Weekly Update: A high-class problem

11-17-2016

This week was packed with morning-through-dinner meetings in Seattle and its suburbs, where the fallout from Trump’s win is on everyone’s mind. In an adviser’s office with a magnificent view of the Puget Sound, he pulled a Trump bobblehead out of his desk drawer. This Trump fan keeps this fact from his clients: “Don’t want to offend anyone.” While waiting in the lobby for another meeting, an adviser was escorting an older couple out, when the Mr. stopped and asked about the ramifications of multinational companies’ “repatriation of those ill-gotten gains.” The Mrs. put her hand on his shoulder disapprovingly, and the adviser replied, “No, they weren’t ill-gotten.” Later, at a delightful all-ladies client luncheon in a private room with a large square table, I mentioned my shoes and the ladies insisted I walk all around the table to show each of them. Love you ladies! The discussion included concerns about whether trickle-down economics works, and whether a growing U.S. population can be environmentally supported—“Do we have enough room to house everyone, and what about pollution and waste?” And a great question—“Why is the market focused on the pro-growth and not the protectionist Trump?’’ I’ve been wondering the same thing. Investors overlook Trump’s anti-trade rhetoric at their peril. He has threatened to terminate important agreements and impose significant tariffs on major U.S. trading partners, seems to truly believe current trade flows are terrible for the U.S., has broad-based authority to unilaterally impose major barriers to trade and has pledged to make trade “a signature feature of my presidency from the moment I take the oath of office.” Yet the market seemingly is ignoring this.

There’s no doubt corporate tax cuts and reform are bullish and likely will get done sooner rather than later. Same for personal income tax cuts and large, immediate changes in the massive scale of regulations passed over the past 2 to 3 years—many can be lifted/eased simply by a stroke of the president’s pen. But we’re still looking at the back half of 2017 before all of these changes begin to start to have a meaningful impact, Deutsche Bank says, with the expected rise in interest rates subtracting from the gains. Warm milk, cold toast. You know what I mean? There’s no historical experience with corporate tax cuts this large—slashing the 35% statutory rate by 15 percentage points to 20%. This should pull capital expenditures (capex) out of their funk, putting the U.S. on the cusp of a secular shift up in investment, productivity and real income growth—a real game changer. Our sources estimate such cuts would instantly boost corporate after-tax profits by 10% to 13%. And this is on top of a profit environment that already was improving. The earnings recession that appears to have ended in Q3 was mostly a severe downturn that rolled through the energy sector—S&P 500 aggregate revenues ex-energy never turned negative on a year-over-year (y/y) basis. Moreover, the aggregate S&P profit margin hit a record-high 10.7% during Q3, and pre-election, analysts’ consensus expectations for 52-week forward S&P revenues were at a record high, as were forward earnings. Now those estimates are being revised up further on prospects for a pickup in growth. As I’ve said ad nauseam, at the end of the day, the market trades on earnings.

While it’s been near-consensus that the Republican sweep has been at the heart of this risk-on move, I wonder, is this true? Could the catalysts instead have been a surge in the global PMI and spike in the economic surprise index—data before the election when yields already were rising? Cornerstone Macro says the correlation between the 10-year yield and global PMI is 80%, enormous for a single-variable equation, and thinks its improvement along with budding inflation talk on oil’s 70% rise since January are at the heart of the jump in yields. Even with their recent ascent, 10-year yields are just back to where they started the year, having risen nearly 100 basis points since their July 6 intraday lows. But according to Ned Davis Research’s proprietary models, these yields have not been more than 30 to 40 basis points above fair value since the financial crisis, suggesting they will have difficulty in sustaining a rise above 2.50% in the short- to intermediate-term. If this trend continues, they should move back to where they were at the end of the 2013’s "taper tantrum," about 3%, over the next 2 to 3 years. That’s still historically very low. Warm milk, cold toast. Know what I mean? As for stocks, the S&P has yet to break its August high. More warm milk, cold toast. Yes, growth and inflation expectations have both turned higher. But we’re still in the throes of the worst post-war recovery in modern history, and inflation is nowhere close to the 4% stress point at which stocks tend to sell off. It hasn’t even reached the Fed’s 2% target. Besides, weren’t we rooting for faster growth to get companies spending again and higher inflation to shove the Fed off its zero-rate perch? I’m on inflation watch and off recession watch. Inflation. A high-class problem.

