CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
February 3, 2020
I. Equity Markets
A. Fears Over the Coronavirus Overwhelm Solid Fundamentals.
- Investors turned their attention during the latter part of January to the extent to which the coronavirus could spread and the subsequent impact on global growth, particularly in China where the virus originated. Investors responded to the initial uncertainty by selling risk assets and bidding up the prices of safe haven assets like gold and Treasury securities. Investors pulled back from the travel industry -- hotels, airlines, casinos, and energy companies -- as well as, apparel retailers and fast food restaurants which have high revenue exposure to China. While these were the hardest hit sectors of the market, few stocks were able to withstand the selling pressure last week.
- Stock prices also slumped in early 2003 amid an outbreak of severe acute respiratory syndrome, or SARS, but stock prices finished the year strong as the hit to economic growth was modest and short-lived. The current fears about the coronavirus come at a time when the market has been on a steady climb for the last several months. The heady gains in stock prices may have made some investors more willing to sell on the health threat and ignore the solid fundamentals underpinning stock prices, discussed later in this ISS. The more lasting effect on stocks from the virus will likely be determined by the extent to which it weakens economic growth in China and the extent to which it spreads to the U.S.
- Prior to investor attention being dominated late in the month by the coronavirus, the feel good of the powerful rally in common stocks in 2019 carried over to January as investors maintained their focus on the promises of December which came to fruition during January. Investors cheered the positive developments, sending stock prices higher over the first three weeks of January.
- The U.S. and China signed the phase one trade deal mid-month, which officials say will lead to a sharp increase in sales of U.S. goods and services to China -- particularly agricultural products -- further open Chinese markets and provide strong new protections for U.S. intellectual property. In exchange, the U.S. agreed to reduce tariffs by half on $120 billion of Chinese imports and suspend plans to implement other tariffs.
- The agreement acts as a cease fire in the almost two year old trade war which has roiled markets world-wide and cut into global growth. However, the agreement does leave in place U.S. tariffs on about $370 billion of Chinese goods. Keeping these tariffs in place provides the U.S. with leverage in negotiating a phase two trade deal which will tackle more difficult issues, including forced technology transfers, Chinese subsidies to domestic companies, and the mercantilist behavior of Chinese state-owned enterprises. Those talks are expected to begin fairly soon, but are not expected to conclude until after the November elections.
- The day following the signing, the U.S. Senate easily passed an overhaul of North American trade rules, referred to as the U.S.-Mexico-Canada Agreement (USMCA), which replaces the 26 year old North American Free Trade Agreement. The agreement updates trading rules to address 21st century technology and safeguards environmental and labor standards in Mexico. It will also create more U.S. manufacturing jobs as it increases the proportion of parts in vehicles which must originate in North America for the cars and trucks to receive duty-free treatment and raises the labor cost of building vehicles in Mexico. Notably, the agreement reassures farmers, manufacturers, and other businesses that tariff-free trade will continue with the two largest trading partners of the U.S.
- While the major stock market measures were positive for the majority of the month, the sharp sell off last week, particularly on Friday, pushed the market indices lower on the month, except for the NASDAQ Composite which posted a gain of 2.0%. The S&P 500 fell by -0.2% during January, the DJIA by -1.0%, and the Russell 2000 Index by -3.3%. This comes after gains of 22.3% to 35.2% during 2019.
B. Solid Fundamentals Supportive of Higher Stock Prices.
- Despite the outsized gains in stock prices last year and the heightened fears over the extent to which the coronavirus will spread and impact global growth, we remain positive on the outlook for common stocks in 2020. The central bank rate cuts from 2019, a healthy consumer sector, better housing activity, and waning trade tensions should lift corporate profits and support higher stock prices. The recession fears of 2019 continue to fade and we see no end in sight for the current economic expansion. Continued growth at a moderate pace should unfold over the next couple years.
- We have consistently stated that the outlook for stock prices comes down to the outlook for earnings, which is dependent upon the outlook for the economy. Corporate earnings were unambiguously positive for common stocks in 2018 as a faster pace of the economic growth combined with the reduction in the corporate income tax rate from 35% to 21% to power operating earnings on the S&P 500 higher by almost 22% over the four quarters of 2018. However, concerns about the outlook for earnings in 2019 following four rate hikes by the Federal Reserve to December 2018 led to a -14% decline in the S&P 500 in 4Q 2018 and a -6.2% drop for all of 2018.
