CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
March 2, 2020
I. Equity Markets
A. Coronavirus Fears Hit Stock Prices.
- Investor fears over the extent to which the new coronavirus could spread and the subsequent impact on global growth intensified during February as the number of cases and deaths in China spiked and new cases of the virus emerged in over fifty countries across the globe. A globalized economy, one that is far more integrated than in the early 2000’s when the SARS virus broke out, is complicating the task of responding to a viral outbreak and assessing the potential impact on domestic and global growth.
- The global economy has also been transformed over the past two decades by China’s booming growth. Chinese consumption and production power growth from Asia to Europe, the Americas, and beyond. Manufacturers world-wide are tethered to China by the tentacles of supply chains that rely on China’s factories for many intermediate and finished goods. Disruptions to global supply chains have caused parts shortages and negatively impacted product supply. U.S. exports to China have fallen sharply from store closures and markedly lowered customer traffic.
- In an attempt to limit the spread of the virus beyond China’s borders, the world has severed many links to China. More than 30 airlines have suspended China service while a 78 nation matrix of rules and quarantines from the U.S. to Singapore have all but banned Chinese travelers from foreign soil.
- While all indications are that the efforts to isolate China and the activity restrictions imposed by the Chinese government -- keeping workers home and restricting shopping trips -- have helped to contain the spread of the virus, China’s economy has taken a significant hit and the U.S. economy could lose about 0.5 percentage point to first quarter growth. The bottom line is uncertainty over the outlook for global and U.S. economic growth has risen sharply, leading investors to lower their appetite for risk and to increase their demand for safe haven assets, like Treasury securities and gold.
- Since the recent high on the S&P 500 on February 19 -- only seven trading days ago -- common stocks sold off hard as investors began to fear that the economic damage from the coronavirus outbreak could develop into a much more serious global problem rather than a relatively short-lived interruption in economic growth. The major stock market measures fell a startling -12.7% to -13.4% from February 19 to the end of the month. For the month of February, the major market measures declined -6.4% to -10.1% and are lower on the year by -4.5% to -11.5%. Keep in mind that the market indices were higher by 22.3% to 35.2% during 2019.
B. Underlying Fundamentals Remain Positive.
- In the January 2 ISS, we expected the positive fundamentals -- solid growth, better earnings, easing trade tensions, low inflation and interest rates -- to support further gains in common stock prices this year. It is interesting to note that the S&P 500 gained 3% to January 17, only to give that gain back to month end on coronavirus fears. Likewise, last month the S&P 500 rose 5% to February 19, only to give all of that gain back, and more, by month end as coronavirus fears intensified as a surge in virus cases and a worrisome spread of the disease outside China sent investors running for safety.
- The tendency for stock prices to rise during the first half of both January and February before being dragged down by coronavirus fears says to us that investors are viewing the underlying fundamentals in a positive light. Inflationary pressures remain very low, virtually assuring that the Federal Reserve will not turn hostile any time soon and that any change in policy is likely to be toward a more accommodative stance.
- While the risk of recession has increased with the onset of the coronavirus, it is still not the most likely scenario as the household sector is being supported by solid job gains and wage growth, financial obligations are near their lowest level in nearly forty years, consumer confidence measures have rebounded from their summer lows, and the personal savings rate is still elevated at 7.7%.
- Yields on longer maturity Treasury securities have fallen to record low levels, providing little competition for common stocks, as well as, valuation support. The housing market is gathering a moderate head of steam and will likely be the best performing sector of the economy this year based on healthy household fundamentals and record low mortgage rates.
- Add in a lessening of trade tensions and the economy should rebound during the second half of 2020 and into 2021 following a hesitation during the first half of this year. While the coronavirus remains a serious, known unknown, continued growth at a moderate pace should unfold over the next couple years.
- We have consistently stated that the outlook for stock prices comes down to the outlook for earnings, which is dependent upon the outlook for the economy. With 88% of S&P 500 companies reporting, operating earnings for 4Q 2019 look to be higher by 8.2% year-on-year, after declining by -3.8% during 3Q 2019, a welcome rebound in corporate profits.
- Currently, the analysts at Standard & Poor’s are looking for operating earnings to grow by a little more than 10% this year. Undoubtedly, earnings estimates will be revised lower in coming weeks and it is likely earnings will not grow this year, but we do not expect a major decline in operating earnings. We look for a small decline in earnings during the first half of the year to be followed by a rebound during the second half.
- The current price-to-trailing operating earnings ratio on the S&P 500 is more attractive at 19x compared to the 21.1x reading at both year end and on the day President Trump was elected. Common stocks were not priced for no earnings growth in 2020 and the dampened outlook for earnings this year is fundamentally the cause of the pullback in stock prices over the past seven trading days. However, it appears stocks have been trading on a “what if” worst outlook for earnings rather than on a “what is most likely” outlook for earnings.
