CenterState Wealth Management
Investment Strategy Statement
March 1, 2018
I. Equity Markets
A. Fundamental Change in the Outlook for the Economy.
- Investors spent the past month or so adjusting to a fundamental change in the economic outlook. From the beginning of the current economic expansion in the summer of 2009 to the day of the presidential election, the economic expansion proceeded at a pace far below the economy’s long run growth rate — 2.2% vs 3.2% — and required very low interest rates and bond yields and several massive bond buying programs to support even that lackluster pace of growth. Inflation remained very low — near 1.5% — and investors were more concerned about disinflationary or deflationary threats rather than mounting inflationary pressures.
- Following the presidential election, both business and consumer confidence began to strengthen. The expected tax increases on the business sector and upper income households, which were central to Hillary Clinton’s legislative agenda, evaporated with Ms. Clinton’s defeat. Instead, hopes for tax reform and tax cuts were on the horizon. Additionally, the trend toward growing regulatory burdens was stopped in its tracks, replaced with hopes for a lighter regulatory backdrop, particularly in the financial and energy sectors of the economy.
- By October of last year, the two major consumer confidence measures were at 17 year highs and the two closely followed business confidence measures were at pre-recession and all- time highs. The purchasing manager surveys were very strong and all of the surveys of regional economic conditions prepared by the various Federal Reserve banks were also pointing to an acceleration in the pace of economic activity.
- Consumer spending last year reflected the boost in confidence with consumer outlays growing 2.8% over the four quarters of 2017, compared to real GDP growing 2.5%. Note that the 2.5% advance for the entire economy for 2017 was greater than the 2.2% rate of growth over the course of the expansion. The consumer confidence boost was also reflected in the personal savings rate declining from 4.8% in 3Q 2016 to 2.7% by 4Q 2017, meaning households felt confident enough about the future to spend at a faster pace than their incomes grew following the presidential election.
- Additionally, the rise in business confidence showed up in business capital spending growing 6.3% over the four quarters of 2017 compared to the economy’s 2.5% growth rate. Of course, we all know how the stock market reacted to Donald Trump’s surprising victory in the presidential election, with the S&P 500 gaining 25% from the night of the election to the end of 2017.
- With the passage of the tax package — which included much needed and very beneficial corporate tax reform — in late December, investors were now looking at another ramp in the economy’s growth rate and a significant boost to corporate earnings. Investors applauded the cut in the corporate tax rate to 21% from 35%, the move to a territorial tax system, a freeing up of the earnings trapped overseas to return to the U.S., and immediate expensing of capital expenditures with the rise in stock prices to the blow off top on January 26.
- We now know that the peak on January 26 was followed by a -10.2% decline in the S&P 500 to the recent low on February 8, the first correction of more than -10% in the S&P 500 since the -14.5% drop from May 21, 2015 to the low on February 11, 2016. That correction was precipitated by the collapse in oil prices and the sharp rise in the dollar which sent operating earnings on the S&P 500 spiraling into a seven quarter long earnings recession from 4Q 2014 to 2Q 2016.
- As we stated in a note to our clients on February 9, equity valuations, momentum, and sentiment got stretched in late January and a pickup in volatility — related to leveraged bets on the persistence of low volatility — a reversal in sentiment, and margin calls which led to forced and indiscriminate selling pressure combined to bring about the sudden and volatile selloff. Equity valuations improved with the drop in stock prices and the continued strong growth in earnings, leading investors to step in and buy common stocks, pushing the S&P 500 5.1% higher from the February 8 low to the end of the month.
- Despite the rebound in common stock prices since the February 8 low, the major market measures posted modest losses for the month of February, with declines of -1.9% to -4.3%. From the January 26 high to the February 8 low, the major market indices fell pretty much in unison, dropping -9.0% to -10.4%. All of the major market measures rose from the February 8 low to the end of the month, advancing 3.3% to 7.3%. For the first two months of 2018, the S&P 500 and the DJIA are higher by 1.5% and 1.3%, respectively, while the technology-heavy NASDAQ Composite has gained 5.4%. The Russell 2000 Index of small company stocks is lower by -1.5% for 2018.
B. What Are the Risks Associated with the Shift in the Economic Outlook?
- As investors, we need to recognize the fundamental shift in the economic outlook which has occurred. The economic expansion has transitioned from below average growth with lingering disinflationary/deflationary concerns which required ultra-low interest rates and bond yields to forward looking growth more in line with the economy’s long run growth rate with disinflationary/deflationary concerns and the era of ultra-low interest rates and bond yields now in the rear view mirror.