- With the economy slowing last year and President Trump escalating the trade war with China, operating earnings look to be higher by only 3.9% for 2019, with 3Q 2019 earnings actually lower by -3.8% on a year-on-year basis. Operating earnings for 4Q 2019 look to be higher by a little more than 10% year-on-year, a welcome rebound in corporate profits. Despite the paltry rise in operating earnings last year, the S&P 500 rose 28.9% in calendar year 2019 as recession fears faded and investors looked for improved growth and solid fundamentals to support stock prices in 2020.
- The analysts at Standard & Poor’s are looking for operating earnings to grow by roughly 10% this year largely due to the Federal Reserve easing policy last year and the signing of the phase one trade deal with China and the USMCA trade agreement. The acceleration in earnings growth this year will moderate the market’s price to operating earnings ratio in a positive manner -- earnings rising rather than prices falling -- helping to support current valuations.
- Consider that the price-to-trailing operating earnings ratio on the S&P 500 is currently 20.5x, a little below the 21.1x reading on the day President Trump was elected. In our view, the small decline in the S&P 500 in January is providing some time for earnings to grow into the price gains of 2019. We remain inclined to buy stocks on any pullback, rather than selling stocks as the bull market advances.
- Despite five Democratic presidential debates, which started back in June of last year, it seems investors are just beginning to focus on the 2020 election and the risks it entails. The recent rise in the polls of Senator Sanders ahead of the Iowa caucuses is raising concerns that some of the more progressive views of the Democratic candidates are gaining momentum. The economic policies that the far left-leaning candidates are advocating would attack the very core of modern capitalism.
- These extremely progressive proposals would materially increase the scope of the federal government in the private sector of the economy, greatly expand entitlement programs, and enact a sweeping array of incentive destroying new taxes and higher tax rates, which could cut the potential growth rate of the U.S. economy by as much as 50%, to roughly one percent. We believe there is little interest in these far left leaning proposals by the vast majority of voters, but the storyline needs to be watched, particularly given the low regard many voters have for President Trump’s deportment.
- As a final thought following the DJIA falling over 600 points last Friday, stock prices will likely remain under pressure until health officials around the world begin to signal that the spread of the coronavirus is under control. Our hunch is that the uncertainty over the spread of the disease may be with us for up to three months based on the travel restrictions being put in place for travel to China and the manner in which travelers returning from China will be screened and quarantined if found to be ill. We do not expect the current sell off to exceed -5% to -7% due to the solid fundamentals supporting stock prices discussed above. As we always say with respect to the outlook for monetary policy, stay tuned!
II. Federal Reserve
A. Monetary Policy Remains on Hold.
- The Federal Reserve left the 1.5% to 1.75% target range for the federal funds rate unchanged at the January 28-29 FOMC meeting and again signaled no appetite for raising rates any time soon. Most observers expected this to be one of the Federal Reserve’s more uneventful meetings in recent memory, and that expectation was met. After cutting rates at three consecutive meetings in 2019 to guard the U.S. economy from the effects of the trade war with China, the slump in business investment, and the global manufacturing slowdown, the central bank views the current level of rates as “appropriate” to support the economy.
- The FOMC Committee’s views on the economy remain largely unchanged from the December FOMC meeting. The Committee cited a strong labor market and economic activity rising at a moderate rate. In a slightly dovish twist, the Committee slightly downgraded its assessment of consumer spending as “rising at a moderate pace,” a downgrade from “strong” in December, and said business investment remained weak.
- The Committee also noted that inflation remains low, but tweaked its description of current policy as supporting inflation “returning” to its 2% target, as opposed to getting “near” its 2% target as the December policy statement noted. In the press conference, Chairman Jerome Powell said the change in verbiage was intended to underscore the central bank’s intention to reach 2% inflation rather than being comfortable with being near, but below 2%.
- Federal Reserve officials have expressed concern in recent months over the inability to get inflation to the 2% target. Inflation has held below the 2% target since the central bank formally adopted it in 2012, except for 3 quarters from 4Q 2017 to 2Q 2018. The core personal consumption expenditures price index rose 1.6% during 2019.
- The Federal Reserve is concerned that low inflation expectations will continue to keep inflation and, consequently, interest rates at very low levels, providing little flexibility for the central bank to lower rates during future economic slowdowns. Jerome Powell and his colleagues hope they can encourage more pricing pressure by committing to keep rates low until inflationary pressures rise. In the press conference, Mr. Powell said the Federal Reserve is determined to avoid inflation persistently below the 2% target.