- Reflecting on the -12.8% drop in the S&P 500 during the seven trading days from February 19 to the end of the month, stock prices will likely remain under pressure until health officials around the world begin to signal that the spread of the new coronavirus is under control. Our working assumption remains that the uncertainty over the spread of the virus may be with us for up to three months based on the attempts to quarantine China from the global economy and the local quarantines put in place where new clusters of infection have developed.
- While concerns over the spread of the coronavirus have dominated investors’ thoughts over the past month or so, the rise of Senator Sanders in the Democratic primaries is likely a secondary, but still noteworthy worry. Mr. Sanders’ economic policies would materially increase the scope of the federal government in the private sector of the economy, greatly expand entitlement programs, and enact a sweeping array of incentive destroying new taxes and higher tax rates, which could cut the potential growth rate of the U.S. economy by as much as 50%, to roughly one percent.
- Our view is that Mr. Sanders is not viewed as a strong threat to unseat President Trump should he win the Democratic nomination. Incumbent presidents usually win a second election when they have a strong economy behind them, so closely watching developments in the labor market following the coronavirus outbreak will be important to Mr. Trump’s re-election hopes. We also believe there is little serious interest in these far left leaning proposals by the vast majority of voters, but the storyline needs to be watched, particularly given the low regard many voters have for Mr. Trump’s deportment.
C. A Final Thought, Hang in There!
- Investors need to keep two things in mind today when thinking about the stock market. First, 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 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.
- Secondly, we should be expecting a temporary hit to domestic growth from the onset of the coronavirus in China. Virtually shutting down the world’s second largest economy for several weeks is going to have some impact on global growth. The key is that the health scare and the disruption to economic growth most likely will be temporary, eventually leading to a rebound over the summer months.
- It appears that the U.S. remains relatively insulated and arguably has the best health care system in the world. Long term investors will look through the short run disruption to earnings and look to invest in the normalized stream of earnings growth which will resume after the disruption.
- 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. Fear and negative psychology is a much stronger short run driver of stock prices than fundamentals and hard facts. Over time, fundamentals and hard facts will win out. Stick with the high quality, dividend paying companies which we recommend as the right path to consistently build wealth over time.
II. Monetary Policy
A. Federal Reserve Closely Monitoring Impact of the Coronavirus, Rate Cut Coming.
- Federal Reserve Chairman Jerome Powell testified before the House Financial Services Committee on February 11 and said the central bank is “closely monitoring” the new coronavirus, its impact on economic growth in China, and the effect it could have on global economic growth.
- Mr. Powell said the new health threat comes just as trade uncertainties have diminished, with the U.S. economy appearing to be “resilient” to global headwinds following the three rate cuts the Federal Reserve delivered last year. Mr. Powell said the economy is growing at a “moderate” pace, the fundamentals supporting household spending are still “solid,” and highlighted the strong gains in the labor market.
- Specifically on the coronavirus, Jerome Powell stated that there will be a negative impact on China growth through some part of the first half of the year, as well as, on China’s close neighbors and trading partners in Asia and Europe. He also said there will be some effects on growth in the U.S., but the impact domestically will depend on whether the outbreak is “persistent” and “material” in nature and that “it is just too early to say” what the virus’ exact impact on the domestic economy will be.
- Beside the uncertainty regarding the potential impact of the coronavirus on the U.S. economy, Mr. Powell repeated the key takeaway from the January 28-29 FOMC meeting that the economy is well positioned after easing monetary policy during 2019 to buffer the economy against trade uncertainties and slowing global growth. Chairman Powell implied that the hurdle was fairly high for a near term change in Federal Reserve policy by stating, “As long as incoming information about the economy remains broadly consistent with this outlook, the current stance of monetary policy will likely remain appropriate.”
- Considering the current threat from the coronavirus and that only downside risks to the economy -- lingering risks to the global economy and difficulty sustaining inflation at the central bank’s 2% target -- were mentioned in the January policy statement, there is virtually no chance of the Federal Reserve raising interest rates any time soon and the likelihood of a rate cut increases every day that the uncertainty over the spread of the coronavirus and its ultimate impact on global and domestic growth persists.
- While it is questionable how effective cutting interest rates, from already low levels, will be in addressing the negative impact on domestic growth from the coronavirus fears, it is virtually certain the Federal Reserve will cut rates fairly soon. A cut in interest rates will apply a psychological band aid for investors and help to keep the decline in stock prices from spiraling further downward. Investors are clearly expecting the central bank to cut rates with the yield on the three-month Treasury bill stuck at 1.27% because the target range on the federal funds rate is 1.5% to 1.75%, while the yield on two-year to ten-year Treasury securities runs from 0.91% to 1.15%.
