Weekly Update: Interest rates aren't nearly as sexy as this election

11-04-2016

I spent part of the week in very blue California, Sacramento and its suburbs, where advisers were worried about a slowing economy, describing a possible peaking of home prices and the sudden availability of plumbers and electricians vs. a 3-month waiting period before. In no surprise, political discussion was at a fever pitch. One adviser described CFO clients sitting on cash, awaiting the election outcome. Got to wait. “The world could come to an end.” Another adviser remarked that nobody’s interested in economic news, “it’s all about grabbing parts and emails.” There is talk congressional investigations and a possible indictment await Clinton if she wins, and of talk of a market crash should Trump win. In the case of Clinton, it may be worth looking at what happened when her husband, then the president, underwent impeachment proceedings in Congress—the S&P 500 rose 12% during the 3 months from the start of the investigations in November 1998 to the Senate’s decision to dismiss charges on Feb. 11, 1999. (There also is talk President Obama, if it comes to it, may be able to issue a blanket pardon for Clinton even before any indictment, just as President Ford did for Nixon, making this all moot.) What if Clinton wins narrowly and Trump challenges the results? Remember 2000’s “hanging chad” election? The S&P fell 4% in the 5 weeks before Bush was officially declared the winner. And of course, consensus agrees a Trump win would spark short-term market volatility at the least. All of this raises concerns of a post-election sell-off.

Clinton has greater advantages than Trump when it comes to the question that matters: who can cobble together 270 or more electoral votes? To do that, Trump must not only hold onto North Carolina and Arizona, which Romney carried in 2012, but also win all of the current tossup battlegrounds—Florida (29), Ohio (18), Iowa (6) and Nevada (6), along with a single electoral vote from vote-splitting Maine's second congressional district, as well as one or more states where Clinton currently has a more comfortable lead, including Pennsylvania (20), Colorado (9), New Mexico (5), Michigan (16) or Wisconsin (10). This is the essential problem for Trump: everything has to go right on election night for him, whereas if Clinton ekes out a victory in Florida or North Carolina, it's over. The biggest question mark in this race comes down to how much Trump is energizing non-traditional working-class voters. Whites without a college degree registered turnout of only 57% in the last presidential election (vs. 74% of those with a college degree), and the sheer number of previously disengaged non-voters from this demographic vastly outweighs the potential upside from a more energized Hispanic demographic. If most people are studying the odds, at this writing, the most likely outcome is they will get a divided Congress and a Clinton presidency.

The market closed down for the eighth straight day Thursday, its worst performance in 8 years and a rare occurrence—the last 3 times this has happened, in September 1991, June 1996 and October 2008, it took the market 3, 6 and 9 months to bounce back, respectively, according to Rhino Trading Partners. The corrective nature of the S&P pullback since its Aug. 23 peak and rapid collapse of bullish sentiment increase the probability we’re undergoing a period of consolidation within an intact bull trend, JPMorgan says. Furthermore, the positive trend in global PMI data (more below) adds credibility to the sharp rally in cyclical equities over the summer. It puts S&P support between 2,060 and 2,090, with a break below 2,060 possibly leading to a 1,992 post-Brexit low. Since late October, volatility has been moving higher in fits and starts and the average level of the VIX has been higher so far in Q4 than in Q3. True, the absolute level is still well within its normal range and below the high 20s reached in January/February. But at current levels, the S&P P/E is stretched relative to the VIX, suggesting small increases in volatility would have an outsized negative impact on the S&P. Firming leading indicators of economic growth, low inflation and depressed bond yields contributed to the increase in equity P/Es. But with monetary policy shifting toward yield steepening rather than negative rates—this week’s Fed statement and actions by other central banks support this view—and inflation readings set to rise through at least Q1 2017, the conditions that supported low volatility and high multiples are deteriorating. The sun will rise again Wednesday; I am worried about the mundane—earnings per share (EPS) and the price we pay for them. EPS is on pace for 5.1% growth in Q3, assuming the current beat rate holds the rest of the reporting season, and 8% ex-energy. This could be the quarter that ends the earnings recession. Have we got an inflation problem? Eighteen percent of household spending is for housing and 17% for health care, and prices for both keep rising. These necessities are responsible for the vast majority of inflation we are witnessing—not good but certainly not evidence of a wage-price spiral. I am on Inflation Watch.