- The key takeaway from this FOMC meeting is unchanged from the December meeting. Namely, the hurdle is fairly high for a near term change in Federal Reserve policy. Given that only downside risks -- lingering risks to the global economy and difficulty sustaining inflation at the central bank’s 2% target -- to the economy are mentioned in the policy statement, we continue to believe the hurdle currently is higher for a rate hike rather than another rate cut as the Federal Reserve is serious about reflating the economy, i.e., getting the economy’s inflation rate up to the central bank’s 2% target.
- Based on the messaging from the Federal Reserve, the tone of the recently released economic data, the phase one trade deal with China being signed last month, and the upcoming presidential election, we feel there is a good chance policy will remain on hold for all of 2020.
- However, it is important to note that Chairman Powell did mention the coronavirus in the press conference when he was discussing the possibility of a rebound in global growth this year. Should the spread of the coronavirus lead to a larger negative shock to U.S. growth than we currently estimate, the Federal Reserve may very well lower rates temporarily to cushion the impact on the U.S. economy. This is not our baseline case, but no one knows currently how far the virus will spread and the resulting impact on global and U.S. growth. As always, stay tuned!
III. Real Economic Activity
A. Economy Slows Further in Fourth Quarter.
- Real GDP grew at a 2.1% annual rate in 4Q 2019, closing out a year in which the economy’s growth rate decelerated to its slowest pace in three years -- 2.3% for 2019 compared to 2.9% in 2018 and 2.4% in 2017-- amid a continuing drag from business investment. The bifurcated nature of the economy’s growth, which was very evident in the previous two quarters, continued into the fourth quarter with solid household spending offsetting businesses taking a more cautious approach due to the headwinds of slowing global growth, the uncertainty which accompanied the trade war with China, and weakness in the energy sector.
- Consumer spending continued to support the economy in 4Q 2019, though the growth rate at 1.8% was well below the 4.6% pace of 2Q 2019 and 3.2% in 3Q 2019. The outsized growth rates in the previous two quarters were not sustainable and a pullback in the pace of consumer spending was inevitable.
- Residential construction was the best performing sector of the economy last quarter, growing at a 5.8% annual rate following a 4.6% gain in 3Q 2019. The back-to-back quarterly gains represent a significant rebound in housing outlays after declining for six consecutive quarters.
- Business capital spending declined at a -1.5% annual rate, the third consecutive quarterly drop. Structure outlays fell at a -10.1% rate last quarter, following declines of -11.1% and -9.9% in the previous two quarters, as outlays related to the oil and natural gas industries plunged -18.2% over the four quarters of 2019 and as business expansion plans were largely placed on hold following the escalation of the trade war with China by President Trump last May.
- Business outlays on equipment declined at a -2.9% rate last quarter, following a -3.8% drop in 3Q 2019 as the trade war, slowing growth overseas, and the resulting mild recession in the manufacturing sector took a toll. The declines in equipment and structure outlays were partially offset by a 5.9% rise in intellectual property products, the best gain since 1Q 2019 and boosted by an 11.6% gain in software investment.
- A narrower trade gap in 4Q 2019 accounted of a large amount of the economy’s growth, as net exports contributed 1.5 percentage points to the economy’s 2.1% growth rate amid the escalating tariff war between the U.S. and China last year. Exports rose 1.4% while imports fell at a -8.7% rate, largely due to President Trump’s tariffs on Chinese imports. The flip side of the drop in imports was a significant reduction in inventory accumulation, which subtracted 1.1 percentage points from the real GDP figure, as businesses drew down inventories which had been built to beat the looming tariff increases.
- The inflation figures remained low last quarter, roundly about 1.5%. The price index for grow domestic purchases, which measures prices paid by U.S. residents, rose at a 1.5%annual rate in 4Q 2019, while consumer prices advanced at a 1.6% pace. The Federal Reserve’s preferred measure of inflation, the core personal consumption expenditures price index, rose at only a 1.3% rate last quarter and was higher by 1.6% on a year-on-year basis.
B. Look for the Economic Expansion to Continue, with Still Low Inflation.
- Despite the economy slowing a touch last year, it still 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. Developments in recent months have brightened the outlook and eased recession fears.
- The Federal Reserve cut rates three times last year and has signaled that monetary policy is on hold with a greater likelihood of a rate cut rather than a rate hike if policy does change. The Trump Administration reached a phase one trade agreement with China that reduced some tariffs and suspended additional tariffs. Congress passed a new trade deal with Mexico and Canada and the odds of a chaotic exit by the United Kingdom from the European Union have declined.
