CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
November 1, 2019
I. Equity Markets
A. After a Slow Start, S&P 500 Hits Record High During October.
- The markets were hit by renewed recession fears in early October as the manufacturing purchasing managers’ index fell to 47.8 in September, the lowest reading in ten years, following 49.1 in August. A reading below 50 indicates a contraction in the sector. The pullback in manufacturing activity triggered fresh concerns about the impact of the trade war with China -- trade flows this year are running at the weakest pace since the financial crisis -- and the global economic slowdown.
- The weak reading on the manufacturing sector was followed by the service sector purchasing managers’ survey slipping to 52.6 in September, the lowest reading since August 2016, from 56.4 in August. The slowdown in the service sector raised concerns that the downturn in manufacturing is spreading to the much larger service sector of the economy. A healthy jobs report for September -- employers added 136,000 jobs and the unemployment rate dropped to 3.5%, the lowest reading since December 1969 -- eased fears that the economy was about to fall into recession. The mixed signals on the economy has investors trying to determine if the economy is about to embark on a prolonged slowdown, a recession, or just another speed bump in the more than ten year economic expansion.
- Investor sentiment received a boost after President Trump announced a “fundamental agreement in principle” for a “phase one deal,” subject to “getting papered”, following the cabinet level negotiations with Beijing in Washington during the second week of October. The partial deal -- in which China will make some $40 to $50 billion purchases of agricultural products over two years and has promised to better protect U.S. intellectual property and permit more foreign financial services -- represents the first step forward to end the trade war in 15 months.
- In return for these concessions from China, the U.S. did not increase tariffs to 30% from 25% on $250 billion of Chinese goods on October 15 as President Trump had planned. Despite Mr. Trump repeatedly describing the trade deal as “tremendous,” it basically boiled down an agreement to postpone the scheduled escalation in the trade war by the U.S. on October 15 in exchange for a two year promise to boost agricultural product purchases by China. Think of the October deal as a truce in the trade war, but it surely beats the alternative of escalating tariffs that have already caused a significant global economic slowdown.
- The two countries also agreed to keep talking toward what Mr. Trump called a “phase two” agreement which would include the thornier issues of Chinese technology theft, greater access to Chinese markets, Chinese support of state-owned firms, and existing tariffs on Chinese imports. The implication is that if sufficient progress is made on “phase two” by early December, President Trump will cancel the tariffs planned for December 15 on a wide array of Chinese goods which would more directly impact U.S. consumers.
- Both sides received something positive in the October truce. China avoids a further boost in tariffs which have been hurting its exports and manufacturing sector, while President Trump gets election year farm purchases which will soften the harm the trade war has done to American farmers. The boost to investor confidence supported stock prices and lifted consumer confidence. The truce will also begin to reduce the uncertainty that has hindered business capital spending and the manufacturing sector in the U.S.
- The S&P 500 reached a new all-time high this week following reports that the U.S. and China made progress in the trade talks, edging closer to finalizing portions of the “phase one deal.” The weakened political positions of both President Trump and President Xi increase the likelihood of a trade deal between the U.S. and China. Both men now have more to lose with the impeachment investigation in the U.S. and the political unrest in Hong Kong.
- Another positive for common stocks is that the S&P 500 companies have largely managed to beat analysts’ earnings estimates for 3Q 2019 earnings, although earnings expectations were low because of the global economic slowdown and the U.S. - China trade fight. The anticipation that the Federal Reserve would cut rates for the third time this year on Wednesday also lifted investors’ spirits.
- At its low point during August, the market was pricing stocks as if the economy was on the footsteps of a recession. The solid gains of 2.4% to 4.5% across the four major market measures during September and October reflect a lowering of recession fears. For the month of October the various stock market measures posted moderate gains of 0.5% to 3.7% and are higher by 15.9% to 25% for the first ten months of 2019.
B. Investor Worries are Subsiding a Touch.
- In the last two ISS’s we wrote about investors worrying that they could be missing something in their analysis which could be very negative, i.e., a black swan event. In particular, investors were concerned about tariff policy, negative policy rates at several major central banks and negative yields on sovereign debt, the inversion of the Treasury curve, and the completely unpredictable and somewhat capricious manner in which President Trump threatens and/or implements tariff policies. The good news is that these worries eased further during October, following some improvement during September.
