CenterState Wealth Management
Investment Strategy Statement
May 1, 2018
I. Equity Markets
A. Trade Fears Subside, Late Cycle Stimulus Fears Rise.
Investors pushed aside the worries over tariffs and trade wars last month, that had so dominated the discourse during March, and returned to the worries associated with late cycle fiscal stimulus, namely inflation and the rising cost of money. We stressed in last month’s ISS 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.
While these developments do not mean the risk of tariffs and protectionist policies are completely behind us, they do support Mr. Trump’s position that tariff threats can create opportunities for serious trade negotiations. While China has made promises along these lines in the past, Mr. Xi making them directly, and at China’s elite Boao Forum, does provide added weight to their intent. We have a greater degree of comfort today in our position that the threat of tariffs will remain a tactic in trade negotiations rather than a blunt policy tool.
With the threat of a trade war pushed to the back burner for the time being, investors turned their attention to the dominant issue impacting the outlook for the domestic economy and the financial markets today. The Trump Administration and Congress have placed the economy in a place it has never been before, late cycle — the expansion was 102 months old at the end of 2017 — with a major dose of fiscal stimulus working its way through the economy — the $1.5 trillion tax cut passed in December and the $300 spending bill on the military and domestic programs passed in February.
These fiscal policy initiatives have led to a fundamental shift in the economic outlook. An acceleration in the economy’s growth rate to a range of 2.5% to 3% is expected, with the disinflationary/deflationary concerns since the financial crisis and the Great Recession and the era of ultra-low interest rates and bond yields now in the rear view mirror. The outlook for earnings has also improved, with operating earnings on the S&P 500 companies expected to grow almost 24% over the four quarters of 2018.
Investors seemed to focus their concerns on the rising cost of money, both the possibility of a more aggressive Federal Reserve and the yield on the ten-year Treasury note finally breaking above the 3% barrier last week for the first time since New Year’s Eve 2013. We view the Federal Reserve making a policy mistake as the primary threat to the economy, with the yield on the ten-year Treasury note hitting 3% a somewhat misplaced psychological barrier, not an economic barrier that investors should fear.
Volatility remained elevated last month, but common stocks were little changed despite a very strong start to 1Q 2018 earnings. The four major stock market measures were unchanged to higher by 0.8% during April. For the first four months of 2018, the S&P 500 and the DJIA have posted small losses at -1.0% and -2.2%, respectively. The Russell 2000 Index of small company stocks is barely positive with a gain of 0.4% for 2018, while the technology company heavy NASDAQ Composite is higher by 2.4%. Common stocks are still showing major gains since the presidential election, higher by 23.8% to 36.1%
B. Late Cycle Stimulus, Budget Deficits, Inflation, and the Federal Reserve.
We raised the topic back in December, before the tax package was passed, that major fiscal stimulus arriving when the economic expansion was over eight years old brought with it a number of risks. Larger budget deficits could exacerbate the upward pressure on Treasury yields at the same time the Federal Reserve is shrinking the size of its investment portfolio. Inflationary pressures could mount if demand was pulled forward and the Federal Reserve could be forced to be more aggressive in hiking interest rates.
The Congressional Budget Office recently revised its forecast for the federal budget deficit following the passage of the tax cut and the spending bill. The budget deficit is set to widen significantly over the next few years and is expected to top $1 trillion again in 2020 despite a forecast of healthy economic growth. Over the next ten years the cumulative deficit is expected to be $1.6 trillion larger than the $10.1 trillion forecast last made in June.
As deficit hawks, we are troubled by these projections for the federal budget deficit and believe the federal spending programs will need to be addressed as the national debt as a percentage of the economy approaches 100%. We look at the rise in the yield on the ten-year Treasury note from 1.86% on the day of the presidential election to 2.95% at the end of April as largely reflecting the expected increase in the federal budget deficit over the next few years.
