INVESTMENT STRATEGY STATEMENT
November 1, 2017
I. Equity Markets
A. Investors Continue to Focus on the Fundamentals.
- Investors were primarily focused on three things last month, with the major market measures advancing again and finishing the month within a whisker of new closing highs, except for the NASDAQ Composite which hit a new record high. First was earnings, as the now five quarter long rebound in operating earnings for the S&P 500 companies continued, with particularly strong earnings growth among technology and energy companies. With 58% of S&P 500 companies reporting, 3Q 2017 operating earnings look to have advanced 10.7% year-over-year, after growing 18.1% over the previous four quarters.
- Investors were also focused on President Trump’s decision on whom to nominate as the next Chair of the Federal Reserve. Janet Yellen’s term as Chair expires in February and a nomination this week will allow sufficient time for the nominee to be confirmed by the Senate. Given that there are fairly disparate views on monetary policy among the leading candidates, the continued move higher in common stock prices seems to point to an expectation that the nominee will likely continue to pursue Janet Yellen’s very gradual approach to removing monetary accommodation. Mr. Trump is expected to unveil his decision tomorrow.
- Finally, investors were focused on President Trump’s push to get tax reform passed before year end. The House of Representatives adopted a federal budget last week that sets the stage for the challenging work of writing, amending, and passing a tax bill on a very tight schedule. The House action followed a 51-49 Senate vote the prior week on the same budget. Both budgets included a $1.5 trillion increase in the federal deficit over the next ten years. The budgeted increase in the deficit is an important detail because it limits the total increase in the deficit from tax reform to $1.5 trillion for the proposal to pass under reconciliation — the process that requires only 50 votes in the Senate to pass the bill rather than 60 votes.
- Congressional Republicans and the White House want to lower tax rates for individuals, corporations, and other businesses, while at the same time repealing or limiting enough tax breaks so that the tax proposal does not raise the projected federal deficit by more than $1.5 trillion over the next decade. The GOP sees the next couple weeks as crucial for their economic agenda — and their political futures. Republican lawmakers are under pressure to deliver on a major tax overhaul which would give the GOP and the White House a much needed legislative victory in advance of the midterm elections next year.
- For the entire month of October, the technology-heavy NASDAQ Composite gained 3.6%, finishing the month at a new all-time high. The other major market measures rose 0.8% to 4.3%, finishing just a touch below new closing highs. The major market indices are higher by 10.7% to 25.0% year-to-date and are higher by 20.4% to 29.5% since the presidential election on November 8.
B. Who Will Be the Next Chair of the Federal Reserve?
- The latest Federal Reserve policymaking meeting will conclude later today. The expectation is that the central bank will not announce any policy changes today, but the policy statement will point toward a December rate hike, assuming the economic expansion remains on track and some firming in the inflation data occurs. The futures market is currently pricing in an 86% probability of the Federal Reserve raising rates in December.
- The minutes of the September 19-20 FOMC meeting were released last month and Janet Yellen gave a speech at an international banking seminar in Washington mid-month. The minutes contained little discussion about the Federal Reserve beginning to shrink the size of its securities portfolio, which is consistent with the consensus view on the FOMC committee that the timing to begin the unwinding process is appropriate and that the gradual runoff will have little impact on the financial markets. A wide-ranging discussion about the outlook for inflation was the main topic at the meeting.
- In her speech to a panel which included central bank officials from Europe, Japan and China, Janet Yellen painted a fairly optimistic outlook for the economy and said that “the ongoing strength of the economy will warrant gradual increases” in short-term interest rates. The Federal Reserve Chair also said that policymakers will be paying close attention to the inflation data in the months ahead. She expects that recent soft inflation readings will not persist and that inflation will rise toward the Federal Reserve’s 2% target, as her “best guess” is that inflation will pick up next year as the labor market strengthens further.