- This shift in the economic fundamentals resulting from the tax package and the passage last month of a $300 billion spending bill — which boosts spending on military and domestic programs and cleared the way for a two year budget deal — does contain some risks. Namely, to what extent will the late cycle fiscal stimulus impact the outlook for inflation by pulling demand forward and flaming wage pressures? What is the likely response of the Federal Reserve to the fiscal stimulus? Finally, what are the implications for the federal budget deficit and Treasury yields?
- Inflation fears picked up last month by the reported 2.9% year-on-year advance in average hourly earnings in the January employment report compared to the prior month’s reading of 2.5%. A deeper look at the report indicated that wages may not be rising at a threatening pace, however. The report showed that wages for nonsupervisory workers, who account for about 80% of employees covered in the report, rose just 2.4% year-on-year, in the same range that that has prevailed for several years. A decline in the average workweek and one- time bonus payments appear to have distorted the reported rise in wages for supervisory workers. The next employment report on March 9 will bear watching in terms of the wage data for February.
- As for the Federal Reserve, time will tell how it responds to the late cycle fiscal stimulus, but we believe the still low rate of inflation, driven largely by structural changes — think worldwide sourcing of goods and comparative price shopping facilitated by ecommerce and the internet — will keep the central bank from moving to a policy stance where it needs to tighten monetary policy in an inflationary environment. To the extent that is true, the Federal Reserve will continue to gradually raise interest rates at a pace which the economic expansion can tolerate. More on the Federal Reserve in the next section of this ISS.
- Lastly, we have been expecting longer maturity Treasury yields to rise a touch this year, with the yield on the ten-year Treasury note taking a run at 3%. Currently, the ten-year Treasury is yielding 2.86%, after reaching 2.95% last week and finishing 2017 at 2.41%. A larger federal budget deficit — likely to approach $1 trillion — and the Federal Reserve shrinking the size of its investment portfolio — at an accelerating pace over the next three quarters — will require higher yield levels to clear the market of the supply of new Treasury securities.
- Remember, however, that higher fixed income yields will offset a portion of the fiscal stimulus from the tax package and the $300 billion spending bill passed last month and the aging baby boomer generation has a growing demand for fixed income, helping to keep a lid on the rise in Treasury yields. More on the outlook for Treasury yields in the last section of this ISS.
- We warned in recent ISS’s that valuations on common stocks had risen and were likely to moderate over the course of 2018. Two things have brought valuations down. First, is the continued rise in operating earnings which for all of 2017 look to have grown 17.7%, with 4Q 2017 operating earnings higher by 23.3% over 4Q 2016 with 86% of S&P 500 companies reporting. At the recent low in stock prices on February 8, the trailing price-to- operating earnings ratio on the S&P 500 fell to 20.8x from 22.6x at year end, and below the 21.1x reading on the day of the presidential election.
- As we mentioned in last month’s ISS, 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 the analysts at Standard & 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 more than 24% over the four quarters of 2018.
- Having covered the outlook for economic growth and earnings, 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 that 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 to the end of 2018.
- As a final thought on common stocks, we view the rise in bond yields so far this year, in concert with the rise in stock prices, as consistent with investors accepting a fundamental change in the outlook for the economy. Namely, look for a pickup in the economy’s growth rate toward long term trend — closer to 3% for 2018 and 2019 — with the disinflationary/deflationary concerns that have prevailed since the Great Recession and the era of ultra-low interest rates and bond yields fading into the background, until the next recession.
- We do view the rather swift decline in stock prices from late January to mid-February 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 continue to look to put money to work on any pullback which approaches -5% with the outlook for the economy and earnings looking up and inflationary pressures still under control.
C. January FOMC Minutes Show Improved Confidence in the Economic Outlook.
- The minutes from the January 30-31 FOMC meeting were released last week and pointed to growing confidence among Federal Reserve officials that the pace of economic growth is strengthening, increasing the likelihood that inflation would rise to their 2% target over the coming years following years of consistently falling short. This somewhat more upbeat assessment of the economy’s forward momentum followed the Federal Reserve raising its growth projections at the December FOMC meeting, largely because Congress was close to agreement on a $1.5 trillion tax cut package.
- The committee members raised their growth forecasts a touch higher at the January FOMC meeting after reviewing the final version of the tax package which turned out to be somewhat more generous in providing tax cuts and stimulus over the next couple years than previously expected. Along with raising their expectations for growth, Federal Reserve officials also appear more certain inflationary pressures will continue to build toward their 2% target given the economy’s very low unemployment rate, which is expected to fall further with the expected ramp in the pace of economic activity.