Positives

Global Recession Watch The global manufacturing PMI jumped the most in nearly 4 years in October to 52, its highest level in 2 years and above its long-term average for the first time since May 2015. Growth in new orders, modest acceleration in export orders and rising input and output prices suggest faster output growth in the coming months—further confirmation that global recession risks are ebbing and global growth trends are broadening. 

Manufacturing, services improve October’s manufacturing ISM rose and Markit’s survey hit its highest level in a year, implying early-year weakness has passed. Both reports cited improvements in employment, factory activity and production. The latter likely was bolstered by robust auto sales, which came in at a better-than-expected 17.8 million annual rate in October, and exports, which rose again in September, helping the trade deficit shrink some more and boosting final Q3 GDP. However, inventories continue to contract, signaling a Q4 inventory boost has yet to surface, and capital expenditures are still MIA, with core capital goods orders down a sharp 1.3%. As for services, the ISM gauge remained robust and the Markit gauge reflected acceleration.

Job growth OK October nonfarm payrolls rose 161K, a bit below consensus, but prior months were revised up. Notably, wages accelerated at their strongest pace since the recession (although bond yields didn’t react), and the broader U6 unemployment rate that includes discouraged and underemployed workers fell to its lowest level since spring 2008. ADP’s measure of private payrolls rose 147K, the smallest increase in 5 months, dropping the 6- and 12-month averages further off cycle peaks. However, the labor market typically tightens as companies face more difficulty filling open positions in aging recoveries such as this one—now in its 88th month, well above the average length. This may be why Challenger layoff announcements through October are running nearly 14% below their year-ago pace—companies are attempting to hold on to the labor they have, another sign of a tight labor market.

Negatives

Will stingy income growth deter Santa? Despite September’s 3.2% y/y increase in personal income, real personal disposable income—the best benchmark for purchasing power—decelerated and barely matched December 2007’s peak, making this recovery the weakest in post-war history for income. Real personal consumption isn’t much better, Dudack Research says, up only 12% from its December 2007 peak. Frustration over meager income growth and rising costs for necessities has been a key driver of growing populism evidenced in this election.

Productivity surprises but … Q3 output per worker rose at a 3.1% annual rate, ending 3 consecutive quarters of decline. A turnaround in productivity would be a boost for profits. But RDQ cautions about significant fluctuations in the quarterly data. Y/y productivity growth is still flat, with unit labor costs up 2.3% and unit prices up only 1.2%, suggesting y/y profits are likely to decline again when the income data behind GDP are released later this month. 

Construction a drag Led again by the government sector, spending declined a second straight month in September and is down y/y for the first time since July 2011. Private construction spending also slipped to a 2.4% y/y pace, its slowest since mid-2011. On the plus side, single and multifamily construction improved, helping lift housing investment in Q3 even as the industrial sector weakened and government spending continued to shrink.

What else

Our long national nightmare is almost over (or is it?) Dudack Research says some psychologists are concerned individuals may suffer from an “emotional letdown” after the election, once the daily drama of leaks, accusations and rebuttals ceases to exist. This is worth mentioning since we shouldn’t underestimate the emotional factors that drive stock prices. 

The 51st State Seeking to draw attention to deplorable state roads along the border, the Oregon counties of Curry, Josephine, Jackson and Klamath and the California counties of Del Norte, Siskiyou and Modoc sought in October 1941 to form a new state, to be named Jefferson. But even though a succession vote passed and newsreels were set to air nationally the week of Dec. 8 about the new state, the movement came to an abrupt end when its leader, Port Orford, Ore., Mayor Gilbert Gable, unexpectedly died Dec. 2, followed 5 days later by Pearl Harbor. Today, Jefferson is a state of mind for folks who live in this area, where they refer to themselves as the 51st state and feel disenfranchised vs. the larger, more liberal areas of California and Oregon. This summer, Lassen County, neighboring Modoc, put the 51st State of Jefferson Split Question on the June 7, 2016 ballot. It was defeated.

Halloween is celebrated in style in California My San Francisco wholesaler took his 3-year-old trick or treating along Washington Street in tony Presidio Heights, where she received a $10 Godiva bar. He also told us that the most consumed candy bar in the world is Kit Kat (418 bars are consumed every second worldwide), to which the adviser replied, “Give me a break!”