- The questions of whom will be leading the Federal Reserve and the makeup of the Board of Governors during the course of the central bank shrinking its balance sheet and continuing on the path of raising interest rates remain open. It is interesting to note that every president since Ronald Reagan has asked the incumbent Federal Reserve Chair to stay in the position at the start of his presidency, which has served to underscore the central bank’s independence from politics on monetary policy decisions.
- One of the four vacancies on the Board of Govenors was filled last month with the Senate approving Randal Quarles, a former Treasury Department official and banking lawyer. Mr. Quarles will be the Federal Reserve’s first vice chairman in charge of bank supervision. While Mr. Quarles will have a vote on monetary policy actions, we do not expect him to be a major voice on monetary policy deliberations.
- As for whom will be leading the Federal Reserve, President Trump is expected to decide this week whom to nominate to run the Federal Reserve when current Chair Janet Yellen’s term expires in February. There are supposedly four candidates, including Ms. Yellen. Janet Yellen and Jerome Powell, currently a Board member, would likely continue Ms. Yellen’s cautious approach to raising interest rates and reducing the size of the central bank’s securities portfolio very gradually.
- Mr. Powell has advocated loosening some of the banking regulations enacted following the financial crisis, while Janet Yellen is generally supportive of the heightened regulatory environment. Based on his record of supporting Ms. Yellen’s monetary policy decisions and his preference for a lighter touch on financial regulation, we think it is likely President Trump will nominate Mr. Powell to lead the Federal Reserve.
- Conversely John Taylor, a longtime adviser to Republican presidents, has been an outspoken critic of the easy money policies adopted by the Federal Reserve during and in the aftermath of the financial crisis. Mr. Taylor is the namesake of a well-known monetary policy rule which would generally advocate higher interest rates. Under the rule, the federal funds rate would be near 3.5% today, rather than the current range of 1.0% to 1.25%. Nominating Mr. Taylor would likely represent a paradigm shift at the Federal Reserve with respect to monetary policy deliberations.
- Kevin Warsh, a former member of the Board of Governors, has expressed deep skepticism of the central bank’s interest rate policies and its bond buying programs and has criticized the central bank of trying to fine tune the economy with each new bit of data. It is clear that Mr. Trump will have his choice of two contrasting views on monetary policy among the four candidates. The resulting level of uncertainty for investors is higher than during recent Federal Reserve leadership transitions because of the disparate views of monetary policy among the candidates.
- As we have stated in the past few ISS’s, investors will need to assess if the composition of the Board of Governors early next year will possess the adeptness, foresight, and cautious approach of the Board members since the financial crisis. Investors will also need to evaluate the implications for monetary policy, depending upon whom the next Chair of the Federal Reserve will be. Should Janet Yellen not be re-appointed as Chair of the Federal Reserve, at least the FOMC committee, by beginning the process of reducing the size of the central bank’s bond portfolio, has resolved that issue for any Yellen successor.
- One source of comfort for investors should Mr. Trump choose one of the current outsiders who have been critical of the course of monetary policy since the financial crisis is that monetary policy decisions in the U.S. are set by the FOMC committee, consisting of all of the Governors of the Federal Reserve, the president of the New York Federal Reserve Bank, and a rotating group of four other regional Federal Reserve bank presidents. A new chairman would need to build consensus among many of the same people who have endorsed Chair Yellen’s strategy of cautiously raising interest rates and reducing the size of the central bank’s securities portfolio in a very gradual manner. As always, stay tuned!
C. Solid Growth with Low Inflation Last Quarter.
- Real Gross Domestic Product was reported to have grown at a 3.0% annualized rate in 3Q 2017, following a 3.1% pace in 2Q 2017, marking the first time since mid-2014 that the economy has strung together two consecutive quarters of at least 3% growth. While the full context of the 3Q 2017 real GDP data are evidence of the durability of the current business expansion — now 99 months long — they are not a harbinger of the economy’s growth rate accelerating to a sustainable pace of 3% or more.
