March, 2017

a bull and a bear facing each other standing on top of stock indexes

“The case for monetary policy tightening has become a lot more compelling.”

William Dudley, president of New York Federal Reserve, March 1, 2017

In this month’s Market Monthly, we discuss next week’s Fed meeting, the Washington agenda and provide a brief market overview. We highlight the recent market rally identifying what we are looking at to see what’s in store.

Summary:

Fed Action: Recent speeches by several Federal Oversight Management Committee (FOMC) members have nudged the odds of a March rate hike to 85 percent. Uncertainty about the substance and timing of tax reform is a Fed wild card. Potential volatility about spring elections in Europe could prompt the Fed to be proactive. President Trump’s appointees to the Fed will be watched closely as the year progresses.

Washington Agenda: President Trump’s 2017 budget will be delivered on March 16th. On, March 6th, the House released the American Health Care Act to replace parts of Obamacare. Details will emerge in the days to come, but with this out of the way, perhaps the tax reform debate can begin soon. Markets are watching and waiting to see if Washington can stay on task.

Market Review: Global stock markets are off to a good start this year. Our long-term equity outlook remains positive that U.S. stocks have already exceeded year-end price targets of many Wall Street strategists and could warrant near-term caution. Bond markets will be dependent on Fed policy, personal tax policy and credit spreads. Currencies bear watching if the Fed hikes rates aggressively.

Outlook:  We remain cautiously optimistic and advise against acting on emotions. Stay the course.

Fed Action: 

Comments by many FOMC members were echoed by Fed Chairwoman Janet Yellen in a speech she gave on March 3rd. She indicated “a further adjustment of the federal funds rate would likely be appropriate.” With that, the odds of a rate hike at next week’s FOMC meeting have climbed to 85 percent. Markets have interpreted this as validation for an economy that is improving. Recent data supports this. The Fed’s dual mandates of full employment and price stability have been met. Initial jobless claims, released last week by the Department of Labor, are at their lowest level since 1973 as the chart below illustrates.

BBT-perspectives-market-monthly-march-2017-FRED-chart

As the year progresses, the dialogue will shift by focusing on Trump’s Fed nominees. He will have the opportunity to shape the FOMC for years to come. Despite his aggressive tone during the election, he needs a somewhat dovish Fed to keep rates low and accomplish his pro-growth policies without significantly increasing the budget deficit.

Markets may view a hike next week as an “all clear” sign the economy is back on natural footing without the need for Fed sustenance but a negative reaction cannot be ruled out. Historically, a tightening Fed is a headwind to U.S. stock prices. Risks associated with subsequent rate hikes include:

  1. A 10-Year U.S. Treasury above 3 percent could be a headwind for both stock and bond prices.
  2. Rate hikes could boost the U.S. dollar causing the U.S. economy to tighten beyond expectations.
  3. Both rate hikes and the composition of the Fed balance sheet could have budget implications that may alter the shape and timing of tax reform.
Washington Agenda:

American Health Care Act: On March 6th, the House released the first part of their solution to replace Obamacare. Details will emerge in the coming days and be relevant due to their budget implications. The House bill will likely pass by month-end and then be sent to the Senate where it will be debated. Once the White House throws its weight behind it, final passage will likely occur by June. Passage of the American Health Care Act is more symbolic than it is economically relevant. Last week both President Trump and Treasury Secretary Mnuchin signaled that repealing and replacing Obamacare must occur before tax reform. The release of the House bill begins to pave the path toward earnest tax reform discussions, which is exactly what the markets want. Full replacement will come in waves and be implemented beyond 2017.

Tax Reform Blueprint: In the summer of 2016, House Republicans formed a Tax Reform Task Force to develop a blueprint for tax reform. This will likely serve as the baseline playbook for upcoming tax reform discussion. Tax reform embodies tax cuts but adds behavioral modifications that encourage U.S. corporations to invest domestically in exchange for favorable tax treatment. Key components include:

  • Tax Rate Cuts: Even though the top tax rate is 35 percent the actual effective tax rate for U.S. corporations is closer to 25 percent due to loop holes. If basic loopholes are limited, such as interest deductibility, then a tax rate of 20 percent could be productive.
  • Repatriation Tax: It is estimated there is a $2.6 trillion cash hoard overseas with retained U.S. corporate earnings that have avoided U.S. taxes. A 10-percent tax holiday on those funds if they were “repatriated” back to the U.S. could generate significant tax revenue for projects such as infrastructure spending. White House and U.S. House plans would allow this tax to be paid in an 8-10 year period, which corresponds nicely with a 10-year infrastructure spending plan. This idea would likely have high bipartisan support.
  • Border Adjusted Tax (BAT): The current U.S. tax system taxes corporations on where goods are produced rather than consumed. A Border Adjusted Tax (BAT) proposes a tax on imported goods but not on exported goods. This is admittedly a gross oversimplification of this concept. This is controversial because of its complexity and due to fear of its leanings toward protectionist trade policy. It will be a challenge to pass a BAT tax or even tariffs in an all-or-nothing fashion. If it were to pass, it would need the full weight of the White House behind it, and it would most likely be rolled out in phases.
Market Review:

