CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
January 2, 2019
I. Equity Markets
A. Rough December Turns Stocks Negative on the Year.
- Growing concerns over a significant slowdown in the economy’s growth rate in 2019, possibly even turning into a recession, drove stock prices lower during October. Those fears remained in place and became even more pronounced during December. As discussed in the last two ISS’s, we blamed growing concerns that the Federal Reserve could make a policy mistake in its current pursuit of raising interest rates, which is intended to provide the central bank with the ammunition to address the next recession by having more than less capacity to lower interest rates.
- 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 thought to be 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 a temporary low on October 29.
- The selloff moderated during November, but accelerated during December, partly spurred on by Mr. Powell’s comments in the press conference after the December 18-19 FOMC meeting which appeared to be out of touch with recent turbulence in the financial markets and growing signs of a slowdown in the global economy -- including the U.S. economy.
- We have held the position that 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 would listen 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 narrowing yield spread between two-year and ten-year Treasury securities.
- On that score, the Federal Reserve did not turn in a stellar performance last month, which led investors to pull back further on risk assets and stampede into Treasury securities in a significant flight into safe haven assets. Following the Federal Reserve’s announcement of the rate hike at 2pm on December 19, the S&P 500 fell by -8.2% and the DJIA by -8.1% to the early close on Christmas Eve.
- Adding on to the disappointment over the messaging from the Federal Reserve, the Trump administration allowed a partial shutdown of the federal government to take place at midnight on December 21 in a fight with Democrats over funding for a southern border wall to prevent illegal immigration into the U.S.
- President Trump also drastically altered U.S. policy by ordering the drawdown of all troops from Syria and as many as half of the 14,000 troops now in Afghanistan, leading to Defense Secretary James Mattis resigning. Also contributing to the selling pressure was extensive tax loss selling resulting from the widespread decline in stock prices, fund managers facing redemption requests, and forced liquidations by investors facing margin calls.
- Adding on to these concerns was new evidence that global economic growth was slowing and facing mounting headwinds in China and Europe. In China, new data showed that the country’s economic slowdown was deepening, hitting both the industrial and consumer sectors, raising the challenge for Beijing to stabilize the economy while fending off the trade conflict with Washington.
- However, with the 90 day tariff truce President Trump and President Xi reached in early December and reports that China is preparing to introduce an industrial policy which is friendlier to foreign businesses in coming weeks, hopes are rising for a comprehensive trade deal with China. The political fallout for both presidents could be significant if no deal is reached.
- In Europe, Italy is hovering on the brink of recession, Germany is struggling to rebound from a third quarter contraction in growth, and anti-government protests in France have stalled the already only modest forward momentum in the economy. In the United Kingdom, growth has slowed to a year-on-year average of 1.4% for 2018 and could slump into a widespread recession if the United Kingdom does not have an orderly departure from the European Union at the end of March. Growth has also slowed in Japan, contracting at a -2.5% annual rate in the third quarter.
- Weighed down by these issues, but primarily by the growing uncertainties about the outlook for growth this year and into 2020, common stocks had a miserable fourth quarter and delivered negative returns on the year for the first time since 2015. Reminiscent of 2015, volatility returned to the stock market with a vengeance last year as uncertainty about the economic outlook reached a level not seen for a couple of years.
- Since October 3, when Jerome Powell stated the central bank was “a long way” from getting interest rates to neutral and the S&P 500 came within a whisker of its all-time high recorded on September 20, the major market measures declined -13% to -19.3% to the end of 2018. The real damage to stock prices took place during December, although the losses were trimmed by a nice rebound to year end from a dramatically oversold position on Christmas Eve when investor sentiment was woefully negative. For the full month of December the various stock market measures were lower by -8.7% to -12%. For all of 2018, the major market measures were lower by -3.9% to -12.2%.
B. Federal Reserve Hikes Rates, Markets Fear Policy Mistake.
- The Federal Reserve raised the target range for the federal funds rate at the December 18-19 FOMC meeting to 2.25% to 2.5%, the ninth such increase since December 2015. The increase was expected, but the tone of the policy statement and Chairman Powell’s comments during the press conference were not as dovish as the markets were anticipating given the recent, marked rise in market volatility, growing signs of a global economic slowdown, and deflationary influences arising from a significant pullback in commodity prices over the past couple months.
- The Committee lowered its median rate forecast contained in the “dot plot” to two rate hikes from three in 2019 and also lowered the growth forecast for 2019 to 2.3%, down slightly from 2.5%. The Federal Reserve also marked down its forecast for core PCE inflation by 0.1%, looking for core inflation to reach 2% in 2019-2020. Mr. Powell also stated that he saw no change in the pace of the central bank shrinking the size of its balance sheet, referring to the runoff over the past 15 months as smooth and having served its purpose.
- While the minor adjustments made to the policy statement and to the forecasts would technically have to be referred to as slightly more dovish, the reaction of the markets, particularly to Chairman Powell’s comments during the press conference, strongly imply the proposed policy moves were not nearly as dovish as investors expected. The DJIA was higher by over 300 points prior to the release of the policy statement and finished lower by -352 points on the day after the press conference.
