INVESTMENT STRATEGY STATEMENT
September 1, 2017
I. Equity Markets
A. Common Stocks Little Changed During August.
- Unfortunately, the dysfunction in Washington, and in particular in the White House, rose to the forefront again during August. President Trump’s reaction to the events in Charlottesville on August 12 appears to have been a turning point for the Trump presidency. Two CEO councils were disbanded as a parade of business and political leaders across the country attempted to distance themselves from the President in response to his failure to more forcefully denounce the racial violence in Charlottesville.
- As Mr. Trump struggled to contain a growing public furor over his response to the deadly melee in Virginia, the President fired his chief strategist, Steve Bannon. Mr. Bannon was seen as the leader of the populist wing of the Trump administration, which has clashed with officials more aligned with traditional Republican priorities, such as tax reform, infrastructure spending, and regulatory rollbacks. His departure is seen as part of new Chief of Staff John Kelly’s effort to bring order to an administration fraught with infighting and power struggles, and increasingly at odds with the Republican Congressional leadership.
- The fallout from a rather tumultuous seven month presidency, capped off by the events in Virginia last month, is that by the 2018 midterm elections many Republicans up for re-election could openly run away from the President, if not sooner. It seems that any coming together between Congressional Republicans and President Trump in the name of moving legislation through Congress will be for mutual survival in front of the 2018 midterm elections.
- A major tax code overhaul was a cornerstone of Donald Trump’s economic agenda and a major goal of the Republican-controlled Congress following the startling Republican sweep in the November elections. However, optimism for a sweeping legislative agenda has faded as finding workable solutions to offset lost tax revenue from comprehensive tax reform will be much more difficult now, with the current polarized political environment posing potentially insurmountable challenges.
- With this backdrop, do not be surprised if the initiative to move legislation forward shifts to Congressional Republicans from the White House and to targeted, incremental tax changes rather than sweeping tax reform. For example, tying an infrastructure spending bill to a proposal to tax repatriated foreign earnings at a one time low tax rate to pay for it is an idea which appears to have broad bipartisan support. The question is whether or not there would be support to permanently change the way foreign profits are taxed.
- Pursuing only a modest reduction in the corporate tax rate, combined with a broadening of the tax base, would eliminate the need to reach agreement on controversial revenue generating proposals, like the border adjustment tax. Likewise, proposing only a minor cut in personal tax rates and/or an increase in the standard deduction would lessen the need to eliminate or reduce popular deductions like those for mortgage interest, charitable giving, or state and local taxes on property and income.
- One could take the position that limited proposals like those mentioned above could waste the once-in-a-lifetime opportunity for an ambitious, pro-growth and much needed economic policy shift which would help restore broad-based domestic prosperity. However, the current political realities make the possibilities of passing legislation similar to the broad outlines of the tax cut and reform package the Trump administration unveiled back in April fairly low.
- As we stated in the May ISS, the difficult work of filling in the details of the tax cut and reform proposal was still to be done and the process of negotiating a bill through Congress was still ahead, where budgetary hurdles and complex politics would make it difficult for the Trump administration to get a quick and complete victory. Following what likely was the worst month for the Trump presidency and the President’s loss of influence and support, House Republicans are likely to “go small” to show they are not a “do nothing Congress” before the mid-term elections where they are in danger of losing their majority.
- Beyond the schism which developed between Corporate America and President Trump last month, investors watched the abrupt collapse of the Republicans’ bid to rework the U.S. health care system, the further escalation of tensions between North Korea and the U.S., another deadly terrorist attack, this time in Barcelona Spain, and the President threatening to shut down his own government if needed to secure funding for his long promised wall along the Mexican border.
- The President has also returned to his previous position to tear up NAFTA, while negotiations among Mexico, Canada, and the U.S. are proceeding. Finally, the devastating impact of Hurricane Harvey along the Gulf Coast of Texas and Louisiana and North Korea launching a ballistic missile over Japan captured everyone’s attention this past week. The S&P 500 declined a modest -1.8% to a recent low on August 18, but rebounded 1.9% to the end of the month as investors continue to look for more attractive entry points.
- For the full month of August, the S&P 500 and the DJIA were largely unchanged with advances of only 0.1% and 0.3%, respectively. The technology-heavy NASDAQ Composite led the way during August with a gain of 1.3%, while the Russell 2000 Index of small company stocks declined -1.4%, lowering its gain on the year to 3.5%. The NASDAQ Composite continues to be the winner year-to-date, soaring 19.4%, with the S&P 500 and the DJIA posting very solid gains of 10.4% and 11.1%, respectively. Since the presidential election on November 8, the major market measures are higher by 15.5% to 23.8%.
B. Inflation, or Lack Thereof, in Focus at the Federal Reserve.
- The minutes of the July 25-26 FOMC meeting were released last month and only reinforced our position on Federal Reserve policy discussed in last month’s ISS. First, while Federal Reserve officials are divided on the outlook for inflation, it appears the core group maintains a growing concern that recent soft inflation readings could be a sign that something has fundamentally changed in the economy, leading them to a position of holding off on raising interest rates again for the time being.
