CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
December 3, 2018
I. Equity Markets
A. Federal Reserve Tries to Walk Back Chairman Powell’s October Comments.
- In last month’s ISS, we blamed growing fears over the Federal Reserve’s efforts to raise interest rates as the key reason for the -9.4% drop in the S&P 500 from the end of September to the recent low on October 29. Throughout 2018, we have consistently stated that whether or not the Federal Reserve would make a policy mistake was the primary risk to the economy and the outlook for stock prices. The risks associated with the course of Federal Reserve policy and its impact on the economy transitioned from uncertainty to fear in early October.
- Specifically, in a questions and answer session on October 3, Federal Reserve Chairman Jerome Powell stated that the central bank was “a long way” from getting interest rates to neutral, a level at which monetary policy is neither stimulating nor restraining the economy’s growth rate. Not coincidentally, in our opinion, the S&P 500 came within a whisker of its all-time high on October 3, only to decline straight away to the October 29 low. We said the key question relative to the outlook for the economy, earnings, and stock prices was whether or not Jerome Powell and his compatriots at the Federal Reserve listened to the message from the markets -- including the drop in stock prices, the decline in Treasury yields since early October, and the continued flattening of the Treasury yield curve as displayed in the shrinking yield spread between two-year and ten-year Treasury securities.
- Would the Federal Reserve pause the rate hiking cycle next year and take some time to assess the impact on the economy from raising interest rates from zero in 2015 to 2% to 2.25% currently? Or would the central bank stay focused on its goal to raise rates to at least 3.25% to 3.5% by 2020 to provide policymakers with more ability to lower rates during the next downturn in the economy and ignore the signals from the markets along the way? The issue for investors is that the Federal Reserve is now tightening monetary policy into a slowing economy that is not showing signs of rising inflationary pressures.
- The Federal Reserve made several attempts to walk back Chairman Powell’s October 3 comments during November. In an interview with Dallas Federal Reserve Bank President Robert Kaplan on November 14, Jerome Powell admitted he was growing cautious about the pace at which the Federal Reserve was raising interest rates. Mr. Powell acknowledged that the pace of global economic growth was slowing.
- Mid-month and again last week, Vice-Chair Richard Clarida went a step further by saying the Federal Reserve is close to being at “neutral” on the level of short-term interest rates and said the central bank needed to be “data dependent” when determining whether or not to increase interest rates further next year.
- The latest act in the Federal Reserve’s walk back effort took place last Wednesday during a speech Chair Powell gave to the Economics Club of New York. Mr. Powell stated that interest rates are “just below” broad estimates of a neutral level, a clear retreat from his comment on October 3. Investors read Jerome Powell’s statement to suggest that the Federal Reserve could pause its efforts to raise interest rates in early 2019. Stock prices climbed immediately after Mr. Powell’s midday remarks, sending the DJIA higher by 617 points on the day.
- The next signpost will be the December 18-19 FOMC meeting. Will the Federal Reserve leave rates unchanged, do a “dovish” hike which alludes to the possibility of pausing in 2019 if inflation remains under control, or deliver an “aggressive” hike with language which stresses the strength in the economy and tightness in the labor market? We will explain our thoughts for a “dovish” hike later in this ISS.
- While we believe the Federal Reserve is the key issue facing investors, a couple other events did impact the markets last month. Investors did react positively -- the DJIA surged nearly 550 points the day after the election -- to the Republicans retaining control of the Senate in the mid-term elections, while losing the House, as expected. Look for the new Congress to be headline heavy and legislation light.
- Given the day last month, investors expressed optimism or pessimism on the prospects of the U.S. reaching a trade deal with China which would ease trade tensions. The new month is opening with a good amount of optimism, however, after President Trump and Chinese President Xi agreed to a truce in the trade war which has weighed on global equity markets for the better part of 2018 after a weekend dinner following the Group of 20 summit in Argentina. The U.S. agreed to leave tariffs on $200 billion of Chinese goods at the current 10% rate and not raise it to 25% on January 1 as the White House proposed back in September.
