CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
April 1, 2019
I. Equity Markets
A. Growth Worries Slow Advance in Common Stocks.
- The strong rebound in stock prices off the December 24 low lost some momentum during March as investors’ anxiety grew about the health of the U.S. and global economies. Following reports of the euro zone flirting with recession, the European Central Bank pushing an interest rate hike into 2020 at the earliest and providing cheap funding to European banks until 2023, the delays and uncertainty surrounding the United Kingdom’s proposed exit from the European Union, the slowdown in China’s growth, and weak reports on domestic retail sales and housing activity, investors are questioning whether the current soft patch of data could be marking the start of a more persistent economic downturn.
- Worries over the outlook for growth led to one measure of the Treasury yield curve inverting for the first time since 2007 -- shorter maturity yields above longer maturity yields -- with the yield on three-month Treasury bills hitting 2.46% and the yield on the ten-year Treasury note hitting 2.44% intraday on March 22. An inversion of the Treasury yield curve is considered an important recession indicator. The inversion occurred as investors stampeded into longer dated Treasury securities, pushing the yield on the ten-year down from 2.72% at the end of February. The sharp decline in the yield on the ten-year Treasury shows just how much the expectations for growth and inflation have receded over the past five to six months since the ten-year Treasury yield peaked at 3.23% on October 8.
- In an ironic twist, it appears investors lost confidence in the outlook for the U.S. and global economies as the Federal Reserve and the European Central Bank downgraded their outlooks for the U.S. and euro zone economies last month. In a healthy economy, the Treasury yield curve slopes upward, as the combined outlook for growth and inflation embodied in the yield of longer dated Treasury instruments exceeds the cost of short-term credit put in place by the Federal Reserve.
- Is the slight inversion of the Treasury yield curve last month forecasting a recession? First, the importance of the yield curve inversion depends upon the extent and period of time the curve is inverted. The greater the extent of the inversion and the longer the inverted condition exists, the higher is the risk of recession. The inversion was gone by the end of March and lasted only five days.
- Second, the inversion last week was likely signaling that the Federal Reserve is going to cut interest rates, to which the futures market is currently assigning a 69% probability by year end. The yield on the three-month Treasury bill is being held artificially high currently by the level of the federal funds rate. Third, with the general level of Treasury yields so low and sovereign yields even lower, or negative in some cases, in major foreign bond markets, even the anticipation of small cuts in rates by the Federal Reserve can result in an inversion.
- We believe the brief three-month to ten-year Treasury inversion last week was not forecasting a recession. It was merely reflecting the current slowdown in the economy, the very low level of sovereign yields overseas, modest inflationary pressures, and that the next move on rates by the Federal Reserve is likely to be a cut. The two-year to ten-year Treasury yield spread, which we monitor closely, remained positive last month, finishing March at 15 basis points.
- With the outlook for the economy coming under heavy scrutiny during March, the results for the major market indices were a mixed bag and require a bit of an explanation. First, the S&P 500 and the NASDAQ Composite posted solid gains of 1.8% and 2.6% for the month, but below the gains recorded during January and February. The DJIA gained only 0.1% and the Russell 2000 Index posted a loss of -2.3%, after advancing sharply over the first two months of the year.
- The DJIA was held back by the slump in Boeing, which was directly related to the grounding of its 737 MAX airliner following a crash in Ethiopia. The DJIA ex-Boeing posted a gain of 1.6% last month. The major market measures are higher by 11.2% to 16.5% over the first three months of the year and by 19% to 24.8% from the dramatically oversold conditions on Christmas Eve.
B. Stock Prices Are Expected to Rise Further.
- We have consistently stated that the outlook for stock prices comes down to the outlook for earnings, which is dependent up on the outlook for the economy. As we covered in last month’s ISS, we expect the economy’s growth rate to slow to a pace near 2% this year, compared to the 3% pace of 2018. The tightening of monetary policy by the Federal Reserve to the end of 2018, the waning stimulus from the tax cuts and the two year $300 billion federal spending program, the negative impact of the trade war with China, and slowing growth overseas is leading the economy back toward its growth rate of roughly 2% over the past two decades.
- The key, however, is that we expect the economic expansion to continue and do not see the economy falling into recession any time soon. We view the downshift in the economy’s growth rate which happened during 4Q 2018 as a longer term positive. If the economy’s growth rate had not pulled back from its 3% pace with the unemployment rate near 4%, we think it was very likely the Federal Reserve would have continued raising rates, driving the economy into an unnecessary recession as inflationary pressures were not building.
