CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
September 3, 2019
I. Equity Markets
A. Tepid Federal Reserve Response and Tariff Threats Roil Markets.
- August was exhausting! Investors were hit with a one-two punch as July turned to August. First, the Federal Reserve disappointed investors by cutting rates by 25 basis points rather than 50 basis points as many had hoped at the July 30-31 FOMC meeting. More importantly, however, Federal Reserve Chairman Jerome Powell did not specifically commit to additional rate cuts. Two dissenting voters provided little indication of a strong desire for more rate cuts by the Committee. Mr. Powell made it explicit in the press conference that the central bank did not see itself embarking on a prolonged easing cycle by referring to the rate cut as a “mid-cycle adjustment.”
- In an ironic turn of events, Mr. Powell noted that one key risk that led the Committee to cut rates -- trade policy tensions -- had gone from “almost boiling over” during the spring to more of a “simmer” at the time of the FOMC meeting. Tensions returned to a “boil” on August 1, however, after President Trump abruptly ended the cease fire with China by moving to extend tariffs to essentially all Chinese imports, apparently to the surprise of most of his administration, escalating a trade conflict that was now poised to hit U.S. households directly. The new 10% tariffs were scheduled to take effect September 1 and cover $300 billion in Chinese goods -- including apparel, laptops and tablets, toys, smartphones, and other consumer products.
- This latest round of proposed tariffs would come on top of 25% tariffs already imposed on $250 billion of imports from China. It appears Mr. Trump threatened to impose the additional tariffs after the late July trade talks in Shanghai did not yield enough progress, particularly on China purchasing additional U.S. farm products and policing illegal drug flow into the U.S. The shift by investors to more of a risk-off position accelerated after China retaliated by allowing the yuan to weaken and halting imports of U.S. agricultural products.
- In a sign that President Trump is coming around to understanding that his top two priorities prior to the 2020 election -- a strong stock market and a tough trade deal with China -- are at odds with each other, the United States Trade Representative office announced the morning of August 13 that the new tariffs on certain consumer goods would be delayed until December 15, while other products were being removed from the new China tariff list altogether. By partially backing off on the new China tariffs, Mr. Trump likely showed just how much pain his administration can tolerate in the runup to the 2020 election.
- The products in the group which had new levies delayed until mid-December include cellphones, video game consoles, laptops, and “certain toys” -- all of which are critical to the U.S. consumer market, especially during the Christmas shopping season. Separately, China’s Commerce Ministry said Vice Premier Liu He had a phone call with U.S. Trade Representative Lighthizer and Treasury Security Mnuchin and that trade talks were set to continue in two weeks, before the September 1 deadline.
- As August drew to a close, investors turned their attention to Federal Reserve Chairman Jerome Powell’s opening remarks at the Federal Reserve’s annual economic symposium in Jackson Hole, Wyoming. Mr. Powell did not push back against market expectations of a second rate cut at the September 17-18 FOMC meeting. He also left the door open to additional rate cuts should the economy weaken further from the escalating trade war with China by stating that, “We will act as appropriate to sustain the expansion.”
- Our assessment of Jay Powell’s remarks is that he was dovish enough relative to investor expectations as far as the Federal Reserve providing additional stimulus to the economy. Before Mr. Powell’s speech, China announced tariffs of 5% and 10% on the remaining $75 billion of U.S. products which have escaped duties since the trade war began a little over a year ago. The markets took that news in stride and stock prices rose modestly during Mr. Powell’s speech and immediately after.
- Shortly after Jay Powell concluded his remarks, however, President Trump unveiled one of the most outrageous torrents of tweets that investors have ever had to deal with. First, Mr. Trump tweeted, “My only questions is, who is our bigger enemy, Jay Powell or Chairman Xi?” President Trump followed that up with, “We don’t’ need China and, frankly, would be far better off without them.” Mr. Trump topped it off with ordering U.S. companies to “immediately start looking for an alternative to China, including bringing your companies HOME and making your products in the USA.”
- Later that day President Trump tweeted that he intended to raise the tariff rate on existing and planned tariffs by an additional five percentage points. Tariffs already in place on $250 billion of China goods will rise to 30% on October 1 and tariffs planned to take effect September 1 and December 15 on roughly $300 billion will rise to 15%.