- A build in business inventories added 0.7 percentage points to the economy’s 3.0% growth rate, while the net foreign trade sector contributed 0.4 percentage points. Removing these two sectors from the data leaves the economy advancing at an annual pace of 1.9% last quarter. Our favorite measure of final demand, domestic private final sales — the sum of consumer spending, business capital spending, and residential construction outlays — grew at the more modest pace of 2.3% last quarter, following a strong 3.3% gain in 2Q 2017.
- Real consumer spending slowed to a 2.4% pace compared to a 3.3% annualized gain in 2Q 2017. The slower pace of consumer spending was largely due to a paltry 0.6% gain in real disposable personal income during 3Q 2017, largely due to an 8.2% rise in personal taxes. The resulting decline in the personal savings rate to 3.4% compared to 4.8% a year ago will act as a headwind to a faster pace of consumer spending in the quarters ahead unless the growth rate for real disposable personal income accelerates.
- While business capital spending grew at a 3.9% annual rate in 3Q 2017, there was a large divergence among its components. Outlays for equipment and intellectual property products rose at solid rates of 8.6% and 4.3%, respectively. The growth in equipment outlays largely reflects the rise in business confidence since the presidential election and the strength in the global economy.
- The -5.2% decline in structure outlays last quarter is likely related to the changing landscape for retail distribution and uncertainty as to how capital outlays will be treated in the pending tax reform, particularly when one takes into account the 21.7% gain in energy structures last quarter — the mining, exploration, shafts, and wells sub-category. Energy structures have grown 77% over the past year, in line with the 63% rise in the rig count, while non-energy structures have fallen -6.1%. More rapid depreciation allowances will support all forms of business capital spending if it is included in the final version of the tax proposal.
- Residential construction outlays fell at a -6.0% rate last quarter, following a decline of -7.3% in 2Q 2017. A pullback in multi-family construction has weighed on housing outlays over the past two quarters and disruptions from hurricanes Harvey and Irma halted activity along the Gulf shore region and in Florida during September. Look for the rebuild from the hurricanes to add to residential construction outlays in a meaningful manner over the next couple quarters.
- The inflation measures were relatively tame again last quarter, with the price index for gross domestic purchases, which measures prices paid by U.S. residents, rising at a 1.8% rate, and the core measure, removing food and energy, rising at a 1.7% pace. The Federal Reserve’s preferred measure of inflation, the core personal consumption index, rose at only a 1.3% rate and is higher by 1.3% year-on-year. The low inflation readings have, and will continue to moderate the pace of rate hikes by the Federal Reserve.
- Looking forward, we continue to see the economy growing at a pace between 2.0% and 2.5%, in line with the 2.2% pace of growth over the course of this business expansion. We continue to expect this expansion to take a run at the longest expansion on record of 120 months under President Clinton.
- The wild card in any forecast for the economy is whether or not the Republican controlled Congress and the White House will pass a tax reform package in the coming months and , if so, the extent to which the proposal will stimulate the economy’s growth rate. Given the inability of the GOP leadership and the White House to unite the various strands of the Republican coalition over the past ten months to pass healthcare legislation, it is impossible to know if a tax proposal will come to fruition, and if so, what it will ultimately look like. As we frequently say, stay tuned!
D. Persistent Economic Growth and Solid Earnings Supporting Common Stocks.
- Earnings continue to carry the day for common stocks, which makes sense as earnings are the primary source of value for common stocks. The transition from a low interest rate driven bull market to an earnings driven bull market over the past year continues. As mentioned earlier in this ISS, the rebound in operating earnings is now five quarters long, supported by consistent and persistent growth in the economy — 2.3% over the past four quarters — the rebound in earnings in the energy sector with the recovery in oil prices and the dollar easing off its early 2016 highs.
- U.S. multinational companies are being supported by strong global growth. In fact, all 45 countries tracked by the OECD — Organization for Economic Co-operation and Development — are set to grow this year and next year for the first time in 50 years, a truly rare synchronized worldwide expansion resulting from years of very aggressive monetary policies by central banks across the globe. Inflation, interest rates, and bond yields are still low and confidence measures across households and small and large businesses are strong.