- We acknowledge, however, that investors have become very concerned about the slowdown in the global and U.S. economies since late summer, and that concern definitely intensified over the past couple months. It seems an unusual confluence of events caused growth to stall as 2018 drew to a close and 2019 commenced. On a global basis, the trade wars started by the Trump administration and fears that they could escalate were akin to placing grains of sands in the gears of world-wide growth and the uncertain economic impact of the timing, scope, and nature of the United Kingdom’s exit from the European Union, i.e., Brexit, added uncertainty, hesitation, and more grains of sand to the economic outlook.
- The global sell off in common stock prices during 4Q 2018 and the partial shutdown of the federal government for 35 days from late December to late January also hurt consumer and business sentiment and likely contributed to the recent stall in the economy. Concern that the Federal Reserve had already made a policy mistake by hiking rates four times during 2018 also weighed on sentiment. Uncertainty leads to hesitation on the part of consumers, businesses, and investors and the level of uncertainty clearly rose since early October.
- We believe the recession fears are overblown and will recede in coming months. First, with numerous reports of significant progress being made in the negotiations between the U.S. and China, it seems very likely the two economic superpowers will reach a trade agreement, if only because such an agreement is in the economic and political self-interest of both countries, not to mention both President Trump and President Xi. In the April 2, 2018 ISS, we offered three overriding principles to keep in mind when thinking about the then upcoming trade negotiations. No country has ever won a trade war, the U.S. market is the prize, and do not bet against rational people arriving at reasonable outcomes.
- Second, the partial shutdown of the federal government, which likely exacerbated the slowing, ended in January and with special counsel Robert Mueller’s long-awaited investigation concluding that President Trump and his election campaign did not conspire, collude, or coordinate with Russia to interfere in the 2016 presidential election, the hope is that the political rancor in Washington will ratchet down a bit. Third, we look for the economic data to point to a rebound during March across multiple dimensions, with stronger retail sales, a bounce back in payrolls, some improvement in auto sales, and steady residential construction activity.
- The labor market remains strong and wage gains are rising at the fastest pace for the current economic expansion. Keep in mind that lower bond yields are also a cure for slowing growth, as lower funding costs will spur borrowing by households for housing and durable goods and by businesses for plant and equipment, providing a boost to growth.
- As discussed above, we think the slight inversion of the Treasury yield curve last week was merely reflecting a federal funds rate that is too high and the current slowdown in the economy, not foreshadowing a recession. We also note that at the longest end of the yield curve, the ten-year to thirty-year Treasury yield spread is positively sloped. In fact, that yield spread has actually widened from 17 basis points on October 8 to 41 basis points at the end of March.
- While the economy has slowed, it is important to note that initial jobless claims remain historically low and both manufacturing and nonmanufacturing purchasing managers’ surveys remain solidly above 50, indicating continued expansion in the economy. Lastly, we do not look for a policy mistake from the Federal Reserve following its sweeping policy reversal at the January and March FOMC meetings. In fact, we feel the odds are fairly strong that the next policy move by the central bank will be to lower rates, unless the economy receives a good sized jolt from the announcement of a trade deal with China. More on this in the following section of this ISS.
- So despite the S&P 500 being higher by 13.1% over the first three months of the year, and 20.6% since the recent low on Christmas Eve, we think stock prices can advance further as the economy gains momentum following its recent rough patch, which was already reflected in the drop in stock prices during 4Q 2018. However, we acknowledge that for stocks to hold on to their gains this year and/or climb higher from here, investors will need to see evidence fairly soon that the economy is back on track in the upcoming economic data.
- We also feel it is important to keep the following perspective in mind. Despite the recent strong advance in stock prices, the S&P 500 is higher by only 6% since year end 2017, even though operating earnings on the S&P 500 grew almost 22% during 2018. As such, the price-to-trailing operating earnings ratio on the S&P 500 currently stands at 18.7x compared to 22.5x at year end 2017, an -16.9% decline. With the economic expansion and earnings still having a runway to grow, better valuations, low inflation, and Treasury yields roughly 60 to 85 basis points below their peak levels during 2018, we expect the major market measures to retake their previous highs reached in late September/early October of last year.
II. Monetary Policy
A. Federal Reserve Confirms Rate Hikes on Hold.
- Recall that in response to volatile financial markets, growing signs of a global economic slowdown, trade tensions, and concerns that the central bank had gone too far in tightening financial conditions, the Federal Reserve made a sweeping policy reversal at the January FOMC meeting. The central bank eliminated forward guidance of further gradual rate hikes and placed additional interest rate hikes on hold by stating “the Committee will be patient as it determines what future adjustments to the target range (currently 2.25% to 2.5%) for the federal funds rate may be appropriate.”
