INVESTMENT STRATEGY STATEMENT
May 1, 2017
I. Equity Markets
A. Geopolitical Worries versus Healthy Earnings.
- Investors turned their attention last month to tomahawk missiles, a U.S. aircraft carrier strike group heading for the Korean peninsula, diplomatic wrangling with Russia, and trade negotiations with China centered on moderating the North Korean risk. Closer to home, the markets had to assess the impact of the Federal Reserve getting closer to shrinking its balance sheet, concerns that President Trump’s domestic legislative agenda has stalled, and the possibility of a federal government shutdown as current funding was set to expire. Finally, investors had cast a wary eye on the presidential election in France for several months as it could lead to France abandoning the euro and the European Union, an outcome which would undoubtedly rattle the financial markets.
- Not surprisingly, this litany of investor concerns led to a moderate flight to safe haven assets,
with gold prices rising 7.3% from March 9 to April 21 and the yield on the ten-year Treasury
note falling to 2.18% in the week before the first round of the French presidential election from
2.61% as recently as March 13. However, common stock prices only had a modest reaction,
with the S&P 500 dropping -0.6% from the beginning of April to the Friday before the French
election. Going back to the all-time high on the S&P 500 on March 1, the decline in stock
prices was only -2% to April 21. We chalk up the very muted response in stock prices to the
healthy rebound in operating earnings, which began in 3Q 2016 and has only strengthened in
4Q 2016 and so far for 1Q 2017.
- Common stock prices recovered a bit last week as the election results in France on April 23
pointed to no French nightmare for the financial markets. The closely fought first round of the
French presidential election looks to have produced the best result investors could have hoped
for — a run-off between centrist Emmanuel Macron and far-right euro skeptic Marine Le Pen
for the presidency on May 7. Polls suggest Mr. Macron will emerge victorious, although some
anxiety over the outcome will linger this week. Should Mr. Macron prevail, it would appear to
lower the political risk in the major European democracies for the time being.
- By voting for Macron, the French people will elect a president who is pro-euro and pro-
European Union whereas Le Pen wants a referendum on EU membership and continued use of
the euro currency. The importance of France remaining in the European Union cannot be
overstated. France and Germany are the twin pillars of the EU and the euro and if either
country pulled out, the project would likely collapse. That outcome would likely be very
negative for European stocks and euro zone sovereign bonds and would have ripple effects in
financial markets across the globe.
- We cautioned in the January ISS that the major risk to the domestic equity market and economy
this year was a potential breakup of the euro zone. A series of elections in Europe this year
were going to test whether a growing public conviction that the EU was not working would
carry the day against mainstream politicians in the EU’s founding nations. The populist
movements in Europe have been pushing for a return to national currencies and control over
domestic fiscal policies and immigration, and an end to bailing out the weaker member nations.
Political stability in the euro zone would allow the world’s financial markets to sidestep a
potentially, very unnerving event for the financial markets.
- Despite the geopolitical concerns which heated up last month, the major stock market measures
posted moderate gains of 0.9% to 2.3% during April. For the first four months of 2017,
common stock prices are higher by 3.2% to 6.5%, with the NASDAQ Composite leading the
way with a 12.3% advance. Since the presidential election on November 8, the major market
measures are higher by a strong 11.4% to 17.2% as investors continue to view positively the
pro-business and pro-growth agenda and mindset that President Trump brings to Washington.
B. Federal Reserve Turns Its Attention to $4.5 Trillion Balance Sheet
- The minutes of the Federal Reserve’s March 14-15 FOMC meeting reinforced the optimistic
perspective Chair Janet Yellen offered in the news conference following the policy meeting,
maintaining the forecast of three quarter point increases in the range for the federal funds rate
this year. The minutes also provided the first direct guidance on the timing of a reduction in its
balance sheet by suggesting that the central bank would likely begin shrinking the $4.5 trillion
portfolio of Treasury and mortgage-backed securities later this year.
- “Provided that the economy continued to perform about as expected, most participants
anticipated that gradual increases in the federal funds rate would continue and judged that a
change to the Committee’s reinvestment policy would likely be appropriate later this year,” the
minutes said. Reducing the size of the Federal Reserve’s balance sheet sends the central bank
into unchartered waters following the bond portfolio growing from less than $1 trillion prior to
the financial crisis to $4.5 trillion currently.
