Orlando's Outlook: It's all about 'Trumponomics'

12-16-2016

 

Bottom Line The post-election financial-market environment has been on fire, with investors pricing in all of the potentially positive aspects of Donald Trump’s surprising presidential victory, while conveniently ignoring the possible negatives. From their Nov. 4 trough, the S&P 500 and the small-cap Russell 2000 have soared more than 9% and 20%, respectively, to a series of record highs, and benchmark 10-year Treasury yields have skyrocketed from 1.75% to 2.60%.

In our view, markets are pricing in the prospect of corporate and personal tax cuts, deregulation, repatriation, more infrastructure and defense spending, as well as fixing health care, immigration and trade. Collectively, these could boost GDP growth from an anemic 2% run rate over the past seven years back to a trend-line growth rate of 3% or better by 2018.

But with stronger economic growth comes higher levels of inflation, which brings the prospect of a more aggressive pace of Fed tightening into play. Not to get ahead of ourselves, but will the newly consolidated Republican Congress also successfully implement all of President-elect Trump’s fiscal-policy plans as discussed, to unleash moribund corporate and consumer animal spirits? And will a damaging trade war break out to possibly mitigate any of the expected positives? Only time will tell, of course. But the early read is that financial markets are excited that there’s a new sheriff in town, with a much more pro-growth agenda than President Obama brought to the White House eight years ago.

Raising our GDP forecast The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met Wednesday to discuss President-elect Trump’s stunning upset victory and its likely impact on the domestic and global economy. As a result, we made the following adjustments to our U.S. GDP model:

  • Third-quarter GDP growth, which was flashed at a stronger-than-expected 2.9%, was revised up to 3.2%. The final revision is coming Dec. 22, and the Bloomberg consensus is now at 3.3%. While this reading certainly looks strong on the surface, remember that it was goosed by a massive shipment of 106 million metric tons of soybeans to China over the summer. Adjusting for this unsustainable surge in exports leaves GDP at a rate closer to 2.0-2.5%.
  • While we’re a little concerned about the strength of the holiday-shopping season, housing, manufacturing and inventories have been healthier. So we’re increasing our fourth-quarter GDP estimate from 2.0% to 2.5%, while the Blue Chip consensus remains unchanged at 2.3% (within a range of 1.5% to 2.9%).
  • Due to the higher nominal third-quarter GDP print and our increased estimate for the fourth quarter, we’re increasing our full-year 2016 GDP estimate from 1.4% to 1.6%, while the Blue Chip consensus is similarly ticking its estimate up to 1.6% (within a very tight range of 1.5% to 1.6%).
  • With the ugliest presidential election in history now behind us, we sense that the economic chilling effect is starting to fade. While we remain concerned about the weather forecast for the third brutal winter in the past four years, we’re still raising our first-quarter GDP estimate from 1.7% to 2.0%, while the Blue Chip consensus is standing pat at 2.2% (within a range of 1.7% to 2.7%).
  • We believe that animal spirits will start to perk up in the spring, as President-elect Trump and the new Republican Congress will start to draft some definitive legislative proposals to cut tax rates and reduce choking regulations. So we’re raising our 2.0% GDP estimate for the second quarter of 2017 to 2.5%, while the Blue Chip consensus remains in place at 2.3% (within a range of 1.7% to 2.8%).
  • We’re hoping that Congress approves its new legislative initiatives—possibly retroactive to the beginning of calendar 2017—before summer recess in early August, which may begin to have a more positive impact on economic growth during the second half of 2017. So we are boosting our 2.5% GDP estimate for the third quarter of 2017 to 3.0%, while the Blue Chip consensus increases its estimate from 2.2% to 2.4% (within a range of 1.8% to 3.0%).
  • We are also similarly raising our 2.5% GDP estimate for the fourth quarter of 2017 to 3.0%, while the Blue Chip consensus raises its from 2.1% to 2.3% (within a range of 1.8% to 2.9%).
  • Our four quarterly increases collectively raise our full-year 2017 GDP estimate from 2.0% to 2.5%, while the Blue Chip consensus ticks its estimate up to 2.3% (within a range of 2.0% to 2.6%).
  • We are initiating a full-year 2018 GDP estimate of 3.0%. There’s no Blue Chip consensus estimate yet, but we wanted to demonstrate our view of what a full-year economic trajectory for a successful implementation of “Trumponomics” might look like.