- The Federal Reserve held interest rates steady at the March 19-20 FOMC meeting and released a revised “dot plot” which showed no further interest rate hikes for 2019 and revised lower their projections for economic growth this year to 2.1% from 2.5% back in September. Speaking at the press conference after the meeting, Federal Reserve Chairman Jerome Powell said that weakening Chinese and euro zone economic activity are acting as deterrents to U.S. growth even as policymakers view the outlook for the U.S. economy as solid. Mr. Powell also cited mild inflation pressures and a sharp pullback in financial risk-taking as reasons for the Federal Reserve to step to the sideline until the economic outlook becomes clearer.
- The Federal Reserve also hinted at the January FOMC meeting that the runoff of the central bank’s securities portfolio could end much sooner than previously expected, possibly as soon as sometime this year. The Committee provided clarity on the securities portfolio at the March FOMC meeting by stating it would lower the monthly runoff of Treasury securities to $15 billion from the current target of $30 billion in May, and will end the runoff of its Treasury securities at the end of September.
- After September, the central bank will continue to allow its holdings of mortgage-backed securities to mature, but will reinvest the maturing proceeds and prepayments into new Treasury securities, ending the runoff of its securities portfolio in total. The goal is that the Federal Reserve’s securities portfolio will return over time to a Treasury-only portfolio, as it was prior to the Financial Crisis and the successive rounds of bond purchases.
- For a central bank that not so long ago was intent on normalizing the level of interest rates from its Financial Crisis-era accommodation levels and had the runoff of its securities portfolio on autopilot, the developments at the January and March FOMC meetings represent a striking change in tone and direction. Recall that after the Federal Reserve raised rates for the eighth time in this rate hiking cycle to 2% to 2.25% at the September 25-26 FOMC meeting, the FOMC was looking for five additional rate hikes to the end of 2020. After raising rates at the December 18-19 FOMC meeting, the FOMC was still looking for three additional rate hikes.
- Currently, the Federal Reserve is only looking for one additional rate hike in 2020, a dramatic shift in the policy outlook in six months. Mr. Powell admitted that the 2020 rate hike is very much in doubt, however, by stating “It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”
B. What Is a Reasonable Outlook for Monetary Policy?
- A year ago when the Federal Reserve raised the federal funds rate to 1.5% to 1.75%, we took the position that the proposed interest rate hikes by the Federal Reserve -- which would have pushed the federal funds rate to 3.25% to 3.5% by 2020 -- were too aggressive, as there was little ability for the economy to tolerate the projected level of interest rates.
- First, we looked at the ten-year Treasury yield which had recently traded in a range of 2.74% to 2.94% and concluded the yield on the ten-year Treasury was inconsistent with a doubling of the federal funds rate by the end of 2020. Secondly, using a zero real, or inflation-adjusted, federal funds rate as a neutral policy rate, we concluded monetary policy was likely at neutral as the most recent core personal consumption reading was 1.6%.
- Lastly, we turned to the financial markets for a read on how tight or loose monetary policy was at that time. Since the summer of 2015, before the Federal Reserve began raising interest rates, we have monitored the yield spread between two-year and ten-year Treasury notes as an indicator of whether the Treasury market 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 in the yield spread -- or too aggressive -- which could lead to a slowdown in the economy and cause a narrowing of the yield spread.
- Notice in the table below that the yield spread dropped to 53 basis points by the end of 2017 after the Federal Reserve hiked rates three times in 2017 from 125 basis points at the end of 2016. Following the rate hike in March 2018, the yield spread fell to 46 basis points, its lowest level since late 2007. We believed the Treasury market was growing increasingly fearful that the Federal Reserve could commit a policy mistake, particularly in light of the emergence of threats of protectionist trade policies from the Trump administration and the marked rise in stock market volatility during February and March.
- Over the remaining months of 2018, it appeared to us the Federal Reserve was not paying enough attention to the messages from the markets. We consistently pointed out that the narrowing yield spread between two-year and ten-year Treasury securities was a signal from the Treasury market that the Federal Reserve had reached the level of the federal funds rate where monetary policy had shifted to the side of beginning to restrain the economy’s forward momentum. Notice the yield spread narrowed throughout the year, reaching only 19 basis points by the end of 2018 after the Federal Reserve raised the federal funds rate for a ninth time, bringing the target range to 2.25% to 2.50%.
- We continue to view monetary policy as tipping modestly to the side of restraint, despite the dramatic shift in tone and direction from the Federal Reserve since the beginning of the year. The Treasury yield spread remains very tight, ending March at 15 basis points. The yield on the two-year Treasury note has fallen from 2.49% at year end to 2.26% at the end of March, pointing to at least one rate cut over the next year.