- The Federal Reserve grew its bond portfolio during three rounds of quantitative easing —
monthly bond buying programs — the first of which was launched in October 2008 to provide
liquidity to the bond market and to hold down longer dated bond yields and provide a boost to
economic growth. The central bank has been reinvesting proceeds of maturing securities into
new mortgage-backed and Treasury securities, maintaining the size of the balance sheet.
Ending the process of reinvesting would cause the balance sheet to shrink.
- There appears to be an ongoing discussion among the Committee members about whether the
Federal Reserve would phase out its reinvestment policy in a gradual process or cease it all at
once. Our sense is that Janet Yellen will choose to phase out its reinvestment policy as that
would likely be the least disruptive approach for the financial markets and the economy.
- We have long stated that since the Federal Reserve began contemplating raising interest rates in
early 2015, the central bank would not be tightening policy against an overheating economy
with rising inflationary pressures. We expected the Federal Reserve to pursue a very measured
and gradual path to removing monetary accommodation and that the central bank would not
undertake any policy actions which could place the economic expansion at risk.
- In our view, the Federal Reserve was entering a prolonged period of seeking the pace of rate
hikes and the level of short-term interest rates that the economic expansion could “tolerate.”
We continue to hold that view of the economy and that the appropriate monetary policy
response continues to require a gradual adjustment of policy. With the Federal Reserve turning
its attention to shrinking the size of its balance sheet, it is logical to expect the central bank to
again adopt a measured and gradual approach.
- It is also likely that the central bank will not hike interest rates at the FOMC meeting that it
announces a tapering of its reinvestment policy. The process of unwinding the balance sheet —
including how quickly, when to start, and to what level — is significant because of its sheer
size. With both raising interest rates and shrinking the size of its balance sheet as stated goals
of the Federal Reserve, we continue to expect policy actions to be undertaken in a manner
which increases the likelihood that interest rates are not back at zero in short order. As such,
we are not expecting a rate hike at this month’s FOMC meeting, but a hike at the June meeting
is very likely.
C. Economy Maintains Persistent, Forward Momentum
- The economy’s growth rate slowed to a paltry 0.7% annual rate last quarter, compared to a
2.1% growth rate in 4Q 2016. However, the headline real GDP figure somewhat understates
the health of the economy and its forward momentum. Businesses liquidated inventories at
a -$39.2 billion pace last quarter after building inventories at a $42.5 billion pace in 4Q 2016.
The drawdown in inventories subtracted -0.9 percentage points from the 1Q 2017 growth figure
and a return to a moderate pace of building inventories will actually support the economy’s
growth rate over the remainder of 2017.
- Government spending fell at a -1.7% pace last quarter as defense outlays declined at a -4.0%
rate. State and local government spending also declined, falling at a -1.6% pace. The rest of
the economy contributed to the economy’s growth last quarter. Our favorite measure of final
demand, real domestic private final sales — the sum of consumer spending, business capital
spending, and residential construction outlays — grew at a 2.2% rate during 1Q 2017, right in
line with the economy’s growth rate over the course of this business expansion.
- Consumer spending slowed to a 0.3% annual rate last quarter, partly due to the mild winter
which moderated the demand for heating and utility production. The resulting rise in the
personal savings rate to 5.7% from 5.5%, the continued solid gains in employment, the uptick
in average hourly earnings, and still low energy prices will support a faster pace of consumer
spending in coming quarters.
- Residential construction outlays rose at a strong 13.7% pace as the mild winter also contributed
to a modest boost in housing starts. Business capital spending rebounded at a solid 9.4% rate
following an average quarterly growth rate of 1.1% over the previous three quarters. The
pickup in business capital spending was led by a strong 22.1% rise in structure outlays as a
rebound in natural gas and oil well drilling spurred an eye catching 449% annual rate of growth
in the mining, exploration, shafts, and wells category.
- Inflation measures picked up a bit last quarter, with the price index for gross domestic
purchases, which measures prices paid by U.S. residents, rising at a 2% rate. Excluding the
more volatile food and energy prices, the core gross domestic purchases price index rose at a
1.9% rate. Prices of goods imported to the U.S. rose at a 5.2% annualized rate as oil prices
were higher on average and the U.S. dollar was a touch lower. The Federal Reserve’s favorite
measure of inflation, the core personal consumption expenditures index, rose at a 1.7% rate.
