October, 2017

BBT perspectives market monthly october 2017 feature

“The Federal Reserve cannot solve all of the economy’s problems on its own.”

Ben Bernanke, former Federal Reserve Chairman in a November 2010 Op-ed in “The Washington Post”

The two primary levers of economic policy find themselves at an inflection point. The Fed is cooling their ultra-accommodative monetary policy while Washington is turning up the heat on economic growth through potential tax reform. Adjusting the faucet too much in one direction could have the unintended consequence of making the economy run too hot or too cold. In this edition of Market Monthly we consider the possible impact of changing Fed and Tax policy on asset prices as we begin to shape our outlook for 2018. For now, the temperature is just right!

Summary:

Busy Time for the Fed: Unwinding nine years of extraordinary Federal Reserve policy will be as unprecedented as the policy itself. Economic growth is strong and accelerating with recent inflation data showing signs of ticking up. Fed chairperson interviews are ongoing with a nomination expected very soon with three additional Fed seats unfilled.

Progress on Tax Reform: On Sept. 27, the White House released the “Unified Framework for Fixing Our Broken Tax Code.” The Framework proposal is a two-step process. First, Congress must pass a budget that reconciles to pass by a 51-vote Senate majority.  Second, the tax bill must be written. Authors of the actual tax bill are likely drafting as we speak and could release a draft as soon as Nov. 1.  Successful passage should be very positive for the economy and the stock market.

Equity Overview: The fourth quarter historically kicks off the most profitable calendar season of the year for investors.  Earnings are expected to grow 2 percent for the historically weak Q3 and rebound for Q4. U.S. stock prices have not yet been spooked by rising interest rates but risks rise as we get deeper into 2018. Sustained economic growth, hopes for pro-growth tax reform, continued low rates and a weak dollar have supported U.S. stocks so far in 2017 but some of those catalysts are expected to fade as we enter 2018.

Fixed Income Overview: Recent inflation data have increased and could rise more in the months to come. The Fed will monitor this closely to confirm their projected path for future rate hikes. A 2.75-percent yield on 10-year Treasury notes is a possibility by year-end if recent inflation data persists. Municipals and high-quality corporate bonds remain attractive with short maturities a preferred way to manage against interest rate risk.

Busy Time for the Fed:

Above-trend economic growth and a recent uptick in inflation are anchoring Fed expectations for continued rate hikes and balance sheet reductions. Consider the following:

  • 97 percent of the world’s developed economies are in expansion territory
  • 90 percent of the world’s economies are growing faster than they were one year ago
  • The Goldman Sachs Current Activity Indicator (CAI) indicates global GDP growth of 4.7 percent
  • The September Institute of Supply Management (ISM) reading of 60.8 (over 50 indicates expansion) was the highest in 13 years confirming that manufacturing is booming

We expect a December rate hike with more to follow in 2018. Likewise, the European Central Bank and Bank of Japan will continue with their accommodative policies although the ECB is likely to announce a gradual tapering of bond purchases at their meeting on Oct. 26.

Interviews for Fed Leadership:  The White House continues interviewing candidates for the Fed chairperson spot, which expires in February. Current chair Janet Yellen is one of five contenders being considered. We would not be surprised to see nominations in rapid succession for both the Fed chairperson position and possibly some of the remaining three vacant seats on the FOMC. A Janet Yellen or Jerome Powell led Fed could have a calming market influence as status quo picks. A John Taylor selection as chairperson could be a market event as he is thought to be far more hawkish than current leadership. However, a Taylor vice-chair position is a distinct possibility.

Why Inflation is important:  There are many economic variables feeding the calculus behind the Fed’s decisions with price stability and full employment broadly comprising the dual mandate that guides their thinking. Specifically, 2-percent inflation and 4.7-percent unemployment have been rough targets for the Fed. The chart below provides an example of both of these forces at work.

Key Points:

  • The dark blue line represents the rate of wage growth (key inflation component)
  • The light blue line indicates the unemployment rate
  • Shaded areas of this chart indicate time periods where a recession occurred
  • Once wage growth reaches 4 percent, recessions tend to occur with greater frequency

BBT perspectives market monthly October 2017 Unemployment and Wage

Takeaway:  The Fed will continue to unwind nine years of unprecedented monetary policy accommodation.