On the outlook for inflation, which we believe holds the key to the outlook for the economy and the financial markets, we expect only a modest build in inflationary pressures to take place. With the unemployment rate at 4.1%, a 17 year low, it is easy to build a cyclical case for rising wage pressures leading to a burst of inflationary pressures. There are, however, structural influences at work that are keeping a lid on inflationary pressures.
A large segment of the consumer population today is conditioned to use technology to seek the lowest possible price. This worldwide sourcing of goods and comparative price shopping facilitated by ecommerce and the internet have brought about an economic sea change relative to inflation pressures. Technology has altered the fabric of consumption and purchasing, changing the manner in which commerce works. Those analysts and investors fearing a significant rise in inflation are failing to fully appreciate the impact of technological adoption and its ability to capture the lowest possible price on the full range of goods and services available today.
As for monetary policy, we do expect the Federal Reserve to raise interest rates two more times this year as the pace of economic growth picks up a bit of steam over the next three quarters. But we are maintaining the position we took in last month’s ISS that the current forecast from the Federal Reserve of another five rate hikes in 2019 and 2020, which would take the federal funds rate to a range of 3.25% to 3.5%, is likely too aggressive. It is our view that there is little ability for the economic expansion to tolerate that pace of rate hikes, as well as that level of interest rates.
The basis for this position is how rapidly the Federal Reserve is approaching the effective “real neutral rate” at which monetary policy is neither stimulating nor restraining the economy. Last summer, both Chair Janet Yellen and Govenor Lael Brainard asserted that the real neutral rate — the federal funds rate minus inflation — was thought to be zero. With the core personal consumption deflator at 1.7% year-on-year in the 1Q 2018 data, the current 1.5% to 1.75% range for the federal funds rate puts in place a real neutral rate which is only slightly below zero.
Two additional rate hikes this year, even if the core inflation rate rose to the Federal Reserve’s 2% target, would put in place a real neutral rate that was slightly positive. This would imply that monetary policy had tilted to the restraint side of the equation for the first time in more than a decade. Five additional rate hikes in 2019 and 2020 would place monetary policy clearly on the side of restraining the economy, unless there was a significant rise in inflation, which neither we nor the markets are expecting.
Since the summer of 2015, before the Federal Reserve began raising interest rates, 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 has fallen to 46 basis points, its lowest level since late 2007. We 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 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.
As a final note on the Federal Reserve, we do not expect the FOMC Committee to raise interest rates at this week’s meeting. The economic data has not contained any surprises since the Federal Reserve hiked rates in March and commentary by Federal Reserve officials over the past month have not given any signals of an imminent rate hike. We look for the central bank to hike rates for the second time this year at the June 12-13 FOMC meeting. As always, stay tuned!
C. Special Factors Hold Back Consumer Spending and Housing Outlays.
The economy’s growth rate slowed modestly to a 2.3% pace in 1Q 2018, compared to an average growth rate of 3.1% over the previous three quarters. The slower growth rate was directly related to a sharp slide in the personal savings rate following the presidential election and a retrenchment in certain sectors following a surge in natural disaster-related spending during 4Q 2017. The economy’s growth rate is expected to accelerate toward 3% over the remainder of the year on the back of the $1.5 trillion tax package and the $300 billion federal spending bill passed in February.
Consumer spending grew at only a l.1% annual rate last quarter, compared to a growth rate of 4.0% during 4Q 2017. All of the slowdown was contained in the goods sector, both nondurable goods which advanced at only a 0.1% rate and durable goods which declined at a -3.3% rate. Following the election of Donald Trump, consumer confidence soared, leading to consumer spending growing 2.8% over the four quarters of 2017 compared to a gain of only 1.8% in real disposable personal income. As a result, the personal savings rate fell from 4.8% in 3Q 2016 to only 2.4% in December.
