Weekly Update: Warm milk, cold toast

10-21-2016

I started the week in Atlanta, a member of a panel discussing the investment outlook before a large group of bank financial advisers. Surveyed in advance, a majority of these advisers had a “neutral” market outlook for 2017. Why? Just because it’s made no real progress for the last 20 months? We panelists tried to mix it up, and I held the more bullish view. Then off to West Virginia and Wheeling, Charleston and Oglebay Park. This driving trip afforded gorgeous views of the finally changing leaves, reminding us that fall, and then, of course, WINTER, IS COMING! Lots of conservatives in West Virginia, laughing about Trump’s pledge to revive the coal mines. Advisers in the state are frustrated (as are their counterparts all over the country) about the lack of investment ideas to make money for their clients. A veteran portfolio manager who reads my weekly emailed his lament, “Nearly everyone I know in the business over the age of 45 is in a state of depression.” Sentiment’s generally in no-man’s land, Renaissance Macro says, with little positioning and survey data to suggest any meaningful implications for equities. Some worry the economy is weakening. Others worry a tight labor market and inflation/higher interest rates are in our near future. My read of the situation is more akin to warm milk, cold toast. Take inflation expectations. They edged down in the Michigan sentiment survey even as market-based measures moved up. This dichotomy may be explained by differences in the distribution of expected outcomes. While the share of surveyed consumers expecting inflation of 3% or more reached an all-time low this month, the share expecting prices to rise by exactly 2% was the highest on record. (Isn’t 2% inflation what we’re rooting for?) Rising prices would help lift earnings growth, igniting the capital expenditures cycle and continuing the earnings grind.

Aided by oil’s recovery, a flattening dollar and diminished geopolitical shocks, sales appear to be at an inflection point, turning positive after 6 quarters of decline. In the past 25 years, Fundstrat says every upturn in sales has led to an upturn in earnings-per-share (EPS) growth. A fifth of the way through this reporting season, revenues are beating by 1.1% and earnings by 7.4%, with EPS on pace to rise nearly 7% and, ex-Energy, to jump 10.5%, based on RBC Capital Markets’ analysis. At the end of the day, the market trades on earnings. But investors appear to want to see more evidence of such before jumping in. In fact, they pulled another $3 billion out of equity mutual funds and ETFs in the past week, bringing the 52-week total to $120 billion, Evercore ISI says. At the same time, they’ve poured $172 billion into bond mutual funds and ETFs. As for the funds themselves, Trust Advisors says fund managers have raised cash balances to 5.8% of their portfolios this month, matching levels not seen since the aftermath of the Brexit vote. The share of cash hasn’t been higher than that since November 2001, shortly after the terrorist attacks in the U.S. The amount of dry powder in portfolios is above that seen during both Europe’s sovereign-debt crisis and the U.S. debt-ceiling debacle, according to Bank of America Merrill Lynch’s monthly survey of money managers. This matches what I have been hearing from advisers all over in the last several months—powder for the pullback. But what if we are in for a little warm milk? While higher-than-normal levels of cash may seem appropriate in a world of political unknowns, until inflation becomes burdensome, overall shareholder yield discounted by exceptionally low rates could push valuations higher still.

The University of Virginia’s Larry Sabato, whose Crystal Ball forecast has accurately called 98% of the races for president, Congress and governor since 2000, projects Clinton will win by a large margin—341 Electoral College votes to 197. Despite Clinton’s strong coattails, however, a Democratic sweep remains unlikely, with the House remaining majority Republican and a neck-and-neck Senate race still to be determined by 6 seats spread evenly across red, purple and blue states. Widespread skepticism of the accuracy of polls is unwarranted, he said, and “hidden” Trump supporters are likely to amount to only 1% to 2% of the vote. Clinton’s approach to politics, which embraces coalition-building, gives her a decent shot at effective governing should she get elected, he says, while Trump’s opposite approach does not. In the 6 months after 21 presidential elections since 1932, the S&P 500 has risen nearly two-thirds of the time by a median of 3%. Since 1936, the market has performed better in the 12-months following a Democrat being elected than a Republican victory, with market highs more often established in the 4th quarter of the 4th year of a presidential election cycle than in any other quarter. So would a Clinton presidency and divided government be the best case for risk assets? Trend Macro isn’t so sure. It sees Clinton’s policies as growth-negative and says her attempts to carry them out in a poisoned post-election atmosphere could erode economic confidence. Politics aside, there arguably have been favorable resolutions to the 3 main economic risks at the start 2016: 1) oil, 2) the Fed and 3) China (more below). Given this backdrop, although the U.S. business cycle is maturing, the probability is for a soft landing, not recession. Warm milk, cold toast will be fine with me. I’ll go get the cocoa mix, jam and some of those income stocks.

