CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
February 1, 2019
I. Equity Markets
A. Recession Worries Fade, Stocks Prices Rise.
- Following a miserable fourth quarter of 2018 when the S&P 500 declined -19.6% from October 3 -- the day Federal Reserve Chairman Jerome Powell said the central bank was “a long way” from getting interest rates to neutral -- to the recent low on December 24, the S&P 500 posted an impressive rebound, rising 15% since Christmas Eve and 7.9% during January. The almost six week long rise in stock prices indicates that the recession fears which gripped investors during 4Q 2018 were overblown and have largely dissipated.
- Investors are encouraged that the Federal Reserve has signaled that it will be patient, flexible, and data dependent in its deliberations on further increases in interest rates, easing fears that it would push the economy into recession. We will discuss our outlook for policy from the Federal Reserve later in this ISS. Investor sentiment was also boosted by hopes that the U.S. and China were making progress on the ongoing trade negotiations.
- In early January, the U.S. and China wrapped up their first face-to-face trade negotiations in Beijing since a 90 day tariff truce was reached between President Trump and President Xi in early December. The two sides made progress on issues such as additional Chinese purchases of U.S. goods, as well as opening China’s markets further to U.S. capital. Several news outlets reported that China pledged to increase its imports of U.S. goods by more than $1 trillion with a goal to bring the annual U.S. trade deficit with China to zero by 2024, compared to the $323 billion trade deficit in 2018.
- The two sides remain divided on important structural issues, however, such as Beijing’s subsidies to Chinese companies and better protection of U.S. intellectual property. One big challenge is figuring out how to enforce any deal with Beijing given what the Trump administration calls China’s poor follow up record on similar pledges China has made over years of previous negotiations. Still, the narrowing of the two sides’ differences on trade paved the way for a second round of trade negotiations taking place this week, which included Chinese Vice Premier Liu, the top economic aide to President Xi.
- Mid-month, Prime Minister Theresa May’s proposed Brexit deal was overwhelmingly rejected by the British Parliament, prompting a no confidence vote against Mrs. May, which she narrowly won. This turn of events only heightened the uncertainty surrounding the United Kingdom’s scheduled exit from the European Union on March 29. The defeat of the proposal by the huge margin of 230 votes showed the depth of dissatisfaction over a deal that would have bound the U.K. 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 an economic cost, a so-called “hard Brexit.”.
- The United Kingdom’s June 23, 2016 referendum on whether or not to remain a member of the European Union 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 membership in a single market.
- Theresa May’s proposal would have left the U.K. indefinitely locked into a customs agreement with the EU to avoid a hard border appearing on the island of Ireland. In a similar manner to the 2016 referendum, the “no” vote in Parliament last month to Mrs. May’s Brexit proposal said nothing about what Parliament does support in turns of a satisfactory separation agreement from the EU.
- Investors also had to weather the partial shutdown of the federal government for 35 days, the longest closure in U.S. history, before President Trump reached a deal with congressional leaders last week to reopen the government for three weeks despite not receiving any funding for a southern border wall to prevent illegal immigration into the U.S. The short-term deal provided financial relief for about 800,000 government workers, who had been furloughed or working without pay for more than a month.
- The Congressional Budget Office estimates that the shutdown will have a miniscule impact on the economy’s growth rate in 2019, but the shutdown likely shifted some spending from January to February and beyond. The major economic impact was on those government workers who were financially challenged to miss two paychecks, despite the income eventually being paid.
- From the dramatically oversold position on Christmas Eve when investor sentiment was woefully negative, the major market measures are higher by a stunning 14.7% to 18.4% to the end of January. For the month of January, the various stock market measures rose by an eye opening 7.2% to 11.2%. The S&P 500, the DJIA, and the NASDAQ Composite recovered all of their 2018 losses during January, with only the Russell 2000 yet to recover its decline during 2018.
B. Federal Reserve Softens Its Stance, Patience and Flexibility Are the Order of the Day.
- Chairman Jerome Powell went to great lengths to change the narrative regarding the outlook for monetary policy at a conference in Atlanta on January 4 compared to the messaging from the Federal Reserve following the December 18-19 FOMC meeting. In the January ISS, we stated that the market did not want a continuation of forward rate guidance from the Federal Reserve -- some further gradual rate hikes -- and wanted the policy statement, “dot plots,” and/or Mr. Powell’s comments to be more in synch with the market’s forecast which was not pricing in even one additional rate hike for 2019, let alone the two hikes that Chairman Powell spoke about during the press conference.
