INVESTMENT STRATEGY STATEMENT
October 2, 2017
I. Equity Markets
A. Investors Continue to Focus on the Fundamentals.
- Once again, investors focused on the solid underlying fundamentals for common stocks last month and looked past a couple natural disasters, serious geopolitical events, and the latest political developments. Consider that during September investors largely ignored hurricanes Harvey and Irma, as well as North Korea’s largest ever nuclear test and second missile launch over Japan in less than a month.
- As the month drew to a close, investors watched the failure of the latest effort by Congressional Republicans to repeal large parts of the Affordable Care Act. Last week the White House proposed a sweeping tax code rewrite despite unresolved intraparty disagreements over how much lost tax revenue is acceptable, how the tax base could be broadened by limiting deductions and exemptions, and how tax cuts should be distributed among middle and lower income families, high income earners, and businesses.
- Investors are also trying to digest the latest development on monetary policy, as the Federal Reserve announced on September 20 that it would begin shrinking its portfolio of bonds this month, starting to close the books on an unprecedented and sometimes controversial policy experiment. To say that investors are relying on the Federal Reserve to continue to nurture along the current economic expansion without the economy overheating or falling into a recession would be an understatement. Much more on this later in this ISS.
- Investors remain focused on the now four quarter long recovery in operating earnings following a seven quarter earnings recession from 4Q 2014 to 2Q 2016 driven by the collapse in oil prices and the strength in the dollar to early 2016. Domestic growth remains lackluster, but very durable at a pace near 2%, and will receive a modest boost over the next couple quarters from the rebuilding and restocking following Hurricanes Harvey and Irma. Overseas growth appears to be finally responding to years of very aggressive monetary policies. Inflation, interest rates, and bond yields are still low and confidence measures across households and small and large businesses are strong.
- For the entire month of September, the S&P 500 and the DJIA advanced 1.9% and 2.1%, respectively. The technology-heavy NASDAQ Composite posted a smaller gain of 1.0% as investors took profits in a number of the high flying technology stocks which had been leading the market higher through August. The Russell 2000 Index of small company stocks led the way last month with an outsized gain of 6.1% after lagging the other major market measures through August. The major market indices are higher by 9.9% to 20.7% year-to-date and are higher by 17.8% to 25.1% since the presidential election on November 8.
B. The Run Off Begins Amidst a Growing Number of Questions.
- As widely expected, the Federal Reserve took its first tentative step at the September 19-20 FOMC meeting to unwind its unconventional and somewhat experimental monetary policy put in place in various stages between October 2008 at the worst of the financial crisis and the Great Recession to October 2014. Through a series of bond buying programs, known as quantitative easing, the Federal Reserve increased the size of its balance sheet from just less than $900 billion before the financial crisis to $4.5 trillion currently.
The original intent of the bond buying was to provide liquidity to the mortgage-backed securities market and to the banking system, which was suffering from losses on subprime real estate loans and mortgages. As the financial crisis eased, the bond buying programs were intended to drive down bond yields, forcing investors into riskier assets as they searched for yield. This gameplan was intended to lift asset prices and spur faster economic growth.
- While the Federal Reserve left interest rates unchanged at last month’s meeting, 12 of the 16 officials on the FOMC Committee predicted another rate increase this year. The Federal Reserve officials also lowered their forecast of the number of rate hikes to the end of 2019 to six from seven and moved a little closer to market expectations by indicating the rate increases are likely to end at a lower point than they had previously projected. The median projection for the longer run level of the federal funds rate edged slightly lower to 2.75% from 3% in June, a level considerably lower than where the Federal Reserve has stopped raising interest rates in the past.
- Starting this month, the Federal Reserve will cease its practice of fully reinvesting the maturing principal payments into new bonds and instead allow $10 billion of holdings to roll off without reinvestment each month. The monthly amounts allowed to roll off will increase by $10 billion each quarter, reaching a maximum amount of $50 billion per month in October 2018. The rationale behind the plan to begin reducing the size of its bond portfolio provided by Federal Reserve Chair Janet Yellen at the press conference following the two day meeting was, “The basic message here is U.S. economic performance has been good.” The unanimous decision to very gradually reduce the central bank’s securities portfolio had been signaled for several months.
- The decision last month by the Federal Reserve to begin the runoff of part of its bond portfolio did leave investors with several questions. First, Janet Yellen implied that the process of shrinking the bond portfolio would largely not be data dependent. Ms. Yellen said there was a “high bar” to end the runoff, or resume reinvestments, and the Federal Reserve would only do so in the event of a “significant shock that is a material deterioration to the outlook.”