- First, President Trump announced in early October that a rough framework toward a “phase one deal” with China had been hashed out during two days of talks between senior U.S. and Chinese officials in Washington. While the two countries remain a long way from a comprehensive trade deal, the truce between the two countries offered encouragement that the ongoing escalation of trade tensions could be over.
- Secondly, yields on longer maturity sovereign bonds, including U.S. Treasury securities, have risen for two months. While negative yields are still in place in several markets overseas, they are less negative. Consider that the ten-year German bund recorded an all-time low yield of -72 basis points on August 28. While still negative, the ten-year German bund ended October with a yield of -41 basis points, continuing its move toward positive territory. In France, the ten-year government bond yield ended October at -11 basis points compared to -48 basis points on August 28.
- As for negative policy rates at several major central banks, our sense is that a consensus is forming that taking policy rates negative provided no substantial boost to economic growth, while they hurt bank earnings, likely providing a headwind to growth. We would not be surprised if the transition from Mario Draghi to Christine Lagarde as the head of the European Central Bank leads to the end of negative policy rates in the euro zone over the next year or so.
- Thirdly, the modest inversions of the Treasury yield curve went away. The inversion from three-months to ten-years hit -50 basis points on August 28, but the yield spread ended October at 17 basis points. The slight inversion -- -4 basis points at its worst -- from two-years to ten-years for four days in late August improved further, with the yield spread ending October also at 17 basis points. We had argued that the yield curve becoming inverted from longer maturity yields falling further than shorter maturity yields fell was not a recession signal, but now that discussion is moot with the inversions washing out of the Treasury market.
- Lastly, President Trump has gone radio silent on new tariffs announcements. It appears his advisors have convinced him that the uncertainty caused by tweeting unexpected tariff policies was hurting the U.S. and global economies, which could undermine his election efforts a year from now. As stated earlier in this ISS, we also believe Mr. Trump’s weakened political position is a positive for ending the trade war with China and for all of the trade conflicts in which he has engaged. In sum, it appears that investors assigned a smaller probability to the worst case scenarios which they have been worrying about actually occurring.
C. Longer Economic Expansion, a Pickup in Earnings, and Longer Bull Market.
- Following the release of the encouraging third quarter real GDP figures this week -- discussed later in this ISS -- and the rate cut the Federal Reserve delivered Wednesday, we believe the economic expansion is capable of extending for several more years. This leads us to believe that the bull market in common stocks could last a lot longer than most investors expect. There are hundreds of companies that are thriving in the current moderate growth, rising productivity, low cost of capital, low bond yields, and low inflation environment.
- While the majority of the advance in stock prices for 2019 is likely already in hand, a large drop in stock prices does not seem to be immediately ahead as there are hardly any signs of a recession on the horizon, stock valuations are not dangerously high, and we believe the Federal Reserve has done its job in trying to extend the current economic expansion by delivering three rate cuts this year as there are few signs of building inflationary pressures.
- With roughly 74% of companies reporting, S&P 500 operating earnings are lower by -3.3% in 3Q 2019 on a year-over-year basis, following gains of 4% and 3.9% over the first two quarters of the year. While this is the first year-over-year decline since 2Q 2016 following the collapse in oil prices, earnings reports have not been nearly as bad as investors had expected coming into 2019. While the global economic slowdown and the trade war with China hurt operating earnings last quarter, the slowing over the first half of the year and the modest drop in operating earnings last quarter are largely due to the roll-off of 2018’s corporate tax rate cut on year-over year comparisons.
- Operating earnings in the current quarter are expected to grow in the realm of 10% to 15% as the more than 40 central bank interest rate cuts this year begin to support the global economy, the uncertainty from the trade war with China stops getting worse, consumer spending and residential construction outlays continue to support the U.S. economy, and year-on-year comparisons become easier. A trade deal with China would just make the backdrop that much more positive.
- Two additional positives for common stocks are the modest gains since January 2018 and the low level of Treasury yields. In the excitement following the passage of President Trump’s tax cuts in late 2017, the S&P 500 hit a then record of 2873 on January 26, 2018. The S&P 500 is higher by only 5.7% since then, while operating earnings are higher by more than 20%. Consequently the price to trailing operating earnings ratio for the S&P 500 has fallen from 23.1x to 19.8x currently, a -14% decline.
