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Weekly Update: Where are we?

08-22-2014

I’m just back from three weeks in beautiful and huge Alaska, knocking off the last state I had yet to visit. Many of us are returning from vacation, trying to remember what we do for a living and getting geared up for the rest of the year. When I left, the market was selling off a new high, but the downdraft proved rather shallow and short-lived, with the S&P 500 down just 4% over a two-week period. This dip was unusual because it was triggered mostly by geopolitical risks, which have been largely ignored during the current bull market. At this writing, the S&P is at a new high, aided by encouraging economic news (see below) and strong earnings and margins. Among the S&P companies who have reported for Q2 (roughly 90%), 78% managed to beat (or meet) their earnings estimate and 62% managed to beat (or meet) their sales estimate. This impressive result marks one of the best quarters for U.S. large caps in the past five years, Bernstein Research says. Moreover, according to Thomson Reuters, profit margins rose to a new record high of 10.2%, with profits growing at more than twice the rate of sales. Empirical Research notes that for the core of the market (excluding financials, energy and utilities), the top line increased by 5%, the best result in several years, and the bottom line by 13%. It sees no signs that margins are about to regress toward their long-term mean; instead the globalization story continues to play out.

Minutes from July’s policymakers’ meeting highlighted that the debate is on whether to raise rates in June 2015 or earlier. The market agrees with the Fed in terms of the timing of the first rate hike, but is pricing only 85 basis-point hikes per year vs. Fed communication of 140 basis points per year. Cornerstone Macros says this discrepancy helps explain why yields are so low across the yield curve. Overall, investors reacted well to the minutes despite a broad consensus among FOMC voters that labor markets have improved faster than anticipated and a growing chorus seeking changes in the language on forward guidance. This may be due to the historical response by the markets to a new rising-rate cycle. Since 1928, the market has done well during the early stages of tightening cycles (likely a function of better growth), with average returns of 16% the year before actual tightening vs. the long-term average of 8%, Ned Davis Research says. While the risk to equities may be more pronounced in the six months leading to the first hike, the market afterward has continued to rise. Moreover, when long-term rates have risen from low levels, stocks typically have performed quite well. Bank of America says the best returns for the S&P (average of 24% annualized) have occurred when rates are low (2-3%) but rising. With the target funds rate effectively 0%, there is nowhere to go but up.

The internal debate at the Fed appears to be centered less on the job market than on inflation. By several key measures, inflation had been moving close to if not slightly above the Fed’s 2% target. However, reports in the past few weeks indicate those price pressures are proving temporary, as Yellen and fellow doves had suggested would be the case. This week, for example, July CPI rose the least in five months, with the core rate up a less-than-expected 0.1%. Energy, agricultural and raw industrial commodity prices have pulled back. Overseas, inflation remains MIA. Indeed, there is more concern about deflation than reflation in the eurozone, and Japanese officials hope Abenomics will finally end deflation in their country. So why the inflation worry? August unemployment claims are below levels that saw wages accelerate in 1996 and 2004, and industrial capacity utilization is near 80%— an operating rate of 85% indicates inflation. But as we noted last week, at roughly 2%, wage growth remains weak. Typically, 4% wage growth is the number that would pressure profit margins, and to be a true inflation problem (like the 1970s), we would need wage growth of 10%. We're nowhere close to that, making an inflation scare (as the Fed tightens) more likely than a significant inflation problem. As we settle back to work, having reviewed the previous three weeks of data and what we’ve learned this week, we remain as we were before we went on vacation—bullish.

Positives

Leading indicators bullish The Conference Board gauge rose a better-than-expected 0.9% in July, the most in four months, to its highest level since October 2007.  Major contributors were the rebound in housing (see below) and the continuing improvement in labor markets—job openings have surged to a higher level than seen in the last expansion, with an uptick in small business hiring suggesting payroll gains of 200K-plus in the months going forward. On a year-over-year basis, the leading index is up 7%, the most since September 2010, indicating growth momentum is strengthening. The composite leading index was up 2.6% on a year-over-year trend basis, which suggests the expansion should strengthen over the next six months.

Manufacturing heating up The Philly Fed manufacturing index hit a three-year high, easily beating consensus even though underlying components were softer than the headline. Thursday’s report, along with the Markit survey findings released the same day, were indicative of the sector’s continuing healthy growth. This accelerating activity has pushed capacity utilization near 80%, a level associated with robust capex.

Housing’s improvement continues Existing home sales rose a fourth straight month vs. expectations for a decline, further suggesting that a brutal winter was a significant depressant. The year-over-year median resale price also accelerated from June to a 7-year high. Construction activity and builder sentiment are rising, as well, with the latter hitting a high for the year. And July housing permits jumped the most in eight months and double consensus, which combined with upward revisions to June, pushed the 12-month average to its highest since October 2008. Multifamily units continued to drive activity, but single-family homes also rose.

Negatives

Labor market woes Despite accelerating job growth and the sharp drop in claims, the overall health of the job market remains a point of contention at the Fed. Two key reasons: sluggish wage growth (the year-over-year change in average hourly earnings for production and nonsupervisory workers was 2.3% in July, well below the 3% average annual gain over the past three decades), and substantial slack (the number of part-time employed for economic reasons is still well above the average since 1994, and the number of long-term unemployed remains twice the size of its average over the previous expansion). 

Eurozone sputters Growth in the 18-country bloc stagnated in Q2, with reports over the past week showing declines in three key members, Germany, France and Italy. On a plus note, growth improved in the peripheries, led by Spain. But overall, eurozone GDP remains substantially below its pre-crisis levels, potentially leading to more easing by the already highly accommodative ECB.

China too Its preliminary HSBC/Market PMI for August fell more than expected on a credit slowdown and continuing property slump. The reading of 50.3 trailed all 22 estimates in a Bloomberg News survey, and was off from July’s final reading of 51.7.

What else

Room to run Bhirud Associates notes that major stock market tops in long bull-market cycles are associated with extended levels of high consumer confidence (at times, even irrational exuberance), a strong economy, rising earnings growth expectations and stretched-out equity valuations.  Although this bull market is five years old, it does not yet see conditions that meet the aforementioned criteria.

Walmart, wages and growth The well-run, high-return, iconic massive retailer posted its sixth quarter of flat-to-down comparable-store sales. Among other things, ISI says, what’s needed for faster Walmart sales is an acceleration in wages. And until Walmart sales accelerate, the U.S. expansion is likely to remain moderate.

Inversion diversion Just 76 companies have left the U.S. to re-domicile in another country for tax purposes over the past 30 years, a number that pales in comparison to the 1.6 million corporations in the U.S. that pay the corporate income tax today. But this is an election year where economic anxiety remains a big issue for voters, Democrats are on the defensive and the size of the companies inverting is getting larger. So this is likely to be a dominant issue when Congress returns in September, Strategas Research says. However, there is no political pressure from voters over inversions. This is largely an “inside-the-Beltway” issue designed to score political points more than anything else.