CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
March 1, 2019
I. Equity Markets
A. Rally in Common Stocks Continues Through February.
- The positive momentum in the stock market during January carried over to February. Federal Reserve Chairman Jerome Powell got the stock rally started by going to great lengths on January 4 to change the narrative regarding the outlook for monetary policy. This led to the central bank making a sweeping policy reversal at the January 29-30 FOMC meeting to a patient approach to interest rate policy compared to calling for gradual rate hikes. These efforts eased fears of the Federal Reserve pushing the economy into a misguided, policy-induced recession with no signs of building inflationary pressures.
- The central bank only reinforced that dovish policy shift during February with several Federal Reserve officials suggesting the central bank will end the runoff of its securities portfolio much sooner than previously expected, possibly as soon as sometime this year. Investors were also encouraged last month by Congress passing and President Trump signing a compromise spending bill which funds the federal government through this fall, avoiding another partial shutdown of the federal government for the time being.
- Positive comments by both the U.S. and China regarding progress on negotiating a new trade deal were also viewed in a positive light. Talks took place in Washington early in February, followed by talks mid-month in Beijing and again last week in Washington. President Trump saw sufficient progress in the trade negotiations to postpone a March 1 deadline to boost the 10% U.S. tariffs on $200 billion worth of Chinese imports to 25%.
- According to sources briefed on the trade negotiations, China has offered to increase purchases of U.S. farm and energy products, ease restrictions on U.S. firms in financial services and auto manufacturing, and improve protection of U.S. intellectual property rights. China also agreed to curb currency manipulation, pledging to keep the yuan steady and not to engage in competitive devaluation to boost Chinese exports. Outstanding issues include government subsidies and support to state-owned companies and an enforcement mechanism to monitor Chinese compliance with an accord.
- For the month of February the various stock market measures rose by 3% to 5.1%, with small company stocks leading the way. All of the major market indices have now recovered all of their losses during calendar year 2018 and are higher by 18.4% to 24.4% since the dramatically oversold conditions on Christmas Eve.
B. Federal Reserve Reinforces Dovish Policy Stance.
- While there was no FOMC meeting during February, the minutes of the January 29-30 FOMC meeting were released last week. The minutes cited that all members of the FOMC Committee supported a patient approach to monetary policy, i.e., placing interest rate hikes on hold until they could better judge the outcome of rising risks to U.S. economic growth which had materialized in the weeks leading up to the meeting. This perspective is consistent with Jay Powell’s comment at the press conference following the January meeting that the “patient period is a function of the data.”
- The minutes said “A variety of factors -- including FOMC communications, weaker than expected data, trade policy uncertainties, the partial federal government shutdown, and concerns about the outlook for corporate earnings -- were cited as contributing to a deterioration in risk sentiment early in the period.” Committee members also expressed concern over the narrowing yield spread between short- and long-term Treasury yields. Officials mentioned that recessions tend to follow, by roughly one to two years, after the yield spread turns negative.
- The discussion over the future path for interest rates was centered on whether to eventually raise interest rates again or to keep them steady -- a discussion of a rate cut did not take place, despite the market pricing in 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 at the conclusion of the meeting. The Committee members were split between one group that expects the economy will be strong enough this year to accommodate at least one additional rate hike and another group that does not expect inflationary pressures to build, allowing the central bank to remain on hold.
- Most Committee members indicated they were supportive of ending the runoff of the Federal Reserve’s securities portfolio later this year and that an action plan should be released to the markets in short order. Officials agreed “such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet.” Such a plan would be another encouraging sign for investors worried about tighter financial conditions. The portfolio has fallen to about $4 trillion from about $4.5 trillion at its peak.
- On Tuesday, Federal Reserve Chairman Jerome Powell testified before the Senate Banking Committee. Mr. Powell described the U.S. economy as healthy, but said the economic data “softened” as financial markets turned volatile toward the end of 2018. Citing ongoing trade negotiations, slower growth in China and the eurozone, and uncertainty over the United Kingdom’s decision to leave the European Union, Mr. Powell said financial conditions “are now less supportive of growth than they were earlier last year.”