- Additionally, Treasury yields on securities between two years and thirty years have fallen -122 to -157 basis points since October 5, 2018, with the yield on the ten-year Treasury note ending October at 1.69%. The low level for Treasury yields does not provide much competition to common stocks which can provide capital gains and a dividend yield of 1.96%, both of which have preferential tax treatment. We remain inclined to buy stocks on any pullback, rather than selling stocks as the bull market advances.
II. Monetary Policy
A. Divided Federal Reserve Cuts Rates Again, Signals a Pause Could Be at Hand.
- For the second consecutive FOMC meeting, a divided Committee cut the target range for the federal funds rate by 25 basis points, to a level of 1.5% to 1.75% at the October 29-30 FOMC meeting. The vote to lower interest rates was 8-2 with two Federal Reserve Bank presidents (Esther George of Kansas City and Eric Rosengren of Boston) preferring to keep the funds rate steady. At the press conference, Federal Reserve Chairman Jerome Powell pointed to the global economic slowdown and trade tensions against a backdrop of muted inflationary pressures as the reasons for the rate cut.
- The Federal Reserve indicated that the moves to ease monetary policy could be nearing a pause by dropping the phrase to “act as appropriate to sustain the expansion” in the policy statement and replacing it with “monitor the implications of incoming information for the economic outlook as it assesses the appropriate path of the target range for the federal funds rate.” In other words, the new language suggests an increased level of data dependence for future policy moves -- the data would need to deteriorate further to justify another rate cut -- rather than an ongoing intent to cut rates further.
- At the press conference following the FOMC meeting, Jerome Powell said that the Federal Reserve would need to see a “really significant move up in inflation” before the central bank thought about hiking interest rates again. Common stock prices rose during the press conference as Mr. Powell struck just the right tone to satisfy investors by signaling it would likely pause rate cuts, but would not think of hiking rates again until the rate of inflation moved noticeably higher.
- The FOMC Committee again expressed little concern over the domestic economy, referring to the labor market as “strong” and economic activity as “rising at a moderate rate,” but did state that business fixed investment and exports “remain weak.” Additionally, the policy statement noted that “overall inflation and inflation for items other than food and energy are running below 2 percent.”
B. What Is a Reasonable Outlook for Monetary Policy?
- Typically the Federal Reserve cuts interest rates because the economy is slowing sharply and is in danger of falling into recession, or has actually entered a recessionary period. At times, however, the Federal Reserve has cut interest rates because the risks to the economic expansion have risen -- a risk management approach to monetary policy.
- This is precisely what the Federal Reserve did in 1995 and again in 1998, cutting interest rates three times for a total of 75 basis points on each occasion, avoiding possible recession both times. The Alan Greenspan-led Federal Reserve took out insurance policies by pre-emptively cutting rates when the economy still appeared healthy, but external threats to the economic expansion were evident.
- It is telling that Chairman Jerome Powell and Vice-Chairman Richard Clarida have referenced the 1995 and 1998 episodes on several occasions. In 1995, the Federal Reserve responded to moderating price pressures after a sustained bout of tightening from early 1994 to early 1995. In 1998, it was the Asian financial crisis, the Russians debt default and the near collapse of hedge fund Long Term Capital Management that led the Federal Reserve to cut rates.
- These episodes appear to be serving as a template for Jerome Powell, a lawyer by training who pays attention to the concept of precedent. With three rate cuts under its belt despite the economy continuing to grow at a moderate pace, the Federal Reserve has clearly taken a risk management approach to monetary policy in light of the uncertainties associated with the Trump administration’s use of tariff policy and the slowdown in the global economy.
- With the Federal Reserve cutting rates three times this year, we no longer view monetary policy as tipping to the side of restraint. Consider that when the Federal Reserve raised the target for the federal funds rate by 25 basis points to a range of 2% to 2.25% at the conclusion of the September 25-26, 2018 FOMC meeting, it marked the first time in a decade that the target for the federal funds rate was above the rate of inflation which was roughly 2% on the core personal consumption deflator at that time. When the central bank raised rates further to 2.25% to 2.5% at the December 18-19, 2018 FOMC meeting, it only pushed the target for the federal funds rates even higher above the inflation rate.
