CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
June 3, 2019
I. Equity Markets
A. Stocks Slump on Escalation of Trade War with China.
- The only thing that really mattered during the month of May was news on the escalating trade war with China. The financial markets basically traded headline to headline on the likelihood of a trade agreement with China. Stock prices were little changed, but choppy, early in the month as investors were discouraged by Federal Reserve Chairman Jay Powell’s characterization of recent soft inflation readings as “transitory,” but were encouraged by the release of a strong jobs report for April, keeping the S&P 500 and the DJIA within a whisker of their record highs recorded during late April at the close of trading on May 3.
- Stock prices turned lower over the rest of the month, however, as President Trump delivered a pair of Twitter messages on May 5, that outlined his plan to raise levies on $200 billion of Chinese imports to 25% from 10% on May 10. Mr. Trump also wrote that he would impose 25% tariffs “shortly” on $325 billion of Chinese goods that had not yet been taxed. The President’s tactics reflected frustration that Beijing had reneged on earlier commitments to detail the laws it would change to implement the trade deal, which the U.S. viewed as a necessary step to produce a preliminary trade agreement during talks scheduled for early May.
- China retaliated to President Trump’s tariff hikes by raising tariffs on roughly $60 billion worth of U.S. imports -- largely agricultural products -- to as high as 25% on June 1. Beijing said it was open to further trade talks, but would not swallow any “bitter fruit” that harmed its interests and would not yield on important issues of principle which impinged on Chinese sovereignty.
- The economic impact of higher tariffs depends upon who pays the tariff. The answer is not straightforward because, as with any tax, the entity paying the tariff doesn’t necessarily bear its burden. If the tariff is simply passed along to the importer, U.S. businesses or consumers bear the burden in terms of lower profits and/or higher prices.
- If Chinese exporters cut prices on their goods to avoid losing sales, they bear the burden. If importers source goods from another country, no one pays the tariff, but the Chinese are burdened by lost jobs and U.S. consumers by potentially higher prices. Should production and assembly shift to the U.S., a portion of what U.S. consumers pay in higher prices flows to U.S. workers as more jobs and wages.
- President Trump’s use of tariffs provides the U.S. with leverage to force China to consider significant changes in its unfair and predatory trade practices, which are necessary to protect U.S. interests. Ever since China was admitted into the World Trade Organization in December 2001, it has stolen U.S. intellectual property and technology as both Democratic and Republican administrations looked the other way, providing a huge subsidy for China’s rapid growth over the past two decades.
- The Trump administration is not just negotiating a trade deal which provides greater access to Chinese markets for U.S. businesses, it is negotiating a truce in a one-sided trade war which has greatly aided China’s development and growth at the expense of the U.S.
- While a successful conclusion to the current trade negotiations with China would yield great benefits to U.S. companies in the long run, investors are currently focusing on three potential near term outcomes: slower global growth, lower earnings for Corporate America, and lower earnings multiples arising from a rise in uncertainty. For the full month of May, stock prices suffered through their first monthly decline since December as investor sentiment cratered with the escalation of the trade war with China and the just announced 5% tariff on all imports from Mexico if steps are not taken to shore up border security.
- While the major market indices fell by -6.6% to -7.9% during May, they are still higher by a solid 6.4% to 12.3% over the first five months of the year, and are higher by a healthy 13.9% to 20.3% since the December 24 lows.
B. Trade Deal with China Not Essential or Necessary.
- We just mentioned China’s unfair and predatory trade practices, let’s expand on that a bit. The U.S. wants China to lower tariffs, protect intellectual property, end forced transfers of technology, ban currency manipulation, and open Chinese markets in a broader context to U.S. produced goods. The U.S. also objects to China’s state capitalism providing subsidies to Chinese companies focused on overtaking U.S. rivals in product segments ranging from basic materials to advanced technologies.
- Fundamentally, the U.S. and China have very different economic systems and the issues between an established power and an emerging power are very complex. What are the real intentions and threats to the U.S. from “China 2025” and Beijing’s “Belt and Road” initiative, and where will the territorial disputes in the South China Sea lead? Most U.S. businesses would be content with gains on access to Chinese markets, some discipline on subsidized production, better intellectual property protection, and more purchases of grains and meats from U.S. farmers. Will the Trump Administration be satisfied with a trade deal which is somewhat limited in scope? Time will tell.
- We have felt good about the outlook for the economy and earnings and the prospects for a trade agreement as it appeared to be in the economic and political self-interest of both the U.S. and China, not to mention both President Trump and President Xi, to reach an agreement. The current entrenched positions of the U.S. and China and an increase in the rhetoric regarding those positions raise the risk of a prolonged standoff, however. Our view was that with President Trump heading into an election in 2020, he would want a trade deal that would benefit the U.S. economy, not a trade war which could undermine growth and stock prices, so it was just a matter of time before an agreement was worked out.
