CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
July 1, 2019
I. Equity Markets
A. Stocks Rebound From May Sell Off, Federal Reserve Signals Rate Cut(s).
- Well, what a difference a month can make! After slumping during May as the ongoing trade war with China was escalated by President Trump, stock prices rebounded sharply during June as investor sentiment was buoyed by signs that the Federal Reserve could soon cut interest rates and some renewed hope for a resolution of the trade war with China. Investors were also encouraged by President Trump suspending plans to impose tariffs on Mexican goods after Mexico agreed last month to take “strong measures” to strengthen immigration enforcement.
- Early in the month, several Federal Reserve officials said they were closely monitoring the recent escalation in trade tensions and indicated they could respond if needed to keep the economy growing steadily. Jerome Powell signaled the Federal Reserve was open to easing monetary policy to boost the economy amid not knowing “how or when” global trade issues will be resolved and that the central bank will “act as appropriate to sustain the economy.” Vice Chairman Richard Clarida said the Federal Reserve “will put in place policies to keep the economy”…“in a very good place” and St. Louis Federal Reserve Bank President James Bullard said that a lowering of rates “may be warranted soon.”
- At the June 18-19 FOMC meeting, the Federal Reserve slightly downgraded its outlook for the economy, tweaked the language in the policy statement to signal lower rates ahead rather than policy being on hold, and lowered its rate forecast through 2020. Jerome Powell also cited research that supports the Federal Reserve moving sooner than later and more aggressively with rates at historically low levels.
- The market also received a boost mid-month as President Trump said he and Chinese President Xi “will be having an extended meeting next week at the Group of 20 meeting in Japan.” Mr. Trump added that he and President Xi “had a very good telephone conversation” and that “our respective teams will begin talks prior to our meeting.” The meeting with Mr. Xi was not expected to yield a trade agreement on its own, but was expected to clear the path for new high level negotiations, along with a delay in the U.S. imposing tariffs on an additional $300 billion of goods imported from China.
- Such an outcome had a precedent. President Trump agreed to delay raising tariffs on $200 billion of Chinese goods from the then current 10% rate to 25% on January 1 following a dinner meeting with President Xi following last year’s Group of 20 summit in Buenos Aires. Mr. Trump subsequently raised those levies to 25% on May 10 after Beijing reneged on earlier commitments to detail the laws it would change to implement the proposed trade deal, escalating the trade war with China. While it is clear there are substantive issues to be worked through in the trade negotiations with China, re-engagement is a positive step.
- With investors looking for the Federal Reserve to lower interest rates and renewed hopes for a successful resolution of the trade war with China, the major market measures were significantly higher across the board last month, posting gains of 6.9% to 7.4%. Since the dramatically oversold conditions on Christmas Eve, the various stock market measures have powered ahead by 22.1% to 29.3%, with the NASDAQ Composite leading the way. For the first six months of 2019, the major market indices are higher by 14% to 20.7%, with the NASDAQ Composite again at the head of the pack.
B. Trade Deal with China Would Be Beneficial, but It Is Not Essential or Necessary.
- While no one knows how the trade negotiations will play out as both sides have hardened their positions over the past couple months, here are a few thoughts to keep in mind as volatility has picked up in the financial markets. First, the domestic economy is on relatively solid footing following the tax cuts enacted in late 2017 and the steps taken to lower regulatory burdens. Assuming the heightened trade tensions last for all of 2019, real GDP and consumer spending should grow in the range of 1.5% to 2%, rather than 2% to 2.5%. Business capital spending could be unchanged versus growing about 4%, while housing outlays could turn positive on the back of the decline in mortgage rates compared to being flat on the year.
- The first round of 10% tariffs on $200 billion of Chinese imports and the threat of additional tariffs could not bring the U.S. and China to a trade deal, and now we will see if the pain of higher tariffs brings the Chinese back to the negotiating table in a constructive manner. With President Trump and President Xi agreeing over the weekend to restart negotiations to settle the trade differences between the U.S. and China, hopes have risen again that a fair and reciprocal trade agreement can be reached, however, the meeting did not provide any concrete timetable for resolving the trade conflict.