- With the core personal consumption deflator currently measuring inflation at 1.7%, the three rate cuts this year have brought the lower end of the current 1.5% to 1.75% target range for the federal funds rate below the inflation rate, i.e., negative real interest rates. While we do not view the current stance of monetary policy as highly accommodative, it is clearly not a tight policy stance. Given this perspective, we do not expect any further rate cuts this year. When the Federal Reserve cut rates at the July 30-31 FOMC meeting, Mr. Powell referred to the rate cut as a “mid-cycle adjustment,” not the beginning of a rate cutting cycle, and we think the appropriate adjustment has been made.
- The wild card, of course, is how the current trade negotiations with China play out. A further escalation in the trade war would negatively impact domestic and global growth and could lead to further rate cuts by the Federal Reserve. As stated previously in this ISS, we do not view that as the most likely outcome, meaning that the precedents of monetary policy in 1995 and 1998 could hold, i.e., three rate cuts in total. As always, stay tuned!
III. Real Economic Activity
A. Solid Third Quarter Growth, No Recession in Sight.
- The 1.9% advance in real GDP during 3Q 2019 pointed to the economy remaining on solid footing, with no recession in sight. While consumer spending slowed from its 4.6% rate of growth in 2Q 2019, the 2.9% growth rate reported for last quarter was better than expected, supported by good jobs growth -- 161,000 monthly average so far in 2019 -- which translated into a 2.9% gain in real disposable personal income last quarter. Goods purchases led the way, growing at a 5.5% annual rate.
- After declining for six consecutive quarters, housing outlays rebounded at a 5.1% annual rate last quarter as mortgage rates fell to the 3.5% area compared to a peak near 5% a year ago. The housing market had been held back by the decline in housing affordability due to sharp gains in home prices and the prior rise in mortgage rates. The cap on the deduction for state and local taxes contained in last year’s tax bill has also had a negative impact on the housing market, particularly in high tax zip codes.
- The bifurcated nature of the economy’s growth which developed in 2Q 2019 continued into the third quarter, with solid household spending offsetting businesses taking a more cautious approach due to the headwinds of slowing global growth and the uncertainty which accompanies the trade war with China. Business capital spending -- which covers spending on software, research and development, equipment, and structures -- declined at a -3% rate, following a -1% decline in 2Q 2019.
- Structure outlays plunged at a -15.3% rate in 3Q 2019, following an -11.1% drop in the previous quarter, as outlays related to the oil and natural gas industries dropped sharply and as expansion plans have largely been placed on hold with the Trump administration placing tariffs on Chinese goods to gain leverage in trade negotiations. Equipment outlays declined at a -3.8% pace last quarter after rising in 11 of the previous 12 quarters as spending on aircraft fell amid the continued grounding of Boeing’s 737 MAX jetliner and the trade war impact. The one bright spot in business investments was a 6.6% rise in intellectual property investment driven by ongoing innovation.
- The inflation figures remained low, largely below 2%. The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose at a 1.4% annual rate in 3Q 2019, while consumer prices advanced at a 1.5% pace. The Federal Reserve’s preferred measure of inflation, the core personal consumption expenditures price index rose at a 2.2% rate last quarter, but was higher by only 1.7% on a year-on-year basis.
B. Look for the Economic Expansion to Continue, with Still Low Inflation.
- It appears to us that the economy’s growth rate will continue at a pace near 1.5% to 2% over the next few quarters, basically in line with the economy’s potential growth rate. The somewhat slower pace of growth this year -- 2% on a year-on-year basis -- compared to the 2.7% average over the previous two years is due to the tightening of monetary policy by the Federal Reserve from 4Q 2015 to 4Q 2018, the waning stimulus from the 2018 tax cuts, and the drags from slowing global growth and the uncertainties created by the trade war with China.
- Consumer spending should grow at a pace near 2% to 2.5% as the solid jobs market keeps incomes growing. Housing outlays should post modest gains as the low level of mortgage rates, growing household incomes, and moderating gains in home prices bolster affordability. Business capital spending is poised to rebound once the uncertainty over the trade war with China clears up, however, that may not be for a year or so. Additionally, the looming presidential election will likely also weigh on business sentiment given the left leaning policies of the leading Democratic candidates.
- 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, technology, and inflation targeting by central banks around the globe 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 and inflation targeting 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 and innovation are making businesses more efficient and productive.