- A source of concern in the economic outlook currently is that the Federal Reserve’s four interest rate hikes during 2018 likely have not been fully felt in the economy. It can take several months for such monetary policy changes to work their way through financial markets and the broader economy.
- As such, if no trade agreement is reached with China, we expect the next move by the Federal Reserve to be a cut in interest rates. Precariously slow global growth, low inflation and slowing U.S. growth will lead the Federal Reserve to lower interest rates, turning monetary policy to more of a neutral, or even an outright accommodative, policy stance.
- Should a successful conclusion to the China trade negotiations occur in short order, we think global and U.S. growth will benefit. A stabilization of the growth outlook will keep Federal Reserve policy on hold, promote some upward movement in ten-year Treasury yields, and result in some widening in the two-year to ten-year Treasury yield spread. As always, stay tuned!
III. Treasury Market
A. Treasury Yields and Global Sovereign Yields Resume Their Decline During March.
- Just as the rise in investors’ anxiety about the outlook for the U.S. and global economies slowed the advance in stock prices during March, so too did it lead to another leg lower in bond yields across the globe. Consider that the yield on the ten-year Japanese note hit a 2018 peak on October 9 at 0.16%, only to fall to -0.02% by the end of February. The yield on the Japanese ten-year security fell a touch deeper into negative territory last month, finishing March at -0.08%.
- Moving to the euro zone, the ten-year German bund reached a 2018 peak on February 2 at 0.77%, only to tumble to 0.18% by the end of February. The yield on the German bund fell into negative territory again during March -- the first time since 2016 -- ending the month at -0.07%.
- Turning to the Treasury market, yields on securities with maturities between two years and thirty years fell between -38 to -58 basis points from the recent peak on October 8 to the end of 2018. Over the first two months of 2019, yields between two years and thirty years stabilized, falling by -2 basis points to rising by 6 basis points. However, during March, yields on Treasury securities between two years and thirty years declined fairly aggressively, falling by -25 basis points to -31 basis points. Of particular interest, the yield on the ten-year Treasury note fell from 3.23% on October 8 to 2.68% on December 31, only to drop to 2.41% by the end of March.
- The combination of the global slowdown, modest inflationary pressures, a shift toward accommodative monetary policies by several central banks across the globe, and heightened investor anxiety that economic headwinds from China, Japan, and the euro zone will drag the U.S. economy into recession, pushed the yield on the ten-year Treasury note to its lowest level since the summer of 2017.
- The announcement by the Federal Reserve that it will reduce the current $30 billion per month runoff of Treasury securities to $15 billion in May and start the effort to return its securities portfolio to a Treasury-only portfolio in September raised the specter of a shortage of Treasury securities in the future. We do not place much credence in that fear given the outlook for trillion dollar federal budget deficits as far as the eye can see.
- Notice in the table above that since the recent peak in bond yields on October 8, implied inflation expectations have declined by -29 basis points, falling from 2.17% to 1.88%, but remain slightly higher than the year end reading of 1.71%. We look at the slightly higher implied inflation outlook currently as consistent with the sweeping policy reversal by the Federal Reserve at the January and March FOMC meetings, which has markedly lowered the risk of the Federal Reserve making a policy mistake and forcing the U.S. economy into recession.
- It seems to us that the more interesting insight in the table is the decline in the Treasury TIP yield -- a widely followed indicator of real growth expectations -- from 1.06% on October 8 to only 0.53% on March 29, a -53 basis point decline. Additionally the Treasury TIP yield has declined by -44 basis points since year end. While expectations for both growth and inflation have receded over the past three and six months, the greater decline has occurred in the growth outlook and the inflation outlook is fairly close to the economy’s 1.9% inflation rate over the past two decades.
- While the decline in the outlook for growth could be interpreted in a variety of ways, we believe it supports our view that the current recession fears are overblown as the TIP yield remains positive. During the last major growth scare in the summer of 2016 following the vote in the United Kingdom to leave the European Union, the ten-year Treasury TIP yield hit zero, without the economy subsequently falling into recession.
- With our expectation that current recession fears are overblown and will recede with a rebound in the economic data over the next couple months, so too, we feel the decline in Treasury yields during March was also overdone and we look for yields to firm and retrace part of the recent decline in the months ahead. We do not foresee a recession on the horizon and the growth outlook will only improve with a trade deal with China, which we expect.
- Last month, the yield on the ten-year Treasury note broke below the lower end of the 2.55% to 2.85% trading range on the ten-year that we identified in the last three ISS’s. We anticipate that the yield on the ten-year Treasury will return to that range as the economic data improves.
Joseph T. Keating
Chief Investment Officer
Pierre G. Allard
Director of Research
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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