- If after 90 days the two countries are unable to reach an agreement on lingering trade issues, the tariff will be raised to 25% according to the White House. Trade negotiations will address forced technology transfer by U.S. companies doing business in China, intellectual property protection for U.S. firms, non-tariff barriers that impede U.S. access to Chinese markets, and cyberespionage.
- The explicit delay in raising the tariff rate is clearly a positive outcome in the short run, as evidenced by the strong advance in stock prices this morning. China also agreed to purchase a “substantial,” but not yet determined, amount of agricultural, energy, industrial, and other U.S. products to reduce the trade deficit the U.S. has with China. Now the onus is on China to convince the Trump administration that it can truly change its mercantilist trade policies.
- Lastly, the markets remain concerned that the Untied Kingdom could soon leave the European Union without a satisfactory separation agreement. The 2016 referendum did not ask what kind of Brexit the voters wanted, providing no guidance on the key issues of EU workers’ freedom to move to the U.K. versus the benefits of single market membership. Prime Minister Theresa May’s government has sought to end freedom of movement of EU citizens to the U.K. and end the role of EU law in the U.K., while the EU has insisted the price for that is a more distant economic relationship that would inhibit the current free flow of trade.
- Not surprisingly, both sides of the debate are not satisfied with Mrs. May’s controversial Brexit plan which has the U.K. bound to EU oversight for an indefinite period after it leaves the EU in March, angering those who want a more decisive break from the EU even if it comes at economic costs. Leaving the EU with no deal come March 29 could cause big disruptions to trade and a breakdown of communications between the EU and the U.K. over suspected terrorists and other criminals. There is really no way of knowing if Mrs. May will retain her leadership role in the U.K. and what sort of Brexit agreement will eventually be negotiated.
- After the strong rally following Jerome Powell’s comments last week, the major stock market measures were higher by 0.3% to 1.8% during November. Since the recent low on October 29, the various stock market indices are higher by 3.8% to 4.5%. For the first eleven months of the year, the NASDAQ Composite is still leading the way with a 6.2% gain, while the S&P 500 and the DJIA are higher by 3.2% and 3.3%, respectively. Only the Russell 2000 is lower on the year, down -0.1%.
B. Federal Reserve Leaves Rates Unchanged at November FOMC Meeting.
- As widely expected, the Federal Reserve left the federal funds rate in a range of 2% to 2.25% at the conclusion of the November 7-8 FOMC meeting and signaled it would continue raising interest rates gradually amidst a “sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective.” Last month’s FOMC meeting was the last for the foreseeable future which will not be followed by a press conference with the chair of the Federal Reserve as Jerome Powell announced in June he would hold press conferences after every meeting starting in 2019, rather than once a quarter, to improve communications.
- The policy statement was largely unchanged from the previous meeting’s statement, with the Committee acknowledging the strength in consumer spending, which in 2Q and 3Q 2018 propelled the economy to its strongest back-to-back quarterly growth in four years. The Committee added, however, that business capital spending recently slowed from the brisk pace recorded during the first half of the year. Somewhat surprisingly, the Committee made no mention of the recent weakness in residential construction.
- By repeatedly emphasizing the economy’s strength in the policy statement, the Federal Reserve offered nothing to dispel market expectations that it would raise rates for the fourth time this year at the December 18-19 FOMC meeting. While the chance of the central bank pausing this month has improved with the heightened volatility in the financial markets over the past two months, we still anticipate the Federal Reserve will hike rates this month.
C. Where Is Janet Yellen When We Need Her?
- Following the Federal Reserve raising the target range for the federal funds rate to 2% to 2.25% at the conclusion of the September 25-26 FOMC meeting, which places the federal funds rate above the rate of inflation for the first time in a decade, we took the position that monetary policy had already reached neutral and that policy would begin to turn slightly restrictive should the Federal Reserve raise rates in December, and would become incrementally more restrictive with further rate hikes in 2019-20.