D. Business Expansion to Continue at Moderate Pace for Now.
- Putting it all together, we see the economy’s underlying growth rate remaining close to 2%
with the business expansion continuing to move ahead. We continue to expect that this
expansion, currently at 93 months compared to the post-WW II average of 58 months, will take
a run at the longest expansion on record of 120 months under President Clinton.
- While the Trump administration has proposed a major tax cut and reform package, it is thin on
details and faces a contentious Congressional review. For 2017, the economy will benefit to a
modest extent from some progress on the regulatory front and from the wave of optimism and
improved confidence washing over business leaders, households, and investors from the probusiness
mindset that President Trump has brought to Washington. In combination with the
domestic economy already gathering some momentum as 2016 drew to a close, there was, and
continues to be, very little downside for the economy.
- It looks to us that the business expansion can continue to advance until the inflationary
pressures begin to build to the extent that the Federal Reserve needs to alter its monetary policy
stance from becoming gradually less accommodative to the first tightening of monetary policy
since 2005-06. In that regard and given the persistent forward momentum in the economy, an
economic agenda that is somewhat smaller in scale and scope than envisioned a couple months
ago can be viewed in a positive manner as it pushes out the timeframe when inflationary
pressures are likely to begin building in the economy to the extent that they become a threat to
- We look for the economy to start benefitting from the President’s economic agenda in 2018. A
growth rate closer to 3% will require the passage of pro-growth tax cuts and reform. Stay
tuned as the details of the Trump economic proposal are developed and negotiated with
Congress over the next 3 to 6 months.
E. What We know, What Has Been Proposed.
- In thinking about the outlook for common stocks, we are staying focused on what we know,
and will let the high level tax cut and reform proposal unveiled by the Trump administration
last week be the icing on the cake. In the October ISS, after the surprising Brexit vote and
before Donald Trump’s election, we argued that investors would return to the fundamentals in
evaluating the outlook for common stocks.
- It looked to us in October that the fundamentals pointed to higher, not lower stock prices. We
took the position that a further advance in common stock prices required the economic
expansion continuing to advance, the earnings recession coming to an end, stock valuations
moderating in a constructive manner, and the Federal Reserve not making a mistake in its
conduct of monetary policy.
- Looking back at the second half of 2016, the global economy was about to benefit from a
synchronized pickup in world growth for the first time over the course of this expansion, with
signs of an improving economic backdrop in China, Japan, and Europe, along with the U.S.
The better economic momentum looks to have carried over into 2017 and the Bank of England,
the European Central Bank, and the Bank of Japan are still pursuing very accommodative
monetary policies. Our review of the 1Q 2017 economic data points to the U.S. economy being
on solid footing with the 2% growth rate over the course of this expansion likely to remain in
place, pending any future policy initiatives.
- The seven quarter long recession in operating earnings came to an end in 3Q 2016, with a yearover-
year advance of 12.8%, only to be followed up by a 21% gain in 4Q 2016. The
improvement in operating earnings has largely been the result of a return to profitability in the
energy sector during the second half of 2016. Earnings additionally benefitted from the U.S
dollar easing about -7% from its peak in January 2016 to the fall of 2016, reversing the
negative effect on the earnings of U.S. multinationals on both sales volumes and earnings
- The earnings rebound looks to be continuing for 1Q 2017. With 64% of the companies in the
S&P 500 reporting, operating earnings are on track to post a year-on-year gain close to 21% for
1Q 2017. The earnings of U.S. multinationals have also benefitted from a pickup in overseas
growth since late last year.
- The earnings recession made common stocks more expensive, pushing the price-to-operating
earnings multiple on the S&P 500 from 17.6x in 3Q 2014 to 22.1x at the end of September
2016. Despite the S&P 500 advancing 10.4% over the past seven months, the rebound in
operating earnings, using the current estimate for 1Q 2017, has actually lowered the P/E ratio
on the S&P 500 to 21.4x. This is the sort of constructive moderation in stock valuations we
were looking for, earnings rising at a faster pace than stock prices.
- Our view remains that the Federal Reserve understands very well that it is not tightening
monetary policy against an overheating economy with rising inflationary pressures. As such,
we have expected the central bank to pursue a very measured and gradual path to higher
interest rates and that the Federal Reserve would not undertake any policy actions which could
place the economic expansion at risk any time soon. The Federal Reserve is engaged in a
prolonged process of seeking the pace of rate hikes and the level of short-term interest rates
that the economic expansion can “tolerate.”
