May, 2017 BBT-perspectives-market-monthly-may-2017-feature

“Don’t wear roller-skates to a tug-of-war.”

Larry Wall

In this edition of Market Monthly, we steer through some conflicting signals the economy and markets have shown us recently so folks don’t feel stuck in the middle of a tug-of-war. We focus on the Fed, Washington’s pro-growth agenda, a fantastic earnings season and changing dynamics for bond investors. We are pulling for growth and believe that slow and steady wins the race through 2018.

Summary:

A Steady Fed: The Fed seems resolute in its path to interest rate and balance sheet normalization despite a weak Q1 Gross Domestic Product (GDP). Economic growth is expected to accelerate. With June rate hikes trending at 90 percent, we could see Fed policy nudge markets out of the current low volatility environment this summer.

Washington Rhetoric and Reality: By passing the American Health Care Act (AHCA), the House has handed the ball off to the Senate. This was a big step to advance the administration’s pro-growth agenda, but the Senate must act quickly to make tax reform happen in 2017 to avoid political costs in 2018.

Earnings Growth and Record Highs: Spectacular corporate earnings have partially validated the market rally, but concerns about near record-high valuations and investor complacency could prompt a correction for an impatient market.

Tax Reform Could Impact Bond Investing: Bond investing could soon enter a new era. Changes to the proposed three tax-bracket system along with a potential reduction in tax rates on interest income could change bond dynamics for bond investors.

A Steady Fed:

The May 3rd, Fed meeting resulted in no change in the Fed’s policy, outlook or path. The Fed continues to transition its policy from “extraordinarily” easy to just plain easy. It remains on track for hikes in June and September and is likely to begin reducing the size of its balance sheet in December by phasing out future bond repurchases. This blended approach to tightening is expected to make for a smoother landing rather than just interest rate hikes, which could cause an unwanted spike in the dollar. The chart below illustrates the Fed’s bloated balance sheet and signifies the Fed’s approaching focus to let a little air  out of it.

Transitory Weakness: BBT-perspectives-market-monthly-may-2017-Fed-Balance-Sheet
Q1 GDP came in at a disappointing 0.7 percent. The Fed viewed this weakness as a temporary soft patch that will likely fade in the coming weeks. The bar for Q1 GDP growth was set high by optimism after last fall’s election and hopes for a pro-growth agenda. A snapback in growth for Q2 is probable. In fact, the Atlanta Fed’s GDP Now Forecast is currently projecting 4.2-percent growth in Q2. Friday’s strong monthly employment report of 211,000 new jobs validated the Fed’s decision to stay the course.

Stocks have ignored the economic soft patch and lunged ahead toward record highs as corporate earnings have surged. Bond markets don’t share the Fed’s enthusiasm or resolve, and the markets expect interest rates to remain lower than the Fed’s projections. Nobody ever accused the bond market of being an optimist.

The Fed remains accommodative even though rates are above zero. The economy did not overheat when the Fed cut rates to 0 percent, and the economy will not be sent into a tailspin as it normalizes back toward 2 percent. The Fed has a steady hand and won’t blink unless weak data supports a pause. The Fed’s current measured path to tighten should return us back to a normal business cycle.

Risks to the Outlook:

  1. Renewed volatility could surface later this summer as additional rate hikes loom.
  2. At 4.4 percent unemployment, wage pressures may build and lead to unexpected inflation.
  3. Unexpected inflation could cause bond rates to spike closer to the Fed’s projected rate path.
Washington Rhetoric and Reality:

Last month’s edition found Republicans reeling from health care defeat. Fast forward to today, and we’ve seen Republicans celebrate (including Freedom Caucus members) the House passage of the American Health Care Act. Additionally, Treasury Secretary Mnuchin and the White House National Economic Council Director Gary Cohn released a sketch of the White House tax-reform plan. We will follow closely in the weeks ahead with great interest and share our views as details emerge.

The White House Tax Proposal:
The president’s proposal was short on details but offered enough to get the conversation started. Some of the highlights include:

Personal Tax:

  • Tax brackets shrunk from seven to three with the top rate falling from 39.6 percent to 35 percent
  • Capital Gains and Dividend tax rate declined from 23.8 percent to 20 percent
  • Standard deductions increased from $12,600 to $24,000 (this may eliminate 70 percent of itemizers)
  • Itemized deductions were eliminated except for mortgage interest and charitable contributions
  • Repeal of the alternative minimum tax and estate tax

Corporate Taxes:

  • Cut the top corporate rate from 35 percent to 15 percent
  • Created a repatriation tax on foreign profits (rate not specified)

House Passage of AHCA:
The House passage of the American Health Care Act was key to advancing the broader agenda of the Trump administration. This increases the odds of a total repeal and replacement of the Affordable Care Act (ACA) this year. The most likely path will be for the Senate to amend the House plan for passage in 2017. The clock is ticking and any delay that pushes tax-reform into 2018 would be a risky proposition for Republicans hoping to hold the House in 2018 mid-term elections.

