Weekly Update: My sincere thanks to you

11-23-2016

They were very crusty in Louisville on this week to give thanks. One adviser complained that he doesn’t believe the government inflation statistics. Another voiced disbelief about the rally, bemoaning the dry power he has waiting for a pullback—“What, do people think Trump walks on water?” Another adviser told us about a comment made by his child’s middle school buddy in the morning-after-election-day carpool, “Today’s a sad day for our country.” And in my final meeting, a client event, the first question asked about the likelihood of the U.S. dollar being trashed and replaced by some new government coin! (I’m reminded that while Kentucky is a very red state, Louisville is consistently blue—it went 54-to-41 for Clinton over Trump.) Despite the Republican sweep, it’s not at all clear it’s going to be smooth sailing in the months ahead. In fact, market expectations of quick fiscal expansion may very well be running ahead of political and legislative realities, as a worsening fiscal backdrop will likely make many in Congress hesitant to support large deficit-financed tax cuts. As a share of GDP, federal debt held by the public is expected to reach 76.6% in fiscal 2017, vs. 25.1% in 1981 and 31.4% in 2001, the last time there were tax cuts.

Despite a clear need for increased infrastructure spending—at 23 years, the average age of America’s fixed assets is the oldest since at least 1925--Congressional Republicans also are almost sure to balk at giving Trump all he wants. They want to use repatriation tax dollars Trump advisers have eyed for infrastructure to lower the corporate tax rate instead. Trump is pushing for private funding for many projects but such an approach comes with its own set of problems, including public opposition to more tolls on roads, bridges, etc. Then there’s the potential for trade wars, a key risk factor for markets. Trump could seek to accomplish his goals without enacting new trade policy through the use of what Washington Analysis calls a Trojan horse—a VAT-like (value-added tax) system that would exempt products, services and intangibles exported from the U.S. from U.S. income tax, while taxing the same if they are imported into the U.S. As envisioned in a House Republican plan unveiled last summer, the money raised through this stealth tariff could be used to lower the corporate tax rate. As it’s not a straight VAT, it’s far from clear this would pass muster with the World Trade Organization (WTO). Trump may not care. He’s looking to be more aggressive on trade and believes VAT gaming already goes on. Most of our trading partners use VATs to support lower corporate tax rates than the U.S. by refunding the VAT on exports and imposing it on imports.

Seasonality remains a tailwind, with all major indexes and the Value Line Index hitting new highs this week. The proximity to year-end has funds chasing equities as they climb, with FBN Securities putting the short-term S&P 500 price target at 2,250. Even though their net exposures remain defensive, investors say they’re more bullish. Macro sentiment measures also are rising. Post-election surveys pushed Michigan sentiment to a 6-month high, Chief Executive Magazine’s monthly confidence index to a 2-year high, and Cornerstone Macro’s proprietary daily consumer confidence survey to a dramatic 10 point jump. Many may be feeling better because they see a way out of the European stagnation path we’ve been on for decades, one that saw real GDP growth progressively weaken from 5% in the 1980s to 2% in the 2010s. A corporate tax revamp and less burdensome regulations, the most likely immediate outcomes of a Republican sweep, could actually shift up real GDP growth for the first time in 35 years, Cornerstone Macro says. Some project growth of 3% as early as next year. This could lift profits 18% for 2018, supporting our longstanding call of 2,500 on the S&P by then. After a potential year-end Santa Claus rally, stocks could pull back early next year.  Moving into 2017, GDP faces many near-term headwinds: higher rates, tight bank lending standards, a stronger dollar, a slowing China, a weaker Europe and possible protectionism. It may be we’ll get a mid-cycle slowdown and market pullback before growth strengthens on the first tax cuts in 30 years for businesses and individuals—cuts that should boost investment, productivity and ultimately incomes. Democrats for years argued big government stimulus was necessary. They now may have to watch as the Republicans prove them right.

Positives

Existing home sales surprise They unexpectedly jumped in October to near a 10-year high, lifting year-over-year (y/y) sales to almost 6%, and September was upwardly revised. Single-family homes led the increase. October wasn’t as strong for new home sales, which unexpectedly fell. Still, y/y new home sales were up nearly 16% and nearly 13% year-to-date. One issue is tight inventories, but builders are addressing it, pushing October starts to their highest level since 2007. Overall, housing momentum seems to be strengthening.

