CenterState Wealth Management
Investment Strategy Statement
September 4, 2018
I. Equity Markets
A. Political and Legal Drama, Trade Developments, and Higher Stock
- Hardly a day went by last month without a significant headline coming our way. However, those headlines were just as likely to give investors angst about their investments as they were to provide investors with confidence. Perhaps the major sense of angst came two weeks ago when two former Trump advisors were found to be guilty of criminal
- A guilty plea by Michael Cohen, Mr. Trump’s former personal lawyer, to tax fraud and campaign finance violations and an admission that he made illegal campaign and corporate contributions “at the direction of” a 2016 presidential candidate with the “purpose of influencing the election” — on the same day former Trump campaign manager Paul Manafort was found guilty of tax evasion, bank fraud, and failure to report foreign bank accounts — raised concerns about the November mid-term
- With the Republican party currently controlling the White House and both the Senate and the House of Representatives, the Trump Administration has been able to enact a historic overhaul of the Federal tax code and place many conservative judges in courts across the nation, including the Supreme Court. The control of the House was already in question as the party in the White House typically loses seats in Congress in the mid-term elections, particularly so when the president’s approval rating is below fifty
- Cohen’s revelations of making hush money payments to two women during the 2016 presidential campaign could bolster the campaign message of the Democratic party that giving them control of the House would counterbalance the Trump administration and the Republican-controlled Senate. Should the Democratic party gain control of the House of Representatives, only a simple majority of the members of the House must vote for charges of misconduct in order to impeach the President.
- After the charges of misconduct are filed, the Senate has the power to try impeachment cases like a court. While the odds of President Trump being removed from office are very low as two-thirds of the senators must vote for conviction, the likelihood of any legislative measures supported by the President being passed during the last two years of his term are very low and the Administration’s focus and attention would largely shift from governing to fighting the impeachment
- Also on the side of investor angst was the Trump administration firing its latest trade salvo at China last month, implementing 25% tariffs on another $16 billion of imports from China, bringing the total to $50 billion. China immediately responded in kind with tariffs against an equivalent amount of U.S. exports. This latest escalation of the trade dispute with China came as representatives from the two sides restarted trade talks in Washington aimed at ending the burgeoning trade war. The talks with China were the first since May when trade talks fell through and both sides later imposed tariffs on $34 billion of goods. By the end of September, the U.S. could add levies on another $200 billion — about half of overall Chinese
- The resumption of trade talks with China was a hopeful sign that a resolution to the trade dispute with China could be advanced through renewed negotiations. The talks were restarted amidst reports from China of growing internal debate of the deterioration in relations between China and the U.S. over trade. Allegedly there are complaints within China’s Communist Party that China’s current stance has been too hard line and the leadership has misjudged the situation and increasingly appears shaken by the Trump administration’s tough
- The supposed cracks within the Party come as China’s stock market has fallen more than -23% since the recent peak in late January and its currency has lost almost -9% of its value, falling to a 15 month low. China’s willingness to restart trade talks is likely an acknowledgement on the part of China that they understand President Trump will continue his efforts to eliminate tariffs and non-tariff barriers and quotas and to stop the theft of intellectual property and the forced transfer of technology — frequently referred to as the crown jewels of the U.S. economy by White House officials.