- As covered earlier in this ISS, now that the Federal Reserve has turned its attention to shrinking
the size of its balance sheet, it is logical to expect the central bank to again pursue a measured
and gradual approach to reducing its $4.5 trillion bond portfolio. Such an approach to
monetary policy, which we believe appropriately characterizes the actions of the Federal
Reserve over the past 28 months since the central bank ended its bond buying program in
November 2014, permits investors to view positive news on the economy as good news for
common stocks as it reinforces the positive outlook for earnings.
- The Trump administration did unveil the broad outlines of a tax cut and reform package last
week, but the lack of details makes it impossible to calculate the fiscal impact of the plan and
how it would impact businesses and individual taxpayers. However, the President did attempt
to go “big,” by proposing a 15% tax rate for all businesses and U.S. companies would owe little
or no U.S tax on future foreign profits, but the proposal did not set the one-time tax rate on U.S.
companies’ earnings held overseas if they are repatriated back to the U.S. Mr. Trump also
proposed lowering personal tax rates, doubling the standard deduction, repealing the estate and
alternative minimum taxes, and broadening the taxable base by eliminating certain deductions.
- We view the broad overview as pro-growth and an ambitious and much needed economic
policy shift that would help restore broad-based domestic prosperity. However, now the
difficult work begins as the details are filled in and the process of negotiating the bill through
Congress commences, where budgetary hurdles and complex politics could make it difficult for
the Administration to get a quick and complete victory. What the tax proposal will ultimately
look like is unknown and the timing is anyone’s guess. We are encouraged, but it is difficult at
the present time to assess the impact of the tax proposal on the economy, the budget deficit, and
the financial markets. As we often say, stay tuned!
- It appears to us that the economy and the stock market entered a sweet spot late last year where
growth is good enough to support further growth in earnings and earnings are in a cyclical
recovery with the rise in oil prices since early February 2016 and the modest move lower in the
dollar since January 2016. Additionally, the ingredients for a recession are not in place and
there is no material evidence of accelerating inflationary pressures. Investors continue to look
for pullbacks to put additional money to work, but have been frustrated by a consistent bid for
common stocks, even during the failed effort to repeal and replace Obamacare during March
and the rise in geopolitical concerns last month.
- It seems to us that 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 should any constructive policy details be released. Additionally,
taking gains is being pushed out in the hope that the tax proposal will include lower capital
gains tax rates. As such, we continue to recommend that investors buy any -3% to -5%
pullback in stock prices this year to position their portfolios for better growth and earnings.
II. Treasury Market
A. Geopolitical Concerns Dominated Treasury Market Last Month.
- Trading in the Treasury market last month was dominated by geopolitical events which sent
investors looking for safe haven assets. As mentioned earlier in this ISS, investors turned their
attention during April to tomahawk missiles and a U.S. aircraft carrier strike group heading for
the Korean peninsula. Investors had been concerned about the presidential election in France
for several months as it could lead to France abandoning the euro and the European Union.
- The yield on the ten-year Treasury note ended March at 2.40%, but it fell in almost a straight
line to 2.18% in the week before the first round of the French presidential election. The tenyear
Treasury yield rose last week after the election results in France on April 23 pointed to
France remaining in the euro and maintaining its membership in the EU, finishing the month at
- Also supporting the Treasury market over the past three months was investors dialing back the
timing and potential impact of the Trump economic agenda. While the Trump administration
did unveil the broad outlines of a tax cut and reform package last week, the lack of details
makes it impossible to calculate the impact of the tax proposal on the economy, the budget
deficit, and the financial markets. Also, timing is, at best, a guess.
B. Treasury Market Still Expecting Only a Modest Rise in Growth & Inflation.
- The fixed income market is looking for only 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 in the table below 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 presidential 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 has fallen a touch lower to 0.36% to the end of April as investors have pushed out
to 2018 before the economy will be impacted by the Trump economic agenda, and likely in a
fairly moderate manner.
- 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, weak
productivity growth, and the burdensome size of the national debt are speed bumps that the
Trump economic agenda will continue to 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
close to 2% since the end of January. This placed the market’s ten year inflation outlook near
2% for the first time since 2014.
- 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. While the yield on the ten-year Treasury note
traded below 2.25% on five days during April as the French presidential election drew closer,
we will stick with our forecast of the yield on the ten-year Treasury note trading in a 2.25% to
2.65% range 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.
CenterState Bank of Florida offers Investments through NBC Securities, Inc. (NBCS”). NBCS is a
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