- Negotiations with China will likely to take a while and volatility will stay elevated. We do not look for stock prices to approach their December 24 lows, however, because in December the Federal Reserve was still looking at “some” further gradual rate hikes and slowing the pace of the runoff of its securities portfolio was not an option under consideration. Following the strong signals from the Federal Reserve last month that a lower level of rates is on the horizon, monetary policy will only be supportive of the economic expansion and the financial markets.
- Our baseline expectation remains that the U.S. and China will still strike a trade deal later this year, but we must acknowledge it may not occur and do not feel it is essential or necessary to keep the U.S. economy and the stock market moving forward. Recession concerns remain overblown, the economic fundamentals are solid, despite a slowing of the economy’s growth rate. We continue to assert that $100 to $150 billion of tariffs -- in a worst case scenario -- spread over a $20 trillion economy will not be significant. Somewhat slower growth? Yes. A hit to earnings for certain companies? Yes. But a large enough impact to send the U.S. economy into recession? No.
- S&P 500 operating earnings rose 4% in the first quarter from a year earlier. While a modest gain, earnings beat expectations as they did not decline, as was widely expected as 2018 drew to a close. We also feel it is important to keep the following perspective in mind. Despite the strong advance in stock prices since the December 24 lows, the S&P 500 is only higher by 10% since year end 2017, even though operating earnings on the S&P 500 have grown about 24%. As such, the price-to-trailing operating earnings ratio on the S&P 500 currently stands at roughly 19.1x compared to 22.5x at year end 2017, a -15% decline.
- With the economic expansion capable of extending for several more years if the Federal Reserve avoids making a policy mistake, the bull market in common stocks could last a lot longer than most investors expect. There are hundreds of companies that are thriving in the current moderate growth, rising productivity, low cost of capital, low bond yields, and low inflation environment. The result is likely to be further gains in earnings coupled with significant returns of capital to investors in the form of dividend payments and share repurchases.
II. Monetary Policy
A. Federal Reserve Lays the Groundwork for Lower Interest Rates.
- The Federal Reserve left interest rates unchanged at the June 18-19 FOMC meeting, but strongly suggested it would lower the federal funds rate in the months ahead. The policy statement dropped the word “patient” in describing the Federal Reserve’s policy stance, which had implied that any rate changes were on hold. Instead, the FOMC said “uncertainties” about the economic outlook have increased, a phrase which has been used previously when rate cuts were on the horizon.
- The policy statement went on to say that inflation is “muted” and that the Committee will “closely monitor” incoming information and “act as appropriate to sustain the expansion.” During the press conference, Federal Reserve Chairman Jerome Powell stated, “The case for somewhat more accommodative policy has strengthened.” The language in the policy statement and Mr. Powell’s comment are fairly clear signals that the Federal Reserve could cut interest rates as soon as the next FOMC meeting on July 30-31.
- Since the last FOMC meeting on April 30-May 1, President Trump escalated trade tensions between the U.S. and China and threatened to impose tariffs on all Mexican goods entering the U.S. if the Mexican government failed to take aggressive measures to stem the flow of immigrants through Mexico and into the U.S. While President Trump later announced that tariffs would not be slapped on Mexican goods after Mexico agreed to take “strong measures” to strengthen immigration enforcement, such threats do take a toll on business sentiment and investment.
- Mr. Powell also acknowledged that weaker global growth had raised the risks of a sharper slowdown for the U.S. economy than the Federal Reserve had anticipated earlier this year. Interest rate projections released after the meeting show the forecasts of the individual Committee members had seven members looking for two rate cuts this year, one for one rate cut, eight for no change in interest rates, and only one for a rate increase. Even though not all Committee members were predicting rate cuts this year, Mr. Powell said “our deliberations made clear that a number of those [officials] agree that the case for additional accommodation has strengthened.”
