CenterState Wealth Management
Investment Strategy Statement
October 1, 2018
I. Equity Markets
A. Another Month, Another Tariff on Chinese Imports.
- With the 2Q 2018 earnings season winding down, the escalation of the trade conflict with China dominated investors’ attention last month. President Trump imposed 10 percent tariffs on an additional $200 billion worth of Chinese imports, and those duties are set to rise to 25 percent at the end of the year. The world’s two largest economies have already imposed tariffs on $50 billion of each other’s goods. The new attack on Beijing brings the amount of Chinese goods subject to new tariffs to $250 billion, roughly half of Chinese exports to the U.S.
- Despite President Trump saying that if China took retaliatory actions his administration would immediately pursue phase three, which is tariffs on approximately $267 billion of additional Chinese imports, Beijing responded by imposing levies of between 5 and 10 percent on $60 billion worth of U.S. products, bringing the total to $110 billion, nearly everything China buys from the U.S. The tariff announcements led to the cancellation of a new round of bilateral talks aimed at dialing back the current trade issues and possibly setting the stage for another meeting between President Trump and President Xi before year end.
- The latest round of tariffs on China are aimed at modifying Beijing’s stance on longstanding trade issues, including subsidies to Chinese companies focused on overtaking U.S. rivals in product segments ranging from basic materials to advanced technologies, intellectual property theft, and forced technology transfers. China is rapidly running out of bullets with which to retaliate as Chinese exports to the U.S. are nearly four times larger than U.S exports to China.
- Since early spring, investors have worried that the prospect of a series of trade wars between the U.S. and our major trading partners was the major threat to the economy, earnings, and the stock market. The preliminary deal to ease trade tensions with the European Union, the bilateral trade agreement reached with Mexico, and the just announced new deal with Canada to replace NAFTA with the United States-Mexico-Canada Agreement have provided investors with a sigh of relief that a much more narrow trade conflict with China alone is the likely outcome, rather than what appeared to be an all-encompassing series of conflicts with all of our trading partners.
- In another positive development on the trade front, President Trump and South Korea President Moon signed a renegotiated free trade agreement last week, representing progress for proponents of free trade between the two countries. The pact also demonstrates the President is willing to accept more modest changes to existing trade agreements than his public demands suggest as the changes made to the trade agreement with South Korea were modest in scope.
- As these developments have taken place, investors have chosen to largely ignore the rising trade tensions with China, choosing instead to focus on the strong U.S. economy and soaring corporate earnings, the two key factors which helped to power the S&P 500 and the DJIA to new record highs last month. Investors are relieved that the impact of U.S. tariffs on Chinese goods and the retaliatory tariffs on U.S. goods will likely impact domestic economic growth and inflation on the order of only a couple tenths of a percent, and for inflation, the impact may well be largely offset by the ongoing appreciation of the U.S. dollar against the Chinese yuan since mid-April.
- Since the end of April when the hard line position the Trump administration was going to take on reaching reciprocal or equal access trade agreements with our major trading partners was well understood by most investors, the major market measures have advanced 9.5% to 13.9%. During September, the S&P 500 and the DJIA posted gains of 0.4% and 1.9%, respectively, setting new record highs, while the NASDAQ Composite and the Russell 2000 fell -0.8% and -2.5%, respectively. So far in 2018, common stocks are higher by 7% to 16.6%.
B. Waiting on a Negotiated Settlement with China vs. Strong Fundamentals.
- While the announcement of tariffs on an additional $200 billion worth of Chinese imports must be viewed as an escalation of the trade skirmish with China by the Trump administration, two subtleties in the announcement are potentially important. First, phasing in the tariffs, starting at 10 percent and rising to 25 percent on January 1 if a trade deal between the U.S. and China is not reached, lessens the impact on U.S. consumers ahead of the holiday shopping season, while likely helping Republicans on the campaign trail ahead of the midterm elections.
- Secondly, the phase in provides manufacturers and distributors additional time to look for alternative suppliers, possibly moderating the impact of the higher tariffs. Do not be surprised if other U.S trading partners — such as Mexico, Canada, South Korea, Taiwan, and Vietnam — step in as alternate trading partners on a variety of products and goods.
- We continue to encourage our readers not to overreact to the back and forth trade retaliation announcements between the U.S. and China, as it is all part of the negotiating process. The heated rhetoric is part of the journey, not the destination. The destination is a global economy with lower trade barriers and tariffs.
- We remain optimistic that negotiations with China will lead to a workable outcome, similar to the recent de-escalation of trade tensions with both the European Union and Mexico. Just this morning we are hearing that the U.S. and Canada agreed to a deal to replace NAFTA shortly before a midnight deadline. While there is clearly resistance on the part of China to altering the terms of trade and rules of engagement they have held to since entering the World Trade Organization in 2001, we anticipate that the mutuality of interests between the countries will eventually lead to a negotiated agreement which all parties can live with, although no resolution is currently apparent and timing remains the biggest unknown.