- The problem with the concept of a neutral interest rate is that it is not directly observable. It is only known for a fact, after the fact, when we can observe how economic growth and inflation responded to a given level of interest rates. 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 following 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, following the most recent rate hike, and to only 20 basis points at the end of November. 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 reached 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 takes a further bite out of households’ purchasing power. We expect the economy’s growth rate to slow to a pace closer to 2% next year from roughly 3% this year, however, we are still not forecasting a recession in the foreseeable future.
- 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 in October, the Federal Reserve increased the reduction in the size of its securities portfolio to $600 billion a year compared to $300 billion over the previous 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.
- We believe the hallmark of Janet Yellen’s term as chair of the Federal Reserve was her pragmatic approach to managing monetary policy. Remember that in both 2015 and 2016 the Federal Reserve signaled four rate hikes in both years and eventually only raised rates once in each year as concerns over global growth made it less likely the U.S economy could tolerate four rate hikes in each year.
- Given the progress made in raising interest rates, uncertainty over the impact of the tariffs on the economy, and the waning effects of the fiscal stimulus next year and into 2020, we think the financial markets would benefit from a good dose of pragmatism from the Federal Reserve currently. A pause in hiking interest rates would allow the FOMC Committee to gain important insights on growth and inflation after raising rates for three years. Hence our question, where is Janet Yellen when we need her?
- The truism facing investors is that the bull market in common stocks will end when investors can no longer incorporate growing earnings streams into their stock valuations. That leads to the dilemma facing investors. The economy currently has decent, but decelerating forward momentum, while some cracks in the housing market, light motor vehicle sales, and business capital spending are evident and possibly growing.
- Unwillingness on the part of consumers to spend on large, long-lasting items like housing and light motor vehicles may signal the susceptibility of consumer confidence and spending to recent market volatility and soft business investment likely reflects uncertainty over the trade/tariff war with China.
- The Federal Reserve is still on record to continue raising interest rates gradually, global growth is slowing, the U.S. dollar continues to rise placing downward pressure on export demand, as well as on import prices, tariffs are beginning to negatively impact some businesses, and worries about the impact of the trade discord with China are weighing on business sentiment. Investors need some reassurances that the economic expansion remains on track and will continue to roll into next year and 2020 at a minimum.
- We have been cautioning since the July ISS that the dialogue regarding the Federal Reserve could soon shift to “Is the Federal Reserve moving too far?” While we understand that interest rates and bond yields are still low from a historical perspective, we find the change in interest rates and bond yields to be more relevant. Consider that since late 2015 the federal funds rate has risen from zero to 2%-2.25%, while the yield on the ten-year Treasury note has more than doubled from its all-time low in July 2016.
- On a more positive note, earnings have been very strong and the current estimate from Standard and Poor’s is that 3Q 2018 operating earnings increased by 32.9% from a year earlier and operating earnings should grow nearly 27% for all of 2018. Operating earnings are expected to advance about 11% in 2019 as the impact from the corporate income tax rate cut washes out of the data, but the expected gain next year would still be well ahead of the 6.5% long run growth rate for operating earnings. While some analysts are concerned that investors will react negatively to a slower growth rate in earnings next year, we feel the key is that earnings are expected to grow next year.
- With the combination of strong earnings growth and only modest gains in stock prices so far in 2018, common stock valuations are much improved. Consider that since the night of the presidential election the S&P 500 is higher by 29%. However, over the past two years, operating earnings on the S&P 500 have risen over 48%. Consequently, the price-to-trailing operating earnings ratio on the S&P 500 has fallen to 18.3x currently, compared to 21.1x on the night of the election and 22.5x at year end 2017. The market’s P/E ratio has fallen -18.7% so far this year.
- We view the lower common stock valuations, as reflected in the decline in the P/E ratio so far this year, as a solid positive for the outlook for the stock market. Additionally, while October’s pullback was sudden and volatile -- only to be largely duplicated last month -- investors need to remember that the October pullback was the 15th decline in the S&P 500 greater than 5% over the course of this bull market. As long as the economy and earnings continue to grow, stock prices can move higher.