We cautioned in the February ISS that the drop in the personal savings rate was a concern for consumer spending early this year as the savings rate was likely to rise, slowing the growth in consumer spending. The savings rate did rise a touch to 3.1% in 1Q 2018, acting as a headwind to the household sector and contributing to the weak advance in consumer spending.
Also adding to the weakness in consumer spending was a -15% drop in motor vehicle sales in 1Q 2018, which accounted for the entire decline in durable goods outlays. The 13.7% jump in durable goods outlays in 4Q 2017, led by a 19% surge in motor vehicle sales, reflected the one-time shot of replacement demand following hurricanes Harvey and Irma during September and the wildfires in California which hit peak devastation during October. A return to a more normal pace of goods purchases, particularly for motor vehicles, produced the decline in durable goods purchases and the slow overall pace of consumer spending last quarter.
The natural disaster effect was also very evident in residential construction outlays, which surged at a 12.8% rate during 4Q 2017 as thousands of homes were destroyed or suffered significant damage by the hurricanes and the wildfires. As that surge in activity is being worked through, housing outlays remained at a high level, but did not advance to a still higher level, winding up unchanged in 1Q 2018 compared to 4Q 2017. The unchanged level of home building likely also reflected the spate of winter storms, higher mortgage rates, and the changes to the tax code which diminished the value of decades-old tax subsidies which had encouraged homeownership.
Business capital spending turned in another solid quarter, growing at a 6.1% rate after advancing 6.3% over the four quarters of 2017. We believe the decline in the effective cost of capital and the ability to write off capital investments in the year in which they are made, key components of the tax package passed in December, are the most economically interesting parts of the tax bill and will likely cause business capital spending to be the strongest sector of the economy this year.
The core inflation measures firmed a bit last quarter, but still appear to be relatively well contained. The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose at a 2.8% rate compared a gain of 2.5% in 4Q 2017. The core gross domestic purchases measure rose at a 2.7% rate compared to 2.0% in 4Q 2017. The Federal Reserve’s preferred measure of inflation, the core personal consumption index, rose at a 2.5% rate compared to 1.9% in 4Q 2017. However, the core measure of inflation in the consumer sector rose only 1.7% over the past four quarters.
As mentioned above, we expect the economy’s growth rate to accelerate to a pace closer to 3% as the backslide from the natural disaster-related surge in spending in 4Q 2017 is washed out of the data, the headwind from the decline in the savings rate abates, and the positive impact from the tax package and the February federal spending bill work their way through the economy. A modest offset from the higher cost of money will subtract a tenth of a percent or two from the economy’s growth rate. The core personal consumption inflation measure should advance to a rate of 2% or slightly higher over the course of the year.
D. With Strong Earnings, Look for Higher Stock Prices.
Despite the mixed performance in common stock prices so far this year and the marked pickup in volatility, we believe the backdrop for further gains in stock prices this year remains positive. The forward momentum in the economy should improve as 2018 unfolds. Improved consumer and business confidence, solid jobs growth, a synchronized worldwide expansion, and the fiscal stimulus signed into law in December and February are expected to ramp the economy’s growth rate to a pace near 3% over the next two years compared to the 2.2% growth rate over the course of this business expansion prior to President Trump’s election.
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 seven consecutive quarters and are on track to grow 22% to 24% in 1Q 2018 compared to 1Q 2017, after growing 17.2% over the four quarters of 2017. The analysts at Standard & Poor’s have been revising their earnings estimates for 2018 sharply 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 close to 25% over the four quarters of 2018.
We cautioned our readers as 2018 began that the stock market had not experienced a double digit decline since the S&P 500 fell -14.5% from May 21, 2015 to the low on February 11, 2016 and that price-to-operating earnings ratios were unlikely to move much higher. The S&P 500 did fall -10.2% from the recent high on January 26 to the low on February 8, and at the low was -3.5% lower on the year.