- The current economic expansion is now the longest on recorded at ten-plus years. There is no reason this expansion cannot continue for several more years with the Federal Reserve currently cutting rates, reversing a tightening which went too far in 2018. The biggest risk to the expansion is the ongoing trade war with China. If the current truce holds, or if tensions are reduced further, that is a positive for the economic outlook.
- If another escalation in trade tensions occurs -- read that as a further increase in tariffs -- then the expansion will be placed on shakier ground if consumer prices rise and business capital spending takes another leg lower. Our view is that mounting political pressures on President Trump and President Xi place the odds of the truce remaining in place, or even progress toward a trade deal, higher than the odds of a worsening of the trade war.
IV. Treasury Market
A. Treasury Yields Continue Their Move Higher.
- As investor sentiment improved during September and October, yields on longer maturity Treasury securities rose modestly and the Treasury yield curve steepened. As covered earlier in this ISS, investor worries over the trade war with China, domestic growth, and the inversion of the Treasury curve eased, leading investors to take on more of a risk-on position, providing a lift to stock prices and Treasury yields.
- Yields on three-month and one-year Treasury bills have fallen -46 and -26 basis points, respectively, over the past two months as the Federal Reserve cut interest rates at both the September 17-18 and the October 29-30 FOMC meetings. Consider that the yield on the three-month Treasury bill was 1.98% at the end of August and ended October at 1.52%.
- From five years to thirty years, yields on Treasury securities have risen 13 to 22 basis points over the past two months following the somewhat panicked flight-to-safety during August which saw yields on Treasury securities from two years to thirty years fall -37 to -57 basis points, representing a truly risk-off move on the part of investors.
- A portion of the rise in yields on longer maturity Treasury securities over the past two months can be attributed to a lessening of the gravitational pull from negative yields on overseas sovereign bonds. Consider that in August some $17 trillion of foreign sovereign debt carried negative yields, the ultimate flight-to-safety by overseas investors. At the end of October, $12.8 trillion of sovereign debt carried negative yields, still a huge number, but the trend is in the right direction in our opinion. Investor sentiment in the euro zone was boosted after the European Union agreed to delay Brexit until the end of January.
- The yield on the ten-year German bund has risen to -41 basis points from -72 basis points in August and the yield on the ten-year government security in France is now -11 basis points compared to -48 basis points in August. The continuation of negative bond yields is reflective of the weakness in overseas economies, uncertainties flowing from President Trump’s use of tariff policy, and a still strong flight-to-safety resulting from both of those concerns, as well as worries over a lack of policy wherewithal to address future recessions.
- Given our view that the U.S. economy was not at risk of falling into recession near term, we stated in the September ISS that it was unlikely yields on longer dated Treasury securities would fall materially below the lows recorded during August. Notice in the table below that the Treasury TIP yield -- a widely followed indicator of real growth expectations -- had fallen from 0.97% at year end to -0.04% at the end of August. It seemed to us that yields on longer dated Treasury securities did not appropriately reflect expectations for U.S. growth and were being held captive to the gravitational pull of negative sovereign bond yields overseas.
- Notice in the table above that as ten-year Treasury yields during rose 19 basis points during September and October, ten-year TIP yields rose 18 basis points from -0.04% to 0.14%, with the implied inflation expectation largely unchanged at 1.55%. We thought that the decline in the ten-year Treasury TIP yield was overstating the risks to the economy, largely due to the strong flight-to-safety by investors as they tried to understand the endgame of tariff policy and the implications of negative policy rates and negative sovereign bond yields across the globe.
- The inflation premium embodied in the ten-year Treasury is virtually unchanged from the end of August and is not noticeably different from year end. The ten-year TIP yield still looks too low currently, given the moderate, albeit decelerating, forward momentum in the U.S. economy. The real unknown is the extent to which growth and yield starved overseas economies and bond markets will keep downward pressure on Treasury yields.
- We continue to believe that with almost $13 trillion of foreign sovereign debt carrying negative yields, global investors are still crowding into longer maturity Treasury securities. The rapid declines in Treasury yields this year makes a much stronger statement about weak growth overseas than it does about the prospects for U.S. growth. We continue to look for the yield on the ten-year Treasury note to rise toward 2% over the next couple months on the back of a resilient U.S. economy.
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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