- As such, Mr. Powell said the Federal Reserve was in no rush to move interest rates while the FOMC Committee members assess the impact on the U.S. economy of slower global growth and financial market turbulence. “With our policy rate in the range of neutral, with muted inflation pressures and with some of the downside risks we’ve talked about, this is a good time to be patient and watch and wait and see how the situation evolves,” Mr. Powell told the Senate Committee.
- So, the Federal Reserve reinforced again during February that interest rate hikes are on hold for now and that future rate movements will be a function of the inflation readings and the economic data as they offer insights into the inflation outlook. As of this writing, the markets expect the central bank to be on hold indefinitely, with only a 2% to 3% probability of a rate hike by year end and a 7% to 15% probability of a rate cut by the end of 2019/early 2020. The bottom line is the Federal Reserve has stepped to the sideline until the economic outlook becomes clearer. As always, stay tuned!
C. Stock Prices Are Expected to Rise Further.
- With the S&P 500 higher by 11.1% over the first two months of the year and higher by 18.4% since the recent low on Christmas Eve, it is fair to ask if stock prices can advance further this year. Our answer is yes and we will lay out the rationale below. Before we do that, however, we think the following perspective is important to keep in mind. Despite the recent strong advance in stock prices, the S&P 500 is only higher by 4.1% since year end 2017, even though operating earnings on the S&P 500 grew more than 24% during 2018. As such, the price-to-trailing operating earnings ratio on the S&P 500 currently stands at 18x compared to 22.5x at year end 2017, a -20% decline.
- As always, the outlook for stock prices comes down to the outlook for earnings, which are dependent upon the outlook for the economy. As covered later in this ISS, we expect the economy’s growth rate to slow to a 2% to 2.5% pace this year, compared to the 3.1% pace of 2018. The tightening of monetary policy by the Federal Reserve to the end of 2018, the waning stimulus from the tax cuts and the two year $300 billion federal spending program, and slowing growth overseas is leading the economy back toward its growth rate of roughly 2% for the past two decades.
- The key, however, is we expect the economic expansion to continue and do not see the economy falling into recession any time soon. We do not look for a policy mistake from the Federal Reserve following its sweeping policy reversal at the January FOMC meeting. We view the moderate downshift in the economy’s growth rate which happened during 4Q 2018 as a longer term positive. If the economy’s growth rate had not pulled back from its 3.1% pace with the unemployment rate near 4%, we think it was very likely the Federal Reserve would have continued raising interest rates, driving the economy into an unnecessary recession as inflationary pressures were not building.
- Consequently, we view the current moderation in the economy’s growth rate in a very positive light as it will help prolong the economic expansion. A longer expansion provides a longer runway for earnings growth. While the roughly 24% advance in operating earnings last year is likely to give way to low single digit earnings growth during the first half of 2019, that markedly slower pace of earnings growth is not a negative in terms of the forward look for stock prices, it was part of the sharp decline in stock prices during 4Q 2018.
- A number of factors are behind the slower pace of earnings growth. The one-time boost to earnings from the cut in the corporate tax rate will have worked its way through the quarterly earnings reports by the end of 4Q 2018. The slower pace of economic activity, the roughly 8% gain in the U.S. dollar over the past year, and the marked slowdown in the eurozone is impacting the earnings of the S&P 500 companies. The trade war with China since mid-2018 has also impacted earnings and has made business capital spending plans more difficult given the uncertainties it has created for companies selling into China and/or using supply chains which incorporate China.
- We expect earnings growth to accelerate a touch during the second half of the year as the economy adjusts to the higher level of interest rates, but also to the lower level of Treasury yields. Lower mortgage rates should breathe a bit of life into the housing market. A trade deal with China will remove a great deal of uncertainty for businesses leading to a further pickup in business capital spending and reset the environment for longer range planning. Low inflation and a continuation of the economic expansion will also contribute to a better earnings picture. A rebound in China growth and better growth in the eurozone would also lift earnings.
