CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
January 2, 2020
I. Equity Markets
A. What a Way to Cap Off the Year!
- Everything came up aces for investors during December as domestic and global uncertainties eased further, pushing the stock market averages to new record highs. First on the economic front, U.S. employers added 266,000 jobs during November -- the strongest pace since January -- and the unemployment rate dropped to 3.5% -- the lowest level since 1969. Wages also advanced, rising 3.1% year-on-year, adding fuel to the economic expansion. Business and household confidence measures also strengthened and the housing market continues to build a moderate head of steam, causing the recession fears of August to fade even further.
- A new U.S. trade deal with Mexico and Canada, referred to as USMCA, will replace the 26 year old North American Free Trade Agreement when ratified by Congress in early 2020. The new trade deal will keep U.S. trade on track with its two largest trade partners. U.S. trade with Mexico and Canada topped $1 trillion through October, more than double the$470 billion of trade with China. The USMCA contains provisions aimed at creating more U.S. manufacturing jobs as it will increase the proportion of parts in vehicles which must originate in North America for the cars and trucks to receive duty-free treatment. It also updates NAFTA in some important new economy ways, such as intellectual property rights and financial and digital services.
- The new trade deal with Mexico and Canada was quickly followed up by the U.S. and China announcing that they had reached a phase one trade deal in principle, roughly 18 months after the start of the trade war. The limited agreement, capping months of sometimes testy negotiations, called for the U.S. to cancel new tariffs set to take effect on December 15 and partially roll back tariff rates placed on Chinese goods in September, while China promised to increase U.S. exports in energy, manufacturing, agriculture, and services.
- U.S. Trade Representative Robert Lighthizer stressed that the phase one deal included measures to improve intellectual property protection -- including counterfeiting, patent and trademark issues, and pharmaceutical rights -- to open the Chinese financial services market and to prevent currency manipulation. The initial deal is expected to lead to a phase two deal which would tackle more difficult issues, including forced technology transfers, subsidies, and the mercantilist behavior of Chinese state-owned enterprises. The phase one agreement is expected to be signed this month.
- While the trade deal with China is not the wide-sweeping deal envisioned by U.S. trade negotiators back in the spring, it is a truce which eliminates the looming damage from tariffs which were pending, boosts U.S. exports to China, and makes some progress on longstanding issues like China’s intellectual property theft. President Trump’s completely unpredictable and somewhat capricious manner in which he threatened and/or implemented tariff policies pushed the U.S. manufacturing sector into a mild recession, caused U.S. businesses to reduce business investment, and hindered U.S. agricultural exports. It appears Mr. Trump understands the damage to the economy from the trade war and is moving in an election year to mitigate the trade uncertainty.
- On the more than three year old Brexit front, British Prime Minister Boris Johnson and his Conservative Party’s convincing victory in the general election paves the way for the United Kingdom’s Parliament to trigger the long-awaited split with the European Union. The U.K.’s break with its largest trading partner will remove some of the uncertainty that has held up investment decisions, forced manufacturers to stockpile inventory, and sapped business and consumer confidence. Mr. Johnson pledged to take quick action on Brexit, lower taxes, and raise government spending to support the U.K. economy. It will also allow the U.K to negotiate trade deals with non-EU countries, like the U.S.
- The Federal Reserve kept rates unchanged at last month’s FOMC meeting and indicated no intention of raising rates anytime soon. The policy statement gave an upbeat view of the economy and Chairman Jerome Powell said at the press conference that he expects the economy to continue growing at a moderate pace. Investors were encouraged that the Federal Reserve’s commitment to keep rates low will be supportive of the economy this year.
- While President Trump achieved legislative successes by clinching Congressional Democratic support for his new North American trade deal and reached a limited trade deal with China, he suffered a historic rebuke. Mr. Trump watched the Democratic-controlled House of Representatives vote to make him just the third president in U.S. history to be impeached. Investors largely ignored the action in the House, however, as the impeachment proceedings are largely viewed a coastal elite story, not a heartland story. There is virtually no chance of President Trump being convicted in the Senate and our hunch is that impeachment is not Topic A at dinner tables across America.
- It is somewhat ironic that the decision by the Democratic-controlled House of Representatives to proceed with impeachment proceedings against President Trump helped bring to a conclusion the new trade deal with Mexico and Canada, as well as, the phase one trade deal with China. House Democrats used the USMCA deal to demonstrate that they could perform their legislative responsibilities while they pursued impeachment, a rare instance of bipartisan cooperation on economic policy during the Trump presidency. Mr. Trump wanted a policy victory in the form of the trade deal with China with impeachment proceedings moving full steam ahead and the election getting closer every day.
