CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
December 2, 2019
I. Equity Markets
A. Relief Gradually Replaces Recession Fears.
- The August lows for both common stock prices and ten-year Treasury note yields continue to look like important bottoms, reflecting an overshoot to the downside by investors in a fit of recession fears which we viewed as unfounded at the time, but worrisome nonetheless. An escalation of the trade war with China, a collapse in sovereign bond yields across the globe, the inversion of the Treasury yield curve, and a slowdown in global growth -- particularly in the euro zone, Japan, and China -- weighed on investor sentiment, leading investors to make a series of risk-off moves.
- The foundation of the rally in U.S. common stocks since the August 14 lows for the S&P 500 and the DJIA remains sturdy and should provide the basis for higher stock prices, with two ongoing and developing storylines which need to be monitored. Consider that during August the yield on ten-year sovereign notes in Germany, France, and Japan troughed at -0.72%, -0.43%, and -0.29%, respectively. Those yields rose to -0.37%, -0.06% and -0.08%, respectively, by the end of November. While still negative, the yields on the major ten-year sovereign bonds overseas are moving toward positive territory. Additionally, the total amount of foreign sovereign debt carrying negative yields has fallen from a peak of $17 trillion in August to $12.3 trillion currently, still a huge number, but the trend is in the right direction in our opinion.
- The Federal Reserve nimbly cut rates three times between late July and late October and has managed market expectations not to expect any further rate cuts over the next couple months. It appears that the worst of the economy’s soft patch occurred during the second half of this year as the recent economic data are showing signs of a modest pickup. Credit conditions look to be healthy and the slight inversion of the Treasury yield curve from three-months to ten-years evaporated during October as the Federal Reserve cut rates and yields on longer-dated Treasury securities rose. The fears of August left many investors underinvested, prone to chase common stocks as they rebounded.
- The most important storyline to watch is the ongoing negotiations with China over a “phase one deal,” as the trade war with China is the main risk to the global economy, particularly if the current truce is not formalized and an escalation of the tariff war occurs. Sentiment remains fairly positive that a narrow trade agreement will be reached in short order -- we continue to take the position that the current political pressures on President Trump and President Xi increase the likelihood of a “phase one deal” between the U.S. and China and a cancelling of the tariffs planned to take effect on December 15.
- The rapid back and forth of leaks, announcements, and statements by both the U.S. and China trade officials over the past month is akin to watching a ping pong ball. The latest volley came last week as China’s top negotiator, Vice Premier Liu, raised hopes of a trade deal between the U.S. and China by saying that “Both sides discussed resolving core issues of common concern (and) reached consensus on how to resolve related problems,” after speaking with U.S. trade representative Robert Lighthizer and Treasury Secretary Steven Mnuchin. Mr. Liu added that both sides “agreed to stay in contact over remaining issues for a phase one agreement.”
- These statements followed news that China said it was willing to agree to key demands from the U.S. on intellectual property theft. China ramping up its plans to protect patents, copyrights, and trademarks is viewed as a major step forward in negotiations. There are also reports that in-person talks may be held before the December 15 tariff deadline. It seems to us that President Trump clearly wants a trade deal with the current impeachment proceedings and the 2020 presidential election less than a year away, and President Xi wants a trade deal with the slowing Chinese economy and the political unrest in Hong Kong.
- The other storyline to monitor is any shift by voters toward the far left-leaning economic policies advocated by a couple candidates for the Democratic presidential nomination which would attack the very core of modern capitalism. These proposals would materially increase the scope of the federal government in the private sector of the economy, greatly expand entitlement programs, and enact a sweeping array of incentive destroying new taxes and higher tax rates, which could cut the potential growth rate of the U.S. economy by as much as 50%. We believe there is little interest in these far left-leaning proposals by the vast majority of voters, but the storyline needs to be watched, particularly given the low regard many voters have for President Trump’s deportment.
- Positive momentum continues to grow for higher stock prices, with the major market measures higher by 10.1% to 11.5% since the recent August 14 lows for the S&P 500 and the DJIA. For the month of November common stocks posted strong gains of 3.4% to 4.5% and are higher by 20.3% to 30.6% year to date.
B. We See Good to Close to Good Fundamentals as 2019 Turns to 2020.
- We have frequently mentioned in these ISS’s that “economic expansions do not die of old age, they tend to be murdered by the Federal Reserve as it combats rising inflationary pressures,” as one of the key axioms through which we assess the outlook for the economy. A related axiom relative to common stocks is that “bull markets do not die of old age, they die of poor fundamentals.” The most important fundamental for common stocks is the ability of companies to generate a growing stream of earnings which will lead investors to invest their capital into shares of the company.
- The ability of a company to grow its earnings is a function of two realities. One is the management of the company and the demand for its products. Companies need to be managed onto a profitable trajectory and its product mix must be a need to have by other businesses or households. The other reality is a growing economy. While some product innovations can overcome a no growth or recessionary period due to the strength of their need to have, riding the wave of a growing economy is a tailwind which helps viable companies to prosper and grow their earnings.