- Ever since the Federal Reserve began the process of winding down its bond buying program in 2014 and then turned its attention to raising interest rates, the central bank has stated that its actions would be dependent upon the economic outlook as characterized by the incoming data. A “high bar” concept is different and only time will tell what it means as the runoff proceeds and we monitor the reaction of the financial markets and the subsequent pace of economic growth over the next few years.
- Secondly, the Federal Reserve has not specified how large its balance sheet should be at the end of the process of running off a portion of its securities portfolio. As mentioned above, its holdings grew to $4.5 trillion from less than $900 billion mid-year 2008. We know the Federal Reserve will end up with more assets than it had before the financial crisis because its liabilities have grown — there is more currency in circulation — but, a target size has not been stated.
- In various speeches, Federal Reserve officials have estimated that the balance sheet could settle out at an amount between $2.4 trillion and $3.5 trillion. The higher figure would mean the Federal Reserve would allow only $1 trillion in bonds to run off, implying the central bank could be finished by late 2019. The lower figure would mean the Federal Reserve would need to allow $2.1 trillion of securities to run off and would not be finished until late 2021. A difference of $1.1 trillion and roughly two years of run off are not insignificant variables for the financial markets to digest.
- Another uncertainty is how the financial markets will react to the Federal Reserve shrinking the size of its bond portfolio. Our view is that a dollar of bonds purchased by the central bank in a liquidity starved market and later on when the economy had not really found its footing has a much larger impact that a dollar of bonds not reinvested when the financial markets are functioning very well (as an example, the yield on the ten-year Treasury note is 2.33% and the major stock market measures are at or near all-time highs) and the economy continues to grow at a very durable pace near 2%. We are not expecting much of a reaction in the financial markets to the runoff process.
- Lastly, investors will be dealing with who will be leading the Federal Reserve during the course of the runoff — Janet Yellen’s term as Chair ends in February and Vice Chairman Stanley Fischer is giving up his seat this month — and the subsequent makeup of the Board of Govenors as there are currently four vacancies — including Mr. Fischer — on the seven member Board. As we have stated in the past couple ISS’s, investors will need to assess if the composition of the Board early next year will possess the adeptness, foresight, and cautious approach of the Board members since the financial crisis.
- Should Janet Yellen not be re-appointed as Chair of the Federal Reserve, at least the FOMC committee, by reaching unanimous agreement on beginning the process of reducing the size of the Federal Reserve’s bond portfolio, has resolved that issue for any Yellen successor. It has also provided more certainty for investors, similar to former Federal Reserve Chairman Ben Bernanke in 2013 announcing plans to gradually reduce, and ultimately end, the central bank’s bond purchases before his term as chairman ended in 2014.
C. An Update on “Too Quickly or Too Slowly.”
- Given these questions and the unchartered waters the Federal Reserve is starting to navigate in reducing the size of its $4.5 trillion securities portfolio, while at the same time wanting to continue raising interest rates, we feel it is crucially important to monitor the Treasury market’s assessment of whether the Federal Reserve is moving too quickly and aggressively to remove monetary accommodation — possibly tipping to a tightening mode, or too slowly which could lead to a build in inflationary pressures. We feel the answer to these questions will be unveiled in the Treasury bond market, specifically in the yield spread between two-year Treasury notes and ten-year Treasury notes.
- Recall that the primary determinants of the yield on longer dated Treasury securities are investor expectations for growth and inflation. If the bond market believes the Federal Reserve is raising interest rates prematurely and/or at too rapid a pace, the yield curve will flatten, i.e., the yield spread between two-year Treasury notes and ten-year Treasury notes will shrink. Likewise, if investors believe the Federal Reserve is proceeding at a pace which is too slow or deliberate, the yield curve will steepen, widening the yield spread between two-year Treasury notes and ten-year Treasury notes.
- The yield spread ended 2015 at 122 basis points and ended 2016 at 125 basis points, compared to a reading of 75 basis points on July 8, 2016 at the peak of concerns over the vote in Great Britain to leave the European Union. Following the recent June 13-14 FOMC meeting where the Federal Reserve stepped up its proposed moves to reduce monetary accommodation, the yield spread fell to 78 basis points, nearly reaching its level on July 8, 2016. With a modest backup in yields at the end of June, the yield spread ended the month at 92 basis points, and finished July at 94 basis points.
- With the growing consensus that the Federal Reserve would announce at the September FOMC meeting that it will begin to reduce the size of its securities portfolio in October, the yield spread narrowed again during August to 79 basis points. Following the actual announcement by the Federal Reserve to start the gradual runoff of a portion of its bond portfolio this month, the yield spread ended September at 85 basis points. In our view, the Treasury market has been, and continues to send a fairly clear message to the Federal Reserve that it needs to be careful in its ongoing effort to reduce the degree of monetary accommodation in the U.S. financial system.