- The selling pressure accelerated during the press conference when Mr. Powell said that slowing the pace of the balance sheet reduction was not an option under consideration at this point, a more automatic pilot/inflexible position on the runoff than investors wanted to hear. The yields on Treasury securities fell over the course of Mr. Powell’s press conference and the yield spread on two-year to ten-year Treasury securities declined to only 11 basis points, the narrowest level is over 11 years.
- We were looking for a “dovish” rate hike at the December FOMC meeting where the policy statement and/or Jerome Powell’s comments at the press conference alluded to the possibility of the central bank pausing in its rate hikes in 2019 if inflation remained under control and the economy’s growth rate slowed from the roughly 3% pace of 2018. However, the policy statement retained a reference that the Federal Reserve saw “some” further gradual rate hikes, only slightly changing the forward guidance by adding the word “some,” rather than eliminating forward rate guidance from the policy statement altogether as the markets expected.
C. Where Is the Disconnect between the Markets and the Federal Reserve?
- Mr. Powell tried to emphasize that the Federal Reserve was not on a preset course to raise interest rates and stressed how little information is found in the “dot plot” for rate hikes, emphasizing the “dot plot” is not a Committee forecast or preset course of future rate movements on the part of the central bank. It is clear the markets did not want a continuation of forward rate guidance -- some further gradual rate hikes -- from the Federal Reserve and wanted a policy statement, “dot plots,” and/or Mr. Powell’s comments to be more in synch with the market’s forecast which is not pricing in even one additional rate hike in 2019, let alone two.
- Chairman Powell emphasized that after getting the federal funds rate to 2.25% to 2.5%, the Federal Reserve will let the economic data speak to the FOMC Committee and form the basis for the outlook for monetary policy. However, with the Federal Reserve looking for a fairly sizeable slowdown in the economy from 3% in 2018 to 2.3% in 2019 and noting that inflation ended 2018 a bit more subdued than expected, but positioning policy for two additional rate hikes this year, this set up does not seem to line up with the Federal Reserve being data dependent. In fact, the markets are looking at the central bank as being somewhat blind to the data.
- It appears the Federal Reserve is not paying enough attention to the messages from the markets. We have pointed out the narrowing yield spread between two-year and ten-year Treasury securities as a signal from the Treasury market that the Federal Reserve has reached the level of the federal funds rate where monetary policy has shifted to the side of beginning to restrain the economy’s forward momentum as the yield spread has fallen from 125 basis points to the end of 2016 to only 19 basis points currently.
- While the concept of a neutral rate -- that rate level at which monetary policy is neither stimulating nor restraining the economy’s growth rate -- is an interesting concept, it cannot be observed directly in real time. Investors and policymakers can only guess at the neutral rate at any point in time. It can only be inferred after the fact in terms of how the economy subsequently performed in response to the level of interest rates the Federal Reserve put in place. The yield spread does a good job of monitoring the Treasury market’s assessment of how tight or easy monetary policy currently is, and it is currently signaling that monetary policy has turned restrictive.
- Also notice from the table on the previous page that the yield on the two-year Treasury note has fallen over the course of the fourth quarter. The two-year Treasury note yield is the longest dated Treasury instrument which is directly related to the current and expected level of the federal funds rate. The two-year Treasury yield actually peaked on November 8 at 2.97%, consistent with the federal funds rate rising close to 3% by 2020. Currently, the two-year Treasury yield is 2.49%, lower by 48 basis points and more consistent with the Federal Reserve pausing this year rather than putting through even one additional rate hike.
- It appears the Federal Reserve is also dismissing the market’s insights on inflation expectations. First, the GS Commodity Index has declined -25% since October 5. Falling commodity prices are reflective of a deflationary environment, and yet the Federal Reserve raised rates last month and is proposing two additional rake hikes in 2019. Additionally, notice in the table below that since the peak ten-year Treasury yield on October 8, the Treasury TIP yield has declined -9 basis points reflecting the coming slowdown in the economy, but the implied inflation expectation over the next ten years has fallen from 2.17% to 1.71%, the lowest inflation reading since the summer of 2016.
- Lastly, as alluded to previously in this ISS, the futures market has priced in only a 12% chance of a rate hike by late 2019, compared to the two hikes this year discussed by Mr. Powell. The Federal Reserve has never hiked rates when the probability of a rate hike at the next meeting was below 70%. So there is a complete disconnect between forward rate guidance from the Federal Reserve and what the market expects.
- The market has also begun to price in a 15% to 30% probability of a rate cut later this year and into early 2020. Yes, that is correct, the market currently is pricing in a greater probability of a rate cut than a rate hike this year. It seems the market fears the higher level of rates, intended to pull the economy out of the next recession when they are subsequently lowered, could be pushing the economy into an unnecessary recession as there are no signs of inflationary pressures building.
