CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
November 1, 2018
I. Equity Markets
A. Stocks Drop as Investors Increasingly Fear a Tighter Monetary Policy.
- Common stocks suffered through a sudden and sharp decline during October, with the S&P 500 and the DJIA giving back all of their 2018 gains to the lows recorded on October 29. Pundits offered many reasons for the pullback, from valuations on high flying technology stocks, the growing trade war with China, slowing growth overseas, to the upcoming midterm elections. While it is realistic to think that all of these issues likely played a hand in the drop in stock prices and the uptick in volatility, we point to growing fears over the Federal Reserve’s efforts to raise interest rates as the key reason for the drop in stock prices.
- Recall that in our February ISS, we commented that the unprecedented turnover in leadership at the Federal Reserve was a major source of uncertainty for investors as 2018 unfolded. Consider that President Trump decided not to reappoint Janet Yellen as chair of the Federal Reserve, instead choosing Jerome Powell as the new head of the central bank. Four of the seven board seats were open, including the position of vice chair. A new president of the New York Federal Reserve Bank was needed as William Dudley had announced his retirement. This is a key position as this person serves as vice chair of the FOMC committee and has a permanent vote on the monetary policy deliberations of the committee.
- We made the observation that investors would need to assess if the eventual composition of the Board of Govenors, under the leadership of Jerome Powell, would possess the adeptness, foresight, and cautious approach of the Board members since the financial crisis. Investors would also need to evaluate if Mr. Powell indeed followed Janet Yellen’s gradualist approach to removing policy accommodation, which adhered to the theme of “doing no harm to the economic expansion” as long as inflationary pressures remained quiescent.
- Throughout 2018, we have consistently stated that whether or not the Federal Reserve would make a policy mistake was the primary risk to the economy and the outlook for stock prices. We defined a policy mistake as the Federal Reserve unnecessarily bringing about the next recession because it raised interest rates clearly to the side of restraint without inflation pressures building in a material manner beyond the Federal Reserve’s 2% target.
- The risks associated with the course of Federal Reserve policy and its impact on the economy transitioned from uncertainty to fear in early October. Specifically, in a question and answer session on October 3, Jerome Powell stated that the central bank was “a long way” from getting interest rates to neutral, a level at which monetary policy is neither stimulating nor restraining the economy’s growth rate. Not coincidentally in our opinion, stock prices peaked on October 3.
- To the low in stock prices on October 29, the major stock market measures declined -7.6% to -12.9. Following the moderate recovery in stock prices the last two days of the month, the losses for October were cut to -5.1% to -10.9%. For the first ten months of the year, the NASDAQ Composite is leading the way with a gain of 5.8%, while the S&P 500 and the DJIA are higher by 1.4% and 1.6%, respectively. Only the Russell 2000 is lower on the year, down -1.6%.
B. Where Is Janet Yellen When We Need Her?
- Following the Federal Reserve raising the target range for the federal funds rate to 2% to 2.25% at the conclusion of the September 25-26 FOMC meeting, which places the federal funds rate above the rate of inflation for the first time in a decade, we took the position that monetary policy had already reached neutral and that policy would begin to turn slightly restrictive should the Federal Reserve raise rates in December, and would become incrementally more restrictive with further rate hikes in 2019-20.
- The problem with the concept of a neutral interest rate is that it is not directly observable. It is only known for a fact, after the fact, when we can obscure how economic growth and inflation responded to a given level of interest rates. That is why we have focused our readers on the yield spread between two-year and ten-year Treasury notes since the summer of 2015 to monitor the Treasury market’s assessment of how tight or easy monetary policy currently is.
- We have monitored the yield spread between two-year and ten-year Treasury notes as an indicator of whether investors viewed the pace of rate hikes by the Federal Reserve as too slow or deliberate -- which could lead to a build in inflationary pressures and cause a widening of the yield spread -- or too aggressive -- which could lead to a slowdown in the economy and keep a lid on inflationary pressures, resulting in a narrowing of the yield spread.
- As a point of clarification, it is not the narrowing of the yield spread which will cause a slowdown or contraction in real economic activity, it is the tightening of monetary policy by the Federal Reserve which will bring about the slowdown or economic downturn. The narrowing yield spread is merely the “canary in the coal mine,” warning of the looming slowdown or downturn, not the cause of it.
- Notice from the table below that the yield spread has declined from 125 basis points at the end of 2016 to only 24 basis points by the end of September, following the most recent rate hike, and a still low 27 basis points at the end of October. In the context of a neutral rate, we take the narrowing of the yield spread as a signal from the Treasury market that the Federal Reserve has reached that level of the federal funds rate where monetary policy is poised to flip from being neutral to the side of restraining the economy’s forward momentum.