- The simple fact is that with our trading partners maintaining higher tariffs on U.S. exports and limiting access to their markets, the U.S. has been subsidizing growth for our trading partners for many years. In the aftermath of WWII, the U.S. espoused global commerce policies to encourage the rebuilding of developed areas, like Europe and Japan, whose industrial bases were largely destroyed. With that goal having been met decades ago, it is reasonable to expect a change in trade policies from the U.S.
- As for China, blatant and repeated violations of the WTO’s market-based trade rules, such as requiring technology transfers as a condition of market access, providing government financed export subsidies, and intellectual property theft are mercantilist trade practices which are detrimental to the interests of U.S. companies. While there is no good time for the U.S. to stand up for fair trade principles, strong U.S. growth this year is so far overwhelming any economic harms from the growing trade skirmish with China.
- By any measure, earnings have been, and should continue to be for the next several quarters, unambiguously positive for stock prices. Following the strong 26.7% year-over-year gain in operating earnings reported for 2Q 2018, operating earnings have now advanced for eight consecutive quarters and the analysts at Standard & Poor’s expect operating earnings to grow 26.7% over the four quarters of 2018 and 12.2% for 2019. With the strong growth in earnings this year, the trailing four quarter price-to-operating earnings ratio on the S&P 500 has fallen from 22.6x at year end to 20.8x at the end of September, a touch below the 21.1x on the day of the presidential election.
- As always, there is no shortage of things for investors to worry about. Investors are watching to see the extent to which inflationary pressures build, assessing the risk of the Federal Reserve making a policy mistake, monitoring the nation’s political mood ahead of the mid-term elections, and looking for the extent to which rising trade tensions with China create a negative feedback loop on the pace of economic growth, particularly on business capital spending initiatives.
- The economy’s forward momentum remains solid and the outlook for earnings is very strong, both benefitting from the fiscal stimulus put in place earlier this year. Any signs of ebullience in the stock market, which were evident to the January 26 high, have evaporated and the yield on the ten-year Treasury has not risen above the May 17 high of 3.11%.
- The pause in the advance in stock prices from late January through April provided investors with an opportunity to put money to work at more attractive prices. As long as the economy and earnings continue to grow, inflation and longer-dated Treasury yields remain under control, and the Federal Reserve does not make a policy mistake during the current rate hiking cycle, stock prices can continue to advance.
II. Monetary Policy
A. Federal Reserve Hikes Rates Again, Policy Turning Restrictive?
- As widely expected, the Federal Reserve raised the federal funds rate by 25 basis points to a range of 2% to 2.25% at the conclusion of the September 25-26 FOMC meeting. This marked the eighth increase in interest rates since the central bank began normalizing monetary policy in December 2015 and the third rate hike this year.
- It also marked the first time in a decade that the target for the federal funds rate will be above the rate of inflation, as the core personal consumption deflator, the Federal Reserve’s preferred inflation measure, is currently at 2%. In the press conference following the FOMC meeting, Chairman Jerome Powell stated that the rate hike “reflected the strength in the economy.”
- The policy statement was largely unchanged from the previous statement, with one material change. The FOMC Committee removed the line that “monetary policy remains accommodative.” That change had been discussed at the July 31-August 1 FOMC meeting and its removal is an acknowledgement that the federal funds rate is approaching, if not at, the level at which monetary policy is neutral, that is, neither stimulating nor restraining the economy’s growth rate.
- The median interest rate projections over the coming years were the same as those made in June, showing the federal funds rate rising in December and three more times in 2019, bringing the federal funds rate to 3% to 3.25%. One additional rate hike in 2020 would take the federal funds rate to 3.25% to 3.5%, compared to the Federal Reserve’s expectation of a long run average of the federal funds rate at 3%.
- The Federal Reserve’s rate forecasts imply that the central bank would maintain interest rates above what it believes the neutral rate to be for a two year period of time. This is where we differ from the Federal Reserve on the outlook for monetary policy. We believe the neutral rate is determined by the dynamics of the economy, not by a committee’s forecast of the long run average of the federal funds rate. Mr. Powell, in his remarks at the Jackson Hole Symposium last month, stressed the uncertainty of estimating the neutral rate, acknowledging that it is generally known after the fact.
- As stated in previous ISS’s, we view monetary policy as already having reached neutral and that policy will begin to turn slightly restrictive should the Federal Reserve raise rates in December, and would become incrementally more restrictive with further rate hikes in 2019. Consider that the yield on the ten-year Treasury note reached 3.10% on Tuesday of last week and was trading at 3.08% prior to the announcement of the rate hike.
- Following the rate hike, the yield on the ten-year Treasury fell to 3.05% and stock prices turned negative on the day. Both market reactions are consistent a view that monetary policy is no longer accommodative and is poised to turn restrictive in the months ahead.
- As we have described in previous ISS’s, trying to ascertain the current level of the neutral rate can be fairly arcane, somewhat arbitrary, and a bit of a moving target. That is why we have focused our readers on the yield spread between two-year and ten-year Treasury notes since the summer of 2015 to monitor the Treasury market’s assessment of how tight or easy monetary policy currently is.