- It would not surprise us if common stocks traded sideways to slightly lower in the near term as investors digest the outsized gains over the past 10 weeks. This would allow investors to absorb the stall in earnings during the first half of the year and turn their attention to the back half of 2019. Our largest concern to mid-year 2020 is the Democratic party attempting to wound the ability of President Trump to win re-election by bringing charges of misconduct in order to initiate impeachment proceedings. Outside of politics, the economic backdrop should support still higher stock prices.
II. Real Economic Activity
A. Best Annual Growth in the Economy Since 2005.
- The tax cut passed in late 2017 -- largely corporate in nature -- and the $300 billion two year federal spending plan combined to propel the economy’s quarterly growth rate to an average of 3.2% over the first three quarters of 2018, compared to the 2.2% annualized growth rate during the current business expansion to the end of 2017. However, the economy’s forward momentum slowed a touch in 4Q 2018, as the economy’s growth rate eased to a 2.6% rate.
- Following the passage of the tax package in December 2017, we raised our outlook for growth in 2018 to 3% and said we would not be surprised by the economy’s quarterly growth rate exceeding 3% for a quarter or two. On a year over year basis the economy grew 2.9% last year and on a fourth quarter to fourth quarter basis grew 3.1%. The economy’s quarterly growth rate hit 4.2% in 2Q 2018 and 3.4% in 3Q 2018. 2018 is the first year the economy’s growth rate hit 3% since 2005.
- Business capital spending was expected to be the strongest sector of the economy in 2018 as the decline in the corporate tax rate and the move to a territorial tax system lowered the cost of capital to Corporate America and from the provision which allowed immediate expensing of capital outlays for a five year period. Business capital spending led the economy last year, growing 7.2% on a 4Q 2018 versus 4Q 2017 basis. During 4Q 2018, business capital spending grew at a 6.2% pace, again leading the economy forward.
- Consumer spending grew at a 2.7% pace over the four quarters of 2018, primarily supported by solid job growth -- nonfarm payroll employment averaged a very strong 223,000 jobs per month during 2018 -- and improving wage gains -- average hourly earnings advanced 3.2% over the twelve months of 2018, the strongest increase over the course of the expansion. During 4Q 2018, consumer spending rose at a 2.8% annualized rate, in line with its growth rate during all of 2018.
- The outlook for the housing market last year was a bit of a mixed bag following the passage of the tax bill, as the cap on the deduction for state and local taxes was expected to have a significant impact on the housing market, creating a series of winning and losing zip codes across the country. The decline in housing affordability, primarily due to strong gains in home prices over the previous four to five years, was also expected to reign in housing outlays. Residential construction outlays was the weakest sector of the economy last year, falling -3% on a 4Q 2018 versus 4Q 2017 basis, and declining in each of the four quarters of 2018. During 4Q 2018, housing outlays remained soft, falling at a -3.5% pace.
- The federal government was expected to add to the economy’s growth rate during 2018, primarily due to the $165 billion two year boost in defense outlays contained in the $300 billion two year federal government spending package passed in February. Federal government outlays rose 2.8% over the four quarters of 2018, led by a strong 5.2% increase in national defense outlays. During 4Q 2018, federal government outlays rose at a 1.6% pace, with national defense spending advancing at a 6.9% rate, while non-defense spending fell at a -5.6% pace due to the partial shutdown of the federal government.
- The best news in the fourth quarter report on the economy may well have been the inflation data. The price index for gross domestic purchases, which measures prices paid by U.S residents, rose at only a 1.6% rate during 4Q 2018 and increased 2.1% over the four quarters of 2018. The Federal Reserve’s preferred measure of inflation, the core personal consumption expenditures price index, rose at a 1.7% rate during 4Q 2018 and rose 1.9% over the four quarters of 2018.
