Orlando's Outlook: Buy the election, sell the inauguration?

01-20-2017

Bottom Line Post-election euphoria drove the S&P 500 up 10%, the small-cap Russell 2000 20% and benchmark 10-year Treasury yields from 1.75% to nearly 2.65% into mid-December, as the surprising prospect of corporate and personal tax cuts, deregulation, repatriation, and more infrastructure and defense spending certainly buoyed investors. But stocks have been drifting sideways over the past month or so, while Treasury yields slipped back to almost 2.30% before bouncing back to nearly 2.50% in the past week, bringing to mind the market’s old “Buy the rumor, sell the news” chestnut. The market’s focus clearly has shifted from the promise of “Trumponomics” to concerns about a stronger dollar, higher levels of inflation, tighter monetary policy from the Federal Reserve (Fed), trade wars and tariffs, and fiscal-policy uncertainty as to whether President Trump’s legislative agenda actually passes into law despite consolidated Republican control of Congress. In our view, the presidential leadership transition from “You didn’t build that” to “Make America great again” will eventually jump-start moribund corporate and consumer animal spirits, boost economic and corporate-earnings growth, and ultimately drive both share prices and bond yields higher.  

No changes to our GDP forecast The fixed-income and equity investment professionals who comprise Federated’s macroeconomic policy committee met for the first time this year on Wednesday to discuss President Trump’s inauguration and the likely impact that his presidency will have on domestic and global economic growth. The committee did the heavy lifting with significant upward GDP revisions at our mid-December meeting:

  • The final revision for third-quarter GDP on Dec. 22 lifted the preliminary reading of 2.9%, which was revised up to 3.2% in November, to a final 3.5% gain, versus 1.4% in the second quarter. While this looks strong at first blush, recall that it was boosted by a massive, one-time 106-million metric ton shipment of soybeans to China over the summer. Adjusting for this unsustainable export surge leaves third-quarter GDP closer to 2.5%.
  • We’re a little concerned about the strength of the holiday-shopping season, so we’re keeping our fourth-quarter GDP estimate unchanged at 2.5%, while the Blue Chip consensus has ticked its estimate down to 2.2% (within a range of 1.5% to 2.9%).  
  • So we’re keeping our full-year 2016 GDP estimate unchanged at 1.6%, while the Blue Chip consensus is also standing pat at 1.6% (within a very tight range of 1.5% to 1.6%).
  • Despite the election results, the first quarter tends to be seasonally slower, so we are keeping our first-quarter GDP estimate unchanged at 2.0%, while the Blue Chip consensus is likewise standing firm at 2.2% (within a range of 1.7% to 2.6%).
  • We’re still expecting economic activity to start to perk up in the spring, as President Trump and the new Republican Congress start to discuss, debate and draft legislation to cut tax rates and reduce regulations. So we’re keeping our estimate for second-quarter GDP unchanged at 2.5%, while the Blue Chip consensus also remains in place at 2.3% (within a range of 1.8% to 2.8%).
  • We’re admittedly optimistic that Congress will approve their new legislative proposals—possibly retroactive to the beginning of calendar 2017—before they leave for summer recess in early August, which may begin to have a positive impact on economic growth during the second half of 2017. So we are keeping our 3.0% GDP estimate unchanged for the third quarter, while the Blue Chip consensus also remains unchanged at 2.4% (within a range of 1.8% to 3.0%).
  • We are also keeping our estimate for the fourth quarter unchanged at 3.0%, while the Blue Chip consensus is similarly standing pat at 2.3% (within a range of 1.6% to 2.9%).
  • This means our full-year 2017 GDP estimate is unchanged at 2.5%, while the Blue Chip consensus is also not changing its 2.3% estimate (within a range of 2.1% to 2.6%).
  • As we look out to next year, we are keeping our full-year 2018 GDP estimate unchanged at 3.0%. This is the key forecast, in our view, due to the timing uncertainty of when Congress actually passes Trump’s tax cuts into law. We believe that trend-line GDP growth of 3% is what a full-year economic trajectory for successful implementation of “Trumponomics” might look like, which is a sizable boost from the anemic 2% run rate that we’ve experienced over the past seven years. In sharp contrast, the Blue Chip consensus has initiated a much more conservative 2.4% estimate for GDP growth in 2018 (within a range of 1.8% to 2.8%). 