- Mr. Powell set the stage for the Federal Reserve to pause in its effort to raise interest rates in coming months in his comments in Atlanta. Jerome Powell pointed to low inflation readings as providing the central bank with an opening to take a step back and assess the impact of the nine rate hikes it has already implemented. “With the muted inflation readings that we have seen coming in, we will be patient as we watch to see how the economy evolves,” he stated at the Atlanta conference.
- Jerome Powell also said that Federal Reserve officials were listening to the message from the recently volatile financial markets and would adjust their plans if recent volatility caused the economy to slow more than anticipated. “We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate,” he said on a panel with Janet Yellen and Ben Bernanke. Chairman Powell commented that the financial markets were looking at the downside risks to Washington policy -- read that as the trade war with China and monetary policy -- and, as such, the Federal Reserve should be focused on risk management.
- We stated in the January ISS that, in our opinion, the Federal Reserve did not turn in a stellar performance at the December FOMC meeting, that the markets viewed the central bank as being somewhat blind to the data, and that the Federal Reserve was not paying enough attention to the message from the markets.
- It appears to us that Jerome Powell was keenly focused on communicating to the markets last month that the Federal Reserve was well aware of what was happening in the financial markets and in economies across the globe and here at home, including widening credit spreads, falling Treasury bond yields, a further narrowing of the two-year to ten-year Treasury yield spread, plunging commodity prices, growing signs of a global economic slowdown, a marked rise in stock market volatility, and no signs of building inflationary pressures.
- It was very telling to us that Mr. Powell opened the conference by reading from several pages of prepared text in response to an impromptu, albeit predictable question about policy, while Janet Yellen and Ben Bernanke simply replied to questions in an off-the-cuff manner. It seems Chairman Powell realized how important his messaging was on January 4, after appearing almost cavalier during the press conference on December 19 about the outlook for rate hikes and the steady monthly runoff of the Federal Reserve’s securities portfolio. His message of patience and flexibility was clearly delivered and received well by the markets.
- Mr. Powell highlighted as an example of the central bank’s flexibility the decision to dial back its plans to raise rates four times in 2016 when worries over China’s economy fueled fears of a global slowdown. The Federal Reserve, under Janet Yellen’s leadership, ultimately raised rates only once that year, in December. Jerome Powell also clarified that reducing the size of the Federal Reserve’s securities portfolio was not on “auto-pilot.” While stating that he does not view the portfolio run off as “an important part of the story” of the recent rise in market volatility, he added, “if we reach a different conclusion, we would not hesitate to make a change.”
- Several other Federal Reserve officials spoke over the following week and a very consistent theme of the central bank being patient and flexible with respect to future rate hikes given the lack of inflation pressures was found in each and every presentation. Other themes included uncertainty over the economic outlook calling for caution and the message from the bond market that the Federal Reserve had gone too far in tightening monetary policy.
- Vice Chairman Richard Clarida reinforced the message of patience and flexibility in a dinner speech at a Money Marketeers dinner in New York and said overseas growth had “moderated somewhat” in recent months, while a selloff in common stocks and higher corporate bond yields meant financial conditions had “materially” tightened. Mr. Clarida said these recent developments represented “crosswinds” to the U.S. economy and appropriate forward-looking monetary policy should seek to offset them. He repeated that Federal Reserve policy was not on a “preset course.”
- It was very interesting that Mr. Powell’s and Mr. Clarida’s comments were followed by one of the Federal Reserve’s most outspoken supporters of raising interest rates saying the central bank should refrain from more rate hikes for the time being while it studies the effects of its previous steps to withdraw economic stimulus. Esther George, the president of the Federal Reserve Bank of Kansas City, said that failing to recognize the lags of monetary policy “could lead to an overtightening of policy, a downturn in economic growth, and an undershooting of our inflation objective.”
- Ms. George’s comments underscore the breadth of the consensus that has emerged since the FOMC Committee voted unanimously to raise interest rates at the December 18-19 FOMC meeting. Esther George said her view on whether to raise rates later this year would depend on the inflation outlook. Inflation pressures have eased in recent months and if that continues, or if the risks to the economy posed by the recent volatility in the financial markets and/or slowing global growth increase, Ms. George said a further pause in rate hikes would be warranted.