- Not surprisingly, stock prices fell on August 23, bouncing off the recent lows of August 7 and August 14, about -5.5% to -6.5% below the high recorded for the S&P 500 on July 26. Treasury yields fell further during August with the yield on the ten-year Treasury note falling below 1.5%, the two-year to ten-year Treasury yield curve went negative at -5 basis points at its worst on August 27, and the yield on the thirty-year Treasury bond fell below 2% for the first time in history.
- Common stock prices rallied last week after President Trump struck a more conciliatory tone on the final day of the Group of 7 Summit held in Biarritz, France August 25-27 and China said it wished to resolve its protracted trade dispute with the world’s largest economy with a “calm attitude.” Common stocks snapped a four week losing streak to end a volatile August with the S&P 500 -3.3% below its all-time high recorded July 26. While the major market indices fell by -1.7% to -5.1% during August, they are still higher by 10.8% to 20% over the first eight months of the year, and are higher by a healthy 18% to 28.6% since the December 24 lows.
B. Investors Worry They Are Missing Something.
- There was a real dichotomy between the health of the economy and the skittishness of investors during August as both yields on longer-dated Treasury securities and stock prices fell sharply. First, the economy looks to be on solid footing with a moderate pace of growth, a low unemployment rate, decent wage growth, rising productivity, low cost of capital, low bond yields, and low inflation.
- This does not mean the trade war and threats of additional tariffs on China goods are helping the overall economic outlook. However, the economic backdrop is still good and far from supporting the near panic buying of Treasury bonds and selling of common stocks that took place.
- While the economy currently does not appear to be a source of concern, investors are worrying that a negative feedback loop from slowing global growth, the disruption to global trade, and the volatility in the financial markets will push the economy into recession over the next year or so. Investors are concerned that they are missing something in their analysis that is very negative as four things, in particular, are perplexing.
- One is the use of tariffs by the Trump administration to provide the U.S. with leverage in negotiations with China to force significant changes in its unfair and predatory trade practices. While we believe the trade issues with China needed to be addressed to protect U.S. interests, tariff policy has not been used extensively for over 80 years. Unveiling and using punitive tariff policy after decades of developing a highly complex and integrated global trading system, with well entrenched supply chains, is very difficult to analyze in terms of its ultimate economic impact.
- The second thing perplexing investors is the notion of negative policy rates at several major central banks and negative yields on sovereign debt across the globe -- currently totaling $16 trillion. Negative policy rates and sovereign yields are unique to the current time and never existed before. Frankly, we find negative yields to be somewhat puzzling and view negative sovereign bond yields as an extreme manifestation of a flight to safety among investors in those countries where negative bond yields are widespread. Negative yields could reflect fears of a lack of policy wherewithal to address a future downturn in economies across the globe.
- The recent inversion of the yield curve is the third perplexing thing investors are facing. An inversion of the Treasury yield curve -- shorter maturity yields above longer maturity yields -- is considered an important recession indicator. The minor inversion of the two-year to ten-year yield curve on August 14 through the end of the month brought about a spike in recession fears, although the three-month to ten-year Treasury yield spread has been narrowly negative since mid to late May, following a brief five day inversion during March.
- While an inversion of the yield curve has proceeded all post-WWII recessions, not all yield curve inversions signal an imminent recession. Specifically, the yield on the three-month Treasury bill ended August at 1.98%, compared to a yield of 1.50% on the ten-year Treasury note.
- It seems to us that the recent inversions along the Treasury yield curve makes more of a statement about rapidly slowing growth overseas, particularly in Europe, rather than in the U.S. We see few excesses or imbalances in the U.S. economy that may lead to a recession in the near term. How the yield curve inversion occurs is very important. A sharp decline in yields on longer maturity Treasury securities has led to the yield curve inversion, not a sharp rise in yields on shorter maturity Treasury securities. Rapid declines in the yield on ten-year German bunds seem to be the key driver in pushing yields on longer maturity Treasury securities lower.
- Lastly, given the completely unpredictable and somewhat capricious manner in which President Trump threatens and/or implements tariff policy, there is no way for investors or business leaders to gameplan for this new addition to the policy tool kit in Washington. Well established supply chains have been or could be further disrupted, corporate profits are impacted in unexpected ways, some business capital spending plans are postponed or cancelled, and a negative feedback loop to consumer demand is possible.
C. U.S. Expansion Remains Intact, Corporate America Went on Sale During August.
- Over more than a year, significant tariff increases on Chinese imports have not turned corporate profits into losses, has not curtailed steady jobs growth, and has failed to flame inflationary pressures. While both sides are losers in a trade war, so far the U.S. has weathered the trade war in a reasonable manner with the major negative being a rise in uncertainty among business leaders which has slowed business investment. It appears that the primary response to the tariffs on Chinese imports is the shifting of supply chains -- both manufacturing and assembly -- out of China.