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

Consumer confidence has soared We believe the decidedly ugly tone of the presidential election—the campaigns, primaries, conventions, debates and the general election itself—may have had a chilling effect on economic activity. But since the stunning election result, there has been a palpable surge in confidence: 

  • Michigan Consumer Sentiment Index rose to a 12-year high of 98.2 with its final December 2016 reading, up from a 2-year low of 87.2 in October. The preliminary January 2017 reading was steady at 98.1.
  • Conference Board’s Consumer Confidence Index soared to a 15-year high of 113.7 in December 2016, up from a 3-month low of 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—and eased slightly back to 61.4 in December—after plummeting to a 6-year low of 51.8 in August.
  • NAHB’s housing market builder-confidence index (HMI) leapt to a downwardly revised 11-year high of 69 (down from 70) in December, up sharply from 59 in August. The HMI slipped to 67 in January 2017.

Earnings recession is over After seven consecutive negative year-over-year (y/y) comparisons through last year’s second quarter, third-quarter revenues and earnings enjoyed y/y gains of 2-3%, finally breaking that downward spiral. With the recovery in energy prices since their definitive February 2016 bottom, we expect another positive quarter in the fourth quarter of 2016. It’s early, as we’re only about 15% into the new earnings season, but revenues and profits appear on pace for solid y/y of about 4-5%.

Is inflation starting to build? The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—fell from 1.8% in October to 1.6% in November on a y/y basis, matching a benign 5-month trend through July 2016. So it still remains below the Fed’s 2.0% inflation target. But the core y/y wholesale Producer Price Index rose from 1.0% in August to 1.6% in November and December. However, the core y/y retail Consumer Price Index rose from 2.3% in August (its highest reading in four years) to 2.1% in both October and November, before recovering a bit to 2.2% in December.

But crude prices (as measured by West Texas Intermediate, or WTI) have surged 30%, from $42 in mid-November to $55 in early January, due to an OPEC and non-OPEC agreement to cut 1.8 million barrels a day from production, starting on Jan. 1. So oil prices, which have settled into a relatively narrow $50-55 trading range in recent months, could grind up toward $60 during 2017.

Dollar and Treasury yields rise Benchmark 10-year Treasury yields rose from 1.75% to 2.60% after the election into mid-December, due to expectations of stronger economic growth and higher levels of inflation, before drifting to nearly 2.30%. But over the course of just this week, yields have spiked back up to 2.50%. Over the course of 2017, we expects yields to rise further, to revisit 2013’s “Taper Tantrum” peak of 3.00%.

Further, the prospect of a tighter monetary policy from the Fed drove the value of the dollar higher by almost 9% versus the euro since the election, from 1.13 to 1.035. But so far this month, the dollar has consolidated about a third of that gain, approaching 1.07. We’re watching this closely, as a 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. Eventually, we expect the dollar will resume its rally against the euro, perhaps approaching parity later this year, which should continue to spark strong performance from domestically oriented small-cap stocks.

Three hikes in 2017 for Fed? The Fed hiked interest rates by a quarter point at its December 2016 policy-setting meeting—its first hike in a year and only its second hike in the past decade—and guided to a more aggressive pace of perhaps three quarter-point rate hikes in 2017, rather than the two hikes we have been forecasting. We believe that the Fed is concerned about whether President Trump’s fiscal policy plans will spark faster economic growth and inflation, forcing the Fed to act more aggressively to stay ahead of the curve. However, we found ourselves at a similar crossroads at this time last year, as the Fed guided the markets to four quarter-point rate hikes in 2016, triggering a sharp 13% equity-market correction to start the new year. But the Fed actually hiked only once last year, and once markets figured out that the Fed had scaled back its plans, stocks rallied 25% from their mid-February trough through year end. We do not expect the Fed to hike rates before its mid-March meeting at the earliest, and the June meeting may be a better bet.