Bottom Line:
We continue to believe Washington will be motivated to get both health care and tax reform done this year but it will not be easy. Democrats have been competitive in special election races by narrowing the gap in areas won by Trump. The party controlling the White House has lost an average of 19 seats in every mid-term election since 1970. The Democrats need 24 to take control. Tax reform may shift toward tax cuts in the interest of getting something done this year, but in either case, markets should respond favorably.

Earnings Growth and Record Highs:

With 83 percent of companies reporting Q1 earnings so far, the results have been terrific. In fact, companies beating both their earnings and sales estimates are the highest in 13 years. Some quick facts:

Earnings:

  • 75 percent of S&P 500 companies have beaten their estimated EPS
  • 13.5 percent year-over-year EPS growth is the highest in six years
  • S&P 500 EPS are beating their estimates by an average of 6.2 percent
  • European EPS are beating their estimates by an average of 10.1 percent
  • Nine of 11 S&P 500 sectors have seen their EPS growth rates increase since March 31st.
  • Large cap earnings have outperformed both mid-cap and small-cap stocks in part due to a weaker dollar in Q1

Sales Revenue:

  • 66 percent of S&P 500 companies are beating their sales estimates
  • 10 out of 11 sectors have reported year-over-year growth in sales revenue
  • Sales revenue is averaging 0.9 percent above estimates

The above results are in conflict with some of the recent weak GDP data. This was a comeback quarter for the large U.S. multinationals who do business abroad and benefit from a weaker dollar. Additionally, corporate buybacks plunged 20 percent from this time last year. Companies whose stocks benefitted from them buying back their own shares the last several years have suffered. This is actually good news. It means the quality of earnings this quarter throughout most sectors and the EPS beats were because business was good – not because companies were buying back their shares. We expect earnings to continue to outperform well into 2018 and any of the corporate tax-reform proposals that become law only boost that confidence in corporate results.

Risk to the Outlook:
High valuations and investor complacency could cause a summer pullback but should not derail the earnings momentum or the aging bull market. Notice in the chart, to the right, the S&P 500 (light blue dotted line) has far outpaced corporate earnings (solid line) since 2014. To close this gap, either prices need to pause allowing earnings to catch up or prices need to correct. Additionally, with the low interest rate environment, bonds have not been much competition for stocks. If the Fed does, in fact, hike rates twice more this summer and fall, bond yields could once again be respectable enough to draw funds out of equities for those seeking income and rising yields could pressure stock valuations. BBT-perspectives-market-monthly-may-2017-S-P500

BBT-perspectives-market-monthly-may-2017-EquityInternational markets continue to outpace the U.S. YTD, as the chart on the right shows. We expect that to continue in 2017, led by Europe’s economic and earnings resurgence with reduced political risk after Emmanuel Macron won the French presidential election on Sunday.

Tax Reform Could Impact Bond Investing:

At this stage, tax proposals are just that, proposals. Two potential changes that bear watching and could impact bond investors include:

  • Trimming the number of tax brackets for individuals from seven to three (income ranges not yet defined).
  • The House Blueprint Plan released last summer recommends cutting the tax rate on interest income to half of one’s tax bracket.

Even if both of these occurred, a change to an existing bond strategy needs to be planned only after carefully considering all the facts. BBT-perspectives-market-monthly-may-2017-Bond

Bond strategies could take on more an asset allocation focus by investing in a broad spectrum of fixed income securities rather than simply investing based on the tax status of a bonds income.

As the chart to the right illustrates, bond markets have been led by high yield bonds, emerging market bonds and municipal bonds. Economic data in the weeks to come will shape the Fed’s June decision. If growth accelerates as we expect, then we would expect bond yields to begin a slow steady climb toward 3 percent by year-end. If this occurs, it is only because the economy exhibits strength.

Key Takeaways:

  • The economic slowdown in Q1 was likely temporary but the bar was probably set too high
  • Economic growth is likely to accelerate in Q2
  • The Fed remains on course for two more hikes and balance sheet reduction in 2017
  • Fed normalization should usher in a more normal business cycle  Washington must get busy to pass both health care and tax reform in 2017
  • Earnings and sales recovery have validated equity prices but need to continue
  • Earnings quality have been high and participation has been broad

Bottom Line:
Robust corporate earnings and last week’s 211,000 new hires jobs report are signals that Q1 weakness will likely give way to Q2 strength. Though the Fed’s policies are tightening, they are not tight. Washington must deliver what it promises in the way of tax reform. This would be an important catalyst to launch us into 2018 with confidence. Our outlook is constructive, and we are pulling for growth.