- We need to acknowledge it is possible that no comprehensive trade deal with China may be on the horizon as both sides appear to have hardened their positions since the trade talks broke down in early May. Right now it seems the best we can hope for is a protracted truce in the trade war with China, or possibly a small deal rather than the type of sweeping trade deal which appeared within reach this spring.
- The signals out of Washington could not be more mixed. While it is hopeful that President Trump delayed most of the threatened new tariffs on China imports to December 15, he also raised those tariffs by five percentage points in two steps effective September 1 and December 15 and raised tariffs on the first tranche of $250 billion of China goods by five percentage points effective October 1. Additionally, does it matter to Beijing that President Trump called President Xi an enemy and ordered U.S. companies to leave China?
- However, it is encouraging that a spokesperson for China’s Ministry of Commerce said, “We firmly reject an escalation of the trade war and are willing to negotiate and collaborate in order to solve the problem with calm attitude,” hinting that Chinese authorities will not retaliate against the latest round of U.S. tariffs.
- We continue to assert that a trade deal with China is not essential or necessary to keep the U.S. economy and the stock market moving forward. Recession concerns are overblown as $100 to $150 billion of tariffs, partly offset by currency devaluations and seller concessions, spread over a $20 trillion economy will not necessarily push the U.S. economy into recession.
- However, investors are also facing several hurdles beyond the heightened trade tensions and the global slowdown -- tensions in the Middle East, the European Central Bank’s leadership transition from Mario Draghi to Christine Lagarde, the increasingly violent antigovernment protests in Hong Kong, and the Brexit October 31 deadline. Unless there is a major breakthrough in the trade negotiations with China which markedly lowers uncertainty and investor’s anxiety, equity markets are likely to trade in a fairly volatile fashion over the course of the next couple months.
- It seems the longer the current economic expansion lasts, the greater is the fear of an oncoming recession. Following the release of the encouraging second quarter real GDP data, solid jobs growth, and the rate cut the Federal Reserve delivered at the end of July and the likelihood of more rate cuts to follow, we believe the economic expansion is capable of extending for several more years.
- Additionally, reassurances of additional monetary and fiscal stimulus from several major economies across the globe should cushion the slowdown in U.S. and global growth. This leads us to believe that the bull market in common stocks could last much longer than most investors expect. We remain inclined to buy stocks on any pullbacks -- and did so during August -- rather than selling stocks as the bull market advances.
- Common stocks become more attractive as their prices fall if there are high quality companies with growing streams of earnings and cash flow behind them. In a lower for longer inflation, interest rate and bond yield environment, high quality dividend paying companies with reasonable expectations of growing their payouts are one of the best places that investors can place their money. There is a wide array of companies yielding 3% or more that became a good deal more attractive during August.
II. Monetary Policy
A. Escalating Trade War Will Bring Additional Rate Cuts.
- Federal Reserve Chairman Jerome Powell stated in the press conference following the July 30-31 FOMC meeting that insuring against the downside risks to the economy from the negative impact of President Trump’s tariff policies was a key reason behind the central bank cutting rates and the possibility of additional rate cuts over the remainder of 2019. It is clear that the escalation of the trade war with China prior to President Trump’s August 1 announcement had already taken a toll on the U.S. and global economies as it has disrupted supply chains and hurt final demand, business confidence, and capital spending plans.
- Despite the partial cease fire announced on August 13, Mr. Trump’s declaration on August 1 to place a 10% tariff on an additional $300 billion of Chinese goods and then threatening to further raise the tariff rates on August 23 only increases the likelihood of the Federal Reserve cutting rates at least once, and more likely two additional times before year end. The so-called neutral level of interest rates -- where policy is neither stimulating nor restraining the economy’s growth rate -- has likely fallen given the weakening pace of global growth and the Trump administration’s extensive use of tariff policy which has led to an escalation of the trade war with China.
B. What Is a Reasonable Outlook for Monetary Policy?
- Following the sharp drop in stock prices and bond yields over the first two weeks of August, several Federal Reserve officials stated that lower interest rates might be warranted later this year amid a more uncertain trade outlook, which makes the economic outlook unusually complicated. Tariff policy is challenging for everyone to figure out -- including for the army of economists at the Federal Reserve -- due to its negative impact on business confidence and capital spending plans as firms rethink and reorganize their supply chains.