- Another possibility, however, is that China believes it can minimize the impact of the higher U.S. tariffs on its economy through other stimulus efforts and holds out on an agreement until after the presidential election. A trade deal only helps Mr. Trump win re-election. If he were to lose, the odds are pretty good that the Democratic nominee will distance himself/herself from the Trump trade negotiations and will be easier to negotiate with. Is that a risk the Chinese will be willing to take in the hopes of maintaining their mercantilist trade practices? Again, time will tell.
- So, we feel it is important to assume the worst case scenario of the U.S. raising tariffs takes place and persists for some time. In that scenario, how will the economy and corporate earnings fare? While the tariff impact -- both U.S. tariffs on Chinese goods and China tariffs on U.S. exports -- is difficult to model, we do not think $100 to $150 billion of tariffs spread over a $20 trillion economy will 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.
- The trade war represents a political trade risk which the economy has not faced since the 1930’s, and no one knows where it might end. Tariffs are border taxes that do arbitrary damage, often on the innocent. The broader cost to the economy is a continuation of policy uncertainty, as businesses and investors have questions about supply chains, cost of goods and raw materials, and how long the tariffs will remain in place. The impact on the economy’s growth rate is difficult to measure, but it is real.
- The sudden deterioration of the trade talks will likely have long-lived implications, reversing the decades long integration of the U.S. and China economies. Supply chains and trade flows will increasingly reflect political priorities rather than considerations of cost, quality, and proximity to customers.
- Even if President Trump eventually lifts the tariffs, multinational companies will know they could be reimposed if trade tensions flare again. To limit their exposure to future trade disruptions, many companies will shift production and assembly of U.S.-bound goods to other SE Asia countries, such as South Korea, Taiwan, and Vietnam -- the real winners from the escalation in the trade war.
- While no one knows how the trade negotiations will play out as both sides have hardened their positions, here are a few thoughts to keep in mind as volatility has picked up in the financial markets. First, the domestic economy is on 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.
- Higher tariffs are like an increase in sales taxes and will result in a one-time hike in consumer, and some industrial, prices. While this will result in a short-term rise in inflation, the Federal Reserve will look through this jump in prices, understanding that the longer term impact of the higher tariffs will be disinflationary in nature as consumer and business demand eases, jobs and income growth slows, and consumer and business confidence takes a hit.
- 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. While the two sides have not set a new date to resume negotiations, one potential development looms on the horizon. Mr. Trump and Mr. Xi will both attend a Group of 20 meeting in Japan this month, providing them with an opportunity to schedule another summit.
- 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 major policy shift in January, the Federal Reserve is clearly on hold currently, if not poised to cut rates before year end, and the runoff of its securities portfolio is scheduled to end at the end of September.
- S&P 500 operating earnings rose 4.5% 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. Due to the limited amount of goods that the U.S. exports to China, we do not expect the increase in tariffs by China on $60 billion of imports from the U.S. to have a noticeable impact on the earnings of Corporate America.
- For now, we wait and remain invested in the high quality, dividend paying stocks we favor. This is no time to move away from a well-thought out investment plan. Long-term investors need to avoid knee jerk decisions based on the latest tweets and headlines. The sharp rise in stock prices off the December 24 low gave investors very few opportunities to get invested as the advance was very rapid and strong. Recession concerns are overblown, the economic fundamentals are solid, inflation is low, and Treasury yields are only moving lower.
- The odds of the Federal Reserve cutting rates this year have increased, with virtually no chance of the central bank raising rates. The current pullback is restoring some value in the stock market. Our baseline expectation is 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.
II. Monetary Policy
A. No Change in Rates, Low Inflation Called “Transitory” by Chairman Powell.
- As widely expected, the Federal Reserve left interest rates unchanged at 2.25% to 2.50% at the conclusion of the April 30-May 1 FOMC meeting. The central bank reiterated that it will remain “patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.” A lack of inflationary pressures outweighed an economy that is growing at a solid rate and a labor market which “remains strong.” On the critical issue of inflation, the policy statement said “market-based measures of inflation compensation have remained low in recent months.”
- The Federal Reserve’s inflation target is 2% and the core personal corruption expenditures price index rose just 1.6% in March from a year earlier, down from 1.8% in January and 2% in December. Federal Reserve Chairman Jerome Powell, speaking at the news conference following the meeting, played down concerns that recent soft inflation data might hint at broader economic weakness. He repeatedly referred to individual price declines which could prove “transitory,” commenting that “the economy continues on a healthy path,” and the committee does not “see a strong case for moving [rates] in either direction.”
- Stock prices swung between small gains and small losses for much of the day of the FOMC meeting before turning lower by -163 points on the DJIA after Mr. Powell used the terms “transitory” or “transient” nine times during the press conference when referring to inflation. The use of those terms likely disappointed traders who had been betting that muted inflation would lead the Federal Reserve to cut rates by the end of year to take out insurance against the risk of inflation persistently undershooting the 2% target.
