Weekly Update: I am at peace

10-14-2016

This week I visited Michigan’s Upper Peninsula, where residents don’t lock their doors and keep their car keys in unlocked cars. I spent several days in Marquette, the largest city in the “U.P.,’’ as they call it, separated from Canada by Lake Superior. Heading into town, the scenery was magnificent. We were surrounded by an abundance of tall trees, reminding me of Alaska. It is difficult to imagine a nicer group of people—“Da Yoopers,” as they refer to themselves. Bumper-sticker souvenirs read, “Say ya to da U.P., eh!” I really want to return on vacation, just not in winter. The lake-effect causes many areas to get 100-250 inches of snow or more. Unlike any place I’ve visited in recent months, the locals insisted they “don’t want to talk politics!” At one of the many meetings squeezed into our trip, I suggested we discuss the upcoming election and a lady replied, “No, I’m eating.” At another, showing my slides, I came upon my political section and a gentleman said, “Please don’t.” At this point, I'm anxious for this election to be over and to take a long, very hot shower. Beyond that, I'm reading the life story of George Washington, which is helping. Last Friday, a D.C. expert visiting our Pittsburgh office answered easily my question as to which demographic would decide this election—white, college-educated women. Washington Analysis reminds us Mitt Romney won this group by 2 points over Obama in 2012; Trump was running 20+ points behind it before the events of the past 10 days. The videotape and the ads that follow will likely only reinforce his underperformance among this group. A brilliant 21-year-old college woman said, “No woman should vote for Trump.” An equally brilliant 60-year-old Trump supporter, a lady, said to all those offended women, “Grow up!” Her support remains. The vast majority of voters I meet across the country have summed up our choice using various words, none of them particularly positive.

October can be treacherous for investors but has an excellent history of creating good buying opportunities. Strategas Research says it rarely pays to be too negative as October matures and puts S&P 500 support in the 2,065-2,075 range, likely deep enough to mark a seasonal low over coming weeks. Much of what happens will depend on earnings. Dudack Research says a rebound is widely expected, both for cyclical reasons and because of oil. The average performance of the S&P tends to follow a long flat trend leading to a breakout at approximately 106 months after the previous earnings peak; as of October, it’s been 106 months since the last peak. What could drive a cyclical earnings rebound? Oil. At $50 per barrel, the price would represent positive Q4 comparisons, triggering favorable energy earnings. Getting past the election also should help as markets don’t like unknowns. As for Q3, hopes that it would mark an earnings turning point have faded, with the consensus bottom-up forecast calling for adjusted earnings-per-share (EPS) to decline 1% year-over-year (y/y), driven mostly by the energy sector. Ex-energy, S&P EPS is forecast to rise 3% and sales to climb even more. Watch oil (upward price moves would be supportive), the yield curve, the dollar and China. Continued curve steepening would indicate improving global growth prospects. On the other hand, continued dollar strengthening could represent a significant risk to equity performance. For its part, China GDP appears to picking up. Recent increases in its PPI, historically correlated with GDP, are in line with growth north of 8% in Q4.

Independent political prognosticators aren't calling for a wave election and Democratic clean sweep (more below) despite Trump’s bad week. This means gridlock is likely to continue, a short-term market positive that fails to address continued mounting debt, tepid growth and ineffective government. The focus may soon turn to what happens 4 years from now. In every election from 1952 save 1988, neither party’s held the presidency more than 2 terms. The enduring power of this pattern—indeed, its special power this year, revealed in a strong preference for change everywhere in the world—can be seen in the fact a figure as unlikely as Trump could get as far as he has, Trend Macro says. Assuming Clinton wins, she’ll likely confront the consequences of a powerful appetite for change that was denied, making her damaged goods in the view of many in the electorate. If the GOP holds the House, its populist wing will be even angrier than it already is. This is a recipe for ongoing brinksmanship, shifting the baseline “secular stagnation” thesis even lower and making the economy more vulnerable to shocks. In the end, Clinton’s may well be a one-term presidency, just as was the case for George H. W. Bush, who in 1988 doused the appetite for change, keeping a Republican in the White House a third straight term. Four years later, H. Ross Perot led an attack from the right flank, helping throw the election to Bill Clinton even though he didn’t win one state. For Hillary, the attack will likely come from her left, possibly in the person of Elizabeth Warren. The only question, Trend Macro surmises, is whether the GOP president elected that year will be Pence or Ryan. I am at peace now.

