CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
May 1, 2019
I. Equity Markets
A. Recession Fears Fade.
- What a difference four months make! During 4Q 2018, which saw a bruising -14% decline in the S&P 500, investors were very concerned that the Federal Reserve would push the economy into an unnecessary recession -- inflationary pressures were not building -- by raising interest rates too high and too quickly. On a global basis, the trade wars started by the Trump administration were disrupting international trade flows, supply chains, and investment spending, leading to an unexpected slowing in global growth.
- In particular, data out of China showed the country’s economic slowdown was deepening, hitting both the industrial and consumer sectors. Growth in the euro zone had stalled, with Italy hovering on the brink of recession. The risk of a disorderly departure from the European Union by the United Kingdom had risen, which raised the risk of the United Kingdom falling into recession. Lastly, the partial shutdown of the federal government in late December weighed on both consumer and investor sentiment.
- Over the past four months, the Federal Reserve has gone to great lengths to change the narrative regarding the outlook for monetary policy, placing additional interest rate hikes on hold by committing to a patient approach to interest rate policy and announcing the end of the monthly runoff of its securities portfolio at the end of September. The market is currently pricing in greater odds of a rate cut by early 2020 than a rate hike.
- Fears of an imminent recession have transitioned to the belief that the December to February slowdown was a temporary pause in the ongoing economic expansion as there are signs that the pace of economic activity is picking up. Concerns over trade have turned into realistic hopes that a trade agreement with China will be finalized in short order. While Japan and the euro zone remain mired in a prolonged period of stagnation, China growth appears to be picking up following stimulus measures put in place by the Chinese government.
- With the Federal Reserve on hold and fears of recession fading, the major market indices were higher across the board last month, with both the S&P 500 and the NASDAQ Composite hitting new all-time highs this week. For the month of April, the major market measures advanced 2.6% to 4.7%, with the NASDAQ Composite leading the way. Since the dramatically oversold conditions on Christmas Eve, the various stock market measures have powered ahead by 22% to 30.7%, with the NASDAQ Composite again at the head of the pack.
B. Common Stocks Need Earnings Growth to Move Higher.
- Corporate earnings were unambiguously positive for common stocks last year as a faster pace of economic growth combined with the reduction in the corporate income tax rate from 35% to 21% to power operating earnings on the S&P 500 higher by almost 22% over the four quarters of 2018. However, concerns about the outlook for earnings in 2019 grew as 2018 wore on, and those concerns were largely responsible for the sharp decline in stock prices during 4Q 2018 in our view.
- Recession fears rose as it appeared the Federal Reserve was ignoring warnings from the financial markets and was about to tighten monetary policy to the extent the economy could fall into recession. Earnings were also expected to struggle this year as the positive impact from the corporate income tax rate cut over the four quarters of 2018 washed out of the earnings data, starting in 1Q 2019. Earnings estimates for 2019 were sharply lowered, with some analysts looking for an earnings recession during the first half of the year.
- Besides the dovish turn by the Federal Reserve since the beginning of the year and hopes for a trade deal with China, the solid performance by the economy in 1Q 2019 and better than expected earnings reports have supported the 17.5% advance in the S&P 500 over the first four months of the year. With roughly 53% of S&P 500 companies reporting, 1Q 2019 operating earnings look to be about two percent higher than 1Q 2018, admittedly a modest advance, but much better than a decline. Additionally, a very healthy 75% of earnings reports have been better than analysts’ estimates and dozens of companies have given upbeat earnings guidance.
- Hardly a day passes that we do not hear an economic pundit assert that a recession is right around the corner given the age of the current business expansion -- 10 years at the end of June, making this economic expansion the longest on record in the second half of 2019. We counter that assertion by reminding our readers that economic expansions do not die of old age. Every recession since WWII was preceded by a tightening of monetary policy by the Federal Reserve to address building inflationary pressures in the economy.
- That is why we focus on wage growth -- the most recent reading on average hourly earnings is 3.2% year-on-year -- and on inflation -- 1.5% year-on-year reading on core personal consumption expenditures price index for March -- to get a read on whether the Federal Reserve needs to shift from its current position of being on hold for additional rate hikes to a resumption of rate hikes.
- Later cycle inflationary pressures have not emerged during the current economic expansion, having been held in check by secular/structural influences -- read that as technological advances which promote enhanced productivity and efficiency and comparison shopping on the internet. As covered later in this ISS, inflation slowed in 1Q 2019, a factor likely to reaffirm the Federal Reserve’s patient and data dependent stance on further rate hikes.
