June, 2017

market-monthly-june-2017-bbt-perspectives-feature

“If you don’t have time to do it right, when will you have time to do it over?”

John Wooden

“Be quick, but don’t hurry” was a saying legendary basketball coach John Wooden had for his many championship teams. His teams understood a thoughtful plan executed quickly was better than a poorly concocted plan done in a hurry. Today, the Fed is demonstrating quickness with a seemingly well executed plan. Washington has a full agenda and must hurry with its summer recess approaching, a list of distractions and mid-term election pressures are looming for 2018. Ultimately, we think Washington will get it done but with delay and dilution.

Summary:

A Disconnect Between Bonds and Fed: The bond market is pricing in too little Fed tightening for the rest of the year. The Fed continues to look past recent mixed economic data and inaction in Washington and remains on course for both rate hikes and balance sheet reductions.

Washington as a Relief Pitcher: Washington will insert fiscal reforms into the eighth or ninth inning of our extended and somewhat tired economic recovery. The irony of this timing, now that we are beyond full employment, is that it could have a bigger impact on inflation than growth but not until late 2018 or 2019. We expect rising volatility between now and the July 28th summer recess as debates ensue.

Corporate Earnings: Quantity AND Quality: Last month we highlighted the numbers behind an outstanding Q1 earnings season. This month we show the quality behind those earnings and share our expectation for additional gains.

A Disconnect Between Bonds and Fed:

The Fed is looking past recent mixed data and remains on course for two hikes and balance sheet adjustment before year-end. We think a .25-percent hike at the June 14th meeting is a foregone conclusion. Recent data raises the possibility of the Fed tapering its balance sheet sooner than expected. This would occur if weaker data appears to be more than “transitory” and have less impact than an outright rate hike. This could slow the Fed’s path but not stop it.

The Fed understands after eight years of “extraordinarily easy” monetary policy it must have ammunition to counter a potential recession later in this cycle. They cannot end this cycle as they began it with 0-percent interest rates and a bloated balance sheet. They must reload their weapons during this period of strength to be prepared for future economic slowdowns.

The bond market is underestimating the Fed’s resolve. The Fed will likely tighten by more than bond markets currently predict. The bond market is anxious about a near-term economic slowdown and doubts that Washington will succeed. When viewed in aggregate, it could be argued that the Fed has not done enough despite three hikes to date. Record high stock prices and a weaker dollar have done as much to ease financial conditions as the Fed has done to tighten them. We expect the Fed to continue down its communicated path of tightening without regard to Washington’s master plan.

Last week’s less-than-expected jobs report is to be taken with a grain of salt. The 4.3-percent unemployment rate is .4 percent less than the Fed’s target so despite only 138,000 new jobs, we are beyond the Fed’s full employment target. It should be noted that the post World War II U.S. economy has never avoided a recession whenever the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point. This bears watching in the months to come. The Fed will turn a keen eye to wage growth for signs of future inflation. A sustained downturn in inflation expectations is a primary factor that could cause the Fed to pause.

In the end, the bond market is a worrier while, in this case, the Fed is the warrior and will march ahead with a combination of rate hikes and balance sheet adjustments.

Washington as a Relief Pitcher:

We are in the late innings of the most shallow economic recovery we have had since World War II. Washington will have a flurry of activity between now and year-end to extend the recovery into 2018-2019. The second half of 2017 offers a packed agenda.

  • The Senate response to the House health care bill
  • Debt limit debate as early as July
  • Spending deadline by Sept. 30th to avoid shutdown
  • 2018 budget outline

It is ironic that just a few years ago, when economic growth was weaker, world economies were on a mission to rein in government spending through fiscal austerity. (Remember the Sequester?) Today, we are at full employment, inflation hovers near the Fed’s 2-percent target, corporate profits have rebounded sharply and anticipated fiscal reforms aim to stimulate economic growth. These are all positive developments.

Given that we are at full employment and in the late innings of the economic cycle there is a good chance the anticipated fiscal stimulus will generate as much inflation as it does growth. This will be something we will watch closely as we head into 2018 to evaluate any unexpected impact on inflation, interest rates, currencies and earnings trends for large multinational U.S. companies. Though the recovery would likely be extended, we remain aware of the potential for unintended consequences.

We think Washington will come through with a tax-reform package toward year-end but it will resemble tax cuts rather than all out reform. Since the targeted tax cuts outnumber the sources of potential tax revenue, it will not be revenue neutral. The compromises along the way will leave us with a scaled down version of the original plan. As we said at the beginning, it may be done in a hurry just to have something on the books before next year’s midterm elections.