  • Balance sheet reduction has begun and further rate hikes are anticipated.
  • Full employment has been reached and wage inflation is ticking up but not excessive.
  • Unexpected inflation that could prompt unanticipated rate hikes remains a risk in 2018.
  • Fed policy has created a wealth effect recovery for some but not an income recovery for all.
  • Financial asset price inflation will become an increasingly important Fed consideration.

From here the question is not:  Will rising rates impact stock prices? The question is:  When will rising rates impact stock prices?

We think those risks increase later in 2018 as the Fed shifts from their “normalization” process and into their “tightening” process to slow down the economy. For now, economic growth remains a tailwind for global investors.

Tax Reform:

The White House Framework released on Sept. 27 was largely in line with expectations and heavily influenced by the House Ways and Means Committee’s Blueprint for tax reform released June 24, 2016.  It is premature for tax payers and investors alike to act on what we’ve seen so far because after all, it is just a proposal. Ultimately, we think the Senate and House will come together in rapid agreement this week on a budget resolution and suspect a first draft of the tax bill could be coming as  soon as Nov. 1. (The same day the Fed meets.) Once we see a draft plan, we will address any longer term investment themes in more detail. Until then here are some high level observations:

  • Reform is necessary: As the chart below shows, the U.S. corporate code is simply not as competitive as most of our trading partners.

BBT Perspectives market monthly October 2017 Statutory Corp Tax Rates

  • Congress will move fast: The chart below suggests if mid-term elections were held today, Republicans would likely lose the House. This simply means there is motivation to deliver tax reform to constituents prior to the election. Failure could be the difference between an election squeaker and a landslide. We think it gets done but the Senate vote math makes it tight.

BBT Perspectives market monthly October 2017 Republican Ballot

  • Corporate Reform is the sticking point: Individual tax proposals are already largely reconciled and revenue neutral. Corporate proposals are only 50-percent funded with offsets and will attract the most debate.
  • Timing is everything: With 2001 tax reform, lawmakers decided to “phase in” tax savings rather than make them immediate and suffered substandard economic growth. Immediate tax savings helps the economy immediately whereas phased in tax savings has a delayed benefit but may be necessary for Congress to balance their checkbook.
  • Permanent or Temporary: Generally speaking, if tax reform is revenue neutral after 10 years then reform can be permanent. If however, tax reform adds to the deficit after 10 years, then reform can be temporary and subject to renegotiation. The expiration of 2001 tax reform in the summer of 2011, without deficit neutrality, is what caused the fiscal cliff of 2012. Recall that this also coincided with the S&P downgrade of U.S. debt.

Bottom Line:  A detailed review of tax reform can only be done once the bill is written. Though we don’t expect many surprises, horse trading will happen along the way to getting a deal done. Until the budget resolution process is complete, the authors of pending tax reform don’t know what answer they are solving for.

Equity Overview:

Twenty-nine percent of S&P 500 companies have reported Q3 earnings through the week ending Oct. 20 with 62 percent beating earnings estimates, 65 percent beating sales estimates and 46 percent beating both. Q3 earnings will remain positive but are expected to slow from Q2 due to seasonal weakness and the recent hurricanes. Recent analyst revisions have pared back already lofty U.S. estimates but increased earnings estimates for international markets. By next week, over half of S&P 500 companies will have reported so we will know the larger trends. Earnings misses have been punished by more than earnings beats have been rewarded. This is typical late cycle stock market behavior.

Is tax reform baked in?  Yes and no. Hopes for tax reform have been priced into some sectors of the markets but tax reform has not yet been priced into earnings estimates. At the proposed 20-percent corporate tax rate, S&P 500 earnings are expected to see a boost of roughly 7 percent and the S&P 600 Small Cap Index an even larger 26-percent increase. Corporate tax reform is a market positive, and we will have to evaluate expected longer term trends with staying power once the bill is complete.

Note below the one-month return of 6.24 percent for Small Cap U.S. stocks just in September. This represents an example of a “tax reform” trade as small companies typically do most of their business in the U.S. and as a result are taxed at higher rates. As September progressed and tax reform looked more possible, small cap stock performance spiked. The real story for 2017 continues to be the resurgence of international stocks, emerging market stocks and growth stocks all performing in the 20 percent or above range.

 BBT Perspectives market monthly October 2017 Stock Index

Final Thought:  The fundamental global economic backdrop remains supportive of global equities. However, we cannot ignore the fact that in almost 90 years of economic history, we are the midst of the third longest stretch of performance for the S&P 500 without experiencing a 5-percent drawdown (330 trading days). There are no signs of a bear market or recession, but current levels of optimism and stretched valuations would leave us unsurprised to see the market let off 3 percent-5 percent of steam. Remember though, bull markets don’t die of old age or valuations alone without some other catalyst. Tax reform failure or escalating levels of North Korean defiance would be two such catalysts.