- The key is that we expect the economic expansion to continue and do not see the economy falling into recession any time soon. 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 view the downshift in the economy’s growth rate which happened during the latter part of 4Q 2018 as a longer term positive. If the economy’s growth rate had not pulled back from its 3% pace with the unemployment rate near 4%, we think it was very likely the Federal Reserve would have continued raising rates, driving the economy into an unnecessary recession as inflationary pressures were not building.
- As for the Federal Reserve, it will release a new policy statement this afternoon following today’s FOMC meeting and Chairman Jerome Powell will hold a press conference. We do not expect any change in interest rates to be announced, nor any change in the central bank’s intention to end the runoff of its securities portfolio at the end of September. The economy’s underlying growth rate has slowed to a pace closer to 2% compared to 3% in 2018 and inflationary pressures remain muted.
- 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, although it widened slightly during April to 23 basis points from 15 at the end of March. The yield on the two-year Treasury note has fallen from its recent month end September high of 2.82% to 2.27% currently, right in line with the futures market indicating a roughly 70% chance of a rate cut by early 2020.
- So despite the S&P 500 being higher by 17.5% over the first four months of the year, and 25.3% since the recent low on Christmas Eve, we think stock prices can advance further as the economy regains momentum following its recent soft patch, which was already reflected in the drop in stock prices during 4Q 2018.
- However, we acknowledge that for stocks to hold onto their gains this year and/or climb higher from here, investors will need to see further evidence that the economy is back on track, as well as, a resumption of earnings growth over the remainder of the year.
- We expect earnings growth to accelerate a touch during the second half of the year as a solid jobs market and growing incomes provide a further lift to consumer spending. 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 a clearer outlook for longer range planning.
- However, 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 18 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. Solid First Quarter Growth, No Recession in Sight.
- The 3.2% advance in real GDP during 1Q 2019 pointed to the economy remaining solid at the start of the year, with no recession in sight. Freezing weather in January and February, the 35 day federal government shutdown, the massive sell off in stocks into late December, and the threat of the March 1 tariff hike on Chinese imports slowed the economy’s forward momentum early in the quarter, but it bounced back as the quarter drew to a close.
- The headline real GDP figure did overstate the strength in the economy last quarter, however, and masked some slowing of the economy’s forward momentum, hence our characterization of a solid performance in the economy, not a strong performance. The most reliable measure of the economy’s underlying growth rate, real domestic private final sales (real DPFS) -- the sum of consumer spending, business capital spending, and residential construction outlays -- grew at a much more modest 1.3% rate last quarter, half of the 2.6% pace of 4Q 2018. Real DPFS rose 2.8% over the past four quarters, led by business capital spending advancing 4.8%.
- Consumer spending -- which accounts for 69% of the economy -- grew at only a 1.2% annual rate, less than half of its 2.5% pace in 4Q 2018. Consumers definitely pulled back late last year and early this year given the sharp decline in stock prices and concerns about the outlook for the economy, as shown in the -1.6% plunge in retail sales in December.
- Consumer spending should pick up during the current quarter as monthly employment has averaged 180,333 so far in 2019, average hourly earnings rose 3.2% over the twelve months ending in March, real disposable personal income rose at a 2.4% pace last quarter, and the personal savings rate hit 7% in 1Q 2019 compared to the 2018 average of 6.7%. We also note that retail sales soared 1.6% during March.
- Residential construction outlays remain the weakest sector, falling at a -2.8% annual rate last quarter, the fifth consecutive quarterly decline. The housing market has been held back by the decline in housing affordability over the past couple years due to strong gains in home prices and mortgage rates hitting 5% last year. The cap on the deduction for state and local taxes contained in last year’s tax bill has also had a significant impact on the housing market. The recent easing in mortgage rates and the strong labor market should support better housing outlays over the remainder of 2019.
- Business capital spending was the strongest sector in the economy last quarter at 2.7%, but momentum slowed here also compared to a 5.4% advance in the previous quarter and a 7% increase over the four quarters of 2018. Business capital spending was expected to be the primary beneficiary of the changes to the tax code last year as the cut in the corporate tax rate lowered the cost of capital to Corporate America and the provision which allowed immediate expensing of capital outlays for a five year period provided strong incentives for companies to invest in productivity enhancing capital outlays.
- The difference between the 3.2% figure reported for real GDP and the 1.3% figure for real DPFS last quarter was mostly accounted for by a faster pace of inventory accumulation, which added 0.7 percentage points to the economy’s growth rate and by net exports which added one percentage point. The inventory rise is directly related to the slower pace of consumer spending in 1Q 2019 and the stockpiling of goods with tariff increases looming, and will likely be reversed during the current quarter.