The chart below illustrates a post war history of Republican presidents facing midterm election challenges. The bottom axis includes the approval ratings for each Republican president since World War II and the left side illustrates how many House seats were lost in midterm elections. It is a straightforward relationship in that the less popular a president is, the more seats his party has lost. As the chart illustrates, based on history and President Trump’s current low approval ratings, it suggests a loss of approximately 40 seats in the House. This would tip the House back to Democrats and a return to stalemate with a divided government. It is far too early to predict anything so we simply raise the possibility.

market-monthly-june-2017-bby-perspectives-Republicans-2018

Bottom Line:

Given the slim Republican majority in the House and currently low approval ratings for President Trump, the House is in play in 2018. As a result, Republicans will craft a compromise partisan tax plan that takes affect for the 2017 tax year rather than returning home to their constituents empty handed. As we move toward July 28th when Congress takes their summer recess, market volatility is not only possible but probable.

Corporate Earnings: Quantity AND Quality:

Last month we highlighted an outstanding earnings season for Q1.

  • 14 percent earnings growth and 7.6-percent revenue growth (best in six years)
  • 75 percent of companies beat their earnings estimates and 64 percent beat their sales estimate
  • 10 out of 11 sectors registered earnings and sales growth (only telecom did not)

We think this trend will continue through the rest of the year but at a more subdued pace.

The quality and breadth of earnings stand out across sectors and other world markets. Below are some factors that stand out for the recently concluded Q1 earnings season.

  • There was a tight spread between operating earnings and reported earnings. This signals a relative lack of earnings manipulation and high earnings quality.
  • Declining share buybacks. Recent years have seen EPS rise due to lower share counts rather than revenue growth. A decline indicates more organic business growth.
  • Top-line revenue growth and cash-flow growth indicate higher earnings quality

As the year progresses, we will watch 2018 earnings estimates with great interest. Current estimates do not include any impact from tax reform since a plan has not yet passed. Likewise current estimates do not yet reflect any affect from a tightening Fed and a rising interest rate structure.

International Equities: The MSCI All Country World Index is a broad-based global stock index that includes markets of 46 countries representing both developed and emerging markets. The U.S. represents a little more than half of its market value. At present more than 89 percent of the countries in that index are above their average price for the last year and more than 89 percent are moving higher. Additionally, more than 70 percent of those countries signal improving earnings growth versus the prior year. It is a good time to be a global investor with more secure underlying fundamentals than we have seen in several years.

Risks to the Outlook:

  • Any reversal to YTD dollar weakness could negatively impact large multinational U.S. stocks
  • Unexpected inflation and corresponding rate increases could call valuations into question
  • We have gone the longest period (249 days) without a 5-percent correction in almost 20 years
  • Q2 must follow through the Q1 earnings season just to validate current record prices
  • The seasonal and political calendar this summer could set the stage for higher volatility

Bottom Line:

We remain of the opinion that stocks will outperform bonds for the next 12 months both in the U.S. and abroad. In the U.S. we cannot ignore the maturity and duration of this bull market versus other parts of the world, which are only now starting to show signs of life. Robust earnings results have done more to backstop already high valuations than they have to set the stage for future advances.

Equity Update:

May results in world equity markets, shown in the chart below, were consistent with the year-to-date trends:

  • Growth stocks led by technology added to its YTD advantage over value
  • International equities continue to far outpace U.S. equities for the first time in several years
  • Small cap stocks continue to underperform large cap stocks

market-monthly-june-2017-bbt-perspectives-equity

Bond Update:

May results in bond markets, shown in the chart below, were consistent with the year-to-date trends:

  • High yield bonds continue to outperform with continued corporate strength
  • Municipal bonds had a good month as tax exemption is safe with proposed tax reform
  • International bonds performed well with emerging market bonds large contributors YTD

market-monthly-june-2017-bbt-perspectives-bond

Key Takeaways:

  • The Fed will hike in June plus once more with balance sheet normalization before year-end
  • Gross domestic product is expected to accelerate in Q2
  • Bonds are fully valued and not fully discounting future Fed rate hikes
  • U.S. equities should continue to outpace bonds through next summer
  • Washington will pass pro-growth stimulus but will fall short of its promised impact
  • International equities should continue to outpace the U.S. (absent currency considerations)

Final Thought:

Global stock and bond markets have surpassed expectations so far in 2017. We believe the second half of 2017 will see increasing levels of volatility to be led by Washington policy deliberations with an increasing focus on the U.S. budget, debt and tax reform. In the end, Washington will create policy to demonstrate some level of progress but will fall short of its promise as it hurries to beat the ticking clock. The Fed is unlikely to back off its path to normalization and will continue to execute its plan absent any unforeseen economic or geopolitical events. Any escalation of Washington scandal is a known unknown but should not be cause for long-term concern. Stay the course, stay invested.