- Of concern to Chinese officials is the possibility of big U.S. companies — think technology companies — moving their production facilities out of China to service the U.S. market and avoid the 25% tariff. The best case scenario would be that the two sides would negotiate an end to the trade dispute ahead of the planned meetings between President Trump and Chinese leader Xi at multilateral summits during November, including the Group of 20 and the Asia-Pacific Economic Cooperation Forum. While the latest round of talks concluded with few signs of progress, we believe the U.S. and China will eventually arrive at a negotiated settlement to the current trade dispute, timing is the biggest
- On a bright note, last week’s announcement of a bilateral trade agreement with Mexico was definitely good news. The new trade agreement is an update to the terms between the U.S. and Mexico within NAFTA, although President Trump referred to it as a new U.S.-Mexico bilateral deal, replacing NAFTA. The best news on the trade agreement may well be that despite the hard line positions the Trump administration takes on trade disputes, it was willing to negotiate in good faith and compromise on certain issues, which should be a welcome development in Europe, Canada, and
- Attention will now turn to what concessions Canada might agree to and whether this bilateral agreement can become a three country agreement as both countries left the door open for Canada to join the agreement. On Friday, talks between the U.S. and Canada failed to reach a deal, however, the talks are scheduled to continue this week. A U.S. withdrawal from the existing NAFTA agreement and the threatened tariffs on auto imports from Canada would cause a major economic disruption for the second largest trading partner of the U.S., just a touch below China and ahead of
- Despite the political drama that seems to continuously swirl around the Trump White House and the escalating trade tensions and retaliatory tariff actions between the U.S. and China, common stock prices pushed higher last month as investors embraced the trade deal between the U.S. and Mexico, the ongoing trade negotiations with Canada, and the backdrop of solid forward momentum in the economy and strong earnings growth. Three of the four major market measures surpassed the previous highs recorded in January, with only the DJIA failing to push through to a new record close last
- For the month of August, the major market measures advanced 2.2% to 5.7%, with the technology-heavy NASDAQ Composite leading the pack and the DJIA bringing up the rear. Since the recent low on February 8, the DJIA and the S&P 500 have risen 8.8% and 12.4%, respectively, while the Russell 2000 is higher by 18.9% and the NASDAQ Composite led the way with an advance of 19.7%. For the first eight months of 2018, the DJIA has posted the smallest gain at 5%, followed by the S&P 500 rising 8.5%. The Russell 2000 is higher by 13.4% on the year-to-date, while the NASDAQ Composite has led the way with a gain of 17.5%.
B. Growing Trade Skirmish with China vs. Strong Fundamentals.
- Rising trade tensions with China have elevated the perceived level of risk and uncertainty, but we again encourage our readers not to overreact to the back and forth trade retaliation announcements between the U.S. and China, as it is all part of the negotiations process. We expect negotiations to lead to a workable outcome, similar to the recent de-escalation of trade tensions with both the European Union and
- The simple fact is that with our trading partners maintaining higher tariffs on our exports and limiting access to their markets, the U.S. has been subsidizing growth for our trading partners for many years. Do not be surprised if the world economy is benefitting from lower trade barriers across the board in the years to come, rather than suffering from an expanding trade
- We understand that the potentially serious political, legal, and constitutional issues the Trump administration has ahead of it and President Trump’s decision to address the inherent bias against the U.S. in almost every trade agreement can impact investor sentiment and stock prices in the short run. However, it is the course of the economy and earnings, the implementation and outlook for monetary policy, and inflation trends which establish the longer term path for stock prices. Keep in mind that bull markets in common stocks end when the outlook for earnings turns negative. Based on the current set of fundamentals, stock prices are likely to post further, moderate
- By any measure, earnings have been, and should continue to be for the next several quarters, unambiguously positive for stock prices. Following the strong 26.4% year-over-year gain in operating earnings reported for 2Q 2018, operating earnings have now advanced for eight consecutive quarters and the analysts at Standard & Poor’s expect operating earnings to grow 26.8% over the four quarters of 2018 and 12.2% for 2019. With the strong growth in earnings this year and the moderate gain in stock prices, the trailing four quarter price-to- operating earnings ratio on the S&P 500 has fallen from 22.6x at year end to 20.7x at the end of August, a touch below the 21.1x on the day of the presidential
- As always, there is no shortage of things for investors to worry about. Investors are watching to see the extent to which inflationary pressures build, assessing the risk of the Federal Reserve making a policy mistake, monitoring the nation’s political mood ahead of the mid-term elections — particularly following last month’s conviction and guilty plea of two of President Trump’s close confidants — and looking for the extent to which rising trade tensions create a negative feedback loop on the pace of economic growth, particularly on business capital spending
