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I spent the week on the West Coast, starting in Seattle, then LA. A once thriving logging center named after an Indian chief and now home to new-economy headquarters (Microsoft, Amazon, Expedia, Starbucks and Costco), Seattle used to have seven hills. There are only two now. That’s because loggers would send sawdust down the hills as the tide came in, build walls and eventually cover them. During my presentations here and in LA, there were a lot of questions about income inequality, declining labor participation and the economic effects of a $15 minimum wage. I met an actuary in Seattle who said his industry is talking a lot about tail risk. In LA, an adviser told me her company is debating volatility strategies. Both remind us these are not your grandfathers' investing environments. Her question, "How do we know when the next 'once in a 100-year event' will occur?" My answer: no one knows. So what are we going to do about that, because I and my fellow baby boomers are going to live to 95 and we need our money to outlast us? My best idea is a diversified-yield strategy, and I have had zero pushback on that suggestion over the last six years. Now, after the presentation was over, a gentleman approached me and told me I shouldn't say I’m going to live until 95 because I won't. "Your life is going to depend upon your access to medical care," he said, referring to death panels and the "useful life" concept described by bioethicist Zeke Emmanuel. He recommended I never retire, because once I do, the panel will no longer find my life useful. Gulp.
The U.S. equity market may be entering a sweet spot where interest rates are low, the economy is gradually improving, credit growth is positive and there is a mountain of cash to invest. Also, while M&A activity has increased significantly, at 9% of GDP, it’s still well below its August 2007 peak of 14%, indicating the current expansion still has three to five years to go. For stocks to correct by a meaningful amount, either a negative event is going to have to come from offshore, or the Fed must dampen speculation. This seems unlikely as the central bank has spent five years coaxing real estate, stock and bond prices higher on hopes of producing a wealth effect that generates faster economic growth and more hiring to recover from the 2008-2009 financial crisis. That game plan has yet to result in sustainable 3% GDP growth or a burst of hiring to push unemployment below 6%, making a course change unlikely—an observation reinforced this week by the Fed (more below). Until Fed policy changes, stocks will likely continue to grind higher. That’s the pain trade as this market keeps climbing a beautiful wall of worry. Oil prices represent the latest marker on this wall, with unsettling events in Iraq pushing them to 52-week highs in the past week. Soaring oil prices led to the recessions of 1973-1975, 1980, 1990-1991, 2001, and 2007-2009. But the VIX fell this week even as ISIS rebels advanced. The market’s relative calm may in part reflect a world that is a much different place than it was before, with the U.S. significantly less dependent on foreign oil. It also likely reflects the reality that the export-oriented southern oilfields appear safe from all the conflict—for now.
Meanwhile, although GDP forecasts are coming down for the year, that’s entirely due to the weather-driven wreck that was the first quarter. There are many reasons to be optimistic about second-quarter and second-half growth. The NFIB’s optimism, employment, capital expenditures and real sales expectations measures have all turned up. Industrial production, ISM new orders, total U.S. employment, the NYSE cumulative advance/decline line and the Conference Board indicators also are in a solid upward trend. Finally, bank lending is expanding and business confidence is on the rise, partly because of increased pricing power, i.e., the core CPI accelerating (more below). Not a peep was heard about inflation in my travels this week despite all the concerns expressed about it in this week’s reports. We finished the week in gorgeous Santa Barbara, where the 2004 Oscar-winning movie “Sideways” was set. My guests said after the character played by Paul Giamatti said "I am not drinking any ####ing Merlot!", sales plummeted and Merlot sold at a discount for the next five years. (Speaking of expletives, the LA mayor is in hot water for his celebratory comment about the Kings winning the Stanley Cup. Summertime news cycle, I guess. And I shall not mention why the mayor of San Marino resigned this week.)
Fed: ‘All systems go’ Its new GDP forecast changed little if the impact of a very weak Q1 is excluded. There was no sign policymakers are concerned about inflation, and while rate projections rose slightly, Fed Chair Yellen sounded very dovish. All this may seem contradictory, Cornerstone Macro observes, but only on the surface. While the economy, labor market and inflation seem to be picking up, it's too soon for the Fed to commit to a substantial policy change. From its perspective, it's better to buy more time, which it did.
Regional punch The Empire and Philly Fed gauges came in above forecasts on broad improvement, building on the strength in the last two months of the quarter and boding well for second-half manufacturing activity. The reports were in line with Strategas Research’s own indicator of future activity, which has seen consistent robust growth in new orders. May industrial production also rose 0.6% on a rebound in manufacturing activity. All of the above are consistent with a 3%+ real GDP growth in Q2.
No summer slowdown ISI's proprietary truckers’ survey climbed to a nine-year high. Along with growing strength in railcar loadings, new highs in the S&P 500 and another wave of upward earnings revisions, this provides more evidence that the “Sell in May and go away’’ strategy is unlikely to hold true this summer.
Inflation watch While Yellen was somewhat dismissive, the recent pickup in inflation is getting hard to ignore. The breadth of May’s gains in headline and core CPI suggests price pressures may be becoming ingrained, with the increase in core inflation pushing its three-month rate of change to 2.8%, the fastest in almost three years. The core continued to be driven by heavily weighted services components, including rents and owner-occupied rents (a barometer for home prices), though there were also large monthly gains in lodging away from home and air fares (and they didn’t even serve peanuts in coach on last week’s 5½-hour flight from LA to Honolulu!).
Housing’s stuttering recovery May starts were down a below-consensus 6.5% after surging in April, with slowdowns in both the single- and multi-family components. However, the April/May average will be the strongest quarterly reading since the recession’s end if it holds through June. Combined with a better-than-expected though still contractionary NAHB sentiment, housing continues to improve from winter’s deep freeze at a sluggish pace.
Worries overseas The German ZEW disappointed, with expectations badly missing forecasts. It’s now declined every month since December to its lowest level since December 2012. In China, foreign direct investment fell nearly 7% year-over-year, vs. an average 10% annual increase the past decade—a sign domestic structural problems has global investors looking elsewhere for opportunities.
Renters vs. buyers Just because millennials continue to rent instead of buy doesn’t necessarily mean economic activity would be weaker. In a piece for The Atlantic, former Carnegie Mellon professor Richard Florida, who specializes in the economics of cities, noted both the fastest population and wage growth is occurring in larger metro areas, and that would seem to favor renting over buying.
An upside, if there is one, to the Iraqi conflict The real risk to oil prices if Iraq’s civil war expands is the potential loss of a planned ramp-up in investment to produce more oil there. If that happens, this would make secure sources of oil such as Canada and domestic U.S. production more desirable, adding to a resurgent North American energy industry being driven by booming shale-oil and oil-sands production.
Maybe not in these shoes Walk Score ranks Seattle as the nation’s 8th most walkable despite hills, I was told, that were once twice as steep as today. Wow, I walked down one of those hills in my heels and can't imagine negotiating anything steeper.