June, 2017

market-monthly-june-2017-bbt-perspectives-feature

“If you don’t have time to do it right, when will you have time to do it over?”

John Wooden

“Be quick, but don’t hurry” was a saying legendary basketball coach John Wooden had for his many championship teams. His teams understood a thoughtful plan executed quickly was better than a poorly concocted plan done in a hurry. Today, the Fed is demonstrating quickness with a seemingly well executed plan. Washington has a full agenda and must hurry with its summer recess approaching, a list of distractions and mid-term election pressures are looming for 2018. Ultimately, we think Washington will get it done but with delay and dilution.

Summary:

A Disconnect Between Bonds and Fed: The bond market is pricing in too little Fed tightening for the rest of the year. The Fed continues to look past recent mixed economic data and inaction in Washington and remains on course for both rate hikes and balance sheet reductions.

Washington as a Relief Pitcher: Washington will insert fiscal reforms into the eighth or ninth inning of our extended and somewhat tired economic recovery. The irony of this timing, now that we are beyond full employment, is that it could have a bigger impact on inflation than growth but not until late 2018 or 2019. We expect rising volatility between now and the July 28th summer recess as debates ensue.

Corporate Earnings: Quantity AND Quality: Last month we highlighted the numbers behind an outstanding Q1 earnings season. This month we show the quality behind those earnings and share our expectation for additional gains.

A Disconnect Between Bonds and Fed:

The Fed is looking past recent mixed data and remains on course for two hikes and balance sheet adjustment before year-end. We think a .25-percent hike at the June 14th meeting is a foregone conclusion. Recent data raises the possibility of the Fed tapering its balance sheet sooner than expected. This would occur if weaker data appears to be more than “transitory” and have less impact than an outright rate hike. This could slow the Fed’s path but not stop it.

The Fed understands after eight years of “extraordinarily easy” monetary policy it must have ammunition to counter a potential recession later in this cycle. They cannot end this cycle as they began it with 0-percent interest rates and a bloated balance sheet. They must reload their weapons during this period of strength to be prepared for future economic slowdowns.

The bond market is underestimating the Fed’s resolve. The Fed will likely tighten by more than bond markets currently predict. The bond market is anxious about a near-term economic slowdown and doubts that Washington will succeed. When viewed in aggregate, it could be argued that the Fed has not done enough despite three hikes to date. Record high stock prices and a weaker dollar have done as much to ease financial conditions as the Fed has done to tighten them. We expect the Fed to continue down its communicated path of tightening without regard to Washington’s master plan.

Last week’s less-than-expected jobs report is to be taken with a grain of salt. The 4.3-percent unemployment rate is .4 percent less than the Fed’s target so despite only 138,000 new jobs, we are beyond the Fed’s full employment target. It should be noted that the post World War II U.S. economy has never avoided a recession whenever the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point. This bears watching in the months to come. The Fed will turn a keen eye to wage growth for signs of future inflation. A sustained downturn in inflation expectations is a primary factor that could cause the Fed to pause.

In the end, the bond market is a worrier while, in this case, the Fed is the warrior and will march ahead with a combination of rate hikes and balance sheet adjustments.

Washington as a Relief Pitcher:

We are in the late innings of the most shallow economic recovery we have had since World War II. Washington will have a flurry of activity between now and year-end to extend the recovery into 2018-2019. The second half of 2017 offers a packed agenda.

  • The Senate response to the House health care bill
  • Debt limit debate as early as July
  • Spending deadline by Sept. 30th to avoid shutdown
  • 2018 budget outline

It is ironic that just a few years ago, when economic growth was weaker, world economies were on a mission to rein in government spending through fiscal austerity. (Remember the Sequester?) Today, we are at full employment, inflation hovers near the Fed’s 2-percent target, corporate profits have rebounded sharply and anticipated fiscal reforms aim to stimulate economic growth. These are all positive developments.

Given that we are at full employment and in the late innings of the economic cycle there is a good chance the anticipated fiscal stimulus will generate as much inflation as it does growth. This will be something we will watch closely as we head into 2018 to evaluate any unexpected impact on inflation, interest rates, currencies and earnings trends for large multinational U.S. companies. Though the recovery would likely be extended, we remain aware of the potential for unintended consequences.

We think Washington will come through with a tax-reform package toward year-end but it will resemble tax cuts rather than all out reform. Since the targeted tax cuts outnumber the sources of potential tax revenue, it will not be revenue neutral. The compromises along the way will leave us with a scaled down version of the original plan. As we said at the beginning, it may be done in a hurry just to have something on the books before next year’s midterm elections.