- A close reading of the policy statement points to the Committee members viewing the economy as fundamentally sound, but persistently low inflation and an increase in uncertainty makes it prudent for a higher level of risk management to be put in place. If the Federal Reserve cuts rates and the economy continues to grow, possibly at even a slightly faster pace, it can live with that outcome. If, however, the central bank does not cut rates and the economy slows further and inflation takes another leg lower, the Committee members would likely regret not taking action.
- If the Federal Reserve were to lower interest rates at upcoming FOMC meetings, it would be the first rate cut since December 2008 when the central bank lowered rates to near zero in the midst of the financial crisis and the Great Recession. The Federal Reserve has embarked upon a rate cutting cycle four times in the past 25 years. In 2001 and 2007, a recession began within three months of the first rate cut. In 1995 and 1998, the central bank lowered rates in time to prevent an economic slowdown from developing into an outright recessionary period.
B. What Is a Reasonable Outlook for Monetary Policy?
- It seems to us that the appropriate lense to use in assessing the outlook for monetary policy is to turn back to the 2014-2015 period when the Federal Reserve shifted away from its bond buying programs and near zero interest rate policy. The central bank ended its third and final bond buying program in October 2014 and raised interest rates for the first time in the recently concluded rate hiking cycle in December 2015. The Federal Reserve began the reduction of its securities portfolio in October 2017, but is scheduled to end the runoff of its securities portfolio at the end of September.
- As the Federal Reserve raised rates nine times over three years to December 2018, we referred to it several times as the central bank searching for the neutral level of interest rates, that level at which monetary policy is neither stimulating nor restraining the economy’s growth rate. The difficulty with trying to place the federal funds rate precisely at neutral is that it cannot be observed directly in real time. Investors and policymakers can only guess at the neutral rate at any point in time. The neutral rate 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.
- In the January 2019 ISS, we took the position that the Federal Reserve was not paying enough attention to the messages from the markets. The narrowing yield spread between two-year and ten-year Treasury securities was a pretty clear 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 as the yield spread had fallen from 125 basis points at the end of 2016 to only 19 basis points at year end 2018.
- In addition, the GS Commodity Index had fallen -25% since October 5, the implied inflation expectation in the ten-year Treasury had fallen from 2.17% on October 8 to 1.71% at year end, and the S&P 500 fell nearly -20% to its low on December 24. Now add in the recent slowing in global growth, the rise of tariff policy by the Trump Administration and the disruptive impact it has on a broad swath of commercial arrangements, and the tone and tenor of the recent FOMC meeting and it is pretty clear a rate cut, or a series of rate cuts, is on the way.
- Given the current dynamics of the economy, it seems the Federal Reserve is preparing to make an adjustment to the level of the federal funds rate, it is not about to embark on aprolonged easing cycle. We look at the next policy move by the Federal Reserve as a continuation of its efforts to prolong the economic expansion, which is certainly appropriate as there are no overt signs of building inflationary pressures in the economy.
- The central bank has tried to bring the economic expansion in on a soft landing by first raising interest rates nine times between December 2015 and December 2018 and now it will modestly lower rates to try and get to that neutral level. In our view, the financial markets have tried to guide Jerome Powell and his compatriots over the past 18 months or so to a level of interest rates which would not place the economic expansion at risk nor lead to an unwanted build in inflationary pressures, even if the policymakers at the central bank were not paying very close attention at times.
- Jerome Powell stated in the press conference that the Federal Reserve was prepared to act aggressively to any economic weakness, drawing from research that says when rates are historically low, as they currently are, the central bank should move faster and more aggressively and not let a downturn gather steam because it has less room to lower rates. The current target range for the federal funds rate is 2.25% to 2.5%. Contrast that with the 5.25% level of the federal funds rate prior to the 2008-09 Great Recession or the 6.5% federal funds rate before the 2001 recession began.