- The policymakers at the Federal Reserve have found it difficult over the past few years to reconcile solid job gains and a low unemployment rate with weak pricing pressures. Under standard economic theory, a strong labor market would lead to higher wages and consumer prices. As we mentioned in last month’s ISS, the typical wage-inflation dynamic of past economic cycles has not developed during the current economic expansion.
- This is the key reason we took the position in the July ISS that we did not expect the full menu of policy moves laid out by the Federal Reserve at the June FOMC meeting — seven additional rate hikes to the end of 2019 and the central bank beginning to reduce the size of its balance sheet “relatively soon” — to take place. It is also the reason Janet Yellen felt it necessary to ease investor concerns in her Congressional testimony during July that the Federal Reserve was not in the process of leaving its very gradual pace of removing monetary accommodation behind.
- However, the minutes of the July meeting did point to a growing consensus around officials’ plans to slowly reduce the central bank’s $4.5 trillion securities portfolio. The participants agreed the runoff would happen smoothly without disrupting the financial markets. “Some” were ready to announce the start of the tapering process in July, but “most preferred to defer that decision until a coming meeting” to gather more information, the minutes said. We continue to expect a formal announcement at the September 19-20 FOMC meeting to begin the process of shrinking the Federal Reserve’s balance sheet, with the implementation starting in October.
- We should note, however, that the officials at the Federal Reserve will be closely assessing the economic impact from Hurricane Harvey on the Gulf Coast economy that stretches from Corpus Christi to New Orleans. It is possible the central bank could delay the start of the balance sheet tapering if the economic impact is determined to have some long lasting repercussions, however, we expect the Federal Reserve to look through the economic impact of Hurricane Harvey as it should be localized and temporary. In fact, the rebuilding activity, motor vehicle purchases, and the restocking of household and business goods and inventories destroyed by the flooding will provide a burst of economic activity to the region over the coming months.
As a final note, Janet Yellen avoided a discussion of monetary policy in her remarks at the Federal Reserve’s Jackson Hole symposium last week, as it appears she felt no need to elaborate further on the central bank’s intentions at this point. The Chair of the Federal Reserve focused her comments on the history of the financial crisis and the actions regulators took in response, which have left the financial system safer today in her opinion. Nothing in Ms. Yellen’s remarks pointed to any concerns over financial conditions at present.
C. An Update on “Too Quickly or Too Slowly.”
- In the last two ISS’s, we discussed at length how to monitor the market’s assessment of whether the Federal Reserve was moving too quickly and aggressively to raise interest rates, which could dampen the outlook for growth and inflation, 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 of last summer. 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 will announce at the September FOMC meeting that it will begin to reduce the size of its securities portfolio in October, the yield spread narrowed sharply last month to 79 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. We continue to hold the position that the Federal Reserve will not be able to raise rates seven times before the end of 2019, which is the central bank’s current forecast.
D. Earnings Momentum and Generally Solid Fundamentals Are Supporting Stock Prices.
- Once again, investors viewed the deterioration in stock prices early last month as an opportunity to put new monies to work, arresting the decline and pushing the markets a touch higher over the past two weeks. A number of fundamental issues are supporting the level of stock prices. Domestic growth remains lackluster, but very durable at a pace near 2% and overseas growth appears to be finally responding to years of very aggressive monetary policies. Operating earnings for the S&P 500 companies have rebounded vigorously and dividends continue to grow. Inflation, interest rates, and bond yields are still low and confidence measures across households and small and large businesses are strong.
- The Federal Reserve has so far removed monetary accommodation in a very gradual manner and Janet Yellen indicated in her Congressional testimony during July that the central bank will continue on a gradualist path. It looks to us that the business expansion can continue to advance until inflationary pressures begin to build to the extent that the Federal Reserve needs to alter its monetary policy stance from becoming less accommodative to the first tightening of monetary policy since 2005-06. The ingredients for a recession are not in place and there is no material evidence of accelerating inflationary pressures.
- Investors continue to look for -5% to -10% pullbacks to put additional money to work, but -2% to -3% opportunities is all they have gotten since early in 2016 as there remains a consistent bid for common stocks, despite the political melodrama which seems to come from Washington on a nearly daily basis. We expect common stock prices to move irregularly higher for the foreseeable future as the fundamentals supporting the market appear quite sturdy. While a pullback in stock prices would not surprise us as it has been more than 18 months since the S&P 500 has fallen at least -5%, it is our expectation that a continuation of the economic expansion will support further gains in earnings and stock prices.
- It is interesting to note that the -13.3% drop in the S&P 500 to the low on February 11, 2016 was driven by mounting fears of a U.S. recession, partly fueled by the Federal Reserve raising interest rates in December 2015 and by the collapse in oil prices. A firmer tone to the economic data, indications that oil prices were forming an important bottom below $30 a barrel, and expectations that the Federal Reserve would back off on its forecast of four rate hikes in 2016 underpinned the rebound in stock prices. Common stock prices are ultimately driven by the outlook for earnings, which are largely dependent upon the outlook for economic growth.