Federated’s Macro Policy Committee also made the following investment observations:

Fed pulls the trigger The Fed correctly did nothing at its policy-setting meetings in September and November. The apolitical central bank historically tends to avoid policy changes during the two-month period between Labor Day and Election Day so as not to unduly influence the economy, the financial markets or the election itself. But with the election now safely behind us, the Fed hiked interest rates by a quarter point Wednesday for the first time in a year and for only the second time in the past decade, as we and many others had thought likely. The curveball, however, is that the Fed guided to a more aggressive three potential quarter-point rate hikes in 2017, rather than the two hikes we had expected. We suspect the Fed is concerned that President-elect Trump’s fiscal policy plans will engineer both faster economic growth and inflation, so the Fed needs to act more aggressively to stay ahead of the curve. Moreover, with Janet Yellen’s four-year term as Fed chair expiring in early 2018, we have no visibility as to the Fed’s longer-term monetary policy plans beyond next year, not knowing whether Trump plans to nominate someone more hawkish or dovish to replace her.

Dollar and Treasury yields soar The prospect of a stronger U.S. economy and tighter central-bank monetary policy have driven the value of the dollar higher by some 8% versus the euro since the election, from 1.13 to our target of 1.05. But in recent days the dollar has broken to a new 14-year high of 1.04, a trend that may continue to parity over time. The stronger dollar could impair the earnings prospects of large-cap, U.S.-based multinational companies, whose exports account for half or more of their business, which is why domestic-oriented small-cap stocks have performed so well recently.

Due to inflationary concerns, benchmark 10-year Treasury yields have risen from 1.75% to 2.60% since the election, slightly beyond our 2.50% year-end target. We can envision yields rising further to 2013’s “Taper Tantrum” peak of 3.00% by the end of 2017, and then perhaps grinding up to 4.00% by 2020. But with relatively low foreign yields, such as German bunds at 30 basis points and Japanese government bond yields at only 5 basis points, there may be some downward pressure on U.S. yields due to outsized demand for high-quality, higher-yielding U.S. paper.

Inflation pressures starting to rise The core Personal Consumption Expenditures (PCE) index—the Fed’s preferred measure of inflation—has been stuck at 1.7% for the past three months through October, a trend that’s expected to continue in November. It still remains below the Fed’s 2% inflation target. But the core year-over-year (y/y) wholesale Producer Price Inflation Index (PPI) rose from 0.7% in July to 1.0% in August to 1.2% in each of September and October, before spiking to a surprising 1.6% in November. However, the core y/y retail Consumer Price Inflation Index (CPI) rose from 2.2% in July to 2.3% in August, which matched its highest reading in four years. Since then, however, CPI has slipped to 2.2% in September and to 2.1% in both October and November.

Food-price increases should remain muted, as corn and wheat prices are sitting near cycle lows due to strong harvests the last few years, and soybeans are still moderately priced. But crude prices (as measured by West Texas Intermediate, or WTI) have surged recently nearly 30%, from $42 in mid-November to $54 this week, on the heels of an historic OPEC and non-OPEC accord to cut 1.8 million barrels a day from production, starting on Jan. 1. Oil prices could grind up towards $60 in coming months, given stronger global economic growth and the severity of the winter.

Earnings at positive inflection point The corporate-earnings recession appears to finally be over. After seven consecutive negative quarters, the third-quarter revenues and earnings enjoyed y/y year gains of 2.9% and 2.3%, respectively, with 72% of companies reporting positive earnings surprises of 5.8%. With the strong rebound in energy prices since their February trough at $26, this positive trend should continue into 2017. Profit margins ex-energy rose 1.3% in the third quarter, driven by a sharp 3.1% improvement in productivity and a modest 0.7% increase in unit labor costs.

We are estimating earnings per share of $115 for the S&P 500 this year, $130 for 2017 and $140 for 2018. Assuming that core PCE inflation slowly grinds higher to 2.0%—a level we have not seen in nearly five years—we are targeting an 18 times price/earnings ratio on stocks, which translates into target prices of 2,250 this year, 2,350 in 2017 and 2,500 in 2018.

Consumer confidence has surged post-election Americans were thoroughly disgusted with the ugly tone of the presidential election campaigns, which may have hampered economic activity. But since the election season has ended:

  • Michigan Consumer Sentiment Index rose to a nearly 11-year high of 98.0 with its preliminary December 2016 reading, up from 87.2 in October.
  • Conference Board’s Consumer Confidence Index surged to a nine-year cycle high of 107.1 in November 2016, up from 100.8 in October.
  • ISM non-manufacturing business activity index (which accounts for about 88% of total economic activity) soared to a 13-month high of 61.7 in November, after plummeting to a six-year low of 51.8 in August.

Bah, humbug for holiday? Despite improved consumer confidence, November retail sales were much weaker than expected (up only 0.1% both nominal and control). So the extreme rollercoaster pattern for retail sales continues this year, marked by a terrible first quarter, a very strong second-quarter rebound, a miserable July and August to start a disappointing Back-to-School (BTS) season, a strong September and October, and now a preliminarily weak November to start the all-important holiday shopping season. Christmas typically has an 80-90% positive correlation with BTS (ex-weather problems), so that raises some early red flags to gauge the potential strength or weakness of holiday spending (measured as November, December and January combined). Looking at “Black November” as a whole, online and “experiences” were better than more traditional brick and mortar sales, which have been very promotional. Because the consumer accounts for 70% of economic growth, holiday spending is very important for the overall health of fourth-quarter GDP.