- The somewhat remarkable series of events during December further boosted investor confidence, reinforcing the relief that replaced recession fears since the August 14 lows for the S&P 500 and the DJIA. The major market measures rose 1.7% to 3.5% during December, are higher by 12% to 15.4% since the recent August 14 lows, and rose an astounding 22.3% to 35.2% for all of 2019. With the presidential election year of 2020 now upon us, we would be remiss if we did not mention that the S&P 500 and the DJIA stand 51% and 55.7%, respectively, above their levels on November 8, 2016, while the NASDAQ Composite leads the way with a gain of 72.8% and the Russell 2000 brings up the rear with a still healthy gain of 39.6%.
B. Monetary Policy on Hold.
- The Federal Reserve left the 1.5% to 1.75% target range for the federal funds rate unchanged at the December 10-11 FOMC meeting and signaled no appetite for raising rates any time soon. After cutting rates three times from the late July FOMC meeting to the late October FOMC meeting to guard the U.S. economy from the effects of the trade war with China, the decline in business investment, and the global manufacturing slowdown, the Federal Reserve thinks rates are low enough to support the economy.
- The “dot plot” of individual members’ future interest rate projections indicated no rate hike in 2020, as 13 of the 17 committee members expect rates to be unchanged through the end of the year. The key takeaway from the policy statement and from Chairman Powell’s comments at the press conference is that the hurdle is fairly high for a near term change in Federal Reserve policy. We believe the hurdle 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.
- In his opening remarks at the press conference, Mr. Powell cited the case for viewing too low inflation as a problem, even though central bankers have traditionally focused on preventing a build in inflationary pressures. “Inflation that runs persistently below our objective can lead to an unhealthy dynamic” in which households expect lower inflation, leading to lower actual inflation. This scenario could make it harder for the Federal Reserve to lower interest rates to stimulate the economy during a downturn, “resulting in worse economic outcomes for American families and businesses.”
- Chairman Powell said he would prefer to let inflation rise and hold above the central bank’s target before considering raising rates. “In order to move rates up, I would want to see a significant move up in inflation that is also persistent before raising interest rates to address inflation concerns,” Mr. Powell said. This comment is consistent with Mr. Powell’s comments in a late October speech in which he said the Federal Reserve is “strongly committed” to meeting its inflation goal of 2%.
- Based on the messaging from the Federal Reserve, the tone of the recently released economic data, and the phase one trade deal with China announced last month, we are not looking for the central bank to cut rates anytime soon and feel there is a good chance policy will remain on hold for all of 2020. Barring the election of a far left-leaning president in November, we expect the economy to strengthen modestly over the next year, providing the economy with a second wind heading into 2021. Under this scenario, do not be surprised if the Federal Reserve makes another mid-cycle adjustment, this time to move rates slightly higher next year. As always, stay tuned!
C. The Fundamentals Look Good as 2019 Turns to 2020.
- In last month’s ISS, we discussed a key axiom that we follow regarding the outlook for common stocks. This axiom is particularly relevant currently as the bull market will reach its eleven year anniversary in early March. While stock prices fell sharply mid-year 2010 and again mid-year 2011 due to worries over Europe’s sovereign debt crisis and the viability of the euro as a currency, as well as, during 4Q 2018 as investors feared the Federal Reserve would push the economy into recession, we look at the primary bull market since March 2009 as still intact, along with the economic expansion which is now ten and a half years old.
- The axiom we discussed last month is “bull markets do not die of old age, they die of poor fundamentals.” The most important fundamental for common stocks is the ability of companies to generate a growing stream of earnings which will lead investors to invest their capital into shares of the company.
- The ability of a company to grow its earnings is a function of two realities. One is the management of the company and the demand for its products. Companies need to be managed onto a profitable trajectory and its product mix must be a need to have by other businesses or households. The other reality is a growing economy. While some product innovations can overcome a no growth or recessionary period due to the strength of their need to have, riding the wave of a growing economy is a tailwind which helps viable companies to prosper and grow their earnings.
- Our review of the economic data suggests that the current economic expansion is capable of extending for several more years, particularly in light of the three rate cuts the Federal Reserve delivered between late July and late October. The labor market remains strong with solid job gains and wage growth, household financial obligations are near their lowest level in nearly forty years, inflation pressures are quiescent, and 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 3.75%, about 0.75% lower than a year ago.
- Last month we mentioned that a key determinant of company fundamentals being good starting 2020 was the U.S. and China negotiating a lasting truce in the trade war which included the U.S. cancelling the new tariffs set to take effect on December 15. As discussed previously in this ISS, the phase one deal between the U.S. and China was agreed to last month, which cancelled the December tariffs, partially rolled back the tariff rates placed on Chinese goods in September, and included promises by China to increase U.S exports. With this agreement in place, we are increasingly confident that the economy will perform well this year and that company fundamentals will be good.
- The trade war with China 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 pick up in business investment and industrial production this year will help extend the current economic expansion. We do not see the economy falling into recession anytime soon and continue to expect the current bull market in common stocks to last much longer than most investors expect. We remain inclined to buy stocks on any pullback, rather than selling stocks as the bull market advances.