- 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 are inclined to follow the message from the markets that disinflation is currently more of an issue for the economy than an unwanted build in inflationary pressures. 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, business hesitation due to the trade war with China hurts business capital spending, and the higher cost of credit takes a further bite out of households’ purchasing power. We look for the Federal Reserve to pause in 2019 as the risk of additional rate hikes on the economic expansion grows. As always, stay tuned!
D. Corporate America Is on Sale!
- The growing fears of a significant and largely unexpected slowdown in economic growth, with even the possibility of a recession being discussed, has put Corporate America on sale. Eight of the eleven sectors of the S&P 500 are in correction territory -- down more than -10% from recent highs -- and 296 of the S&P 500 companies are in bear market territory -- down more than -20% from their recent highs.
- This is somewhat extraordinary considering that the economy is expected to grow around 2% this year, admittedly below the roughly 3% of 2018, but pretty much in line with economy’s current growth potential. Additionally, operating earnings are on track to grow over 26% for 2018 and are expected to grow in the mid to high single digits for 2019, which should be in line with or slightly 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 this year, we feel the key is that earnings are expected to grow this year.
- With the combination of strong earnings growth and moderate losses in stock prices in 2018, common stock valuations are much improved. Consider that since the night of the presidential election the S&P 500 is higher by 17.2%. 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 16.7x currently, compared to 21.1x on the night of the election and 22.5x at year end 2017.
- As such, the market’s trailing P/E ratio fell almost -26% during 2018. We view the lower common stock valuations, as reflected in the decline in the P/E ratio, as a solid positive for the outlook for the stock market. Lower stock prices and more attractive valuations on high quality stocks reflect lower risk investment opportunities for investors, not higher risk investment situations to shy away from.
- Unless the Federal Reserve makes a policy mistake, there is no recession in sight in the U.S., despite the slowdown in growth overseas. We expect that Jerome Powell and the other officials at the Federal Reserve will be forced to listen to the message from the markets. It looks to us that the stock market is setting up for a solid 2019, with the market recapturing most, if not all, of the price declines of 2018.The catalyst will be some clarity that the Federal Reserve will not make a policy mistake. The markets will remain choppy and volatile until then.
E. A Final Thought, Hang in There!
- Investors need to keep in mind that investing in common stocks is a long term proposition and that the excess return over cash equivalents and intermediate bonds earned by investing in common stocks over time is not free. The excess return is earned by withstanding the inherent volatility associated with owning common stocks in the short run. Of course, no one is concerned about volatility when stock prices are rising, it is only the volatility that accompanies falling stock prices which gives investors angst.
- Volatility has been amplified by momentum-influenced trading done by computers which has created an unprecedented herd effect that moves in unison and blazingly fast, bringing about sharp and exaggerated price swings. While unsettling, it is just part of the market dynamics investors are forced to deal with these days. This is a time for investors to stay the course and stay with and/or add to the wealth-building assets which create household wealth over time. It is not a time to turn your back on a well thought out investment program, stick with the high quality, dividend paying companies which we recommend as the right path to consistently build wealth over time.
II. Treasury Market
A. Treasury Yields Continue to Drop.
- After reaching a recent peak of 3.23% on October 8, the yield on the ten-year Treasury note declined to 3.14% to the end of October, to 2.99% at the end of November, and to an eleven month low of 2.68% on December 31. A powerful confluence of events caused Treasury yields to fall in a significant manner since October 8. After getting to this point in the ISS, we can all recite them.
- Consider slowing growth overseas, concerns that the Federal Reserve was tightening monetary policy too aggressively, uncertainty over the trade war with China, a sharp slump in commodity prices since early October, and the sharp and sudden slump in stock prices since early October which set off a massive flight into Treasury securities. The only factors exerting upward pressure on Treasury yields were mounting supply -- from the growing federal budget deficit and the continued runoff of securities from the Federal Reserve’s investment portfolio. That growing supply was easily absorbed over the past three months.
- Since the recent high yield on the ten-year Treasury note on October 8, yields on Treasury securities two years and longer have declined by -38 to -58 basis points. As pointed out earlier in this ISS, a sharp decline in implied inflation expectations in the ten-year Treasury note -- from 2.17% on October 8 to 1.71% on December 31 -- has been the key driver pushing Treasury yields lower. This marks the inflation expectation falling below 2% on the ten-year Treasury note for the first time since the end of 2017.
- We 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 will not hike rates this year, the economic expansion will continue through 2019 and into 2020, and a tight labor market will keep modest upward pressure on wages which will keep core inflation closer to 1.5% to 2% versus 1% to 1.5%. Should the central bank follow through on two additional rate hikes this year, however, look for the yield curve to invert with shorter-term yields rising and longer-term yields falling sharply. This is not our forecast of the most likely outcome.
- There is no change to the primary factors which will exert upward pressure on ten-year Treasury yields this year, the more aggressive pace at which the Federal Reserve is shrinking the size of its securities portfolio since October and the greater issuance of Treasury securities to fund the growing federal budget deficit. 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 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.