasury securities declined -3 to -6 basis points, bringing about a flattening of the yield curve. We offer two thoughts for the move lower in longer dated Treasury yields last month. First, investors could well be dialing back the timing and impact of the Trump economic agenda.
- Treasury Secretary Steven Mnuchin has stated that he is committed to tax reform by August, as it will be very difficult in the near term to get tax reform and health care resolved concurrently. The magnitude of the administration’s proposals will likely be restrained, to some extent, with the national debt currently standing at around 77% of nominal GDP, comparted to 25% in 1981 (Reagan tax cut) and 31% in 2001 (Bush tax cut).
- The other factor likely supporting Treasury prices is the looming political uncertainty in the euro zone, and France in particular, where far-right presidential candidate, Marine Le Pen is widely expected to make it to the second round of voting this May. Le Pen has said she would pull France, one of the European Union’s founding nations, out of the euro, proposing to spend the first six months in office negotiating the return of the French franc.
- That could mean redenominating France’s government debt, which in the view of the rating agencies could effectively trigger a default. Just as the pending vote in Great Britain to leave the European Union triggered a flight to safety in Treasury securities last June, the political uncertainty in France should keep Treasury securities well bid over the next few weeks.
B. Treasury Market Still Expecting Only a 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 last summer to exit the European Union as investors feared that global growth could suffer in its aftermath. While that growth scare and negative TIP yields passed fairly quickly, 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 and eased a touch further to 0.38% at the end of February as investors pushed out to late 2017 before the economy will be impacted by the Trump economic agenda.
- We should also note that the ten-year TIP yield is below its level at the end of 2015. The market is likely expecting that the growth headwinds from the aging U.S. population and the burdensome size of the national debt are speed bumps that the Trump economic agenda will confront as the economy rolls into 2018.
- 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 a touch from a range of roughly 1.5% to 1.75% from the end of 2014 to election day, to over 2% since the end of January. This placed the market’s ten year inflation outlook over 2% for the first time since 2014. The market’s inflation expectation has hovered right around 2% since late January.
- 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.
- Since the beginning of the year, we have expected the yield on the ten-year Treasury note to trade in a range between 2.35% and 2.75%. The ten-year yield only traded below the lower band of that range two days over the past two months. With our expectation that the Federal Reserve will likely raise rates at the March FOMC meeting and the political uncertainty in the euro zone rising over the next couple months, we are lowering the expected trading range on the ten-year Treasury note to 2.25% to 2.65% for the near term.
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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