C. Federal Reserve Pledges “Patient” Approach, Wants “Ample” Bank Reserves.
- Following the chorus of Federal Reserve officials saying the central bank would be patient, flexible, and data dependent during January, the Federal Reserve left rates unchanged at the January 29-30 FOMC meeting, as expected. The big news from the meeting, however, was that the policy statement and Jerome Powell’s comments in the press conference provided investors with virtually everything they wanted to remove all fears that the central bank could make a policy mistake in the near term as was widely feared following the December FOMC meeting.
- First, the policy statement dropped the forward guidance language -- some further gradual rate hikes -- that more rate hikes would likely be necessary. Investors had largely expected that phrase to be eliminated from the December FOMC policy statement and were roundly disappointed when it was not. Secondly, policy officially went on hold by stating, “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.” Mr. Powell reinforced that policy statement by saying, the central bank would be “patient” and that a “wait and see approach” is warranted.
- The FOMC committee addressed the runoff of the Federal Reserve’s $4.05 trillion securities portfolio it has accumulated on its balance sheet since the financial crisis in a separate three paragraph statement, a topic which had come up previously mostly in the minutes following FOMC meetings. The statement said the Federal Reserve expected to operate with “an ample supply” of bank reserves.
- Jerome Powell stated the ultimate size of the securities portfolio would be determined by demand for reserves by financial institutions, which is turning out to be larger than previously estimated. Taken together, these statements imply the roughly $40 billion monthly runoff of bond holdings could end much sooner than previously expected, possibly as soon as sometime this year.
- It is interesting that Mr. Powell opened the press conference by stating that the Committee had one goal, “to sustain the current economic expansion,” making sure that everyone understood the Federal Reserve was committed to not making a policy mistake. He stated that various government policies domestically and abroad posed downside risks -- “cross currents” -- to the economic outlook. The chairman also stated that “financial conditions tightened in late 2018” and that “common sense risk management says to wait” on further rate hikes.
- Chairman Powell displayed the data dependency of the Federal Reserve by stating, “The case for raising rates had weakened somewhat.” While the U.S. jobs market continues to steadily add jobs, the manufacturing sector and some interest rate sensitive sectors of the economy, like housing and autos, have slowed. The Federal Reserve is essentially stepping to the sideline until the economic outlook becomes clearer.
- During the fourth quarter when the Federal Reserve appeared to be ignoring the signals from the financial markets that it was likely tightening policy too quickly and too aggressively, we asked the question, “Where is Janet Yellen when we need her?” Well, it is clear after Wednesday’s FOMC meeting that Janet Yellen’s wise counsel and cautious approach to guiding monetary policy is alive and well at the Federal Reserve.
- Taking a page from Janet Yellen’s playbook, Jerome Powell said the length of the “patient period is a function of the data.” Finally, the Federal Reserve is on hold, for how long will be a function of the inflation readings and the economic data as they offer insights into the inflation outlook. The markets expect the central bank to be on hold indefinitely, with only a roughly 2% probability of a rate hike by year end and a 25% to 36% probability of a rate cut by the end of 2019/early 2020. As always, stay tuned!
D. Stock Prices Are Expected to Rise Further.
- We stated in last month’s ISS that following the almost -20% drop in stock prices to December 24 that Corporate America had gone on sale. As investors’ concerns over the economy falling into a misguided, policy-induced recession this year subsided, investors took advantage of the drop in stock prices to add to their stock holdings. The combination of strong earnings growth during 2018 and the moderate drop in stock prices led to much improved common stock valuations. The price-to-trailing operating earnings ratio on the S&P 500 fell to 16.7x at the end of 2018 compared to 22.5x at the start of the year, a -26% decline.
- We viewed the lower stock valuations, as reflected in the decline in the P/E ratio, as a solid positive for the outlook for the stock market. The major uncertainty, in our view was the possibility of the Federal Reserve making a policy mistake and pushing the economy into an unnecessary recession as there were no signs of mounting inflationary pressures. There were actually some disinflationary signs late last year as commodity prices declined -25% from October 5 to the end of the year.
- Despite the substantial gain in stock prices during January, the price-to-trailing operating earnings ratio is only slightly higher at 17.2x compared to the 16.7x at year end as we are now using preliminary 4Q 2018 earnings as the fourth quarter earnings releases are made available. Despite the analysts at Standard & Poor’s still looking for about an 8% gain in operating earnings for 2019, several strategists are looking for flat earnings this year. While the outlook for earnings has become more murky for 2019 due to the slowdown in growth, better valuations, lower Treasury yields, and a less aggressive Federal Reserve should be enough to support still higher stock prices even if earnings do not grow in 2019.