- The current low level of rates is one of the reasons the central bank is looking to lower rates. During each of the recessions since WWII, the Federal Reserve has cut rates by an average of five percentage points. Currently it could only get about halfway there before hitting zero and having to relaunch bond buying programs and other unconventional policies like it did following the financial crisis. It is reasonable to expect that the Federal Reserve is consequently more prepared to head off even the slightest risk of recession, particularly with persistently low inflation, than in the past.
- As such, it is not out of the question that the Federal Reserve could cut rates as soon as the July 30-31 FOMC meeting and that the federal funds rate could be lowered by 50 basis points. The sooner the central bank acts and the larger the rate cut, the more likely it is that the Federal Reserve could be one and done with its ongoing search for the neutral level of the federal funds rate. The central bank will need to balance the risks of easing too soon and somewhat aggressively with the potential costs of waiting too long and not going big. The agreement over the weekend by the U.S. and China to declare a truce in the trade war does lower the odds of the Federal Reserve going big, however.
- It appears the economy remains on solid footing following the tax cuts enacted in late 2017, the much higher levels of consumer and business confidence since Donald Trump was elected president, and the steps taken to lower regulatory burdens. However, the escalation of the trade war with China has taken a toll on the economy’s growth rate and the threats of more tariffs hurt business confidence and capital spending plans. So, the neutral level of interest rates has likely fallen somewhat, but we doubt it has dropped precipitously. A 50 basis point cut, in one or two moves, could be the extent of the adjustment the Federal Reserve needs to make. As always, stay tuned!
III. Treasury Yields
A. Fears Lead to Hope and Possibly a Bottom in Yields.
- While the surge in stock prices over the first six months of the year has garnered the most attention among investors, the S&P 500 and the DJIA are only a touch higher than their previous highs reached during August-September of last year, while the NASDAQ Composite is a touch below its late April high, and the Russell 2000 is almost -13% below its peak reached in August. The truly remarkable move in the financial markets since October is the massive decline in Treasury yields.
- The decline in Treasury yields has taken place in three distinct moves. First, yields fell from their October peaks to year end 2018 as investors feared that the Federal Reserve was on track to make a policy mistake and push the U.S. economy into recession despite the fact that inflation remained low and deflationary influences were evident in the significant drop in commodity prices during 4Q 2019. The yield on the two-year Treasury note fell from its October 22 peak of 2.91% to 2.49% at year end, while the yield on the ten-year Treasury note fell from its October 5 peak of 3.23% to 2.68% on December 31.
- Over the first three months of 2019, the combination of growing signs of a global slowdown, modest inflationary pressures, and heightened investor anxiety that economic headwinds from China, Japan, and the euro zone could drag the U.S. economy into recession pushed the yield on the two-year Treasury note to 2.26% and the yield on the ten-year Treasury to 2.41%. This marked six months of falling Treasury yields resulting from growing fears of slower growth possibly turning into a recession.
- Treasury yields resumed their decline during the months of May and June as President Trump escalated the trade war with China which raised investors’ concerns of another headwind facing the U.S. economy. However, a series of strong signals from Federal Reserve officials, including a fairly dovish posturing at the June 18-19 FOMC meeting, strongly suggested that lower interest rates were on the horizon. The two-year Treasury yield fell further to 1.76% , while the yield on the ten-year Treasury briefly fell below 2%, only to end the month at 2.01%.
- Let’s not forget two other strong forces which have helped to push Treasury yields to levels not seen since before Mr. Trump was elected. First, a strong flight-to-safety into Treasury securities has been in play as investors have not had to deal with higher tariffs as a widely used policy tool since the 1930’s. Lower yields overseas have also brought foreign buyers to the Treasury market as roughly $11 trillion of sovereign debt globally carries negative yields, highlighted by the -16 basis points and -32 basis points yield on ten-year Japanese securities and ten-year German bunds, respectively.