May, 2017 BBT-perspectives-market-monthly-may-2017-feature

“Don’t wear roller-skates to a tug-of-war.”

Larry Wall

In this edition of Market Monthly, we steer through some conflicting signals the economy and markets have shown us recently so folks don’t feel stuck in the middle of a tug-of-war. We focus on the Fed, Washington’s pro-growth agenda, a fantastic earnings season and changing dynamics for bond investors. We are pulling for growth and believe that slow and steady wins the race through 2018.

Summary:

A Steady Fed: The Fed seems resolute in its path to interest rate and balance sheet normalization despite a weak Q1 Gross Domestic Product (GDP). Economic growth is expected to accelerate. With June rate hikes trending at 90 percent, we could see Fed policy nudge markets out of the current low volatility environment this summer.

Washington Rhetoric and Reality: By passing the American Health Care Act (AHCA), the House has handed the ball off to the Senate. This was a big step to advance the administration’s pro-growth agenda, but the Senate must act quickly to make tax reform happen in 2017 to avoid political costs in 2018.

Earnings Growth and Record Highs: Spectacular corporate earnings have partially validated the market rally, but concerns about near record-high valuations and investor complacency could prompt a correction for an impatient market.

Tax Reform Could Impact Bond Investing: Bond investing could soon enter a new era. Changes to the proposed three tax-bracket system along with a potential reduction in tax rates on interest income could change bond dynamics for bond investors.

A Steady Fed:

The May 3rd, Fed meeting resulted in no change in the Fed’s policy, outlook or path. The Fed continues to transition its policy from “extraordinarily” easy to just plain easy. It remains on track for hikes in June and September and is likely to begin reducing the size of its balance sheet in December by phasing out future bond repurchases. This blended approach to tightening is expected to make for a smoother landing rather than just interest rate hikes, which could cause an unwanted spike in the dollar. The chart below illustrates the Fed’s bloated balance sheet and signifies the Fed’s approaching focus to let a little air  out of it.

Transitory Weakness:
Q1 GDP came in at a disappointing 0.7 percent. The Fed viewed this weakness as a temporary soft patch that will likely fade in the coming weeks. The bar for Q1 GDP growth was set high by optimism after last fall’s election and hopes for a pro-growth agenda. A snapback in growth for Q2 is probable. In fact, the Atlanta Fed’s GDP Now Forecast is currently projecting 4.2-percent growth in Q2. Friday’s strong monthly employment report of 211,000 new jobs validated the Fed’s decision to stay the course.BBT-perspectives-market-monthly-may-2017-Fed-Balance-Sheet

Stocks have ignored the economic soft patch and lunged ahead toward record highs as corporate earnings have surged. Bond markets don’t share the Fed’s enthusiasm or resolve, and the markets expect interest rates to remain lower than the Fed’s projections. Nobody ever accused the bond market of being an optimist.

The Fed remains accommodative even though rates are above zero. The economy did not overheat when the Fed cut rates to 0 percent, and the economy will not be sent into a tailspin as it normalizes back toward 2 percent. The Fed has a steady hand and won’t blink unless weak data supports a pause. The Fed’s current measured path to tighten should return us back to a normal business cycle.

Risks to the Outlook:

  1. Renewed volatility could surface later this summer as additional rate hikes loom.
  2. At 4.4 percent unemployment, wage pressures may build and lead to unexpected inflation.
  3. Unexpected inflation could cause bond rates to spike closer to the Fed’s projected rate path.
Washington Rhetoric and Reality:

Last month’s edition found Republicans reeling from health care defeat. Fast forward to today, and we’ve seen Republicans celebrate (including Freedom Caucus members) the House passage of the American Health Care Act. Additionally, Treasury Secretary Mnuchin and the White House National Economic Council Director Gary Cohn released a sketch of the White House tax-reform plan. We will follow closely in the weeks ahead with great interest and share our views as details emerge.

The White House Tax Proposal:
The president’s proposal was short on details but offered enough to get the conversation started. Some of the highlights include:

Personal Tax:

  • Tax brackets shrunk from seven to three with the top rate falling from 39.6 percent to 35 percent
  • Capital Gains and Dividend tax rate declined from 23.8 percent to 20 percent
  • Standard deductions increased from $12,600 to $24,000 (this may eliminate 70 percent of itemizers)
  • Itemized deductions were eliminated except for mortgage interest and charitable contributions
  • Repeal of the alternative minimum tax and estate tax

Corporate Taxes:

  • Cut the top corporate rate from 35 percent to 15 percent
  • Created a repatriation tax on foreign profits (rate not specified)

House Passage of AHCA:
The House passage of the American Health Care Act was key to advancing the broader agenda of the Trump administration. This increases the odds of a total repeal and replacement of the Affordable Care Act (ACA) this year. The most likely path will be for the Senate to amend the House plan for passage in 2017. The clock is ticking and any delay that pushes tax-reform into 2018 would be a risky proposition for Republicans hoping to hold the House in 2018 mid-term elections.