- Investors need to watch that the Federal Reserve’s policy actions do not pivot to a tightening posture given the low inflation rate and the central bank looking to continue raising rates while beginning the initiative to reduce the size of its securities portfolio. Additionally, with the potential for several key changes to the Board of Govenors over the next ten months, investors will need to assess if the composition of the Board next June possesses the adeptness, foresight, and cautious approach of the Board members since the financial crisis.
- Unfortunately, before we leave the outlook for common stocks, we need to mention the looming risk of the federal government shutting down if Congress does not pass legislation to fund the federal government before September 30 and the risk of a default on outstanding Treasury debt if the debt ceiling is not raised before October 15. Of the two threats, the far more significant issue is Congress failing to raise the debt ceiling, lest a replay of the market turmoil of the summer months of 2011 takes place. So far, the markets are not showing much fear of a default, likely because the economic and political costs of a default are sufficiently high to more than likely force action by Congress before the deadline.
- It is much more difficult to know whether a federal government shutdown will take place, however. While government shutdowns cause uncertainty, the economic effects tend to be negligible. Most nonemergency functions of the federal government would halt, furloughing workers and closing office buildings and public facilities; but essential government functions would not be interrupted. With a full month in front of us, there appears to be sufficient time for Washington to arrive at a budget compromise, however, there is no way of knowing if Congress or the White House will use a shutdown, with its relatively low costs, to further other political agendas.
- For now, we continue to recommend that investors buy any -3% to -5% pullback in stock prices this year to position their portfolios for better growth and earnings. We have taken advantage of every -2% drop in the S&P 500 this year to place money being averaged into the market to work. We repeat our hope that the unnecessary political distractions from the Trump White House move off center stage and pro-growth policy proposals and structural tax reform come into the limelight.
II. Treasury Market
A. Modest Decline in Longer Dated Yields.
- The events of August placed modest downward pressure on longer dated Treasury yields. Amid the backlash over President Trump’s response to the racial violence in Charlottesville, two CEO councils were disbanded, adding to investors’ doubts about how effective the administration will be in pushing tax reform/cuts and infrastructure spending proposals through Congress. Low inflation readings, the risk of a government shutdown or debt ceiling crisis, and escalating tensions between North Korea and the U.S. provided additional weight on yields on Treasury securities with maturities between five and thirty years, which declined between -14 to -17 basis points last month.
- Despite a pickup in the economy’s growth rate in 2Q 2017 to 3.0% compared to 1.2% in 1Q 2017, the nation’s inflation readings remain very soft. The core personal consumption deflator rose at only a 0.9% annual rate in 2Q 2017 and is higher by 1.5% on a year-on-year basis. In response, the implied inflation expectation embodied in the ten-year Treasury note has declined from 1.96% at the end of 2016 to 1.77% at the end of August.
- The Federal Reserve reaffirmed its commitment to begin reducing the size of its securities portfolio in the minutes of the July 25-26 FOMC meeting which were released last month, indicating the process could begin “relatively soon.” Janet Yellen did not address the outlook for monetary policy in her remarks at Jackson Hole last week. We stated earlier in this ISS that a likely scenario would be that the policy statement following the September 19-20 FOMC meeting will announce that the process of reducing the Federal Reserve’s balance sheet will commence in October.
- A smaller Federal Reserve securities portfolio should provide less downward pressure on longer dated Treasury yields, on the margin. However, the slide in inflation expectations is currently moderating the potential for upward pressure on yields at the longer end of the Treasury yield curve from a proposed reduction in the size of the Federal Reserve’s securities portfolio.
- To us, a 2.12% yield on the ten-year Treasury note points to the ability of the bond market to absorb some additional supply. Much of the uncertainty surrounding the effects of gradually ending the reinvestment of maturing securities from the Federal Reserve’s $4.5 trillion balance sheet stems directly from the operation’s unprecedented scale and the persistently low level of inflation in the economy.
- The crosscurrents hitting the Treasury market are coming from several directions and must be carefully monitored in the months ahead. Economic growth remains stuck near 2%, the Trump economic agenda appears to be stalled, the inflation measures are decelerating, the Federal Reserve is entering its next phase of removing accommodation — with the market watching carefully to see if the policy moves could tip into tightening — and the ECB is looking to pivot to its first move to reduce the degree of monetary accommodation it is providing. With the yield on the ten-year Treasury note ending August at 2.12% and the tapering of the Federal Reserve’s securities portfolio on the horizon, we will stick with our forecast of the yield on the ten-year Treasury remaining in a range of 2.10% to 2.50% for the near term.
Joseph T. Keating
Chief Investment Officer
The opinions and ideas expressed in the commentary are those of the individual making them and not necessarily those of CenterState Bank of Florida, N.A. The statistical information contained herein is obtained from sources deemed reliable, but the accuracy of such information cannot be guaranteed. Past performance is not predictive of future results.
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