Weekly Update: That taper has been pushed off for months and months
This week, I stayed close to home, traveling to nearby Oglebay Resort in Wheeling, W. Va. For my presentation, my hosts suggested that an officer of their company advance my slides since the remote wasn't working. No problem, this has occurred often. It also was suggested that I complete my remarks by 5:30, as the group of approximately 150 would have a buffet dinner immediately after my remarks. I said sure as I usually do, not knowing how long it would actually take for me to complete my remarks. However, at 5:30 on the dot, my officer friend Robert reported that the machine was stuck and would no longer advance my slides. Why that was the most polite hook I have ever had! Here as elsewhere in my travels of late, I have been receiving a lot of pushback on my bullish call. Last week, it was on inflation (more below). This week, it was on housing (more below) and valuations created by the Washington drama (Gallup polls find the major source of weakness has been fears about political dysfunction rather than such variables as job growth). My response continues to be that the two things we are watching most closely are China (more below) and corporate sales (more below). It was a wonderful audience and I enjoyed many positive responses to my message. But the best one came from a fellow Italian, a gentleman who kissed my hand and said, “You’re going to be in my will.”
Such chivalry was sorely lacking the past few weeks in Washington, but as expected, a deal got done and the can got kicked … again. Now a bipartisan committee is trying to come up with a comprehensive budget agreement by Dec. 13. But a grand bargain is virtually impossible until either one party controls the government or there is a 180-degree turn in the way the two parties work together. The last time we had serious tax and entitlement reform was when President Reagan and Democratic Party leaders bent over backward to compromise. We will quickly learn whether the two parties are serious when they name their conference committee members. Back in 2011, the Super Committee was doomed to failure from the beginning—despite all their hard work—because only one of the 12 members was a moderate. Apparently the two parties decided to play it “safe” and make sure any deal coming out of the committee would be acceptable to both liberal Democrats and conservative Republicans. That, of course, left little scope for actual agreement. Last spring, both the continuing resolution and the debt ceiling were extended with little fanfare, suggesting that the fall might also bring a peaceful extension. That proved woefully optimistic. In September, a major battle became inevitable when the Affordable Care Act was put on the table. The risk is that fiscal conservatives go back to fighting over spending cuts and another big fight ensues as we near another continuing resolution deadline on Jan. 15 and a debt-ceiling deadline three weeks later.
Since 2011’s apex of modern budget dysfunction, the last two fiscal fights (year-end 2012 and the past month) were progressively less disruptive. This time, investors called the politicians' bluff, with the S&P 500 rallying 2.4% during the 16-day shutdown (and 24% year-to-date). The benchmark fell by a median of 0.3% during the 17 previous stoppages since the current budget process was adopted in the mid-1970s. This indicates strategic toying with the markets and economy over trumped-up fights that have little bearing on real fiscal challenges is going the way of the zombie. Such tactics have morphed from surprising (March 2010) to frightening (2011 and 2012) to something as ineffectual as most neighborhood haunted houses. Trick or treat! The market’s attention is back to earnings, where the Q3 consensus expects 3% year-over-year growth and 2.7% sales growth. Q4 guidance will be critical. The current consensus is for 25% growth off easy year-ago comparisons because of Hurricane Sandy and Fiscal Cliff II, but the question is how disruptive was the shutdown. Multiple expansion has played a big role the past 12 months, sourcing about two-thirds of the S&P’s return, and the forward P/E currently stands at about 15, in line with the 2003-2007 average. Further expansion will require a continued reduction in the deficit, improved lending conditions (50% of small business are started by people who borrow against their homes) and a stair-step progression of interest rates (a spike would be a disaster), Empirical Research says. If another ratio, between the Fed’s balance sheet and the S&P, holds steady as it has the past three years, a 7% expansion through continued QE through December would suggest an S&P above 1,800 by year-end. Care to fight the Fed, hmm?