- We should note that the January upward revision to the central bank’s economic forecast was made prior to Congress passing a two year budget deal which will increase federal government spending on the military and various domestic programs — a $165 billion increase in military spending and nearly $90 billion in funding for disaster relief efforts in Texas, Florida, and Puerto Rico — by $300 billion over the next two years. The funding bill turned out to be far more generous than most observers anticipated, which will provide the economy with a further boost this year and next, by an amount roughly equal to the boost expected from the tax package signed into law in late December.
- At the December FOMC meeting, the committee members forecast three additional rate hikes during 2018. Following the actual passage of the tax package and Congress approving the larger than expected federal government spending plan last month, we feel there is no doubt the Federal Reserve will raise rates at the March 20-21 FOMC meeting. We stated in last month’s ISS that the central bank was likely to hike rates three times this year as the business expansion should be able to “tolerate” the rate hikes following the passage of the tax package. Three rate hikes is still our call for 2018.
- Following Congress approving the additional $300 spending bill, the odds of a fourth rate hike this year have risen. In fact, it would not surprise us if the quarterly update of economic projections which the Federal Reserve will release following this month’s FOMC meeting, was adjusted to reflect four rate hikes in 2018.
- As we have consistently stated since the summer of 2014, the Federal Reserve wants to raise rates so that it has the ability to lower rates during the next economic downturn. The major consideration the Federal Reserve had to acknowledge since it began raising rates in 2015 was the ability of the economic expansion to “tolerate” the rate hikes. The central bank needed to avoid raising rates at a pace which would return the federal funds rate to zero in short order. We still hold that general view, but acknowledge that the legislative actions since late December have greatly increased the economy’s ability to continue to grow in the face of a slightly faster pace of rate hikes. As always, stay tuned!
D. Jerome Powell Testifies Before Congress.
- In testimony before the House Financial Services Committee on Tuesday, newly appointed Federal Reserve Chairman Jerome Powell echoed the confidence in the economic outlook found in the January FOMC meeting minutes. Mr. Powell emphasized that the job market remains robust, consumer spending is solid, and wage growth is accelerating. He also stated that a stronger global economy and stimulative fiscal policy are new “tailwinds” for the economy. In sum, “the economic outlook remains strong.”
- Jerome Powell suggested that the firmer economic data gave Federal Reserve officials confidence that inflation will hit the central bank’s 2% target, which has long proved elusive, in coming years. Mr. Powell characterized inflation as “low and stable” and reiterated the Federal Reserve’s expectation that “further gradual increases” in the federal funds rate would likely be warranted, despite the added stimulus from tax cuts and a higher level of government spending.
- Reflecting our view of a fundamental change in the economic outlook taking place, Mr. Powell pledged to “strike a balance” between the risk of an “overheating” economy and the need to keep growth on track. The use of the term “overheating” is a first since before the Great Recession and the Financial Crisis, and a marked shift in tenor from that which prevailed over the past decade.
- The Federal Reserve Chairman hinted in response to a question that more aggressive action on rate increases could be warranted this year. Jerome Powell acknowledged that the FOMC Committee’s last economic projections done in December had three rate hikes as the median forecast for 2018. However, Mr. Powell went on to say that “Now since then, what we’ve seen is incoming data that suggests a strengthening in the economy.” While not an explicit upward revision to the Committee’s rate forecast, Mr. Powell’s response is consistent with the possibility of more than three rate hikes this year. We and the policymakers at the Federal Reserve will need to see how the economic data plays out.
E. An Update on “Too Quickly or Too Slowly.”
- Given our view that a fundamental change in the economic outlook has taken place over the past fifteen months, the largely unprecedented turnover among the Federal Reserve’s top monetary policy decision makers currently taking place, the unchartered waters the central bank began to navigate last October to reduce the size of its $4.3 trillion securities portfolio, and the expectation for three to four rate hikes this year following five rate hikes over the previous 27 months, we feel it is crucially important to monitor the Treasury market’s assessment of whether the Federal Reserve is moving too quickly and aggressively to remove monetary accommodation — possibly tipping to a tightening mode, or too slowly — which could lead to a build in inflationary pressures.
- We feel the answer to these questions will be unveiled in the Treasury bond market, specifically in the yield spread between two-year Treasury notes and ten-year Treasury notes. Recall that the primary determinant of the yield on longer dated Treasury securities is investor expectations for inflation, with the outlook for growth a secondary consideration. The yield on the two-year Treasury note is closely related to the actual level of the federal funds rate and expectations for short-term interest rates over the next year or so.