- Our review of the economic data suggests that the current economic expansion is capable of extending for several more years, particularly in light of the three rate cuts the Federal Reserve delivered between late July and late October. The labor market remains strong with solid job gains and wage growth, household financials obligations are near their lowest level in nearly forty years, inflation pressures are quiescent, and the housing market is gathering a moderate head of steam. As such, we view company fundamentals as likely to fall between good and close to good as the calendar turns from 2019 to 2020.
- A successful conclusion to the current talks to negotiate a lasting truce in the ongoing trade war with no escalation of the trade conflict on the horizon will be the key determinant of the fundamentals being good starting in 2020. An unsuccessful conclusion to the trade talks will result in fundamentals which are close to good, still positive, but not as good as they would be if true progress on resolving the trade war with China took place.
- The trade war has definitely hurt the demand for tradeable goods across the globe in the highly integrated global economy in which companies operate today. Domestically, the largest impact appears to be on business capital spending, which has naturally suffered as the manufacturing sector has stalled and business uncertainty has soared with the actual and potential disruptions to supply chains -- from procurement to assembly to manufacturing -- for businesses small to large.
- Common stocks will perform better with good fundamentals to start 2020 rather than with a close to good starting point. Under either scenario, however, the returns on common stocks will not face much competition from the prevailing low level of yields on Treasury securities. We continue to expect the bull market in common stocks to last a lot longer than most investors expect as we do not see any signs of a recession on the horizon. We remain inclined to buy stocks on any pullback, rather than selling stocks as the bull market advances.
- While common stocks have a nice head of steam as we head into the final month of the year, there are three risks that investors need to watch over the coming weeks. First, is the strength of the holiday shopping season. The consumer sector has been carrying the economy over the past couple quarters and will need to continue doing so until a resurgence of business capital spending can take place in the event of a favorable outcome on the trade war with China.
- Secondly, an important deadline in the trade war is December 15, when President Trump has threatened to impose punitive tariffs on about $156 billion worth of Chinese mobile phones, video game consoles, laptops, toys, and other consumer products. An expansion of the tariffs on Chinese goods, particularly on top-selling consumer goods, would be a clear signal that progress toward a “phase one deal” was not on track and would hurt consumer spending, likely leading to a consumer backlash against the China trade offensive.
- Lastly, President Trump signed into law two bills supporting Hong Kong last week which are aimed at preserving Hong Kong’s rights and autonomy. The bills come amid wide spread criticism of heavy-handed treatment of protestors by the Hong Kong police and government, which Beijing supports. So far, Chinese officials involved in economic policy making stressed that the trade negotiations are still on track, and as long as Mr. Trump does not implement any of the new law’s measures, Beijing still has strong incentives to move ahead with the trade deal to help alleviate pressure on its slowing economy. This situation warrants monitoring to the extent it derails the current momentum toward a trade deal.
II. Monetary Policy
A. Federal Reserve on Hold and Data Dependent.
- After the Federal Reserve cut the federal funds rate to a range of 1.5% to 1.75% at the October 29-30 FOMC meeting, the policy statement suggested an increased level of data dependence for future policy moves -- the economic data would need to deteriorate further to justify another rate cut -- rather than the central bank having an ongoing bias to cut rates further. At the press conference following the FOMC meeting, Chairman Powell said new information which prompted a “material reassessment” of the economic outlook would be needed to cut rates again.
- Jerome Powell also stated at the press conference that the Federal Reserve would need to see a “really significant move up in inflation” before the central bank thought about hiking interest rates again. In reviewing the minutes of the October FOMC meeting, it was clear that the bar for raising rates is so high that the possibility of raising rates was not even seriously discussed by the Committee. Message received, the Federal Reserve is on hold after three rate cuts between late July and late October.
- In a speech in Providence, Rhode Island last week, Mr. Powell expressed a sense of urgency in meeting the inflation part of the Federal Reserve’s dual mandate -- maximum employment and stable prices -- saying the Federal Reserve is “strongly committed” to meeting its inflation goal of 2%. With the nation’s inflation rate consistently running below the 2% threshold over the course of the current business expansion, Mr. Powell’s remarks are further indication that the central bank is unlikely to raise the target range for the federal funds rate any time soon.
B. A Rate Hike in 2021?
- Based on the messaging from the Federal Reserve and the tone of the recently released economic data, we are not looking for the Federal Reserve to cut rates at this month’s FOMC meeting and feel there is a good chance policy will remain on hold for all of 2020, particularly if a narrow trade deal with China can be successfully negotiated over the next few weeks. The futures contract on the federal funds rate only indicates a roughly 50% chance of one more rate cut by the middle of next year.
- While near term observations in the futures market for the federal funds rate do a good job of predicting changes in Federal Reserve policy, longer dated observations take on more of a hedging orientation. This leads us to view the 50% chance of a rate hike next summer as more of a hedge by investors against a worsening of the trade war and/or a tight presidential race with a far left-leaning candidate heading the Democratic ticket, both of which would likely weigh on business and household spending decisions.
- If things play out as we anticipate, the U.S. and China will agree over the coming weeks to a “phase one deal” -- essentially formalizing a truce in the trade war -- and far left-leaning policies do not resonate with enough voters in the key battleground states, the economic expansion will receive a second wind heading into 2021. Under this scenario, do not be surprised if the Federal Reserve makes another mid-cycle adjustment, this time to move rates slightly higher. As always, stay tuned!