D. More on the Rate Hiking Cycle.
- Following the June FOMC meeting when the Federal Reserve raised the target range for the federal funds rate to 1.0% to 1.25%, forecast seven additional rate hikes to the end of 2019, and suggested that the central bank would likely begin shrinking its $4.5 trillion portfolio of Treasury, Agency, and mortgage-backed securities later this year, we stated that we did not expect the full menu of policy moves laid out by the Federal Reserve to take place.
- This begs the questions of how high the Federal Reserve will be able to raise rates during this rate hiking cycle without pushing the economy into recession. We have felt that a 2% level of the federal funds rate is very important, for two reasons. First, that was the level of the federal funds rate prior to the Federal Reserve moving to an emergency level of interest rates — ultimately zero — between October and December 2008.
- Secondly, a 2% federal funds rate would put in place a roughly zero real, or inflation-adjusted short-term interest rate, if the underlying rate of inflation in the economy reached the 2% target of the Federal Reserve. This could be compared to the negative real federal funds rate, which has averaged approximately -1.5%, which has been in place since the late fall/early winter of 2008 to the present day.
- This concept of a zero real, or inflation-adjusted short-term interest rate came into play during July in Janet Yellen’s Congressional testimonies and in a speech by Lael Brainard, a Governor of the Federal Reserve. Both Ms. Yellen and Lael Brainard stated that the Federal Reserve “may not have much more to do” in terms of rate hikes, given the level of real, or inflation-adjusted, short-term interest rates.
- In separate appearances, the Federal Reserve officials said that considering the low level of inflation — which had been reported at 1.4% year-on-year for the core personal consumption deflator at the time of their remarks — the central bank, with a 1.0% to 1.25% target for the federal funds rate, was near its effective “neutral rate” in which monetary policy is neither stimulating nor restraining the economy. Brainard explicitly stated that the neutral rate goal — the federal funds minus inflation — is estimated to be near zero.
- The level at which the federal funds rate ends this rate hiking cycle will be a function of the level of inflation and whether or not the economy begins to overheat which would require a tightening of policy by the Federal Reserve. If core inflation remains at or below 2%, then the federal funds rate likely will not rise materially above the 2% marker, less the central bank tip into a tightening of monetary policy. A more robust core inflation rate would support a higher federal funds rate.
- Guiding rate hike decisions over the next couple years will be a dynamic process requiring a great deal of judgment by the Federal Reserve as to what level of short-term interest rates the economic expansion can tolerate and whether policy needs to shift from becoming less accommodative to a tightening posture. Given the underlying rate of inflation in the economy at the moment, the Federal Reserve could likely raise rates in December without any negative ramifications for the economy.
- But, what could happen in December is not really the point. During the course of this rate hiking cycle it will be the pace of rate hikes and the level of the federal funds rate compared to the economy’s inflation rate that will determine how high the federal funds rate can rise without stalling the economy, unless that becomes the goal of the Federal Reserve to contain building inflationary pressures. Of course, the larger and more pro-growth the proposed tax rewrite becomes, the higher would be the effective “neutral rate” to which the federal funds rate could rise. As always, stay tuned!
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 sweeping changes to the tax code proposed by the Trump administration last week be the icing on the cake. What we know is that the transition from a low interest rate driven bull market to an earnings driven bull market continues. As mentioned earlier in this ISS, operating earnings on the S&P 500 companies have risen sharply over the past year — four quarter trailing operating earnings are higher by 18.1% — after a seven quarter long earnings recession which came to an end in 3Q 2016.
- The rebound in earnings allowed stock prices to advance without further stretching the stock market’s price-to-operating earnings ratio. Consider that the S&P 500 has advanced 12.5% so far in 2017, however the market’s P/E ratio has fallen from 22.1x at year end 2016 to 21.7x 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.
- It looked to us prior to the presidential election 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.
- The economic expansion is currently benefitting from a synchronized pickup in world growth for the first time over the course of this expansion, with an improving economic backdrop in China, Japan, and Europe. Our review of the economic data over the first nine months of 2017 points to the U.S. economy being on solid footing with an underlying growth rate a touch above 2%. The economy is expected to receive a modest boost over the next three to four quarters from the rebuilding and restocking along the Gulf Coast and in Florida following the destruction from the hurricanes.
- 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 has been 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, the Federal Reserve announced last month its intention to begin reducing the size of its securities’ portfolio. The proposed pace of run off is very gradual and with a 2.33% yield on the ten-year Treasury note, we do not expect the process of not reinvesting a portion of the maturing principal each month to cause a major disruption in the financial markets.