The chart below illustrates a post war history of Republican presidents facing midterm election challenges. The bottom axis includes the approval ratings for each Republican president since World War II and the left side illustrates how many House seats were lost in midterm elections. It is a straightforward relationship in that the less popular a president is, the more seats his party has lost. As the chart illustrates, based on history and President Trump’s current low approval ratings, it suggests a loss of approximately 40 seats in the House. This would tip the House back to Democrats and a return to stalemate with a divided government. It is far too early to predict anything so we simply raise the possibility.

market-monthly-june-2017-bby-perspectives-Republicans-2018

Bottom Line:

Given the slim Republican majority in the House and currently low approval ratings for President Trump, the House is in play in 2018. As a result, Republicans will craft a compromise partisan tax plan that takes affect for the 2017 tax year rather than returning home to their constituents empty handed. As we move toward July 28th when Congress takes their summer recess, market volatility is not only possible but probable.

Corporate Earnings: Quantity AND Quality:

Last month we highlighted an outstanding earnings season for Q1.

  • 14 percent earnings growth and 7.6-percent revenue growth (best in six years)
  • 75 percent of companies beat their earnings estimates and 64 percent beat their sales estimate
  • 10 out of 11 sectors registered earnings and sales growth (only telecom did not)

We think this trend will continue through the rest of the year but at a more subdued pace.

The quality and breadth of earnings stand out across sectors and other world markets. Below are some factors that stand out for the recently concluded Q1 earnings season.

  • There was a tight spread between operating earnings and reported earnings. This signals a relative lack of earnings manipulation and high earnings quality.
  • Declining share buybacks. Recent years have seen EPS rise due to lower share counts rather than revenue growth. A decline indicates more organic business growth.
  • Top-line revenue growth and cash-flow growth indicate higher earnings quality

As the year progresses, we will watch 2018 earnings estimates with great interest. Current estimates do not include any impact from tax reform since a plan has not yet passed. Likewise current estimates do not yet reflect any affect from a tightening Fed and a rising interest rate structure.

International Equities: The MSCI All Country World Index is a broad-based global stock index that includes markets of 46 countries representing both developed and emerging markets. The U.S. represents a little more than half of its market value. At present more than 89 percent of the countries in that index are above their average price for the last year and more than 89 percent are moving higher. Additionally, more than 70 percent of those countries signal improving earnings growth versus the prior year. It is a good time to be a global investor with more secure underlying fundamentals than we have seen in several years.

Risks to the Outlook:

  • Any reversal to YTD dollar weakness could negatively impact large multinational U.S. stocks
  • Unexpected inflation and corresponding rate increases could call valuations into question
  • We have gone the longest period (249 days) without a 5-percent correction in almost 20 years
  • Q2 must follow through the Q1 earnings season just to validate current record prices
  • The seasonal and political calendar this summer could set the stage for higher volatility

Bottom Line:

We remain of the opinion that stocks will outperform bonds for the next 12 months both in the U.S. and abroad. In the U.S. we cannot ignore the maturity and duration of this bull market versus other parts of the world, which are only now starting to show signs of life. Robust earnings results have done more to backstop already high valuations than they have to set the stage for future advances.

Equity Update:

May results in world equity markets, shown in the chart below, were consistent with the year-to-date trends:

  • Growth stocks led by technology added to its YTD advantage over value
  • International equities continue to far outpace U.S. equities for the first time in several years
  • Small cap stocks continue to underperform large cap stocks

market-monthly-june-2017-bbt-perspectives-equity

Bond Update:

May results in bond markets, shown in the chart below, were consistent with the year-to-date trends:

  • High yield bonds continue to outperform with continued corporate strength
  • Municipal bonds had a good month as tax exemption is safe with proposed tax reform
  • International bonds performed well with emerging market bonds large contributors YTD

market-monthly-june-2017-bbt-perspectives-bond

Key Takeaways:

  • The Fed will hike in June plus once more with balance sheet normalization before year-end
  • Gross domestic product is expected to accelerate in Q2
  • Bonds are fully valued and not fully discounting future Fed rate hikes
  • U.S. equities should continue to outpace bonds through next summer
  • Washington will pass pro-growth stimulus but will fall short of its promised impact
  • International equities should continue to outpace the U.S. (absent currency considerations)
Final Thought:

Global stock and bond markets have surpassed expectations so far in 2017. We believe the second half of 2017 will see increasing levels of volatility to be led by Washington policy deliberations with an increasing focus on the U.S. budget, debt and tax reform. In the end, Washington will create policy to demonstrate some level of progress but will fall short of its promise as it hurries to beat the ticking clock. The Fed is unlikely to back off its path to normalization and will continue to execute its plan absent any unforeseen economic or geopolitical events. Any escalation of Washington scandal is a known unknown but should not be cause for long-term concern. Stay the course, stay invested.

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Ned Davis Research, BCA Research Inc., Morningstar

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.