- We continue to hold the position that the current economic expansion is capable of extending for several more years. Consumer spending is expected to return to trend growth of 2% to 2.5% this year as the labor market remains strong with solid job gains and wage growth, household financial obligations are near their lowest level in nearly forty years, consumer confidence measures have rebounded from their summer lows, and the personal savings rate is still elevated at 7.7%. The housing market is gathering a moderate head of steam and could easily be the best performing sector of the economy this year with thirty-year mortgage rates near 3.5%, about a full percentage point lower than a year ago.
- The trade war with China last year definitely hurt the demand for tradeable goods across the globe in the highly integrated global economy in which companies operate today. Domestically, the largest impacts were on the manufacturing sector and business capital spending as industrial production declined modestly year-on-year and business uncertainty rose with the actual and potential disruptions to supply chains -- from procurement to assembly to manufacturing -- for businesses small to large. We are not looking for a dramatic rebound in industrial production and business capital spending, but a moderate recovery should unfold this year.
- One silver lining from the pullback in business capital spending and industrial production over the past year is that a rebound this year will help extend the current economic expansion. We do not see the economy falling into recession anytime soon, but acknowledge that new threats have emerged, however, including the coronavirus in China, U.S-Iran tensions, and Boeing’s suspension of its 737 MAX airliner production -- which by itself could subtract a half percentage point from the current quarter’s growth rate. Lastly, President Trump’s broader trade battles with China and the European Union still loom and business uncertainty could well rise as the November presidential election draws closer.
- 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.
IV. Treasury Market
A. Treasury Yields Move Lower on Growth Fears and Strong Flight-to-Safety.
- After rising for four consecutive months from the recent lows on August 27 when recession fears peaked, Treasury yields resumed their decline during January. Treasury yields were rising on the prospect that the slowdown in the global economy and the U.S. economy had run its course and better growth was ahead. While we maintain that the outlook for growth has improved with central banks around the world cutting rates on 130 separate occasions last year and the U.S. and China reaching agreement on a phase one trade deal, uncertainty over the impact of the coronavirus on global growth, and on China growth in particular, has clouded the economic outlook.
- Worries over the spread of the coronavirus has caused a significant flight-to-safety on the part of investors across the globe, pushing several foreign sovereign bond yields back into negative territory, or further into negative territory. While the yield on the ten-year Treasury note fell from 1.92% at year end to 1.51% at the end of January, yields in Ireland fell to -0.14% from 0.12%, in France to -0.16% from 0.12%, in Japan to -0.06% from -0.01% and in Germany to -0.42% from -0.19%. Sovereign yields in Spain fell from 0.47%, but stayed positive at 0.25% and in Portugal to 0.23% from 0.44%. The total amount of foreign sovereign debt carrying negative yields fell from a peak of $17 trillion in August to$11.3 trillion at year end, but has risen back to $13.9 trillion at month end.
- The yield on three-month Treasury bills was unchanged during January as the Federal Reserve left the target range for the federal funds rate unchanged at last week’s FOMC meeting. Yields on Treasury securities from five years to thirty year declined by -38 basis points to -41 basis points last month, showing the concerns over growth as 2020 unfolds with the unexpected breakout of the coronavirus and the subsequent flight-to-safety.
- The extent of the flight to safety is very evident by looking at the dramatic drop in ten-year Treasury TIP yields -- a widely followed indicator of real growth expectations -- over the past thirteen months. Notice that at year end 2018, despite the Federal Reserve raising rates four times that year, the ten-year Treasury TIP yield was 0.97%. The TIP yield fell into negative territory at the low in Treasury yields on August 27 at -0.07% when the fears of recession peaked.
- The ten-year Treasury TIP yield fell to -0.13% at month end as investors scrambled into safe haven assets, while the yield on the nominal ten-year Treasury note at 1.51% remains above the recent low yield of 1.47% back on August 27. This leads us to believe that while concerns over the global economy taking a hit to growth over the potential spread of the coronavirus are pushing Treasury yields lower, the flight-to-safety is also having a significant impact.
- Expect Treasury securities to remain very well bid until health officials around the world begin to signal that the spread of the coronavirus is under control. As mentioned previously in this ISS, our hunch is that the uncertainty over the spread of the disease may be with us for up to three months. Once this health scare passes, we expect the yield on the ten-year Treasury note to resume its climb toward, and eventually above 2%, as the economy receives a second wind following the phase one trade agreement between the U.S. and China and the easing of monetary policy last year.
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, 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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