Fixed Income Outlook:

The chart below shows a disconnect between market forecasts of 10-year U.S. Treasury notes and the futures market. The futures market indicates how markets are actually pricing bonds whereas forecasts are human judgment calls on where they think markets will be in time. There remains a big difference between the two. In short, forecasters expect continued economic growth, falling unemployment, rising wages and further Fed rate hikes. The futures market on the other hand is a doubting Thomas and will believe it when they see it.

BBT Perspectives market monthly October 2017 10-year Treasury

September was a challenging month for most bond categories as firming inflation and a determined Fed caused yields to rise and prices to fall. Earlier this year we described 2017 as a year where best expectations for bond investors could be characterized as a “keep your coupon” environment. This has largely been true for U.S. Treasury notes, but there have been additional gains to be had from municipals and high-yield corporates.

Municipals have bounced back from being undervalued early this year when their tax exempt status was uncertain with tax reform. That is no longer an issue.

High-yield corporate bonds have added to their high levels of interest income by appreciating as their spreads have tightened to investment grade bonds. This source of return for high-yield bonds has likely run its course.

Strategies that limit interest rate sensitivity and maximize credit quality should be emphasized for any new money committed to bonds in the months to come.

BBT Perspectives market monthly October 2017 Bond Index

Final Thoughts:

  • For now, Fed policy is unwavering and we look for additional rate hikes starting in December
  • Inflation is firming and will be monitored by the Fed to avoid getting behind the curve
  • Global economic growth is robust but could signal a peak in coming months
  • Unwinding unprecedented Fed policy could have unprecedented consequences
  • Tax reform should stimulate the economy but must be implemented immediately not in phases
  • Global equities remain attractive long-term with supportive economic fundamentals
  • High valuations and excessive optimism are a near-term concern
  • Any market drawdowns, absent a catalyst, should be contained and should be bought
  • Rising bond yields (income) over the next year may be neutralized by falling prices

October, 2017

BBT perspectives market monthly october 2017 feature

“The Federal Reserve cannot solve all of the economy’s problems on its own.”

Ben Bernanke, former Federal Reserve Chairman in a November 2010 Op-ed in “The Washington Post”

The two primary levers of economic policy find themselves at an inflection point. The Fed is cooling their ultra-accommodative monetary policy while Washington is turning up the heat on economic growth through potential tax reform. Adjusting the faucet too much in one direction could have the unintended consequence of making the economy run too hot or too cold. In this edition of Market Monthly we consider the possible impact of changing Fed and Tax policy on asset prices as we begin to shape our outlook for 2018. For now, the temperature is just right!

Summary:

Busy Time for the Fed: Unwinding nine years of extraordinary Federal Reserve policy will be as unprecedented as the policy itself. Economic growth is strong and accelerating with recent inflation data showing signs of ticking up. Fed chairperson interviews are ongoing with a nomination expected very soon with three additional Fed seats unfilled.

Progress on Tax Reform: On Sept. 27, the White House released the “Unified Framework for Fixing Our Broken Tax Code.” The Framework proposal is a two-step process. First, Congress must pass a budget that reconciles to pass by a 51-vote Senate majority.  Second, the tax bill must be written. Authors of the actual tax bill are likely drafting as we speak and could release a draft as soon as Nov. 1.  Successful passage should be very positive for the economy and the stock market.

Equity Overview: The fourth quarter historically kicks off the most profitable calendar season of the year for investors.  Earnings are expected to grow 2 percent for the historically weak Q3 and rebound for Q4. U.S. stock prices have not yet been spooked by rising interest rates but risks rise as we get deeper into 2018. Sustained economic growth, hopes for pro-growth tax reform, continued low rates and a weak dollar have supported U.S. stocks so far in 2017 but some of those catalysts are expected to fade as we enter 2018.

Fixed Income Overview: Recent inflation data have increased and could rise more in the months to come. The Fed will monitor this closely to confirm their projected path for future rate hikes. A 2.75-percent yield on 10-year Treasury notes is a possibility by year-end if recent inflation data persists. Municipals and high-quality corporate bonds remain attractive with short maturities a preferred way to manage against interest rate risk.