- The economy’s forward momentum remains solid and the outlook for earnings is very strong, both benefitting from the fiscal stimulus put in place earlier this year. Any signs of ebullience in the stock market, which were evident to the January 26 high, have evaporated and yields on longer-dated Treasury securities have eased from the May 17
- We do caution investors that volatility could rise in the near term. September is historically the weakest month of the year, the Trump administration is looking to escalate the trade conflict with China later this month, and the Federal Reserve is poised to raise interest rates at the September 25-26 FOMC meeting. By keeping the proper long term perspective and investing in a high quality portfolio of companies, investors should be well positioned to navigate the unchartered waters we have
II. Monetary Policy
A. Trump Criticism and Thoughtful Comments from Jerome
- The Federal Reserve left the target range for the federal funds rate unchanged at 1.75% to 2.0% at the conclusion of the July 31-August 1 FOMC meeting. The policy statement did offer an upbeat assessment of the economy’s performance, repeatedly emphasizing the economy’s strength when describing the economy and the labor market, suggesting another rate hike is likely at the September 25-26 FOMC meeting. If the Federal Reserve does raise interest rates at this month’s meeting, it would mark the third rate hike this year and the eighth during this rate hiking
- Lest anyone think that President Trump’s criticism of the Federal Reserve raising interest rates was a one time vent which would fade into the background, Mr. Trump again suggested in an interview last month that he was “not thrilled” with recent interest rate hikes and that he should be “given some help by the Fed.” Such comments were not uncommon before the early 1990’s. President Clinton adopted a policy against commenting on Federal Reserve policy to boost investor confidence that inflation would be held in check. Presidents Bush and Obama maintained this hands-off approach which insulated the central bank from political interference and
- We strongly doubt that Chairman Jerome Powell and the Federal Reserve will be swayed to change its policy course based on comments from President Trump, and we believe Trump knows he cannot really influence Federal Reserve policy. It seems to us that the President’s public criticism of Mr. Powell and the Federal Reserve is a deliberate attempt to pre-emptively blame the central bank and its interest rate hikes when the economy inevitably slows, and it is likely to become a recurring theme over the next couple years. The political danger for Mr. Trump is that the economy weakens as the 2020 election approaches with the fiscal stimulus fading and rate hikes taking a toll, hence the White House has set up the Federal Reserve to take the blame.
- Jerome Powell spoke at the Federal Reserve’s Annual Symposium on Monetary Policy in Jackson Hole, Wyoming last month and presented a thoughtful outline of the longer term factors which should shape the Federal Reserve’s path on monetary policy. He described the central bank’s current strategy of gradual rate hikes as a balancing act between moving too quickly and aggressively and shortening the economic expansion and raising rates too slowly and risking an overheating economy. Mr. Powell emphasized that he saw no serious risk currently of the economy overheating and bringing about an unwanted build in inflationary
- Chairman Powell emphasized the uncertainty over the neutral level of real interest rates as evidence that the Federal Reserve’s “navigational guides” had been shifting. Our take on Powell’s comments is that the central bank sees no need to be pre-emptive in the conduct of monetary policy to head off a build in inflation. With structural changes — ecommerce and technology — and an aging population moderating wage growth and inflation, the need for the Federal Reserve to boost the federal funds rate above neutral does not exist, in our opinion. Taking rates to neutral and then pausing to see how the economy plays out for a few quarters in terms of growth and inflation seems like a likely, pragmatic course of policy.
B. Rate Hiking Cycle Nearing an End?
- As Mr. Powell commented on during his Jackson Hole speech last month, the near term focus of the Federal Reserve is centered on how much further the central bank will need to raise interest rates over the next two years. In the minutes of the July 31-Aug 1 FOMC meeting released last month, the FOMC committee stated that as rates continue to rise, the policy statement will need to stop referring to monetary policy as “accommodative” because the federal funds rate will approach the neutral rate. The minutes stated that the change could happen “at some point fairly soon,” suggesting the change could happen following the rate hike later this
- If this change in verbiage took place following the September 25-26 FOMC meeting, it would be consistent with our view that monetary policy is poised to flip from being slightly accommodative or neutral to the side of being slightly restrictive. As we have described in previous ISS’s, trying to ascertain the current level of the neutral rate can be fairly arcane, somewhat arbitrary, and a bit of a moving target. 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.