- An important storyline to monitor this year is any shift by voters toward the far left-leaning economic policies advocated by a couple candidates for the Democratic presidential nomination which would attack the very core of modern capitalism. These 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%. 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, returns for 2019 were very strong as the economic expansion rolled along, inflationary pressures remained low, bond yields fell, and the Federal Reserve nimbly cut rates three times between late July and late October. Keep in mind, however, that a good portion of the 28.9% rise in the S&P 500 last year resulted from the -6.2% drop in the S&P 500 during 2018, and in particular, the -14% decline during 4Q 2018. Returns on common stocks in 2020 will not benefit from a decline in stock prices during the previous 12 months.
- Common stocks do not face much competition from the prevailing low level of yields on Treasury securities, while the global and domestic economy will benefit from central banks around the world cutting rates on 130 separate occasions last year and from the truce in the trade war between the U.S. and China. Do not be surprised if investors take some gains in early 2020 after the strong advance in 2019, but stock prices should grind modestly higher over the course of the year.
II. Treasury Market
A. Treasury Yields Continue Their Gradual Move Higher.
Yields on long dated Treasury securities continued their rebound from near all-time lows in late August, sending one of the clearest signals yet that investors’ recent recession fears have waned. Treasury yields are rising for a good reason, which is that the global economy and the U.S. economy look to have bottomed and better growth is ahead. Central banks around the globe cut rates during 2019, a phase one U.S-China trade agreement was agreed to last month, and recent economic data has modestly surprised to the upside.
The yield on the ten-year Treasury note reached its low point on August 27 at 1.47% and then steadily rose to 1.92% by December 31. Besides longer date Treasury yields rising, foreign sovereign bond yields have also risen. Ten-year bond yields in Ireland (0.12%), Spain (0.47%), and Portugal (0.44%) returned to positive territory during November and in France (0.12%) during December. Ten-year bonds in Japan ended December at -0.01%compared to -0.29% in August and the ten-year German bund yield has risen from -0.72%in August to -0.19% at the end of December.
While some yields on major sovereign bonds remain in negative territory, they are steadily moving toward positive territory. Additionally, the total amount of foreign sovereign debt carrying negative yields has fallen from a peak of $17 trillion in August to $11.3 trillion currently, still a large number, but the trend is in the right direction in our opinion. Negative yields on foreign sovereign bonds were, and are, the result of an extreme flight to safety by investors and an improving economic outlook globally is reversing the risk-off positioning by investors which peaked in August.
The rebound in longer dated Treasury bond yields over the past four months marks a significant reversal for the bond market. During August, Treasury yields were falling so quickly -- the yield on the ten-year Treasury security declined by -51 basis points -- that many investors and analysts were worried that they could drop below zero, joining the $17 trillion of sovereign debt with negative yields around the world. While Treasury yields stayed in positive territory, the Treasury yield curve did become inverted -- yields on longer term Treasury securities below yields on shorter term securities -- between three-months and ten-years, reaching -50 basis points at the most extreme point.
The Treasury yield curve has almost completely become uninverted, with yields on Treasury securities getting progressively higher from the one-year Treasury bill all the way to the thirty-year Treasury bond. Despite the rebound in yields, the ten-year Treasury yield remains very low at 1.92%, sitting closer to the record low of 1.37% on July 7, 2016 than the 3.23% level it hit on October 5 of last year.
Yields on three-month and one-year Treasury bills have fallen -43 and -18 basis points, respectively, from August 27 to the end of December 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 December at 1.54%.
From five years to thirty years, yields on Treasury securities have risen 31 to 45 basis points since August 27 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 during the month, representing a truly risk-off move on the part of investors. A portion of the rise in yields on longer maturity Treasury securities since August 27 can be attributed to a lessening of the gravitational pull from negative yields on overseas sovereign bonds.
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 below the lows recorded during August. Notice in the table on the following page that the Treasury TIP yield -- a widely followed indicator of real growth expectations -- had fallen from 0.97% at year-end 2018 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 also in the table that as ten-year Treasury yields rose 42 basis points from the end of August to the end of December, ten-year TIP yields rose 17 basis points from -0.04% to 0.13%, with the implied inflation expectation moving slightly higher to 1.79%. We thought that the decline in the ten-year Treasury TIP yield during August 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, the implications of negative policy rates and negative sovereign bond yields across the globe, and the inversion of the Treasury yield curve.
The inflation premium embodied in the ten-year Treasury is a little higher compared to the end of August and is basically unchanged from year end 2018. The ten-year TIP yield still looks too low currently, given the moderate pace of 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 continue to exert downward pressure on Treasury yields.
We continue to believe that with $11.3 trillion of foreign sovereign debt carrying negative yields, global investors are still crowding into longer maturity Treasury securities. The rapid declines in Treasury yields to the end of August made a much stronger statement about weak growth overseas than it did about the prospects for U.S. growth. We continue to look for the yield on the ten-year Treasury note to rise above 2% in relatively short order and then to continue moving higher toward 2.25% on the back of a resilient U.S. economy, which is receiving a second wind following the phase one trade agreement between the U.S. and China.
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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