Positives

Global Recession Watch Global leading economic indicators are slowly gaining ground, with a growing share above their long-term averages. All 6 countries and regions in the monthly Sentix sentiment survey recorded net optimism (i.e., a reading above 0) and saw expectations rise both on a monthly and y/y basis. The only times in this indicator’s 13-year history that’s happened in tandem was 2013 and 2009, which in both cases denoted an end to global recession. Equity markets were profoundly stronger up to a year later after meeting this criteria, up an average 26%, with notable strength within the first 1 to 6 months.

The consumer’s all right September retail sales bounced back in line with expectations and, combined with the weak summer months, put the three-month average annualized increase at a solid 2.9%. Nominal sales continue to rise less than nominal income, with more consumer spending going to hard-to-measure items such as higher education, rent, health care, Uber, Airbnb, apps, sports and entertainment, Evercore ISI says, suggesting spending may be stronger than official data reflect. Michigan’s initial take on October sentiment disappointed, falling back below 90. But the decline was centered in the expectations component; the current conditions component rose.

Rising earnings lower recession risk Evercore ISI thinks average hourly earnings have entered an accelerating wave that could reach 4% y/y in the next few years. Accelerating wages would significantly reduce recession odds for 2017. Fed models put just a 12% chance of recession in the U.S. over the next 12 months.

Negatives

More signs of moderating job growth The job openings rate declined in August by the most in a year, though the number of unemployed per job opening remained near April 2007 levels, indicating tight labor market conditions. The Fed’s September measure of labor-market conditions also slipped deeper into negative territory, where it’s been in 8 of the past 9 months, further suggesting slowing improvement. The job market is still OK—the Conference Board’s employment trends index rose in September, as did wages. And jobless claims continue to hover at multigenerational lows. But there are increasing signs of businesses struggling to find workers (more below).

Slide in small business confidence deepens The NFIB optimism index hit a 4-month low in September and is significantly below its cycle high as businesses have grown more cautious. Job openings matched a 2-year low, with firms reporting increasing difficulty in finding qualified workers. Slowing employment growth at small and medium-sized companies that account for 78% of total jobs could suggest recent wage gains are peaking, Cornerstone Macro says—bad news for income growth and a potential headwind for spending as the holidays approach.

Inflation Watch September’s producer prices reflecting a firming in core prices, as did August import prices. But the Michigan sentiment report showed long-term inflation expectations falling to their lowest in the history of the survey, one reason the monthly gauge disappointed (more above). This begs the question: do we worry about accelerating inflation or not enough inflation? This week’s minutes from September’s Fed meeting didn’t reveal much new beyond the consensus for a rate hike before year-end, a view firming core inflation reinforces.

What else

Political Watch The math remains extremely difficult for Democrats hoping to take over the House. Republicans would have to lose 30 seats; current polls show they’re on track to lose 10. The Senate is a different story. The current Republican 54-to-46 majority is likely to lose between 2 and 7 seats, so the range of outcomes is 52-48 Republican to 53-47 Democratic. But neither would be close to the 60 votes needed to give either party “control’’ of the Senate. As long as the minority party in the Senate has 41 votes, and this would be the case in either majority scenario, one-party Senate control will not exist. The only exception to this legislative rule is the “budget reconciliation” process, through which tax legislation has been approved by both parties over the years.

Buybacks vs. capex In sharp contrast to the 1990s, when businesses borrowed to invest substantially in capital expenditures (capex), the bulk of net new corporate borrowing the past 4 quarters has gone into buybacks, with corporate debt relative to revenue reaching a record high for an expansion. Cornerstone Macro says this lack of productivity-enhancing capex not only contributes to low productivity, it also reinforces sluggish economic growth, further dampening demand for more capex.

Hey stock market, I need a new pair of shoes Over the past 20 years, there's been an 87% correlation between U.S. holiday sales and the performance of the S&P in Q4. Last week, the National Retail Federation said it expected a solid 3.6% increase in holiday sales this year vs. a 3% gain last year. To be consistent with this expectation, the S&P would have to end the year at 2,230, up nearly 4% from its current level.