- We have monitored the yield spread between 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 keep a lid on inflationary pressures, resulting in a narrowing of the yield spread.
- As a point of clarification, it is not the narrowing of the yield spread which will cause a slowdown or contraction in real economic activity, it is the tightening of monetary policy by the Federal Reserve which will bring about the slowdown or economic downturn. The narrowing yield spread is merely the “canary in the coal mine,” warning of the looming slowdown or downturn, not the cause of it.
- Notice from the table on the previous page that the yield spread has declined from 125 basis points at the end of 2016 to only 24 basis points by the end of September. In the context of a neutral rate, we take the narrowing of the yield spread as a signal from the Treasury market that the Federal Reserve has reacted that level of the federal funds rate where monetary policy is poised to flip from being neutral to the side of restraining the economy’s forward momentum.
- We continue to believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake. We believe the Federal Reserve is underestimating the extent to which the economy is likely to lose forward momentum next year, as the boost from the fiscal stimulus fades and the higher cost of credit begins to bite.
- Additionally, while the focus is on where the central bank will take the federal funds rate, behind the scenes the Federal Reserve continues to shrink the size of its securities portfolio. The dual approach of hiking interest rates while reducing the securities holdings tightens monetary conditions at a more aggressive pace than increasing interest rates alone. Starting this month, the Federal Reserve will increase the reduction in the size of its securities portfolio to $600 billion a year compared to $300 billion over the past twelve months.
- We will continue to watch the two-year to ten-year Treasury yield spread for the market’s assessment of whether monetary policy has moved into the restrictive zone. We doubt the Federal Reserve will deliberately raise interest rates in such a manner that it pushes the yield on the two-year Treasury note above the yield on the ten-year Treasury note if inflationary pressures remain low. This is the primary reason we believe the proposed policy moves of another rate hike this year and four more in 2019-20 by the Federal Reserve are too aggressive.
- Our view remains that the Federal Reserve raises interest rates at the December FOMC meeting to push against the fiscal stimulus, and then becomes data dependent in 2019 with respect to any further rate increases. The most important data to follow in the coming months will be the wage and inflation data. It would not surprise us if the dialogue shifts over the next 6 to 12 months from “Is the Federal Reserve behind the curve?” to “Is the Federal Reserve moving too far?” As always, stay tuned!
III. Treasury Market
A. Ten-Year Treasury Yield Breaks Above 3% Again.
- After trading below 3% from late May through mid-September, the yield on the ten-year Treasury noted traded above 3% the past two weeks, ending September at 3.06% compared to 2.86% at the end of September. In fact, yields rose across the Treasury curve last month, from 19 basis points on the two-year Treasury note to 21 basis points on the seven-year Treasury note.
- The rise in Treasury yields last month arose from a combination of fundamental factors and an easing of recent geopolitical concerns. From a fundamental perspective, the acceleration in the economy’s growth rate, a firming in the core inflation rate to the Federal Reserve’s 2% target in recent months, larger federal budget deficits, and the Federal Reserve shrinking its holding of government bonds have pushed yields on Treasury securities higher. The recent moderate flight-to-safety into Treasury securities abated on increased optimism that trade disputes, Italy’s political crisis, and problems in emerging markets will not derail the global economy.
- One sign that last month’s climb in Treasury yields was based on investors’ increased appetite for risk can be seen in the stability of inflation expectations embodied in Treasury yields. Notice in the table below that of the 20 point rise in the yield on the ten-year Treasury note last month, 15 basis points was accounted for in a rise in TIP yields, and the implied inflation outlook only rose 5 basis points. Also notice that since the recent peak in Treasury yields on May 17, the implied inflation outlook has traded in a very narrow range, generally just above 2.1%.
- The fundamental factors which have pushed yields on longer dated Treasury securities higher on the year — the acceleration in the economy’s growth rate, a firming in the nation’s core inflation rate to the Federal Reserve’s 2% target in 2Q 2018, larger federal budget deficits, and the Federal Reserve shrinking its holding of government bonds — will continue to place a floor on ten-year Treasury yields.
- Keeping a lid on ten-year Treasury yields is the Federal Reserve’s effort to raise short-term interest rates which is increasing borrowing costs, the roughly 7% gain in the U.S. dollar since early February which lowers the cost of imports, and maybe the heightened trade tensions with China. We say maybe because it seems a backing off of concerns over the escalating trade skirmish with China over the past couple weeks may be the key factor which has pushed the yield on the ten-year Treasury note back over 3% over the past two weeks.
- We continue to balance the factors placing a floor under Treasury yields with those keeping a lid on Treasury yields. It is also important to acknowledge the more aggressive pace at which the Federal Reserve will shrink the size of its securities portfolio and the recent upward momentum in yields on longer dated Treasury securities which pushed the yield on the ten-year Treasury back over 3% last month. Taking all these issues into consideration, we have decided to keep the near term trading range for the ten-year Treasury note at 2.80% to 3.10%.
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.