Nontraditional indicators point to stronger growth Weekly rail shipments, which have a 76% correlation with GDP and reflect activity across a broad range of industries, are accelerating. So are weekly U.S. lumber orders, which since 1996 have had a 97% correlation with housing starts. Elsewhere, the ISM manufacturing gauge's employment component, which has a 95% correlation with payroll gains, has been trending higher; the chemical industry, which typically leads the business cycle given its early position in the supply chain, has seen production trend higher; and ISI’s tax receipts survey covering 16 of the largest states has ticked up above 57, well above the “as expected’’ 50 level. All of this fits with the 3% real GDP growth scenario we’ll need to get a sustainable move higher in stocks.
China sends positive forward signals China GDP accelerated in the third quarter, rising a slightly better-than-expected 7.8%. Despite higher inflation and weaker export data, its currency, 10-year yields and both the ChiNext (its Nasdaq) and broader Shanghai indices have moved higher. A customs office survey of 2,000 enterprises suggests exports may recover in the coming two or three months, according to spokesman with the General Administration of Customs, who added that fewer exporters reported a decline in the value of their new orders and less pessimistic outlooks. As we have said, we are watching China closely.
Fed likely to be accommodative for longer “Data-driven” Fed policymakers will have trouble changing course after a month in which official data collection has been impaired by the government shutdown—it may not be until early next year before all the static and delays work their way through the data. It also seems unlikely the Fed will risk tapering in December or January assuming the new budget negotiations go down to the wire again. The Fed’s Beige Book didn’t seem to indicate any urgency to act. It found economic activity grew at a “modest to moderate pace” in September and early October. An all-in Fed is supportive of stocks.
It’s only a lull in housing’s recovery … The NAHB/Wells Fargo housing index’s 2-point decline in October to a three-month low of 55 was blamed on the recent "spike in mortgage rates" and "paralysis in Washington." But keep in mind it’s still near the August’s 58, which was the highest level since November 2005, and was up 14 points from year ago. Moreover, despite their recent run-up mortgage rates remain historically low, builders are seeing signs of pent-up demand across the country and housing affordability remains elevated relative to prior business cycles. This suggests housing has ample room to run in the intermediate term.
… and in regional manufacturing, too The Philly Fed’s manufacturing index slipped slightly in October, though it still came in above forecasts and had upward moves in new orders, employment and the business outlook index, which rose to its highest level since 2003. The Empire index fell much more than expected but was still expansionary and saw new orders—the most-forward looking component—more than triple from September levels. The six-month outlook also continued to improve, suggesting businesses are looking beyond the current mess in Washington. In general, robust vehicle sales, a recovery in exports and rising order backlogs all bode well for the manufacturing sector in the near term.
Consumers don’t like fiscal impasses Bloomberg’s monthly consumer economic expectation survey plunged 22 points in October to its lowest level since November 2011, and the share of pessimists jumped by the most since Lehman's 2008 collapse. Consumer confidence, which has a relatively weak 40% correlation with retail sales, had been on an upward trend recently. The shutdown’s real impact, if any, should become apparent with holiday sales.
It’s too early to worry about inflation What little data we have for the CPI suggest limited near-term inflationary pressure. According to AAA, a gallon of regular unleaded gasoline is now at its lowest level since the end of January, with the average price at the pump 1.2% below that for August and well below where it stood a year ago ($3.53/gallon in September 2013 vs. $3.85/gal in 2012).
We love dividends Perhaps most impressive on the stronger side last week was the 3Q report of S&P dividends surging 14.8% year-over-year 25.9% above their 2008 peak. And because the dividend payout ratio is still in record-low territory, dividends still have lots of room to increase.
I have often said I’m as happy as a lark “[W]here ignorance is bliss, ’tis folly to be wise” is a phrase coined by Thomas Gray in his poem titled “Ode on a Distant Prospect of Eton College.” The Urban Dictionary defines “ignorance is bliss” as follows: “The lack of knowledge to a situation. Usually once the whole truth is revealed you realize you were happier being clueless.” These may be how many wish they felt after watching Washington.