Positives

Housing stays steady September's increase in existing home sales beat consensus as more first-time buyers entered the market, and median prices also climbed. Despite monthly choppiness, the 6-month average of single-family sales is its highest since May 2007. Separately, housing starts disappointed, declining to their lowest level since March 2015. But the downturn was concentrated in multifamily units; single-family homes rebounded the most in 7 months. Permits, meanwhile, jumped the most in 10 months while builder confidence pulled back modestly but remained elevated.

Milquetoast manufacturing The Philly Fed’s index slipped but, at 9.7, was above consensus as new orders and shipments improved substantially. But the Empire gauge came in below expectations, dropping further into contraction territory (not a big surprise as the Fed’s Beige Book said New York was the only district where manufacturing activity didn’t increase). Strategas Research’s proprietary leading indicator of future manufacturing activity also reflected a muddle-through scenario as manufacturing has moved off its recent bottom—manufacturing output rose 0.2% in September, lifting overall industrial production to 0.1%—but isn’t moving much.

China Watch China’s markets are sending important signals that its broader economy may have bottomed. 13D Research notes the Shanghai Composite Index 50-day moving average (DMA) moved above the 200-DMA in early September—the first time this “golden cross” pattern has happened since the start of the last bull market in Chinese equities several years ago. The Hang Seng China Enterprises Index also experienced a golden cross in August. If sustained, these patterns would be the strongest indications yet that China’s economy is on sounder footing. Other evidence: monthly freight volume growth turned positive in August for the first time this cycle, while a September survey in 31 major cities showed the unemployment rate below 5% for the first time in years. 

Negatives

Inflation Watch September consumer prices rose the most in 5 months at the headline level but were up just 0.1% ex-food & energy, dropping the year-over-year (y/y) core rate to 2.2%. Still, inflation trends suggest underlying pressures are building, particularly in services, with the core CPI services up 3.2% y/y, near its fastest pace since September 2008. The Fed's latest Beige Book described price inflation as “mild,” similar to the "slight" and "modest" assessment in early September.

Milquetoast economy Conference Board leading indicators rebounded an in-line 0.2% in September, but only half of the components contributed. Y/y, the index is up 1.5%, below its 2.2% historical average, implying subdued growth the next 6 months. Separately, the Beige Book survey of economic conditions across Fed districts was similarly tepid.

Milquetoast consumers Due to a likely slowdown in personal income growth and to consumers’ desire to save, retail sales and overall consumer spending are both likely to slow into 2017, Cornerstone Macro says. It says a secular shift up in the demand for savings as a result of the severity of the Great Recession should keep the savings rate elevated. At the same time, personal income growth may slow from 4% y/y in this year’s first half to 2.5% y/y over the next few quarters as corporations hold the line on wages & salaries to offset stagnant revenue growth. Banks also are tightening auto loan standards, another anchor for already slowing auto sales.

What else

Political Watch The best outcome for stocks if Clinton wins would be Republicans retaining the Senate, the GOP House majority shrinking to no less than roughly 20 seats and Proposition 61—a ballot measure to cap drug prices—failing in California, JP Morgan says. The odds are better than Trump’s sinking poll numbers would suggest. While Clinton’s lead was in the double digits in the latest Wall Street Journal/NBC poll, on the question of which party should control Congress, the Democrats’ lead actually shrank from 4 points in August to 2, indicative of a lot of deliberate “ticket-splitting.”

Clinton an energy hawk? Clinton’s energy policy likely would be more moderate than her public rhetoric on the campaign trail suggests based on many energy policy related e-mails being gradually released by WikiLeaks. This should ease various investor concerns on energy policy associated with the widely expected Democratic victory, particularly for those involved with hydraulic fracturing, Washington Analysis says. The leaks also show Clinton and her staff very critical of environmental groups, including the “keep it in the ground” movement; open to reforming the ethanol mandate; and concerned about supporting a carbon tax.

Missing my vacay is as unthinkable as missing my hair-coloring appointment A new report found American workers collectively leave $272 billion in vacation time unused. Experts attribute this to a company’s culture and lingering job insecurity, among other factors. But experts say that not taking enough time off can lead to burnout—something neither the worker nor the employer wants.