Positive capex signals Durable goods for October surprised sharply to the upside, nearly triple consensus, on broad-based strength. Notably, increases in core capital goods orders and shipments suggest momentum is building for capital expenditures (capex), a missing ingredient for much of the recovery. If today’s Markit and Richmond Fed reports on manufacturing are representative, the pickup in orders is likely to carry over into November. Both showed activity picking up.

Small Business Watch Forces that have kept small business sentiment from fully recovering from its financial crisis lows—higher taxes, rising regulations and new health-care mandates—are likely to reverse in the months and quarters ahead. As a result, Wolfe Research believes small business likely will be a primary driver of trend U.S. real GDP growth accelerating from 1.5-2% currently to north of 3%.

Negatives

Fed Watch Chair Yellen warned that tax-cut-focused stimulus could increase the risk of above-consensus inflation. That is, focusing on demand rather than supply-side stimulus (infrastructure spending to boost productivity, which in theory would keep inflation from rising too quickly) could drive inflation higher too quickly, prompting the Fed to raise rates faster. Ned Davis Research says this effect could be further fed by a tight labor market that increases wage pressures as growth accelerates. Investors currently are discounting a rate hike in December and 2 in 2017.

Inflation Watch A Bank of America Merrill Lynch survey of fund managers last week shows higher inflation is now expected by 85% of those 177 polled, a 12-year high. In addition, 13D Research said 82% of those surveyed expect higher rates—the largest since 2013, and they are putting cash to work at the fastest pace since August 2009. There also seems to be almost a universal conviction that inflation and interest rates have bottomed secularly, even though core goods inflation remains in deflationary territory on a weaker China and dollar strength plus evidence of slowing rents could cool a key driver of headline CPI in coming months.

Keep an eye on this The NYSE daily 52-Week new highs and lows both exceeded 10% of issues traded last week—there’s no day that’s been even remotely comparable in almost 75 years of NYSE history, the Leuthold Group says. Simultaneously large lists of new highs and new lows indicate extreme internal market dispersion, a condition that eventually becomes dangerous if it persists, with 1- and 3-month market performance significantly worse.

What else

Not Reagan 2.0 It may be appealing to compare Trump’s election to Reagan’s, but there are many differences. In 1981, the long bond was peaking at 15%, short-term rates were peaking at 21.5%, inflation was in the double-digits, stagflation was the dominant theme, the dollar was extremely undervalued, the U.S. stock market had gone sideways 6½ years and the economy was coming out of a deep recession. Today, we’re coming out of a period of record low rates, 36 years of disinflation/deflation, an economy in year 8 of expansion and a U.S. equity market that’s risen nonstop 7½ years. When Reagan took office, U.S. federal debt held by the public was 25.5% of GDP. It’s now 3 times higher. Net interest expense was higher in relative terms—8.9% of outlays vs. 6.5% now—but this difference largely is a byproduct of the lowest rates in capitalism’s history. Finally, according Nobel economist Robert Shiller, the CAPE ratio for the U.S. stock market that averaged 16.7 since 1881 was 9.3 in 1981. It’s now 26.6. The 10-year Treasury yield that averaged 4.6% since 1871 was 12.6% in 1981. Today, it’s 2.4%.

Don’t count on those lower taxes just yet Individual tax reform—the lowering of tax rates and broadening of the tax base—is a very difficult and time-consuming process. It took President Reagan nearly 2 years to complete the Tax Reform Act of 1986, despite winning 49 out of 50 states in the 1984 election. Moreover, while a 52-48 Republican Senate majority will be able to use budget reconciliation to move tax legislation with just a simple majority 51 votes, budget rules will require a super-majority of 60 to pass a bill that is “deficit negative.” That could limit the size and scope of tax relief to whatever they can persuade at least 8 Senate Democrats to support, and suggests corporate tax reform comes first.

Happy Thanksgiving—and a cheaper one, too The cost of a Thanksgiving dinner that can feed 10 has dropped to $49.87 this year, down from a high of $50.11 in 2015, according to the American Farm Bureau Federation. The cost of the meal is lower now, after adjusting for inflation, than it was 31 years ago, an official with the federation said.