Labor market has tightened We’re at an interesting crossroads in the labor market. On the one hand, at 4.7% in December 2016, the (U-3) unemployment rate is sitting at roughly full employment, and nonfarm payrolls have declined 22% from a monthly average of 212,000 in the third quarter to only 165,000 jobs in the fourth quarter. At the same time, wages increased 2.9% y/y in December, the fastest such pace in more than seven years, as companies have had to pay up to attract a shrinking pool of qualified, skilled labor. True, ADP (an important leading indicator) at only 153,000 jobs was soft in December, but the January survey week for initial claims at 234,000 was just off a 43-year low, so we may see a bounce in January. The average weekly hours worked slipped a tick to a 2-year low at 34.3 hours in December.

Mixed picture for Christmas sales Higher-than-expected auto sales fueled by discounts and easy credit, rising gasoline prices and a surge in online holiday shopping masked weak results in department stores, restaurants and electronics stores during December. So while nominal sales in December rose an impressive 0.6% month-over-month (m/m) and 4.1% y/y, the sales gain flattens out when autos, gas, building materials and food service are excluded, as so-called “control” sales rose just 0.2% in December—half what was expected versus breakeven in a soft November. So we need to see how strong gift-card redemptions are post-Christmas into January to gauge the overall strength of the holiday season.

Autos end 2016 on a high note Total auto sales rose 3.0% in December to 18.29 million annualized units, a new 10-year cycle high. But questions have arisen about how promotional December was and the abundance and quality of subprime auto loans. Regardless, auto sales have more than doubled from their cycle trough of 9.02 million units in February 2009 to 18.29 million cars in December 2016. The average age of the U.S. auto fleet is now at an all-time high of 11.5 years old, compared to 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.

Is housing peaking here? Housing-market momentum has been strong, thanks to low mortgage rates, a solid labor market, rising wages and increased household formations. But we expect results to plateau at present due to the recent spike in interest rates, seasonality and the reality that recent strength is likely due to locking in a home purchase before rates rise even higher. New-home sales (an important housing leading indicator because they are calculated when a contract is signed, typically several months before closing) rose 5.2% in November to at an annualized run rate of 592,000 units, their second-fastest pace in nine years. Existing home sales, which are a lagging indicator because they are calculated when a purchase contract actually closes and which now account for about 90% of total home sales, rose for the third-consecutive month on a m/m basis 0.7% in November 2016 to 5.61 million annualized units, a new nine-year high. While housing starts (an important housing leading indicator) rose 11.3% in December to 1.226 million annualized units, that’s still below October’s new nine-year cycle high of 1.34 million units. Building permits slipped marginally in December to 1.21 million annualized units, but that’s still below October’s cycle high of 1.26 million units.

Manufacturing confidence spikes, too Since the election, several of the key manufacturing confidence metrics that we monitor have soared:

  • ISM manufacturing index had fallen into contraction territory for the first time in six months at 49.4 in August. But it rebounded back into growth mode (above 50) in each of the past four months, with a surprisingly stronger-than-expected reading of 54.7 in December, a two-year high.      
  • Empire regional manufacturing index rose from a negative 6.8 in October to a revised 7.6 in December, before easing back to 6.5 in January.      
  • Philadelphia regional manufacturing index spiked from a negative 2.9 in July to a much stronger-than-expected 23.6 in January, its highest reading since November 2014.
  • Kansas City regional manufacturing index leapt from negative 6 in July to a much stronger-than-expected 11 in December.
  • Richmond regional manufacturing index rose from negative 11 in August to a better-than-expected 8 in December.
  • Dallas regional manufacturing index improved from negative 18.3 in July to a higher-than-expected 15.5 in December.

Bloated inventory levels in 2015 and the first half of 2016 contributed to slower GDP growth and negative y/y 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 $7.1 billion in the third quarter. Now that inventories have been right-sized, we may be in the early stages of an inventory rebuilding cycle in 2017, which rising energy prices should help. Industrial production and capacity utilization also rebounded nicely in December, gaining 0.8% m/m and rising to 75.5, respectively. Factory orders fell 2.4% in November for the first time in four months, although wholesale and business inventories rose 1.0% and 0.7%, respectively, in November. Finally, durable goods orders fell by 4.5% in November, although the core capital goods shipments rose a modest 0.2%.

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