- The gain from net exports resulted from a 3.7% rise in exports and a -3.7% drop in imports. Firms boosted imports in late 2018 ahead of anticipated increases in trade tariffs, which did not materialize due to progress in U.S. – China trade talks, leading to a decline in imports during 1Q 2019. Distortions to the economy’s underlying growth rate from net exports and changes in business inventories have been exaggerated over the past four quarters by the threatened and actual imposition of tariffs by the Trump administration and by the response of our trading partners.
- The best news in the GDP report was likely the inflation data. The price index for gross domestic purchases, which measures prices paid by U. S. residents, rose at only a 0.8% rate during 1Q 2019 and increased 1.7% over the past four quarters. The Federal Reserve’s preferred measure of inflation, the core personal consumption expenditures price index, rose at a 1.3% rate during 1Q 2019 and increased 1.7% over the past four quarters. These inflation measures need to be compared to the Federal Reserve’s inflation target of 2% and point to the wisdom behind the Federal Reserve moving to a patient approach to further rate hikes earlier this year.
B. Look for the Economy to Grow at a Pace Near 2%, with Continued Low Inflation.
- It appears to us that the economy’s growth rate will slow to a pace near 2% 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 compared to last year’s 3% growth rate 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 $300 billion two year federal spending program beginning to wane.
- Consumer spending should grow at a 2% rate this year as the solid jobs market keeps incomes growing. Housing outlays should be flat to slightly positive in 2019 given the recent 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 dynamics grounded in e-commerce and technology continue 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 to 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 to a pace closer to 2% 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. 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 Firm and Rise a Touch.
- Following the -58 to -85 basis point drop in yields on Treasury securities with maturities between two years and thirty years from the recent peak on October 8 to the end of March, Treasury yields firmed and rose a touch during April. The decline in Treasury yields since October was directly related to a rise in investors’ anxiety about the outlook for the U.S. and global economies. While the yield on the two-year Treasury note only rose one basis point last month as there was no change in the outlook for rate hikes by the Federal Reserve, yields on five-year to thirty-year Treasury securities rose 5 to 12 basis points.
- Upward pressure on yields arose from signs that the pace of economic activity is picking up -- consider that initial claims for unemployment insurance are the lowest in 50 years -- when the economy was half of its current size -- and retail sales jumped in March and regional manufacturing surveys have firmed. Downward pressure on yields was found in the first quarter inflation readings -- the price index for gross domestic purchases and the core personal consumption expenditures price index rose at only 0.8% and 1.3% annual rates, respectively.
- Notice in the table on the following page that since the recent peak in bond yields on October 8, implied inflation expectations declined by -46 basis points to year end, falling from 2.17% to 1.71%, as recession fears reached a peak. As those recession fears have faded, implied inflation expectations have risen 24 basis points to 1.95%, still below the Federal Reserve’s 2% target, however.
- We look at the slightly higher implied inflation outlook currently as consistent with the sweeping policy reversal made by the Federal Reserve at the January and March FOMC meetings, which has markedly lowered the risk of the Federal Reserve making a policy mistake and forcing the U.S. economy into recession.
- It seems to us that the more interesting insight in the table is the decline in the Treasury TIP yield -- a widely followed indicator of real growth expectations -- from 1.06% on October 8 to only 0.53% on March 29 and 0.55% at the end of April, a -51 basis point decline. While expectations for both growth and inflation have receded over the past seven months, the greater decline has occurred in the growth outlook and the inflation outlook is fairly close to the economy’s 1.9% average annual inflation rate over the past two decades.
- In last month’s ISS we stated that the 0.53% TIP yield supported our view that the recession fears at the end of 2018 and right through the end of 1Q 2019 were overblown. During the last major growth scare in the summer of 2016 following the vote in the United Kingdom to leave the European Union, the ten-year Treasury TIP yield hit zero, without the economy subsequently falling into recession.
- We also stated that given our expectation that the recession fears were overblown and would recede with a rebound in the economic data over the next couple months, so too, we felt the decline in Treasury yields during March was also overdone and we looked for yields to firm and retrace part of the recent decline in the months ahead. We did not foresee a recession on the horizon and the expected growth outlook would only improve with a trade deal with China, which we still expect.
- During March, the yield on the ten-year Treasury note broke below the lower end of the 2.55% to 2.85% trading range on the ten-year that we identified in the previous three ISS’s. We continue to anticipate that the yield on the ten-year Treasury will return to that range as the economic data improves and, in fact, the yield on the ten-year Treasury did trade above 2.55% on seven days during April.
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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