III. Treasury Market
A. Treasury Yields Continue Their Gradual Move Higher.
- Yields on long dated Treasury securities continued their rebound from near all-time lows in late August, sending one of the clearest signals yet that investors’ recent recession fears have waned. Treasury yields are rising for a good reason, which is that the global economy and the U.S. economy look to have bottomed and better growth prospects are ahead. Central banks around the globe have cut rates on 122 separate occasions so far in 2019, progress toward a U.S-China trade agreement is being widely reported, and recent economic data has modestly surprised to the upside.
- The yield on the ten-year Treasury note reached its August low point on the 27th at 1.47% and then rose to 1.67% on September 30, 1.69% on October 31, and ended November at 1.78%. Besides longer date Treasury yields rising, foreign sovereign bond yields in Ireland, Spain, and Portugal returned to positive territory in recent weeks. As mentioned earlier in this ISS, ten-year sovereign yields in Germany, Japan, and France remain negative, but much less so than over the summer months. Better economic data and hopes for a U.S.-China trade deal are lifting foreign sovereign bond yields.
- The rebound in longer dated Treasury bond yields over the past three months marks a significant reversal for the bond market. During August, Treasury yields were falling so quickly -- the yield on the ten-year Treasury security declined by -51 basis points -- that many investors and analysts were worried that they could drop below zero, joining the $17 trillion of sovereign debt with negative yields around the world. While Treasury yields stayed in positive territory, the Treasury yield curve did become inverted -- yields on longer term Treasury securities below yields on shorter term securities -- between three-months and ten-years, reaching -50 basis points at the most extreme point.
- Highlighting the turnaround in sentiment, the amount of negative yielding foreign sovereign debt has dropped by almost $5 trillion to $12.3 trillion since August. Additionally, the Treasury yield curve has almost completely become uninverted, with yields on Treasury securities getting progressively higher from the one-year Treasury bill all the way to the thirty-year Treasury bond. Despite the rebound in yields, the ten-year Treasury yield remains very low at 1.78%, sitting closer to the record low of 1.37% on July 7, 2016 than the 3.23% level it hit on October 5 of last year.
- Yields on three-month and one-year Treasury bills have fallen -40 and -16 basis points, respectively, from August 27 to the end of November as the Federal Reserve cut interest rates at both the September 17-18 and the October 29-30 FOMC meetings. Consider that the yield on the three-month Treasury bill was 1.98% at the end of August and ended November at 1.57%.
- From five years to thirty years, yields on Treasury securities have risen 25 to 31 basis points since August 27 following the somewhat panicked flight-to-safety during August which saw yields on Treasury securities from two years to thirty years fall -37 to -57 basis points during the month, representing a truly risk-off move on the part of investors.
- A portion of the rise in yields on longer maturity Treasury securities since August 27 can be attributed to a lessening of the gravitational pull from negative yields on overseas sovereign bonds. As mentioned above, in August some $17 trillion of foreign sovereign debt carried negative yields, the ultimate flight-to-safety by overseas investors. At the end of November, $12.3 trillion of sovereign debt carried negative yields, still a huge number, but the trend is in the right direction in our opinion. Investor sentiment in the euro zone has received a boost from the recent uptick in the economic data.
- Given our view that the U.S. economy was not at risk of falling into recession near term, we stated in the September ISS that it was unlikely yields on longer dated Treasury securities would fall below the lows recorded during August. Notice in the table below that the Treasury TIP yield -- a widely followed indicator of real growth expectations -- had fallen from 0.97% at year end to -0.04% at the end of August. It seemed to us that yields on longer dated Treasury securities did not appropriately reflect expectations for U.S. growth and were being held captive to the gravitational pull of negative sovereign bond yields overseas.
- Notice also in the table that as ten-year Treasury yields rose 28 basis points from the end of August to the end of November, ten-year TIP yields rose 20 basis points from -0.04% to 0.16%, with the implied inflation expectation moving slightly higher to 1.62%. We thought that the decline in the ten-year Treasury TIP yield during August was overstating the risks to the economy, largely due to the strong flight-to-safety by investors as they tried to understand the endgame of tariff policy, the implications of negative policy rates and negative sovereign bond yields across the globe, and the inversion of the Treasury yield curve.
- The inflation premium embodied in the ten-year Treasury is little changed from the end of August and is not noticeably different from year end. The ten-year TIP yield still looks too low currently, given the moderate pace of forward momentum in the U.S. economy. The real unknown is the extent to which growth and yield starved overseas economies and bond markets will keep downward pressure on Treasury yields.
- We continue to believe that with $12.3 trillion of foreign sovereign debt carrying negative yields, global investors are still crowding into longer maturity Treasury securities. The rapid declines in Treasury yields to the end of August made a much stronger statement about weak growth overseas than it did about the prospects for U.S. growth. We continue to look for the yield on the ten-year Treasury note to rise toward 2% over the next couple months on the back of a resilient U.S. economy.
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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