Equities: In our Oct. 13, 2016, commentary we discussed the positive calendar effect on U.S. stock market returns beginning in the month of November for the period of 1900-2015. We wrote: “The November-April six month period has been the No.1 ranked six month return.” This trend has stood the test of time and the past four months have been no different. Market momentum and optimism have magnified this year’s calendar effect since the election. Investing in stocks using only momentum (recent trend history) and sentiment (optimistic or pessimistic) as a primary lens can lead to poor decision-making and disappointment. Stick with your long-term plan. Know what you are buying and what you are paying for it.

The S&P 500 has been positive 26 times in both January and February going back to 1950. In those 26 instances, the S&P 500 has earned a positive return for the rest of the year 24 times.

  • The average return for the rest of those 26 years was 12.02 percent.
  • The average correction for the rest of the year was -8.6 percent.

The two exceptions were:

  • On Black Monday on Oct. 19, 1987, the U.S. market crashed falling 22.6 percent in a single day.
  • Aug. 6, 2011, Standard & Poor downgraded U.S. debt from a AAA rating and Europe was in a sovereign debt crisis.

Market history adds perspective, not clairvoyance. U.S. markets have history on their side, but even a modest correction in line with history would simply reset U.S. stocks to near where they began the year. We take a longer view.

The Bull Argument:

  • Though Gross Domestic Product (GDP) growth remains range bound between 1.5-2.5 percent it appears to be off Federal Reserve life support and growing naturally on its own.
  • Fourth-quarter earnings grew at a rate of 4.9 percent and experienced the first year-over-year growth for consecutive quarters in two years.
  • Since year-end, eight of the 11 S&P 500 sectors have seen their growth rates accelerate.
  • Tax-reform should boost earnings and capital investment.

The Bear Argument:

  • It has been more than 100 days since the last 1-percent daily decline in the S&P 500 (longest since 2006).
  • The S&P 500’s median stock has a price-earnings ratio of 24.2, the highest since the dot com era.
  • Many investors have abandoned hedging strategies, becoming complacent.
  • Investor sentiment is indicating excessive optimism, often a contrary indicator.

Base Case: The bull argument is viewing markets through a long-term lens focusing on fundamentals. The bear argument is viewing markets through a short-term lens and could make a contrary case for either a pause or a shallow short-term correction within an aging bull market.

Though we are in a mature bull market, we expect that eventual tax reform will do more to help growth than Fed tightening will do to harm growth. International stock markets are contributing to returns this year as the chart below illustrates. Easy monetary and fiscal policies in Europe and Japan are having an impact. A stable dollar would support this continuing.

We view the markets through many lenses and this guides us toward more objective decision-making.

Bonds: Bond markets have largely priced in an expectation for a March rate hike by the Fed. The 10-Year U.S. Treasury has climbed back from its recent 2.36 percent yield to its present 2.51 percent as odds for a rate hike have increased significantly. The path for the rest of the year will likely follow the path of the Fed. It is hard to see the 10-year U.S. Treasury moving past 3 percent by year-end based on what we know now. If that occurred it would be due to unexpected GDP growth, unexpected inflation or both.

Once the tax reform debate takes shape, we will watch municipal bonds closely as they could react to reform that calls for reducing tax rates on interest income. This could create new opportunities for fixed-income investors willing to invest across the entire bond spectrum.

Credit spreads reflect the incremental yield an investor can expect to receive for taking risk beyond a treasury bond. When spreads are wide, investors receive additional compensation for taking the extra risk. As spreads have tightened, high yield bonds have performed well as the chart above illustrates. When spreads are low like they are today, investors may not be adequately compensated for taking on credit risk.

BBT-perspectives-market-monthly-march-2017-bond-returns

Outlook:

This market has many moving parts like we have not seen in several years. There is a risk that as Fed Policy, Tax Reform, ACA Repeal, U.S. Budget negotiations, European elections and deregulation take hold, any one of these could distract from the rest and shake market confidence. The global economy seems to have sustained strength, and we see no recessions on the horizon.

High quality in both stock and bond portfolios is a consistent theme that should serve investors well this year as the bull market matures. Divergence among equity sectors is another 2017 theme as leadership among sectors and stocks is likely to change with investors risk tolerances and changing market dynamics.

As we’ve said before, we remain cautious optimists.