Busy Time for the Fed:

Above-trend economic growth and a recent uptick in inflation are anchoring Fed expectations for continued rate hikes and balance sheet reductions. Consider the following:

  • 97 percent of the world’s developed economies are in expansion territory
  • 90 percent of the world’s economies are growing faster than they were one year ago
  • The Goldman Sachs Current Activity Indicator (CAI) indicates global GDP growth of 4.7 percent
  • The September Institute of Supply Management (ISM) reading of 60.8 (over 50 indicates expansion) was the highest in 13 years confirming that manufacturing is booming

We expect a December rate hike with more to follow in 2018. Likewise, the European Central Bank and Bank of Japan will continue with their accommodative policies although the ECB is likely to announce a gradual tapering of bond purchases at their meeting on Oct. 26.

Interviews for Fed Leadership:  The White House continues interviewing candidates for the Fed chairperson spot, which expires in February. Current chair Janet Yellen is one of five contenders being considered. We would not be surprised to see nominations in rapid succession for both the Fed chairperson position and possibly some of the remaining three vacant seats on the FOMC. A Janet Yellen or Jerome Powell led Fed could have a calming market influence as status quo picks. A John Taylor selection as chairperson could be a market event as he is thought to be far more hawkish than current leadership. However, a Taylor vice-chair position is a distinct possibility.

Why Inflation is important:  There are many economic variables feeding the calculus behind the Fed’s decisions with price stability and full employment broadly comprising the dual mandate that guides their thinking. Specifically, 2-percent inflation and 4.7-percent unemployment have been rough targets for the Fed. The chart below provides an example of both of these forces at work.

Key Points:

  • The dark blue line represents the rate of wage growth (key inflation component)
  • The light blue line indicates the unemployment rate
  • Shaded areas of this chart indicate time periods where a recession occurred
  • Once wage growth reaches 4 percent, recessions tend to occur with greater frequency

BBT perspectives market monthly October 2017 Unemployment and Wage

Takeaway:  The Fed will continue to unwind nine years of unprecedented monetary policy accommodation.

  • Balance sheet reduction has begun and further rate hikes are anticipated.
  • Full employment has been reached and wage inflation is ticking up but not excessive.
  • Unexpected inflation that could prompt unanticipated rate hikes remains a risk in 2018.
  • Fed policy has created a wealth effect recovery for some but not an income recovery for all.
  • Financial asset price inflation will become an increasingly important Fed consideration.

From here the question is not:  Will rising rates impact stock prices? The question is:  When will rising rates impact stock prices?

We think those risks increase later in 2018 as the Fed shifts from their “normalization” process and into their “tightening” process to slow down the economy. For now, economic growth remains a tailwind for global investors.

Tax Reform:

The White House Framework released on Sept. 27 was largely in line with expectations and heavily influenced by the House Ways and Means Committee’s Blueprint for tax reform released June 24, 2016.  It is premature for tax payers and investors alike to act on what we’ve seen so far because after all, it is just a proposal. Ultimately, we think the Senate and House will come together in rapid agreement this week on a budget resolution and suspect a first draft of the tax bill could be coming as  soon as Nov. 1. (The same day the Fed meets.) Once we see a draft plan, we will address any longer term investment themes in more detail. Until then here are some high level observations:

  • Reform is necessary: As the chart below shows, the U.S. corporate code is simply not as competitive as most of our trading partners.

BBT Perspectives market monthly October 2017 Statutory Corp Tax Rates

  • Congress will move fast: The chart below suggests if mid-term elections were held today, Republicans would likely lose the House. This simply means there is motivation to deliver tax reform to constituents prior to the election. Failure could be the difference between an election squeaker and a landslide. We think it gets done but the Senate vote math makes it tight.

BBT Perspectives market monthly October 2017 Republican Ballot

  • Corporate Reform is the sticking point: Individual tax proposals are already largely reconciled and revenue neutral. Corporate proposals are only 50-percent funded with offsets and will attract the most debate.
  • Timing is everything: With 2001 tax reform, lawmakers decided to “phase in” tax savings rather than make them immediate and suffered substandard economic growth. Immediate tax savings helps the economy immediately whereas phased in tax savings has a delayed benefit but may be necessary for Congress to balance their checkbook.
  • Permanent or Temporary: Generally speaking, if tax reform is revenue neutral after 10 years then reform can be permanent. If however, tax reform adds to the deficit after 10 years, then reform can be temporary and subject to renegotiation. The expiration of 2001 tax reform in the summer of 2011, without deficit neutrality, is what caused the fiscal cliff of 2012. Recall that this also coincided with the S&P downgrade of U.S. debt.