- We continue to believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake. We believe the Federal Reserve is underestimating the extent to which the economy is likely to lose forward momentum next year, as the boost from the fiscal stimulus fades and the higher cost of credit takes a further bite out of households’ purchasing power.
- Additionally, while the focus is on where the central bank will take the federal funds rate, behind the scenes the Federal Reserve continues to shrink the size of its securities portfolio. The dual approach of hiking interest rates while reducing the securities holdings tightens monetary conditions at a more aggressive pace than increasing interest rates alone. Starting in October, the Federal Reserve increased the reduction in the size of its securities portfolio to $600 billion a year compared to $300 billion over the previous twelve months.
- We will continue to watch the two-year to ten-year Treasury yield spread for the market’s assessment of whether monetary policy has moved into the restrictive zone. We doubt the Federal Reserve will deliberately raise interest rates in such a manner that it pushes the yield on the two-year Treasury note above the yield on the ten-year Treasury note if inflationary pressures remain low. This is the primary reason we believe the proposed policy moves of another rate hike this year and four more in 2019-20 by the Federal Reserve are too aggressive.
- Given our perspective and the insights which we glean from tracking the yield spread in the Treasury market, we think investors responded to Jerome Powell’s comment of rates being “a long way” from neutral as a warning that the Federal Reserve was likely to respond to the current forward momentum in the economy by raising interest rates at least five additional times to 2020, and possibly more.
- If that were the case, monetary policy would become increasingly restrictive, leading to a slowdown in growth, or possibility a mild recession. Naturally, investors began to question the outlook for the economy, earnings, and stock prices in 2019-20 and started the process of lowering the risk in their portfolios by selling stocks and moving some assets to cash and/or fixed income with the yield on ten-year Treasury notes a little above 3%.
- We believe the hallmark of Janet Yellen’s term as chair of the Federal Reserve was her pragmatic approach to managing monetary policy. Remember that in both 2015 and 2016 the Federal Reserve signaled four rate hikes in both years and eventually only raised rates once in each year as concerns over global growth made it less likely the U.S economy could tolerate four rate hikes in each year.
- Given the progress made in raising interest rates, uncertainty over the impact of the tariffs, and the waning effects of the fiscal stimulus next year and into 2020, we think the financial markets would benefit from a good dose of pragmatism from the Federal Reserve currently. A pause in hiking interest rates would allow the FOMC Committee to gain important insights on growth and inflation after raising rates for three years. Hence our question, where is Janet Yellen when we need her?
C. Monetary Policy Uncertainty vs. Solid Fundamentals and Better Valuations.
- So from our perspective, the key question relative to the outlook for the economy, earnings, and stock prices is - will Chairman Powell and his compatriots at the Federal Reserve listen to the markets? Will they pause the rate hiking cycle next year -- following Janet Yellen’s lead in 2015 and 2016 -- and take some time to assess the impact on the economy from raising interest rates from zero in 2015 to 2% to 2.25% currently? Or will the central bank stay focused on their goal to raise rates to at least 3.25% to 3.5% by 2020 to provide themselves with more ability to lower rates during the next downturn in the economy and ignore the signals from the markets along the way?
- This is the key issue which will decide whether or not the economy and stock prices can continue to advance. Currently the economy has solid forward momentum as indicated by the 3% year-on-year gain the economy reported last week for 3Q 2018. However, certain sectors have weakened -- notably housing and light motor vehicle sales -- and businesses capital spending outlays have disappointed given the incentives contained in the tax reform for capital outlays which went into effect in January.
- Some capital expenditures are likely being delayed as companies try to figure out the short and long run impacts of the higher trade tariffs with China in terms of the disruption to existing supply chains. Tariffs raise costs and create uncertainty that affects tens of thousands of business decisions -- in purchases foregone, sales lost, or investments not made. Exports are also at risk from the roughly 9% rise in the U.S dollar since February and the growing trade war with China.
- Earnings have been very strong and the current estimate from Standard and Poor’s is that operating earnings should grow nearly 26% for all of 2018. Operating earnings are expected to advance about 12% in 2019 as the impact from the corporate income tax rate cut washes out of the data. The bull market in common stocks will end when investors can no longer incorporate growing earnings streams into their stock valuations.
- With the combination of strong earnings growth and little gain in stock prices so far in 2018, common stock valuations are much improved. Consider that since the night of the presidential election the S&P 500 is higher by 26.7%. However, over the past two years, operating earnings on the S&P 500 have risen over 45%. Consequently, the price-to-trailing operating earnings ratio on the S&P 500 has fallen to 18.2x currently, compared to 21.1x on the night of the election and 22.5x at year end 2017.