- The rise in earnings is moderating common stock valuations, despite the rise in stock prices. Despite the 15% gain in the S&P 500 so far in 2017, the market’s price-to-trailing operating earnings ratio has fallen from 22.1x at year end 2016 to 21.6x currently as the gain in earnings has exceeded the advance in stock prices. This is the sort of constructive moderation in stock valuations we started looking for roughly a year ago, earnings rising at a faster pace than stock prices.
- Our review of the economic data over the first ten months of 2017 points to the U.S. economy being on solid footing with an underlying growth rate between 2% and 2.5%. The economy is expected to receive a modest boost over the next couple quarters from the rebuilding and restocking along the Gulf Coast and in Florida following the destruction from the hurricanes. Additionally, the ingredients for a recession are not in place and there is no material evidence of building inflationary pressures.
- The bottom line is we remain positive on the outlook for common stocks due to the outlook for the economy and earnings. However, over the next couple months the market could experience some turbulence as investors deal with the uncertainty over the GOP’s effort to pass significant tax reform. We view the majority of the advance in stock prices since the presidential election as supported by the persistence of the economic expansion, the sharp rebound in operating earnings, and the fact that no new taxes were enacted and no further ramp up in growth inhibiting regulations occurred this year because Hillary Clinton was not elected president.
- It does seem that some probability of tax reform, particularly corporate income tax reform, has been priced into stock prices over the past two months as the push from the White House gathered momentum. The S&P 500 advanced another 4.2% since the end of August despite the Federal Reserve starting the runoff of a portion of its securities portfolio and the uncertainty over whom will be leading the Federal Reserve come February of next year.
- Given how the policies of the central bank have dominated the course of the economy and the financial markets over the past decade, the leadership of the Federal Reserve cannot be underestimated in terms of its significance. Those concerns were likely soothed, however, by investors looking for a beneficial handoff from the very accommodative monetary policies of the past decade to pro-growth tax policies.
E. The Obvious and the Not So Obvious.
- While we all await the specifics on the GOP’s tax proposal, let us state the obvious and the not so obvious. First, investors are clearly hoping for corporate tax reform with a lower statutory tax rate on corporate earnings. Additionally, a move to a territorial tax system, including a one-time, low repatriation tax rate on earnings trapped overseas which should lure the money back to the U.S. where it can be spent on jobs, business capital spending projects, dividends, and share repurchases would be well received.
- Investors would also applaud a simplification and partial reform of the personal tax code which results in a tax cut for lower and middle income tax payers. A tax cut for high income tax payers that results in much larger budget deficits could prove troublesome for the likelihood of the proposal getting through Congress and could have negative implications for yields on Treasury securities.
- The not so obvious consideration is that the larger the tax cut is and the larger the resulting budget deficits turn out to be, the more likely it is that the tax proposal will hasten the end of the current business expansion. We need to keep in mind that the current movement toward a tax proposal is coming with an economic expansion that is over eight years removed from the Great Recession and the economy is posting consistent gains in the jobs market, consumer spending, and business capital spending on equipment.
- Add in that the nation’s unemployment rate is at a 16 year low at 4.2% and an improving global economy is boosting U.S. exports, industrial production, and capacity utilization. The major tax cuts under Presidents Reagan and Bush came with the economy in recession or just beginning to rebound. The one saving grace at the moment is that the economy is not showing any signs of rising inflationary pressures, but slack in the economy is becoming a scarce factor.
- Remember that every recession since WWII was preceded by a tightening of monetary policy by the Federal Reserve. While we would characterize current monetary policy as becoming less accommodative rather than tightening, it is closer to tightening than it is to easing. We applaud tax reform which eliminates distortions in economic incentives, encourages productivity, and makes the U.S. more competitive on the global stage.
- However, large tax cuts financed through massive budget deficits at this point in the economic cycle run the risk of flaming inflationary pressures which would eventually be followed by a tightening of monetary policy by the Federal Reserve. As a wise person once said, “Be careful what you ask for!”