With the S&P largely unchanged so far in 2018 and the surge in earnings, the P/E ratio on the S&P 500 has fallen from 22.5x at year end 2017 to just over 20x using Standard & Poor’s estimate for operating earnings for 1Q 2018. Consider that the P/E ratio the night of the presidential election was 21.1x. We view the lower common stock valuations, as reflected in the decline in the P/E ratio so far this year, as a solid positive for the outlook for the stock market over the remainder of 2018.
We continue to view the rather swift decline in stock prices from late January to mid-February and the more recent selloff in mid-March as harbingers of more price volatility this year than in the previous 22 months. Investors are watching for a rise in inflationary pressures, assessing the risk of the Federal Reserve making a policy mistake, following the ongoing political drama that the Trump administration has brought to Washington, monitoring the nation’s political mood ahead of the mid-term elections, and hoping that the threat of tariffs is only a tactic in trade negotiations rather than a policy tool meant to shrink the nation’s trade surplus.
There is surely no shortage of things to worry about, but we continue to expect only a modest rise in inflation and Treasury bond yields, the Federal Reserve to raise rates to a level and at a pace which the economic expansion can tolerate, and the threat of tariffs to remain a tactic rather than a policy tool. Stability, or lack thereof, in the Trump administration and the outcome of the mid-term elections are wild cards that no one can predict. Solid growth, strong earnings, and fiscal stimulus are still in place and we look for common stock prices to move higher over the remainder of the year.
II. Treasury Market
A. Treasury Yields Firm during April.
Treasury yields rose across the yield curve for six consecutive months, from September 2017 through February 2018. Improving economic growth, modest upward pressure on inflation, continued rate hikes by the Federal Reserve, projections of the federal budget deficit widening significantly over the next few years, and the Federal Reserve beginning to shrink the size of its investment portfolio in October all contributed to the rise in Treasury yields.
A one-two punch of escalating trade tensions and renewed selling pressure in the stock market during March interrupted that rise in Treasury yields, leading to yields on Treasury securities five years and longer easing -8 to -15 basis points. The yield on the ten-year Treasury note fell from 2.86% at the end of February to 2.74% at the end of March.
With stock prices firming last month and trade tensions easing, the fundamental reasons behind the rise in Treasury yields since September took center stage once again. Yields across the Treasury curve rose 10 to 24 basis points, with the yield on the ten-year Treasury ending April at 2.95%.
B. Modestly Higher Treasury Yields on the Horizon.
In last month’s ISS, we took the position that the yield on the ten-year Treasury note would not likely take a run at 3% for some time and would not have been surprised if the 2.94% high yield on the ten-year Treasury note recorded on February 21 was not challenged for some time. We cited the expected moderation in 1Q 2018 real GDP growth, the ongoing concerns over the escalation of trade tensions, and the aggressive rate forecast from the Federal Reserve as reasons not to expect a material rise in Treasury yields.
We also stated that if the threat of tariffs turned out to be more of a tactic in trade negations rather than a policy tool, the economy’s forward momentum remained solid, and investor’s risk appetite returned, both stock prices and Treasury yields would likely rise. That was the case during April and the ten-year Treasury yield closed above 3% for one day on April 25, before ending the month at 2.95%. As long as fears of a trade war remain in the background, we expect Treasury yields to remain firm, but do not look for a further significant rise in Treasury yields.
As we have noted in previous ISS’s, notice that 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 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 rise in 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 a touch above 2% since the end of 2017. While not looking for a significant move higher in inflation this year, we expect some modest upward pressure which should take the current 1.7% year-over-year rise in the core personal consumption expenditures index to 2% or slightly higher during 2018.
The extent to which the $1.5 trillion 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, once again, break through the 3% barrier.
The expected increase in the federal budget deficit at the same time that the Federal Reserve is shrinking its holdings of government bonds, along with the increase in the cost of servicing the national debt with the rise in Treasury yields, will all contribute to upward pressure on Treasury yields. For the next couple months we look for a trading range of 2.85% to 3.10% for the ten-year Treasury note yield.
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.