- Notice from the table on the following page that the yield spread has declined from 125 basis points at the end of 2016 to only 23 basis points by the end of August. We continue to believe the Treasury market is growing increasingly fearful that the Federal Reserve could commit a policy mistake. 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 is approaching 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
- We will 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 two more rate hikes this year and four more in 2019-20 by the Federal Reserve are too
- Our view remains that the Federal Reserve raises interest rates at this month’s FOMC meeting and possibly again at the December meeting to push against the fiscal stimulus, and then becomes data dependent in 2019 with respect to any further rate increases. The most important data to follow in the coming months will be the wage and inflation data. It would not surprise us if the dialogue shifts over the next 6 to 12 months from “Is the Federal Reserve behind the curve?” to “Is the Federal Reserve moving too far?” As always, stay tuned!
III. Treasury Market
A. Further Flattening of the Yield Curve Last
- Following the release of strong growth data for the economy in 2Q 2018 at the end of July, the yield on the ten-year Treasury note traded between 2.93% and 3% over the first seven trading days of August. As the month wore on, however, concerns over the economic and diplomatic turmoil in Turkey and Mr. Trump’s former lawyer, Michael Cohen, implicating the President in criminal campaign finance violations, spurred a renewed push into Treasury securities, with the ten-year Treasury yield trading between 2.82% and 2.89% over the last three weeks of August, closing the month at 86%.
- During August, yields on three-month and one-year Treasury bills rose 7 and 4 basis points, respectively, as the market is expecting the Federal Reserve to raise interest rates for the eighth time in the current rate hiking cycle later this month. Yields on Treasury securities five years and longer declined -6 to -12 basis points. This further flattening of the Treasury yield curve took the yield spread between two-year and ten-year Treasury notes down to only 23 basis points at the end of August, as we covered earlier in this ISS.
- As we have mentioned in previous ISS’s, as the yield on the ten-year Treasury note rose from the recent low recorded last year on September 5, both the real, or TIP, yield and the implied inflation expectation embodied in the nominal ten-year Treasury have risen, as shown in the table below. However, since the recent high ten-year Treasury note yield on May 17, the 25 basis point decline in the ten-year Treasury yield has been driven by a 17 basis point drop in the TIP yield — reflective of a softening in the market’s outlook for economic growth — along with a modest 8 basis point decline in the market’s inflation outlook.
- Looking at the larger drop in the ten-year Treasury TIP yield since May 17 compared to the modest decline in the implied inflation outlook, says that investors are less worried about a significant change in the inflation outlook than they are about a policy mistake by the Federal Reserve or the trade skirmish with China potentially becoming headwinds to economic growth over coming quarters. While we admit these changes in the Treasury TIP yield and the implied inflation outlook are somewhat nuanced, it is important to keep track of how investor expectations are
- The fundamental factors which have pushed yields on longer dated Treasury securities higher on the year — the acceleration in the economy’s growth rate, a firming in the nation’s core inflation rate to the Federal Reserve’s 2% target in 2Q 2018, larger federal budget deficits, and the Federal Reserve shrinking its holding of government bonds — will continue to place a floor on 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, and the Trump administration’s aim to seek reciprocal or equal access trade agreements with our major trading partners — of which rising trade tensions is a natural result of the process. Balancing the market’s concerns about the Federal Reserve raising interest rates and the uncertainties for growth from the Trump administration’s trade policies with the fiscal stimulus the economy is currently benefitting from, we are looking for a near term trading range of 2.80% to 3.10% for the ten-year Treasury note.
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, 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, N.A. 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.