- Despite the Federal Reserve cutting rates at the July 30-31 FOMC meeting, we continue to view monetary policy as tipping to the side of restraint. As seen in the table below, the Treasury yield spread between two-year and ten-year Treasury securities was zero at month end following the two-year to ten-year yield spread first turning slightly negative on August 14. Investors need to remember that yield curve inversions do not cause recessions, they can only signal that monetary policy is tight, which could cause a recession depending on how tight policy becomes and how long policy remains tight.
- We have commented that whereas the shorter end of the Treasury yield curve, three-months to two-years, belongs to the Federal Reserve, the longer end reflects increasingly growth and yield starved overseas economies and bond markets. With some $16 trillion of sovereign debt carrying negative yields, global investors are crowding into longer maturity Treasury securities. The decline in yield on the ten-year Treasury note makes a much stronger statement about weak growth overseas than it does about the prospects for U.S. growth.
- It seems as though President Trump is going to give Jay Powell ample opportunities to follow through on his vow to “act as appropriate to sustain the expansion” after his remarkable series of tweets on August 23. Mr. Powell had already warned at Jackson Hole about the risks to the U.S. economy from escalating trade tensions and the limited ability of the Federal Reserve to cushion any fallout. He cautioned that the central bank’s policy tools are not well suited to counter rising business and investor anxieties over the intensifying trade war between President Trump and President Xi.
- Mr. Powell stated that there are “no recent precedents to guide any policy response to the current situation.” Moreover, while monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a “settled rulebook for international trade.” Jay Powell’s comments implicitly blamed the trade war for aggravating a global economic slowdown that has weakened U.S. manufacturing and business investment, clouding an otherwise solid domestic outlook.
- The sharp decline in Treasury yields, particularly since the beginning of the year, and the federal funds futures market are pointing to at least an additional 50 basis point reduction in the target range for the federal funds rate by year end. While the forthcoming economic data will guide monetary policy, we expect the Federal Reserve will be inclined to lower the front end of the yield curve given the very low level of yields on longer dated Treasury securities. As always, stay tuned!
III. Treasury Market
A. Investors Stampede Into Longer Maturity Treasury Securities.
- Following President Trump threatening to escalate the trade war with China during August, sovereign yields across the globe plunged, with the yield on the ten-year Treasury hitting its lowest level since early August 2016. Growing concerns that the U.S. and China will remain far apart on current trade negotiations has fed into an already anxious global bond market worried that growth is slowing in China and the rest of Asia, with a recession in the euro zone as likely as not.
- After finishing July at 2.01% following a precipitous drop from its recent high yield of 3.23% on October 5, ten-year Treasury yields fell to 1.47% in late August in a somewhat panicked flight-to-safety. Germany’s ten-year bund hit a new closing low of -0.71% following the report of a -1.5% decline in German industrial production in June, and lower by -5.2% year-on-year, another sign that global manufacturing is slowing down rapidly.
- The yield on the three-month Treasury bill fell -8 basis points last month to 1.98% as it is being held artificially high by the 2% -2.25% target range for the federal funds rate, but yields on Treasury securities from two years to thirty years declined by -37 to -57 basis points. The weakness in overseas economies, uncertainties flowing from President Trump’s use of tariff policy, and a strong flight-to-safety resulting from both of those concerns is weighing on global sovereign yields, including Treasury yields.
- Given our view that the U.S. economy is not currently at risk of falling into recession, we feel it is unlikely yields on longer dated Treasury securities will 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 -- has fallen from 0.97% at year end to -0.04% at the end of August. It seems to us that yields on longer dated Treasury securities are being held captive to the gravitational pull of negative sovereign bond yields overseas.
- It looks to us that the decline in the ten-year Treasury TIP yield is overstating the risks to the economy, largely due to the strong flight-to-safety by investors as they try to understand the endgame of tariff policy and the implications of negative policy rates and negative sovereign bond yields across the globe. Notice the inflation premium embodied in the ten-year Treasury is a touch lower, but not noticeably different from year end.
- Treasury yields just look too low currently, given the moderate, albeit decelerating, forward momentum in the U.S. economy. The real unknown is the extent to which weakening economies overseas will pull Treasury yields even lower. The more the Federal Reserve cuts rates beyond an additional 25 basis points, the greater is the chance that the yield on the ten-year Treasury note is able to rise back above 2%.
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.