II. Treasury Market
A. Treasury Yields Rise Across the Yield Curve Last Month.
- For the second month in a row, Treasury yields rose across the yield curve last month. Against a backdrop of solid economic growth, still low inflationary pressures, and the Republican – led Congress and the White House pushing for a major tax proposal, investors needed to respond to the recent policy move by the Federal Reserve and an expected policy adjustment before year end. Specifically, October was the first month that the Federal Reserve began the process of shrinking the central bank’s $4.5 trillion bond portfolio.
- The Federal Reserve did not reinvest $10 billion of maturing securities last month and will follow suit in November and December. The central bank will raise the monthly runoff amount by $10 billion in each of the next four quarters until monthly runoff reaches $50 billion per month in October 2018. This impact was expected to be felt a little further out the yield curve and yields on five to thirty year Treasury securities rose a modest 2 to 8 basis points during October.
- This follows yields rising 13 to 24 basis points on Treasury securities five years and longer during September when the central bank announced that the monthly runoff would begin during October. Following the moderate adjustment in Treasury yields during September, we were looking for only some additional modest yield adjustments once the actual runoff began.
- The expected policy move that investors responded to during October is the Federal Reserve raising the range for the federal funds rate from 1.0% to 1.25% to a range of 1.25% to 1.5% at the December FOMC meeting. Recall that the central bank is intent on opportunistically raising interest rates, as long as it does no harm to the economic expansion, which will allow the Federal Reserve to lower interest rates during the next recession.
- With the economy continuing to push forward at an underlying pace between 2.0% and 2.5% and the hurricane-related rebuild, repair, and restocking by households, businesses, and government kicking in during the current quarter, the Federal Reserve is likely to boost rates in December.
- The only thing that could hold the central bank back would be the low inflation rate, however, the officials at the Federal Reserve remain steadfast is their belief that inflation will firm in the quarters ahead as the slack in the economy continues to be reduced. In response to this view, yields on Treasury securities two years and less rose 9 to 13 basis points last month, following a rise of 5 to 15 basis points during September.
- The yield on the ten-year Treasury note ended October at 2.38% compared to 2.33% at the end of September. While the ten-year yield did hit 2.44% to 2.45% last week, the ten-year yield closed the month below the 2.44% yield at the end of 2016 when the markets were encouraged that Donald Trump would bring an economic agenda to Washington which would have been good for business, households, and the economy in general. With the current focus on the GOP’s tax proposal, it is not surprising Treasury yields have approached the levels that prevailed from December through March when hopes were high that major tax legislation would move forward over the summer months.
- As the yield on the ten-year Treasury note rose last month, notice in the table above that both the real, or TIP, yield and the implied inflation expectation were largely unchanged, but did rise a touch. The larger move took place during September as the Federal Reserve announced that the runoff would begin in October and the push for a tax proposal gathered steam. While the implied inflation expectation has moved modestly higher over the past two months, it is still below the expected inflation rate over the next ten years recorded at year end.
- Where Treasury yields go from here over the next quarter or two will be materially impacted by the scale, scope, and timing of the tax proposal, including whether or not the GOP can corral its somewhat disparate factions to back the passage of a bill at all. For the time being with the solid 2.0% to 2.5% forward momentum in the economy, modest inflationary pressures, and with the uncertainty of a tax proposal of some unknown economic punch becoming law sometime in early 2018, we look for a slightly higher trading range of 2.25% to 2.75% for the ten-year Treasury to take hold in the near term.
- Should a viable tax proposal pass Congress over the next few months, the yield on the ten- year Treasury could take a run at 3%, a level we have not seen since late December 2013. The more pro-growth and deficit financed the proposed tax rewrite turns out to be, the possibility exists that the entire Treasury yield curve could shift still higher. Not only would Treasury yields need to adjust to a faster growth rate in the economy, but also to a potential increase in the federal budget deficit at a time that the Federal Reserve is shrinking its holdings of government bonds and the cost of servicing the national debt is rising with the rise in 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.