- The Trump administration did unveil the framework of a far-reaching tax reform proposal which would cut taxes for businesses and individuals, move to a territorial corporate tax system, and simplify the tax system. We are encouraged by the idea of replacing our outdated, inefficient, and burdensome tax code with pro-growth tax legislation that lowers tax rates, particularly the corporate tax rate, and moves to a territorial tax system. Keep in mind that the practical and political problems with massive tax cuts, which are not funded by offsetting tax revenues elsewhere, are the resulting massive budget deficits, however.
- Now the difficult work begins as the details of the tax legislation 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. Given the obstructionist stance of Congressional Democrats and the inability of Congressional Republicans to unite the various strands of the Republican coalition to pass healthcare legislation, investors have no idea if comprehensive tax legislation will get signed into law, and if it does, what the legislation will actually look like. As we often say, stay tuned!
- Our assessment continues to be 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 strong cyclical rebound with the rise in oil prices since early February 2016 and the renewed downdraft in the dollar this year following the roughly two month rebound in the dollar following the Republican sweep in the November elections.
- Additionally, the ingredients for a recession are not in place and there is no material evidence of building 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 rise in geopolitical concerns over the past few months and the dysfunction which persists in Washington in general, and in the White House, in particular.
- It seems to us that investors are looking for further gains in earnings which will allow stock prices to continue grinding higher. While it does not appear investors have baked any pro-growth tax reform benefits into stock prices, there appears to be a reluctance to be out of the stock market should pro-growth tax legislation get signed into law. For now, we continue to recommend that investors buy any -3% to -5% pullbacks in stock prices to position their portfolios for better growth and earnings.
II. Treasury Market
A. Treasury Yields Rise Across the Curve Last Month.
- Treasury yields responded to a surge in geopolitical risks early in September, only to react to the economic data and the latest policy move by the Federal Reserve over the past two weeks. Investors moved into safe haven assets, particularly U.S. Treasury securities, following North Korea’s largest ever nuclear test on September 3, defying growing international efforts to force the rogue nation to abandon course. The yield on the ten-year Treasury note dropped slightly to 2.06% (2.02% on an intraday basis) from 2.12% at the end of August.
- As the month wore on, investor attention turned to the economic implications of Hurricane Harvey which hit the center of the nation’s energy complex and Hurricane Irma which caused wide-spread damage across Florida. Gasoline prices rose as refineries were shut down in Houston and produce prices have firmed as a wide swath of the citrus and vegetable crop in Florida was destroyed.
- After an initial spate of demand destruction from both hurricanes, the economy will receive a temporary boost from the widespread physical damage over the next three to four quarters. Think of the impact from the hurricanes as destruction of a portion of the capital stock of households, businesses, and government. The rebuilding, repair, and restocking of household and business goods and inventories destroyed by the flooding and wind damage will provide a burst of economic activity to the affected areas and a modest boost to the nation’s growth rate in the coming quarters.
- The markets also had to respond to the announcement by the Federal Reserve that it will begin the process of shrinking the size of the central bank’s $4.5 trillion bond portfolio this month. While the proposed process of allowing a portion of maturing securities to run off without reinvesting the proceeds is designed to be very gradual, some impact, however modest, was expected to show up in the bond market. Much of the uncertainty surrounding the effects of the latest policy move by the central bank stems from the operation’s unprecedented scale.
- Yields on Treasury securities with maturities longer than two years rose 13 to 24 basis points during September. The yield on the ten-year Treasury note rose to 2.33% from 2.06% in early September and 2.12% at the end of August, but remained 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. So far, the Administration and Congressional Republicans have not been able to deliver on that hope. Time will tell.
- As the yield on the ten-year Treasury note rose last month, notice in the table above that both the real, or TIP, yield rose from 0.35% to 0.48% and the implied inflation expectation rose from 1.77% to 1.85%. While higher, this inflation expectation is still below the expected inflation rate over the next ten years recorded at year end.
- The crosscurrents hitting the Treasury market are coming from several directions and must be carefully monitored in the months ahead. Economic growth remains solid at a pace slightly above 2% while the Administration and Congressional Republicans have proposed a sweeping tax code rewrite. The inflation measures have been soft over the past couple months, but the recent rise in energy prices and the decline in the dollar could lead to a modest firming of the inflation data.
- The Federal Reserve has just kicked off its latest policy move and investors need to watch carefully that the almost three year long effort to reduce policy accommodation does not tip over to a tightening of monetary policy. Additionally, the ECB is looking to pivot to its first move to reduce the degree of monetary accommodation it is providing. Putting all of this together, we will stick with our forecast of the yield on the ten-year Treasury note remaining in a range of 2.10% to 2.50% for the near term.
- We must acknowledge, however, that the entire Treasury yield curve could shift still higher the larger and more pro-growth the proposed tax rewrite turns out to be. 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. 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 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.
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