- We view the lower common stock valuations, as reflected in the decline in the P/E ratio so far this year, as a solid positive for the outlook for the stock market. Additionally, while October’s pullback was sudden and volatile, investors need to remember that the recent pullback was the 15th decline in the S&P 500 greater than 5% over the course of this bull market. As long as the economy and earnings continue to grow, stock prices can move higher.
- As for the Federal Reserve, we expect Jerome Powell and the other officials at the Federal Reserve to increasingly listen to the message from the financial markets -- both the shrinking yield spread between two-year and ten-year Treasury notes and the decline in stock prices last month. We look for the Federal Reserve to raise rates for the ninth time during this rate hiking cycle at the December 18-19 FOMC meeting.
- We look for a “dovish” hike, however, where the policy statement and/or Mr. Powell’s comments at the press conference allude to the possibility of pausing in 2019 if inflation remains under control and the economy’s growth rate slows from the roughly 3% pace of 2018. In that regard, some not so good economic data -- which we expect -- could be good for the stock market as it would increase the likelihood of the Federal Reserve pausing in early 2019. Lastly, Jerome Powell and the other members of the FOMC Committee should not feel they must continue to raise interest rates simply because President Trump is lobbying them not to do so.
II. Economic Growth
A. Strong Consumer Spending, Weak Housing, Business Capital Spending Stalls.
- The U.S. economy grew at a 3.5% annual rate in 3Q 2018, following a 4.2% growth rate in 2Q 2018 and was 3% higher on a year-over-year basis. Consumer spending rose at a strong 4% pace, supported by a strong jobs market, a moderate pace of wage gains, and the modest cut in personal income tax rates contained in the tax legislation passed late last year. Real disposable personal income did not quite keep pace with consumer spending, growing at a 2.5% annual rate, leading to a modest drop in the personal savings rate to 6.4% from an average of 7% during the first half of the year.
- The remaining details of the report pointed to some weakness in the rest of the private sector of the economy. Business capital spending eked out a small gain last quarter, growing at only a 0.8% rate, despite the hefty incentives contained in the tax legislation. The cut in the corporate tax rate and the immediate expensing of capital spending outlays were expected to spur healthy gains in business capital spending throughout 2018 and outlays on software, equipment, intellectual property, and structures did grow at a 10.1% annual rate during the first half of the year.
- Somewhat surprisingly, equipment outlays were basically flat at 0.4%, with a stall in spending on information processing equipment, softness in industrial equipment, and declines in transportation and other equipment. Structure outlays declined at a -7.9% rate last quarter, led by a -9.7% drop in energy structures as the oil rig count was largely unchanged in 3Q 2018 after growing by more than 2.5 times over the previous two years.
- The uncertainty over tariffs is likely causing some companies to hold off on making additional investments until there is more clarity on whether the trade war with China will escalate further or come to a near term resolution. Outlays on intellectual property products -- research and development on items from pharmaceuticals to entertainment, literary, and artistic originals -- rose at a strong 7.9% pace.
- Residential construction outlays declined at a -4% annual rate, the third consecutive quarterly drop after a hurricane-induced surge in 4Q 2017. A combination of rising mortgage rates and home prices have materially cut into affordability and the changes in the tax laws which reduced the incentives -- read that as subsidies -- for homeownership have weighed on the housing sector, for both new and existing homes, this year.
- Net exports subtracted -1.8 percentage points from the economy’s growth rate in 3Q 2018, after adding 1.2 percentage points to the economy’s 4.2% growth rate in 2Q 2018. Exports fell -3.5% after surging 9.3% in the previous quarter when a temporary spike in soybean and corn shipments were rushed to port to beat the imposition of tariffs by China. Imports surged 9.1% last quarter, again in an attempt to beat the imposition of tariffs, this time by the U.S.
- Inventories added 2.1 percentage points to the economy’s growth rate last quarter after subtracting -1.2 percentage points in 2Q 2018 when goods which would have been stockpiled got shipped to China and Europe to beat the tariffs. Inventories were replenished last quarter as exports fell and imports rose and as retailers stocked the shelves ahead of the coming holiday spending season.
- The distortions to the economy’s underlying growth rate from net exports and changes in business inventories have been exaggerated over the past two quarters by the threatened and actual imposition of tariffs by the Trump administration and by our trading partners in response. That is a key reason why we always track our favorite measure of final demand, domestic private final sales -- the sum of consumer spending, business capital spending, and housing outlays. Real DPFS rose at a solid 3.1% annual rate in 3Q 2018, slightly below the 3.5% gain in real GDP.
- The $300 billion two year federal spending bill -- which included a $165 billion increase in military spending -- showed up again in the GDP data with a 3.3% gain in federal government spending last quarter, following a 3.7% gain in 2Q 2018. Government spending was led by a 4.6% rise in national defense outlays, coming on the heels of a 5.9% jump in 2Q 2018. Improving state and municipal tax receipts led to a solid 3.2% gain in state and local government spending, the fastest pace in over two years.