Bottom Line:  A detailed review of tax reform can only be done once the bill is written. Though we don’t expect many surprises, horse trading will happen along the way to getting a deal done. Until the budget resolution process is complete, the authors of pending tax reform don’t know what answer they are solving for.

Equity Overview:

Twenty-nine percent of S&P 500 companies have reported Q3 earnings through the week ending Oct. 20 with 62 percent beating earnings estimates, 65 percent beating sales estimates and 46 percent beating both. Q3 earnings will remain positive but are expected to slow from Q2 due to seasonal weakness and the recent hurricanes. Recent analyst revisions have pared back already lofty U.S. estimates but increased earnings estimates for international markets. By next week, over half of S&P 500 companies will have reported so we will know the larger trends. Earnings misses have been punished by more than earnings beats have been rewarded. This is typical late cycle stock market behavior.

Is tax reform baked in?  Yes and no. Hopes for tax reform have been priced into some sectors of the markets but tax reform has not yet been priced into earnings estimates. At the proposed 20-percent corporate tax rate, S&P 500 earnings are expected to see a boost of roughly 7 percent and the S&P 600 Small Cap Index an even larger 26-percent increase. Corporate tax reform is a market positive, and we will have to evaluate expected longer term trends with staying power once the bill is complete.

Note below the one-month return of 6.24 percent for Small Cap U.S. stocks just in September. This represents an example of a “tax reform” trade as small companies typically do most of their business in the U.S. and as a result are taxed at higher rates. As September progressed and tax reform looked more possible, small cap stock performance spiked. The real story for 2017 continues to be the resurgence of international stocks, emerging market stocks and growth stocks all performing in the 20 percent or above range.

 BBT Perspectives market monthly October 2017 Stock Index

Final Thought:  The fundamental global economic backdrop remains supportive of global equities. However, we cannot ignore the fact that in almost 90 years of economic history, we are the midst of the third longest stretch of performance for the S&P 500 without experiencing a 5-percent drawdown (330 trading days). There are no signs of a bear market or recession, but current levels of optimism and stretched valuations would leave us unsurprised to see the market let off 3 percent-5 percent of steam. Remember though, bull markets don’t die of old age or valuations alone without some other catalyst. Tax reform failure or escalating levels of North Korean defiance would be two such catalysts.

Fixed Income Outlook:

The chart below shows a disconnect between market forecasts of 10-year U.S. Treasury notes and the futures market. The futures market indicates how markets are actually pricing bonds whereas forecasts are human judgment calls on where they think markets will be in time. There remains a big difference between the two. In short, forecasters expect continued economic growth, falling unemployment, rising wages and further Fed rate hikes. The futures market on the other hand is a doubting Thomas and will believe it when they see it.

BBT Perspectives market monthly October 2017 10-year Treasury

September was a challenging month for most bond categories as firming inflation and a determined Fed caused yields to rise and prices to fall. Earlier this year we described 2017 as a year where best expectations for bond investors could be characterized as a “keep your coupon” environment. This has largely been true for U.S. Treasury notes, but there have been additional gains to be had from municipals and high-yield corporates.

Municipals have bounced back from being undervalued early this year when their tax exempt status was uncertain with tax reform. That is no longer an issue.

High-yield corporate bonds have added to their high levels of interest income by appreciating as their spreads have tightened to investment grade bonds. This source of return for high-yield bonds has likely run its course.

Strategies that limit interest rate sensitivity and maximize credit quality should be emphasized for any new money committed to bonds in the months to come.

BBT Perspectives market monthly October 2017 Bond Index

Final Thoughts:
  • For now, Fed policy is unwavering and we look for additional rate hikes starting in December
  • Inflation is firming and will be monitored by the Fed to avoid getting behind the curve
  • Global economic growth is robust but could signal a peak in coming months
  • Unwinding unprecedented Fed policy could have unprecedented consequences
  • Tax reform should stimulate the economy but must be implemented immediately not in phases
  • Global equities remain attractive long-term with supportive economic fundamentals
  • High valuations and excessive optimism are a near-term concern
  • Any market drawdowns, absent a catalyst, should be contained and should be bought
  • Rising bond yields (income) over the next year may be neutralized by falling prices

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