- As we have consistently stated all year, the major risk to the economy is the Federal Reserve making a policy mistake by unnecessarily slowing the economy’s growth rate below 2% or pushing it into a mild recession without a sustained rise in inflationary pressures above the central bank’s 2% target. The current expansion will be ten years old at the end of 2Q 2019, tying the record for the longest expansion on record. There is no reason this expansion cannot continue for several more years if the Federal Reserve does not make a policy mistake by fighting the inflation bogeyman which is not currently evident.
- We expect Jerome Powell and the other officials at the Federal Reserve to increasingly listen to the message from the financial markets -- the decline in Treasury yields, the shrinking yield spread between two-year and ten-year Treasury notes, and the decline in stock prices during October and November. We believe Mr. Powell’s comment last Wednesday -- that interest rates are “just below” neutral -- are consistent with this perspective. However, due to the slowing, but still positive momentum in the economy and the strong jobs market, we look for the Federal Reserve to raise rates for the ninth time during this rate hiking cycle at the December 18-19 FOMC meeting.
- We look for a “dovish” hike, however, where the policy statement and/or Mr. Powell’s comments at the press conference allude to the possibility of pausing in 2019 if inflation remains under control and the economy’s growth rate slows from the roughly 3% pace of 2018. In that regard, some not so good economic data -- which we expect -- could be good for the economy’s longer run prospects as it would increase the likelihood of the Federal Reserve pausing in early 2019. Lastly, Jerome Powell and the other members of the FOMC Committee should not feel they must continue to raise interest rates simply because President Trump is lobbying them not to do so.
II. Treasury Market
A. We Have Seen High Ten-Year Treasury Yield for 2018.
- After reaching a recent peak at 3.23% on October 8, the yield on the ten-year Treasury note declined to 3.14% to the end of October. The market took another run to 3.23% on November 8, only to back away more vigorously to a yield of 2.99% on November 30 as signs of the economy slowing began to emerge, particularly in the housing market, light motor vehicle sales, and business capital spending. Of course, the selloff in common stocks which began on October 3 also contributed to the drop in Treasury yields with investors seeking the safety of Treasury securities as their appetite for risk dried up.
- In fact, yields have fallen across the yield curve since the peak in the ten-year Treasury yield on October 8, with yields on Treasury securities two years and longer falling -10 to -27 basis points. The ten-year Treasury note yield traded below 3% last Friday for the first time since September 14. It is also interesting to note that the yield on the two-year Treasury note declined ten basis points to 2.79% over that timeframe, which is consistent with the market pricing in a lower terminal level of the federal funds rate over the next two years.
- Notice two things from the table on the following page. First, as the ten-year Treasury yield fell from 3.14% at the end of October to 2.99% at the end of November, the TIP yield has declined six basis points, while the implied inflation expectation embodied in the nominal ten-year Treasury security eased nine basis points. Second, the drop in the inflation expectation fell below 2% for the first time since the end of 2017. An expectation that the economy’s growth rate will slow next year, building retail inventories which will spur price concessions, and collapsing oil prices are helping to moderate the market’s outlook for inflation.
- We dare say the peak in ten-year Treasury yields has been made for 2018 at 3.23%. Our view that inflation will remain under control -- not to exceed the Federal Reserve’s 2% target in any material manner -- and that the economy will slow to a pace closer to 2% in 2019 -- which will surprise most investors and the Federal Reserve -- should keep a lid on ten-year Treasury yields next year.
- The main items which will exert upward pressure on ten-year Treasury yields will be the more aggressive pace at which the Federal Reserve will shrink the size of its securities portfolio over the next twelve months and the greater issuance of Treasury securities to fund the growing federal budget deficit. Taking all these issues into consideration, we look for a near term trading range for the ten-year Treasury note of 2.90% to 3.20%.
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.
CenterState Bank of Florida 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.