- However, our view is that operating earnings will grow at a mid-single digit pace this year because we expect the economic expansion to continue, albeit at a pace closer to 2% rather than the roughly 3% pace of 2018. There are no signs of recession on the horizon now that the Federal Reserve has signaled that it will be patient, flexible, and data dependent with respect to further rate hikes. The current slowdown in the economy is viewed as a late, or possibly mid-cycle, pause which could add several years onto this economic expansion.
- While not sure of the timing, it seems very likely the U.S. and China 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 ISS, we offered three overriding principles to keep in mind when thinking about 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.
- Additionally for China, the U.S. imports more than four times the amount of products from China than China imports from the U.S. It is likely that U.S. negotiators are reminding their Chinese counterparts that China grew at its slowest pace in nearly three decades during 2018. The need for growth in China is key to the current administration remaining in power, as roughly 11 million Chinese migrate from a rural to urban environment annually. Significantly slower growth will hurt standards of living and could plant the seeds for another revolution.
- So, we do not look for a policy mistake from the Federal Reserve following its sweeping policy reversal this week, the economic expansion and earnings still have a runway to grow, and a trade deal with China is more likely than negotiations falling apart. Taken with better valuations, low inflation, and Treasury yields which are roughly 50 to 60 basis points below their peak levels in 2018, we expect the major market measures to retake their previous highs reached in late September/early October of last year.
- This is not to imply that the markets will face only clear sailing over the next few months. Ahead of us are incremental updates on trade negotiations with China, a resolution to the Brexit situation in the United Kingdom, the threat of another partial shutdown of the federal government, the recent sharp decline in consumer sentiment measures, and the threat that the House of Representatives could vote for charges of misconduct in order to impeach President Trump. We look for higher stock prices, but the path will likely remain choppy.
II. Treasury Market
A. Treasury Yields Largely Unchanged During January.
- Treasury yields ended January between 2 basis points higher and -7 basis points lower across the yield curve compared to the end of 2018. The yield on the two-year Treasury note fell 11 basis points to 2.38% over the first two days of the month as the recession fears which developed during 4Q 2018 lingered. Jerome Powell reset the market’s expectations for monetary policy on January 4 and the yield on the two-year Treasury note rose to 2.61% over the next two weeks, before ending January at 2.46%, three basis points below where it opened the month.
- Similarly, the yield on the ten-year Treasury note fell 13 basis points to 2.55% over the first two days of January on lingering recession fears, only to rise to 2.78% as those concerns subsided. The ten-year Treasury yield ended January at 2.63%, slightly below the 2.68% at the end of December. Additionally the yield spread between two-year and ten-year Treasury notes was largely unchanged at 17 basis points at month end versus 19 basis points at year end. We believe this is consistent with the Treasury market indicating that the federal funds rate is at, or very close to neutral, that level of short-term interest rates at which monetary policy is thought to be neither stimulating nor restraining the economy’s growth rate.
- Notice in the table below that since the peak ten-year Treasury yield on October 8, the Treasury TIP yield is now lower by 29 basis points, reflecting the current slowing in the economy’s growth rate. The implied inflation expectation over the next ten years has fallen from 2.17% to 1.86%.
- While the 1.86% is a touch above the 1.71% at year end, it is still below 2% and taken with the December reading, they are still the lowest implied inflation readings since the summer of 2016. We look at the slightly higher implied inflation outlook at the end of January as consistent with the sweeping policy reversal the Federal Reserve unveiled this week, markedly lowering the risk of the central bank making a policy mistake and forcing the U.S. economy into recession.
- We still expect Treasury yields to be a little changed in 2019, with the yield curve steepening a bit. This is based on our expectation that the Federal Reserve is not likely to hike rates this year, the economic expansion will continue through 2019 and into 2020, and a tight labor market will support modest upward pressure on wages which will keep core inflation closer to 1.5% to 2% versus 1% to 1.5%.
- There is no change to the primary factors which will exert upward pressure on ten-year Treasury yields this year. First is the more aggressive pace at which the Federal Reserve is shrinking the size of its securities portfolio since October, although the central bank signaled this week that the runoff of the securities portfolio could end much sooner than previously expected.
- The greater issuance of Treasury securities to fund the growing federal budget deficit will continue to exert upward pressure on Treasury yields, although that growing supply has been easily absorbed over the past four months. An easing of trade tensions with China would improve the growth outlook and would be supportive of higher, rather than lower, Treasury yields. Taking all these issues into consideration, we continue to look for a near term trading range for the ten-year Treasury note of 2.55 % to 2.85%.
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.
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.