- The Federal Reserve did live up to its commitment to begin the process of ending the runoff of its securities portfolio. During May the central bank lowered the monthly runoff of Treasury securities to $15 billion from the previous target of $30 billion and will end the runoff of its Treasury securities at the end of September.
- After September, the Federal Reserve will continue to allow its holdings of mortgage-backed securities to mature -- roughly $20 billion a month -- but will reinvest the maturing proceeds and prepayments into new Treasury securities, ending the runoff of its securities portfolio in total. The goal is to return the Federal Reserve’s securities portfolio to a Treasury-only portfolio, as it was prior to the Financial Crisis and the successive rounds of bond purchases.
B. Monetary Policy Remains Tight, Look for a Rate Cut Before Year End.
- We continue to view monetary policy as tipping modestly to the side of restraint, despite the dramatic shift in tone and direction from the Federal Reserve since the beginning of the year. As seen in the table below, the Treasury yield spread remains very tight, at 21 basis points at the end of May compared to 19 basis points at year end 2018 when recession fears were rampant. The yield on the two-year Treasury note has fallen from its recent high of 2.91% on October 22 to 1.92% currently, right in line with the futures market indicating a roughly 95% chance of a rate cut by year end and a 72% probability of another rate cut during the first six months of 2020.
- As stated earlier in this ISS, following the escalation in the trade war with China last month, we feel there is virtually no chance of the Federal Reserve raising rates this year and the odds of a rate cut have increased significantly. Should a rise of a couple tenths of a percentage point in the economy’s inflation rate take place as higher tariffs are passed on in the prices of consumer goods, the Federal Reserve will look through that rise as a one-time adjustment to final goods prices. Ultimately, a prolonged standoff with China would be disinflationary as it would present a headwind to the economy’s forward momentum. As always, stay tuned!
III. Treasury Yields
A. Yields Renew Decline Following Trade War Escalation.
- After firming a touch during April, Treasury yields resumed their decline during May as investor concerns about the outlook for global growth rose following the escalation of the trade war with China. A strong flight-to-safety also helped lower Treasury yields as investors have not had to deal with higher tariffs as a policy tool since the 1930’s. Lower yields overseas brought foreign buyers to the Treasury market as roughly $11 trillion of sovereign debt globally carries negative yields, highlighted by the -9 basis points and -20 basis points yield on ten-year Japanese securities and ten-year German bunds, respectively.
- Yields on two-year to thirty-year Treasury securities are lower by -83 to -116 basis points since the recent high ten-year Treasury yield on October 5, -45 to -60 basis points since year end 2018, and -35 to -37 basis points during the month of May. The decline in Treasury yields to year end 2018 was directly related to a rise in investors’ anxiety about the outlook for the U.S. and global economies. After stabilizing a bit over the first four months of the year, Treasury yields fell sharply last month. The yield on the ten-year Treasury note ended May at 2.13%, its lowest level since September 2017.
- Notice in the table below that since the recent peak in longer dated yields on October 5, implied inflation expectations declined by -43 basis points, falling from 2.17% to 1.74% 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 0.39% at the end of May, a -67 basis point decline. While expectations for both growth and inflation have receded over the past eight 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 over the past month.
- In the last two ISS’s, we stated that TIP yields of 0.53% to 0.55% at the end of March and April, respectively, supported our view that the recession fears at the end of 2018, which lingered to various degrees over the first four 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 last month, we are encouraged by the only modest decline in the ten-year Treasury TIP yield to 0.39% last month from 0.55% at the end of April. We continue to believe the U.S. economy is on solid footing and that the current recession fears are overblown.
B. Modest Yield Curve Inversion Is Not Forecasting a Recession.
- Much was made last month over one measure of the Treasury yield curve inverting -- shorter maturity yields above longer maturity yields -- again last month, following a five day inversion during March. Specifically, the yield on the three-month Treasury bill ended May at 2.34%, compared to a yield of 2.13% 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 last month, as the yield on the three-month Treasury bill is largely unchanged 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 2.13% from 2.68% at year-end 2018. 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 21 basis points.
- Second, the inversion last month was likely signaling that the Federal Reserve is going to cut interest rates, to which the futures market is currently assigning a 95% probability by year end. 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 occurred last month 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 21 basis points. Additionally, the ten-year to thirty-year Treasury yield spread was basically unchanged last month at 44 basis points.
- Following the rate hikes by the Federal Reserve last year and the higher tariffs put in place by the U.S. and China last month, the equilibrium level of Treasury yields has declined. If the trade war persists for all of 2019, look for yields on shorter maturity Treasury securities to drop 25 to 30 basis points as the Federal Reserve cuts rates, while the yield on the ten-yield Treasury will trade in a range of 2% to 2.25%. 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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