- The futures market for the federal funds rate currently is pricing in more than a 100% probability of a rate cut at the March 17-18 FOMC meeting and more than two rate cuts by the June 9-10 FOMC meeting. As a potential harbinger of a rate cut coming fairly shortly, Friday afternoon Federal Reserve Chairman Jerome Powell issued a statement that “…the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.” As always, stay tuned!!
III. Treasury Market
A. Treasury Yields Move Lower on Growth Fears and Strong Flight-to-Safety.
- The bond market has been pricing in since mid-January an expectation that global growth is likely to be negatively impacted in a meaningful manner from fears over the spread of the coronavirus and measures taken to limit the spread of the virus beyond China’s borders. While the efforts to isolate China by restricting travel and the activity restrictions imposed by the Chinese government have been relatively successful in containing the spread of the virus, China’s economy has taken a significant hit and other countries around the globe have seen their exports to China and imports from China fall, along with shortfalls of product supply as supply chains have been disrupted.
- Treasury yields had risen for four consecutive months since the recent lows on August 27 to December 31 on the prospect that the slowdown in the global economy and the U.S. economy had run its course and better growth was ahead. While we maintain that the outlook for growth had improved with central banks around the world cutting rates on 130 separate occasions last year and the U.S. and China reaching agreement on a phase one trade deal, uncertainty over the impact of the coronavirus on global growth, and on China growth in particular, has clouded the economic outlook.
- The yield on the ten-year Treasury security fell to an all-time low of 1.15% by month end as the drop in stocks accelerated. The new low yield on the ten-year Treasury beat the previous low of 1.36% recorded on July 8, 2016 following the vote in the United Kingdom to leave the European Union. The drop in Treasury yields marked the latest milestone in a decades-long bond rally driven by persistently low inflation.
- Worries over the spread of the coronavirus has caused a significant flight-to-safety on the part of investors across the globe, pushing several foreign sovereign bond yields back into negative territory, or further into negative territory. While the yield on the ten-year Treasury note fell from 1.92% at year end to 1.15% at the end of February, yields in Ireland fell to -0.19% from 0.12%, in France to -0.29% from 0.12%, in Japan to -0.15% from -0.01% and in Germany to -0.59% from -0.19%. Sovereign yields in Spain fell from 0.47%, but stayed positive at 0.29% and in Portugal to 0.30% from 0.44%. The total amount of foreign sovereign debt carrying negative yields fell from a peak of $17 trillion in August to $11.3 trillion at year end, but has risen back to $14.6 trillion at month end.
- The change in Treasury yields along the yield curve between July 8, 2016 and the end of February is fairly interesting. Yields on Treasury securities from three-months to two-years are higher by 30 to 100 basis points as the target range for the federal funds rate is currently 1.5% to 1.75% compared to zero to 0.25% back in July 2016. Yields on five-year Treasury securities are lower by one basis point while yields on seven-year to thirty-year Treasury securities are lower by -13 to -42 basis points with the yields on ten and thirty year Treasury securities at all-time lows of 1.15% and 1.68%, respectively.
- The yield on three-month Treasury bills is lower by -27 basis points since year end as the Federal Reserve left the target range for the federal funds rate unchanged at the January 28-29 FOMC meeting. Yields on Treasury securities from two years to thirty have declined by -66 basis points to -77 basis points since year end, showing the concerns over growth as 2020 unfolds with the unexpected breakout of the coronavirus and the subsequent flight-to-safety.
- The extent of the flight to safety is very evident by looking at the dramatic drop in ten-year Treasury TIP yields -- a widely followed indicator of real growth expectations -- over the past fourteen months. Notice that at year end 2018, despite the Federal Reserve raising rates four times that year, the ten-year Treasury TIP yield was 0.97%. The TIP yield fell into negative territory at the low in Treasury yields on August 27 at -0.07% when the fears of recession peaked last year.
- The ten-year Treasury TIP yield fell to -0.28% at month end as investors scrambled into safe haven assets, while the yield on the nominal ten-year Treasury note at 1.15% is a new all-time low. This leads us to believe that while concerns over the global economy taking a hit to growth over the potential spread of the coronavirus are pushing Treasury yields lower, the flight-to-safety and the gravitational pull from $14.6 trillion of foreign sovereign bonds carrying negative yields are also having a significant impact.
- Expect Treasury securities to remain very well bid until health officials around the world begin to signal that the spread of the coronavirus is under control. As mentioned previously in this ISS, our working assumption is that the uncertainty over the spread of the disease may be with us for up to three months.
- Once this health scare passes, we expect the yield on the ten-year Treasury note to resume its climb toward 2% as the economy receives a second wind following the phase one trade agreement between the U.S. and China and the easing of monetary policy last year and an expected rebound in economic activity during the second half of the year in the aftermath of the lull in economic activity during the first half of the year due to the coronavirus fears.
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.