B. Look for the Economy’s Growth Rate to Slow, with Continued Low Inflation.
- It appears to us that the economy’s growth rate will slow to a 2% to 2.5% rate during 2019, more in line with the economy’s potential growth rate which is estimated at 2%. The somewhat slower pace of growth this year is due to the tightening of monetary policy by the Federal Reserve since 4Q 2015 which has raised the cost of credit to households and businesses and from the stimulus from the tax cuts and the federal spending program beginning to wane.
- There is some risk that growth in 1Q 2019 could be reported near 1% due to an expected drawdown in business inventories, the reported drop in retail sales in December, smaller than expected tax refunds, and the residual effect of the partial shutdown of the federal government to late January.
- Consumer spending should lead the economy this year as the solid jobs market keeps incomes growing. Housing outlays should be flat to slightly positive in 2019 given the decline in mortgage rates after falling during 2018. Business capital spending should again be the strongest sector of the economy this year as the lower cost of capital and the incentives to increase investment spending remain in place. A trade deal with China would provide a further boost to business capital spending if it can be successfully negotiated.
- Inflation is expected to remain at or below the Federal Reserve’s 2% target for the foreseeable future as the structural dynamic grounded in e-commerce and technology continues to keep a lid on inflationary pressures. Price competition has moved to unprecedented levels with the ability to source product from anywhere in the world.
- A fallout from this extreme price competition is an unwillingness on the part of employers to raise wages because they fear an inability pass those higher wages on to higher prices for their products and services. In addition, technological advances are making the business community more efficient and productive.
- While we expect the economy’s growth rate to slow a touch in 2019, the bottom line is the economy is much healthier today than it was two years ago prior to President Trump being elected. The much higher levels of consumer and business confidence, the efforts to loosen regulations, and the lower personal and corporate tax rates have combined to boost the economy’s growth rate. The aging of the workforce and slower population growth are fundamental factors which will keep the economy’s growth rate closer to 2% on a longer term basis.
- 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. Keep in mind that economic expansions do not die of old age. Every economic expansion since WWII has ended with a tightening of monetary policy by the Federal Reserve to fight mounting inflationary pressures.
III. Treasury Market
A. Treasury Yields Remarkably Stable So Far in 2019.
- After declining between -38 to -58 basis points from the recent peak on October 8 to the end of 2018, Treasury yields on securities between two years and thirty years are lower by -2 basis points to higher by 6 basis points over the first two months of 2019. A powerful confluence of events caused Treasury yields to fall in a significant manner during 4Q 2018. Regular readers of these ISS’s can easily 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 from early October, and the sharp and sudden slump in stock prices from 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.
- Over the first two months of 2019, there has been little reason for Treasury yields to rise in a material manner as inflation pressures remain muted, domestic and global economic growth has little chance of noticeably accelerating in the near term, and the Federal Reserve is clearly signaling an end to the runoff of its securities portfolio some time before year end. Only the growing federal budget deficit is exerting upward pressure on Treasury yields, although that growing supply has been easily absorbed over the past five months.
- There likewise has been little reason for Treasury yields to fall materially further as the labor market remains strong and the Federal Reserve has paused in its effort to raise interest rates -- virtually eliminating the chance of the central bank making a policy mistake and pushing the economy into recession for the foreseeable future. Additionally, a tight labor market will keep modest upward pressure on wages which will keep core inflation closer to 1.5% to 2% rather than 1% to 1.5%.
- 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 slowing in the economy’s growth rate over the past three to four months. The implied inflation expectation over the next ten years has also fallen, from 2.17% to 1.95%.
- While the 1.95% implied inflation expectation is higher than the 1.71% at year end, it is still below 2%, and taken with the December and January month end readings, they are still the lowest implied inflation readings since the summer of 2016. We look at the slightly higher implied inflation outlooks at the end of January and February as consistent with the sweeping policy reversal the Federal Reserve unveiled at the January FOMC meeting, 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 little changed during the first part of 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. A trade deal 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.