March, 2017

a bull and a bear facing each other standing on top of stock indexes

“The case for monetary policy tightening has become a lot more compelling.”

William Dudley, president of New York Federal Reserve, March 1, 2017

In this month’s Market Monthly, we discuss next week’s Fed meeting, the Washington agenda and provide a brief market overview. We highlight the recent market rally identifying what we are looking at to see what’s in store.

Summary:

Fed Action: Recent speeches by several Federal Oversight Management Committee (FOMC) members have nudged the odds of a March rate hike to 85 percent. Uncertainty about the substance and timing of tax reform is a Fed wild card. Potential volatility about spring elections in Europe could prompt the Fed to be proactive. President Trump’s appointees to the Fed will be watched closely as the year progresses.

Washington Agenda: President Trump’s 2017 budget will be delivered on March 16th. On, March 6th, the House released the American Health Care Act to replace parts of Obamacare. Details will emerge in the days to come, but with this out of the way, perhaps the tax reform debate can begin soon. Markets are watching and waiting to see if Washington can stay on task.

Market Review: Global stock markets are off to a good start this year. Our long-term equity outlook remains positive that U.S. stocks have already exceeded year-end price targets of many Wall Street strategists and could warrant near-term caution. Bond markets will be dependent on Fed policy, personal tax policy and credit spreads. Currencies bear watching if the Fed hikes rates aggressively.

Outlook:  We remain cautiously optimistic and advise against acting on emotions. Stay the course.

Fed Action

Comments by many FOMC members were echoed by Fed Chairwoman Janet Yellen in a speech she gave on March 3rd. She indicated “a further adjustment of the federal funds rate would likely be appropriate.” With that, the odds of a rate hike at next week’s FOMC meeting have climbed to 85 percent. Markets have interpreted this as validation for an economy that is improving. Recent data supports this. The Fed’s dual mandates of full employment and price stability have been met. Initial jobless claims, released last week by the Department of Labor, are at their lowest level since 1973 as the chart below illustrates.

BBT-perspectives-market-monthly-march-2017-FRED-chart

As the year progresses, the dialogue will shift by focusing on Trump’s Fed nominees. He will have the opportunity to shape the FOMC for years to come. Despite his aggressive tone during the election, he needs a somewhat dovish Fed to keep rates low and accomplish his pro-growth policies without significantly increasing the budget deficit.

Markets may view a hike next week as an “all clear” sign the economy is back on natural footing without the need for Fed sustenance but a negative reaction cannot be ruled out. Historically, a tightening Fed is a headwind to U.S. stock prices. Risks associated with subsequent rate hikes include:

  1. A 10-Year U.S. Treasury above 3 percent could be a headwind for both stock and bond prices.
  2. Rate hikes could boost the U.S. dollar causing the U.S. economy to tighten beyond expectations.
  3. Both rate hikes and the composition of the Fed balance sheet could have budget implications that may alter the shape and timing of tax reform.
Washington Agenda

American Health Care Act: On March 6th, the House released the first part of their solution to replace Obamacare. Details will emerge in the coming days and be relevant due to their budget implications. The House bill will likely pass by month-end and then be sent to the Senate where it will be debated. Once the White House throws its weight behind it, final passage will likely occur by June. Passage of the American Health Care Act is more symbolic than it is economically relevant. Last week both President Trump and Treasury Secretary Mnuchin signaled that repealing and replacing Obamacare must occur before tax reform. The release of the House bill begins to pave the path toward earnest tax reform discussions, which is exactly what the markets want. Full replacement will come in waves and be implemented beyond 2017.

Tax Reform Blueprint: In the summer of 2016, House Republicans formed a Tax Reform Task Force to develop a blueprint for tax reform. This will likely serve as the baseline playbook for upcoming tax reform discussion. Tax reform embodies tax cuts but adds behavioral modifications that encourage U.S. corporations to invest domestically in exchange for favorable tax treatment. Key components include:

  • Tax Rate Cuts: Even though the top tax rate is 35 percent the actual effective tax rate for U.S. corporations is closer to 25 percent due to loop holes. If basic loopholes are limited, such as interest deductibility, then a tax rate of 20 percent could be productive.
  • Repatriation Tax: It is estimated there is a $2.6 trillion cash hoard overseas with retained U.S. corporate earnings that have avoided U.S. taxes. A 10-percent tax holiday on those funds if they were “repatriated” back to the U.S. could generate significant tax revenue for projects such as infrastructure spending. White House and U.S. House plans would allow this tax to be paid in an 8-10 year period, which corresponds nicely with a 10-year infrastructure spending plan. This idea would likely have high bipartisan support.
  • Border Adjusted Tax (BAT): The current U.S. tax system taxes corporations on where goods are produced rather than consumed. A Border Adjusted Tax (BAT) proposes a tax on imported goods but not on exported goods. This is admittedly a gross oversimplification of this concept. This is controversial because of its complexity and due to fear of its leanings toward protectionist trade policy. It will be a challenge to pass a BAT tax or even tariffs in an all-or-nothing fashion. If it were to pass, it would need the full weight of the White House behind it, and it would most likely be rolled out in phases.
Market Review