Labor market mixed Despite a stronger-than-expected ADP report with 216,000 jobs and the lowest initial weekly unemployment claims in 43 years at 233,000 workers during the all-important survey week, November’s labor-market report was disappointing across the board. Nonfarm and private payrolls were weaker than expected at only 178,000 and 156,000, respectively, with downward revisions for October. Manufacturing at -4,000 and retail hiring at -8,000 were negative for the fourth- and second-consecutive months, respectively. Wage growth surprisingly declined 0.1% month-over-month (m/m) in November, and hourly wages rose on a y/y basis 2.5% in November, but that’s down from 2.8% in October (the most since 2009). Hours worked were flat for the third-consecutive month. The only positive aspect was the rebound in the household employment survey, which rose by 160,000 jobs after losing 43,000 in October.

The unemployment rate (U-3) fell to a nine-year low of 4.6%, but that’s only because of a 15% m/m surge in discouraged workers, who have left the labor force and have stopped looking for work. The labor-impairment rate (U-6) fell to 9.3% in November because of the increase in discouraged workers, a new eight-year cycle low, and the labor force participation rate declined to 62.7%.

Autos plateau Total auto sales, which slipped 0.9% in November to 17.75 million annualized units, have seemingly plateaued over the back half of 2016, ranging from a low of 16.7 million units in June to a high of 17.9 million cars in October. It appears the 10-year cycle high of 18.0 million units, which we saw for three consecutive months in September, October and November 2015, represents the peak of the auto cycle. The average age of the U.S. auto fleet is now at an all-time high of 11.5 years old, versus a normal average age of about 7.5 years, and low-rate customer financing remains abundant, so auto sales should remain in the 16-18 million unit level. But they’ve clearly slowed over the course of 2016, with questions arising about the quality of some sub-prime auto loans.

Seasonal peak for solid housing market? While housing-market momentum has remained strong, thanks to low mortgage rates, a solid labor market, rising wages and increased household formations, we do believe that results are flattening out at present due to seasonal trends. But the recent spike in interest rates may also accelerate some activity, to beat even higher interest rates later in the cycle. To that point, the HMI builder-confidence index surprisingly soared to 70 in December from 63 in both October and November, an 11-year cycle high.

New-home sales (an important housing leading indicator, because they are calculated when a contract is signed, typically several months before closing) fell 1.9% in October to a four-month low at an annualized run rate of 563,000 units sold, down from a nine-year high of 659,000 units in July. Existing home sales (which are a lagging indicator, because they are calculated when a purchase contract actually closes and now account for about 90% of total home sales) rose 2.0% for the second-consecutive month on a m/m basis in October 2016 to 5.6 million annualized units, a new nine-year high. Housing starts (an important housing leading indicator) surged 27.4% in October to a new nine-year cycle high of 1.34 million annualized units, but fell nearly 19% in November. Building permits rose 2.9% in October to a new cycle high of 1.26 million annualized units, but fell 4.7% in November. Pricing has plateaued with 5% y/y gains for the past four months through September, and mortgage delinquencies and foreclosures continue to grind lower (after peaking in 2010 at 10.06% and 4.64%, respectively) to 4.52% and 1.55% in the third quarter.

Manufacturing picture improving Bloated inventory levels in 2015 and the first half of 2016 contributed to slower GDP growth and negative year-to-year earnings comparisons, as companies sharply reduced inventory accumulation. But companies actually cut inventory by about $9.5 billion in the second quarter of 2016, and started to add inventory again by $7.6 billion in the third quarter. With oil prices starting to rise again, we are in the early stages of an inventory re-building cycle in 2017.

After falling into contraction territory for the first time in six months at 49.4 in August, the ISM manufacturing index rebounded back into growth mode (above 50) in each of the past three months, with a reading of 53.2 in November, a five-month high. In the post-election regime, manufacturing activity has improved from October into December in six of the seven regions we monitor, with huge upside December surprises in New York and Philadelphia. Although factory orders have now been positive four months in a row, rising 2.7% in October, wholesale inventories have declined in three of the past four months, falling 0.4% in October, while business inventories also fell a larger-than-expected 0.2% in October. Industrial production and capacity utilization took a step back in November. Finally, durable and cap goods orders and shipments have begun to demonstrate some improvement over the last four months through October after a very difficult spring through June, although the core readings were negative in two of the last four months.

Merry Christmas & Happy Hanukkah!

To see Phil Orlando’s thinking in action, click here.