Positives

Consumers in early holiday mood October retail sales rose a better-than-expected 0.8% and September’s gain was revised up to 1%, the biggest back-to-back increases in 2½ years. The data suggest consumers will be a key driver to Q4 growth, which the Atlanta Fed’s GDPNow Model is now tracking at 3.3% annualized, with personal consumption expenditures contributing 2 percentage points to the projection. On a y/y trend basis, retail sales were up the most since January 2015, suggesting consumer spending has gained momentum and could be robust over the holidays (more below). 

Housing looks healthy Builders’ sentiment remained elevated this month on robust sales expectations and rising buyers’ traffic. The overall strength in the forward-looking indicators was a good signal of housing starts activity six months ahead, consistent with an ongoing, modest recovery in the housing sector. As for October, starts jumped well above consensus to a 9-year high, with single-family units up sharply and multifamily jumping 68%, more than reversing September’s 38% decline.

Manufacturing improves Headline industrial production disappointed in October, unchanged on the month because of warm temperatures that cut into utilities’ output. But the underlying detail in manufacturing showed broad-based stability in non-energy output. Meanwhile, September’s inventories-to-sales ratio dipped to its lowest level in over a year, indicating manufacturers may have to ramp up if sales pick up as October’s numbers suggest (see above). Finally, the first two regional reads on November activity, New York’s Empire index and the Philly Fed, were constructive. The first rose the most in 5 months while the latter continued to signal modest expansion. 

Negatives

Here, if you want to worry about inflation October producer prices were unchanged and, ex-food and energy, were up just a tick, while core CPI disappointed, slowing to a 2.1% annual rate. The headline was stronger, but was still up only 1.6% y/y. The latest report is indicative of some moderating in what had been firming pipeline pressures, with the PPI’s personal consumption component, a good leading indicator of CPI, slowing to 1.1% y/y. Import prices showed some upward momentum but were still down 0.2% y/y—the slowest pace of decline since July 2014 as fuel prices have recovered.

We better hope interest rates stay low The biggest pushback to a bullish view is that fiscal policy is extremely limited, given that at about 74%, the federal debt held by the public as a percentage of GDP remains close to all-time post-war highs. At the same time, the current low-rate environment has resulted in interest expense as a percentage of GDP at a below average 1.2%, Wolfe Research says. As such, over the intermediate term, there is room for the federal government to enact fiscal stimulus programs that would increase annual deficits by $200-$300 billion. 

Infrastructure may be hard to do After passing a 5-year highway bill last year, congressional Republicans may not have the stomach for $100 billion/year in infrastructure projects under the Trump plan, Washington Analysis says. With the lure of tax credits, Trump would like to lean on private funding for projects, but the public is weary of toll roads/bridges, and airlines and airport retailers will likely fight any efforts by airports to use higher rents as a mechanism to fund improvements. Trump also has suggested using repatriation proceeds, but Republicans are eyeing them to help pay for corporate tax cuts. It’s early but uncertainty over funding could be a roadblock to getting something done quickly on this Trump priority.

What else

GOP Sweep Implications Under a relatively conservative assessment that Trump's policies boost growth into the 2.25-2.5% range, Chair Yellen's preferred Taylor rule would imply the Fed may pursue 1 more rate hike next year than currently expected. Under a more optimistic 3% growth scenario, the target funds rate could be 75 basis points higher, Deutsche Bank says. Still, it expects inflation to moderate in early 2017 and the Fed to initially stay on its gradual pace path, with the growth benefits from fiscal stimulus only starting to be felt in the year’s back half, when faster increases could come as growth spawns wage-price pressures as the jobless rate nears levels associated with accelerating inflation.

GOP Sweep Implications Thanks to Trump, Paul Ryan was endorsed by the Freedom Caucus for House speaker, a big deal that helped the incumbent win unanimously. This means the unification and consolidation of the congressional GOP is well underway and that corporate America is now on the offense in Washington for the first time since 2005. It also means top shared priorities of a Trump administration and the Republican Congress (tax reform at 20%, repatriation at 10%, Obamacare reform) have a high likelihood of becoming law because Congress can use the special budget reconciliation process, which unlike any other U.S. legislative process needs just simple majorities in each house to approve them.

Ask me! Now 7 in 10! According to the National Retail Federation’s Holiday consumer survey, nearly 6 in 10 consumers plan to buy for themselves, spending an average $139.61, up 4% from last year and marking the second-highest level of personal spending in the survey’s 13-year history.