- The best news in the GDP report was likely the inflation data. The GDP price index rose at a 1.7% annual rate after rising at a 3% pace in 2Q 2018. The easing in inflationary pressures was led by a -1.0% drop in prices for durable goods and a modest -0.1% drop in nondurable goods prices. The favorite inflation measure of the Federal Reserve -- the core personal consumption expenditures index – rose at only a 1.6% annual rate and was higher by 2% on a year-on-year basis, right in line with the central bank’s inflation target.
B. Consumers to Carry the Economy, however, at a Somewhat Slower Pace.
- We expect the economy to grow a touch below 3% in 4Q 2018 and just below 3% for all of 2018. Should the economy grow 3% this year, it would be the first time calendar year growth hit 3% since 2005. For 2019, the economy’s growth rate should slow to 2.5% as the Federal Reserve’s efforts to tighten monetary conditions and raise the cost of borrowing take a bigger bite out of household spending budgets and corporate cash flow and the stimulus from the tax cuts and the federal spending program begin to wane.
- Consumer spending should lead the economy next year as the solid jobs market keeps incomes growing. Housing outlays should be flat after falling a touch during 2018. Business capital spending will be flat to only moderately higher if the trade war with China persists, but could rebound at a mid-single digit pace on the back of the capital spending incentives if a resolution to the trade war is worked out.
- The distortions from net exports and changes in business inventories should lessen following their exaggerated influences during 2018. We expect inflationary pressures to remain near 2%, although some tariff related aberrations could add or subtract a couple tenths of a percent to the inflation figures on a quarter to quarter basis.
- 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 surge in consumer and business confidence, the efforts to loosen regulations and the fiscal stimulus 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.
- As stated earlier in this ISS, the major risk to the economy is the Federal Reserve making a policy mistake by unnecessarily slowing the economy’s growth rate below 2% or pushing it into a mild recession without a sustained rise in inflationary pressures above the central bank’s 2% target. 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.
III. Treasury Market
A. Ten-Year Treasury Yields Hit a Peak on October 8.
- After trading above 3% in mid-September, the yield on the ten-year Treasury note traded higher to a peak of 3.23% on October 8, compared to a yield of 3.06% at the end of September. It appears that the rise in the ten-year Treasury yield to the October 8 high was based on investors temporarily revising higher their outlook for growth. Notice in the table on the following page that of the 17 basis point rise in yield to October 8, only 3 basis points was accounted for by an increase in inflation expectations, while the TIP yield -- a proxy for growth -- rose by 14 basis points.
- The rise in the ten-year Treasury yield followed Federal Reserve Chairman Jerome Powell’s assertion that the central bank was “a long way” from getting interest rates to neutral, from which investors boosted their outlook for the economy’s growth rate. However, it appears the resulting turbulence in the stock market and some burgeoning signs of weakness and the low inflation readings in the 3Q 2018 GDP data led investors to slightly lower their inflation expectations and increase their purchases of longer maturity Treasury securities. Notice that as the ten-year yield fell from 3.23% on October 8 to 3.14% at month end, the TIP yield rose two basis points, while the inflation outlook declined by 11 basis points.
- The rise in Treasury yields since the end of August resulted from a combination of fundamental factors and an easing of recent geopolitical concerns. From a fundamental perspective, the acceleration in the economy’s growth rate this year, a firming in the core inflation rate to the Federal Reserve’s 2% target in recent months, larger federal budget deficits, and the Federal Reserve’s shrinking of its holdings of government bonds have pushed yields on Treasury securities higher. The moderate flight-to-safety into Treasury securities over the summer abated over the past two months on increased optimism that trade disputes -- outside of China -- Italy’s political crisis, and problems in emerging markets will not derail the global economy. These factors will continue to place a floor under ten-year Treasury yields.
- Keeping a lid on ten-year Treasury yields is the Federal Reserve’s effort to raise short-term interest rates, which is increasing borrowing costs -- which in turn is contributing to the weakness in housing and light motor vehicle sales -- and the roughly 9% gain in the U.S. dollar since early February which lowers the cost of imports and hurts U.S. exports.
- We continue to balance the factors placing a floor under Treasury yields with those keeping a lid on Treasury yields. It is also important to acknowledge the more aggressive pace at which the Federal Reserve will shrink the size of its securities portfolio over the next twelve months and the recent upward momentum in yields on longer dated Treasury securities which pushed the yield on the ten-year Treasury back over 3% again in mid-September. Taking all these issues into consideration, we look for a near term trading range for the ten-year Treasury note of 2.90% to 3.25%.
Joseph T. Keating
Chief Investment Officer
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.