- Notice in the table below that since the recent peak in longer dated yields on October 5, implied inflation expectations declined by -46 basis points, falling from 2.17% to 1.71% as expectations for slower growth, including recession fears, have significantly impacted the inflation outlook, pushing it a fair amount below the Federal Reserve’s 2% inflation target.
- An equally interesting insight from the table is the decline in the Treasury TIP yield -- a widely followed indicator of real growth expectations -- from 1.06% on October 5 to only 0.3% at the end of June, a -76 basis point decline. While expectations for both growth and inflation have receded over the past nine months, the greater decline has occurred in the growth outlook following the four rate hikes by the Federal Reserve last year and the escalation in the trade war with China during May.
- In the last three ISS’s, we stated that TIP yields ranging from 0.55% to 0.39% over the March to May period supported our view that the recession fears at the end of 2018, which lingered to various degrees over the first three months of the year, were overblown. During the last major growth scare during the summer of 2016 following the Brexit vote in the United Kingdom, the ten-year Treasury TIP yield hit zero, without the economy falling subsequently into recession.
- Given the heightened concerns over the outlook for growth globally and in the U.S. following President Trump raising tariffs on imports from China during May, we remain encouraged by the only modest decline in the ten-year Treasury TIP yield to 0.3% last month from 0.55% at the end of April. We continue to believe the U.S. economy is on relatively solid footing and that the current recession fears are overblown.
B. Modest Yield Curve Inversion Is Not Forecasting a Recession.
- Much has been made during the past two months over one measure of the Treasury yield curve inverting again -- shorter maturity yields above longer maturity yields -- following a five day inversion during March. Specifically, the yield on the three-month Treasury bill ended June at 2.09%, compared to a yield of 2.01% on the ten-year Treasury note. An inversion of the Treasury yield curve is considered an important recession indicator. How the inversion occurs is very important, however.
- Traditionally, the yield curve inverts as the three-month Treasury bill yield rises sharply, and above the yield on longer dated Treasury securities, as the Federal Reserve hikes the federal funds rate to fight building inflationary pressures. Not so much over the past two months, as the yield on the three-month Treasury bill is only lower by -27 basis points from the end of 2018 -- the Federal Reserve last raised rates in December -- while investors have stampeded into longer dated Treasury securities, pushing the yield on the ten-year Treasury note down to 2.01% from 2.68% at year end 2018, a -67 basis point decline. Additionally, there are no signs of building inflationary pressures.
- The sharp decline in the yield on the ten-year Treasury note since year end, and since October 5, reflects the lowered outlook for both growth and inflation, but not an outlook for a recession, in our opinion. The importance of the yield curve inversion relative to the growth outlook 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 yield curve has maintained an inverted position only since May 23 and is inverted by only -8 basis points.
- Second, the inversion since May 23 is likely signaling that the Federal Reserve is going to cut interest rates, to which the futures market is currently assigning a 100% probability of a rate cut at the July 30-31 FOMC meeting and an 77% probability of another rate cut by the September 17-18 FOMC meeting. 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 modest three-month to ten-year Treasury inversion which has been in place since May 23 is not forecasting a recession. It is merely reflecting the concerns over the outlook for 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 May at 25 basis points. Additionally, the ten-year to thirty-year Treasury yield spread actually widened last month to 52 basis points compared to 44 basis points at the end of May.
- Following the rate hikes by the Federal Reserve last year and the higher tariffs put in place by the U.S. and China during May, the equilibrium level of Treasury yields has declined. If President Trump is not satisfied with the progress in the trade negotiations and places additional tariffs on Chinese goods, look for yields on shorter maturity Treasury securities to drop another 25 to 30 basis points as the Federal Reserve cuts rates up to 75 basis points, while the yield on the ten-yield Treasury will likely trade in a range of 1.75% to 2%. Should a resolution of the trade war occur in short order, we look for shorter maturity Treasury yields to be largely unchanged, while ten-year Treasury yields can approach 2.50%.
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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