Equities: In our Oct. 13, 2016, commentary we discussed the positive calendar effect on U.S. stock market returns beginning in the month of November for the period of 1900-2015. We wrote: “The November-April six month period has been the No.1 ranked six month return.” This trend has stood the test of time and the past four months have been no different. Market momentum and optimism have magnified this year’s calendar effect since the election. Investing in stocks using only momentum (recent trend history) and sentiment (optimistic or pessimistic) as a primary lens can lead to poor decision-making and disappointment. Stick with your long-term plan. Know what you are buying and what you are paying for it.

The S&P 500 has been positive 26 times in both January and February going back to 1950. In those 26 instances, the S&P 500 has earned a positive return for the rest of the year 24 times.

  • The average return for the rest of those 26 years was 12.02 percent.
  • The average correction for the rest of the year was -8.6 percent.

The two exceptions were:

  • On Black Monday on Oct. 19, 1987, the U.S. market crashed falling 22.6 percent in a single day.
  • Aug. 6, 2011, Standard & Poor downgraded U.S. debt from a AAA rating and Europe was in a sovereign debt crisis.

Market history adds perspective, not clairvoyance. U.S. markets have history on their side, but even a modest correction in line with history would simply reset U.S. stocks to near where they began the year. We take a longer view.

The Bull Argument:

  • Though Gross Domestic Product (GDP) growth remains range bound between 1.5-2.5 percent it appears to be off Federal Reserve life support and growing naturally on its own.
  • Fourth-quarter earnings grew at a rate of 4.9 percent and experienced the first year-over-year growth for consecutive quarters in two years.
  • Since year-end, eight of the 11 S&P 500 sectors have seen their growth rates accelerate.
  • Tax-reform should boost earnings and capital investment.

The Bear Argument:

  • It has been more than 100 days since the last 1-percent daily decline in the S&P 500 (longest since 2006).
  • The S&P 500’s median stock has a price-earnings ratio of 24.2, the highest since the dot com era.
  • Many investors have abandoned hedging strategies, becoming complacent.
  • Investor sentiment is indicating excessive optimism, often a contrary indicator.

Base Case: The bull argument is viewing markets through a long-term lens focusing on fundamentals. The bear argument is viewing markets through a short-term lens and could make a contrary case for either a pause or a shallow short-term correction within an aging bull market.

Though we are in a mature bull market, we expect that eventual tax reform will do more to help growth than Fed tightening will do to harm growth. International stock markets are contributing to returns this year as the chart below illustrates. Easy monetary and fiscal policies in Europe and Japan are having an impact. A stable dollar would support this continuing.

We view the markets through many lenses and this guides us toward more objective decision-making.

Bonds: Bond markets have largely priced in an expectation for a March rate hike by the Fed. The 10-Year U.S. Treasury has climbed back from its recent 2.36 percent yield to its present 2.51 percent as odds for a rate hike have increased significantly. The path for the rest of the year will likely follow the path of the Fed. It is hard to see the 10-year U.S. Treasury moving past 3 percent by year-end based on what we know now. If that occurred it would be due to unexpected GDP growth, unexpected inflation or both.

Once the tax reform debate takes shape, we will watch municipal bonds closely as they could react to reform that calls for reducing tax rates on interest income. This could create new opportunities for fixed-income investors willing to invest across the entire bond spectrum.

Credit spreads reflect the incremental yield an investor can expect to receive for taking risk beyond a treasury bond. When spreads are wide, investors receive additional compensation for taking the extra risk. As spreads have tightened, high yield bonds have performed well as the chart above illustrates. When spreads are low like they are today, investors may not be adequately compensated for taking on credit risk.

BBT-perspectives-market-monthly-march-2017-bond-returns

Outlook

This market has many moving parts like we have not seen in several years. There is a risk that as Fed Policy, Tax Reform, ACA Repeal, U.S. Budget negotiations, European elections and deregulation take hold, any one of these could distract from the rest and shake market confidence. The global economy seems to have sustained strength, and we see no recessions on the horizon.

High quality in both stock and bond portfolios is a consistent theme that should serve investors well this year as the bull market matures. Divergence among equity sectors is another 2017 theme as leadership among sectors and stocks is likely to change with investors risk tolerances and changing market dynamics.

As we’ve said before, we remain cautious optimists.

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, stlouisfed.org

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.