Bottom Line:
We continue to believe Washington will be motivated to get both health care and tax reform done this year but it will not be easy. Democrats have been competitive in special election races by narrowing the gap in areas won by Trump. The party controlling the White House has lost an average of 19 seats in every mid-term election since 1970. The Democrats need 24 to take control. Tax reform may shift toward tax cuts in the interest of getting something done this year, but in either case, markets should respond favorably.

Earnings Growth and Record Highs:

With 83 percent of companies reporting Q1 earnings so far, the results have been terrific. In fact, companies beating both their earnings and sales estimates are the highest in 13 years. Some quick facts:

Earnings:

  • 75 percent of S&P 500 companies have beaten their estimated EPS
  • 13.5 percent year-over-year EPS growth is the highest in six years
  • S&P 500 EPS are beating their estimates by an average of 6.2 percent
  • European EPS are beating their estimates by an average of 10.1 percent
  • Nine of 11 S&P 500 sectors have seen their EPS growth rates increase since March 31st.
  • Large cap earnings have outperformed both mid-cap and small-cap stocks in part due to a weaker dollar in Q1

Sales Revenue:

  • 66 percent of S&P 500 companies are beating their sales estimates
  • 10 out of 11 sectors have reported year-over-year growth in sales revenue
  • Sales revenue is averaging 0.9 percent above estimates

The above results are in conflict with some of the recent weak GDP data. This was a comeback quarter for the large U.S. multinationals who do business abroad and benefit from a weaker dollar. Additionally, corporate buybacks plunged 20 percent from this time last year. Companies whose stocks benefitted from them buying back their own shares the last several years have suffered. This is actually good news. It means the quality of earnings this quarter throughout most sectors and the EPS beats were because business was good – not because companies were buying back their shares. We expect earnings to continue to outperform well into 2018 and any of the corporate tax-reform proposals that become law only boost that confidence in corporate results.

Risk to the Outlook:
High valuations and investor complacency could cause a summer pullback but should not derail the earnings momentum or the aging bull market. Notice in the chart, to the right, the S&P 500 (light blue dotted line) has far outpaced corporate earnings (solid line) since 2014. To close this gap, either prices need to pause allowing earnings to catch up or prices need to correct. Additionally, with the low interest rate environment, bonds have not been much competition for stocks. If the Fed does, in fact, hike rates twice more this summer and fall, bond yields could once again be respectable enough to draw funds out of equities for those seeking income and rising yields could pressure stock valuations.BBT-perspectives-market-monthly-may-2017-S-P500

International markets continue to outpace the U.S. YTD, as the chart below shows. We expect that to continue in 2017, led by Europe’s economic and earnings resurgence with reduced political risk after Emmanuel Macron won the French presidential election on Sunday.

BBT-perspectives-market-monthly-may-2017-Equity

Tax Reform Could Impact Bond Investing:

At this stage, tax proposals are just that, proposals. Two potential changes that bear watching and could impact bond investors include:

  • Trimming the number of tax brackets for individuals from seven to three (income ranges not yet defined).
  • The House Blueprint Plan released last summer recommends cutting the tax rate on interest income to half of one’s tax bracket.

Even if both of these occurred, a change to an existing bond strategy needs to be planned only after carefully considering all the facts.

Bond strategies could take on more an asset allocation focus by investing in a broad spectrum of fixed income securities rather than simply investing based on the tax status of a bonds income.

As the chart below illustrates, bond markets have been led by high yield bonds, emerging market bonds and municipal bonds. Economic data in the weeks to come will shape the Fed’s June decision. If growth accelerates as we expect, then we would expect bond yields to begin a slow steady climb toward 3 percent by year-end. If this occurs, it is only because the economy exhibits strength.

BBT-perspectives-market-monthly-may-2017-Bond

Key Takeaways:

  • The economic slowdown in Q1 was likely temporary but the bar was probably set too high
  • Economic growth is likely to accelerate in Q2
  • The Fed remains on course for two more hikes and balance sheet reduction in 2017
  • Fed normalization should usher in a more normal business cycle  Washington must get busy to pass both health care and tax reform in 2017
  • Earnings and sales recovery have validated equity prices but need to continue
  • Earnings quality have been high and participation has been broad

Bottom Line:
Robust corporate earnings and last week’s 211,000 new hires jobs report are signals that Q1 weakness will likely give way to Q2 strength. Though the Fed’s policies are tightening, they are not tight. Washington must deliver what it promises in the way of tax reform. This would be an important catalyst to launch us into 2018 with confidence. Our outlook is constructive, and we are pulling for growth.

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.