- If the bond market believes the Federal Reserve is raising interest rates prematurely and/or at too rapid a pace, the yield curve will flatten, i.e., the yield spread between two-year Treasury notes and ten-year Treasury notes will shrink. Likewise, if investors believe the Federal Reserve is proceeding at a pace which is too slow or deliberate, the yield curve will steepen, widening the yield spread between two-year Treasury notes and ten-year Treasury notes.
- Notice in the table above that the yield spread between two-year Treasury notes and ten-year Treasury notes ended 2015 at 122 basis points following one rate hike and ended 2016 at 125 basis points following a second rate hike. After three rate hikes last year and the central bank starting the process of shrinking its securities portfolio, the yield spread collapsed to only 53 basis points at year end 2017, sending a fairly clear message to the Federal Reserve that it needs to be careful in its ongoing effort to reduce the degree of monetary accommodation in the U.S. financial system.
- The yield spread ended February at 61 basis points, slightly higher than at year end. We feel the slightly higher yield spread is consistent with the fiscal stimulus arriving from Washington which will impact the economy in a positive manner this year and next. However, it appears to us that the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake as it continues along the current path of raising interest rates.
- Guiding rate hike decisions over the next two years will be a dynamic process requiring a great deal of judgment by the Federal Reserve as to what level of short-term interest rates the economic expansion can tolerate. We feel the level of short-term interest rates the economy can tolerate has definitely increased with the new policy agenda in Washington that came with Donald Trump’s election and the fiscal stimulus which has been enacted since late December.
- Inflationary pressures will be the key economic variable to monitor. If core inflation rises to and settles out around 2%, a federal funds rate of 2% or slightly higher will be an important level to monitor in terms of its impact on the economy. Should inflation build beyond a 2% pace, it will eventually force the hand of the Federal Reserve to shift its policy approach toward a tightening of policy rather than gradually removing accommodation. At that point, the countdown to the next recession will begin.
II. Treasury Market
A. Longer Dated Treasury Yields Rise for Sixth Straight Month.
- After falling to a low on September 5 of last year — 2.06% on the ten-year Treasury note — yields at the longer end of the Treasury yield curve have risen for six straight months, while yields at the shorter end of the yield curve have risen consistently since the presidential election as the Federal Reserve raised rates four times over the past 15 months. Yields on three-month to two-year Treasury securities have risen 123 to 142 basis points from November 8, 2016 to the end of February. In particular, the yield on the two-year Treasury note has risen from 0.85% on the day of the presidential election to 2.25% at yesterday’s close.
- At the longer end of the Treasury yield curve, yields on five-year to thirty-year Treasury securities have risen 45 to 100 basis points from the September 5 low in longer dated yields last year to the end of February. In particular, the yield on the ten-year Treasury note has risen from 2.06% on September 5 to 2.86% at last night’s close.
- Yields at the longer end of the Treasury yield curve are being impacted by two things. First, investors are 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 $300 billion spending bill, 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 February, yields at the shorter end of the yield curve rose 11 to 19 basis points, while yields on securities five years and longer rose 13 to 19 basis points.
- Investors are also reacting to 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 in 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.
B. Look for Further, Modest Upward Pressure on Longer Dated Treasury Securities.
- As the yield on the ten-year Treasury note rose from the low recorded on September 5, both the real, or TIP, yield and the implied inflation expectation embodied in the nominal ten- year Treasury yield have risen, as shown in the table below. While the Federal Reserve kicking off its effort to shrink its investment portfolio likely had some impact on the ten- year Treasury yield, we think the majority of the rise in the real yield and the inflation premium has been caused by the fundamental change in the economic outlook following the boost in consumer and business confidence since the presidential election and the late cycle fiscal stimulus measures passed by Congress since late December.
- Also notice that following the presidential election, the implied inflation expectation moved fairly consistently toward 2%, the Federal Reserve’s inflation target. The rise in the inflation outlook at the end of 2016 was fueled by the anticipation of a tax package and the actual passage of the tax package kept inflation expectations close to the 2% level as 2017 drew to a close.
- Now, as investors assess the impact on the economy from the tax package and the federal spending bill, inflation expectations have moved slightly above 2% as of the end of February. 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. For the next couple months we look for a trading range of 2.75% to 3.25% for the ten-year Treasury note yield.
- The extent to which the tax package and the $300 billion federal spending bill accelerates the economy’s growth rate and inflationary pressures rise over the next two years, we continue to expect the entire Treasury curve to shift even higher and the ten-year Treasury yield to break through the 3% barrier, a level we have not seen since late December 2013. The expected increase in the federal budget deficit at a time that the Federal Reserve is shrinking its holdings of government bonds and the increase in the cost of servicing the national debt with the rise in Treasury yields 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.
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.