Weekly Update: Winter break

02-10-2017

People who say Naples, Fla., is “heaven’s waiting room” are jealous fools. The people here are truly relaxed and well-tanned. The women wear colorful clothes and much bling and the men, shorts and tennis shoes. Our client event “lunch” meeting lasted until 3:30, when we had to break up the party to head to our dinner event! The audiences were predominantly conservative; I heard only one biting comment about President Trump this trip. My advisor host shared that he has “never seen anything like it. Everyone is engaged in the political discussion.” These successful, retired investors were well informed. Interestingly, several voiced concern about the health of the global economy in the event that our politics really does make “America first.” But the most common discussion here centered on the future of our health-care system. At our luncheon, my advisor host told the group that 10,000 people per day are turning 70, an age at which the average person take 4 prescription meds daily. At 80, the number goes up to 10. Health care as an investment theme? But wait, at dinner, I sat with two physicians, one who tried to sell her business but no one wanted it. The gentleman challenged me to guess what a physician’s income is from treating a pregnant patient, from first meeting through delivery—about $1,000 (!!), and “we keep liability for the child’s next 18 years!” There was much discussion about how we got here, who is winning (not a simple matter of ascribing shame to the insurance companies), and what will likely happen. We didn’t solve this problem but I had some agreement with my view that nationalized health care is inevitable, given the size of the baby boom generation and our expected longevity.

The market is expensive vs. history across many metrics, with the S&P 500 trading just over 17 times forward earnings, a level briefly reached in 2015 but prior to that not seen since early 2004. The current 12-month trailing operating P/E multiple is 20.5, higher than any of the long-term averages. But on an historical price to free-cash-flow basis, the S&P is trading at a 20% discount, and the sum of trailing 12-month operating P/E and inflation is 22.3, suggesting equities are within fair value range as long as inflation remains modest (the so-called Rule of 20, which says stocks are fairly valued if the sum inflation and P/E is around 20). At the end of the day, the market still trades on earnings, and with the Q4 reporting season winding down, they are on track for their best performance since Q3 2014. Analysts are projecting a steady rise in the quarters ahead, and this is before the potential impact of any corporate tax reform. If tax reform passes, it’s estimated S&P earnings could be 9% higher than current forecasts. Valuations were so cheap when Obama took office (a P/E of 11.4) that decent stock market performance during his presidency was practically baked in the cake. Trump, meanwhile, takes office with a P/E that’s almost doubled in the last eight years and from an historical perspective now sits in the 90th percentile. In looking at the extent to which initial valuations have been a determinant of stock market returns during the subsequent presidential term, the Leuthold Group says the data show a powerful, inverse relationship between P/Es and forward returns. While a new president has no control over these initial conditions, there’s little doubt they help shape his legacy. Highly regarded Republican presidents Eisenhower and Reagan took office when both the national mood and stock market valuations were depressed. Meanwhile, less well-regarded presidents such as Hoover and George W. Bush were elected during periods when the national mood was euphoric and the stock market was priced accordingly. Trump takes office with the unusual mix of a relatively dour national mood and inflated P/E ratios.

Yesterday’s broad rally, which as of this writing is continuing, was driven by Trump’s telegraphing that his goal of lowering corporate taxes was moving “ahead of schedule.’’ JPMorgan says the comment should have been considered “old news’’ or at least “expected news’’ as every U.S. president expresses his fiscal objectives around the February/March time frame. It really doesn’t matter what Trump (or Ryan for that matter) want as the Senate will determine what eventually happens (not just on fiscal matters but also health care, entitlements, financial regulatory reform, etc.). The fiscal road ahead is still enormously nebulous (more below) and the gap between perception and reality with regard to Washington remains too large (taxes, entitlements and health care are the big third rails in Washington and Republicans are trying to grab all of them simultaneously). The faith in pro-growth policies is proving to be tremendously unflappable—while some doubts are being voiced, they are nearly all focused on timing (i.e., tax reform slipping into 2018) and not scope, magnitude or efficacy (which is the real risk). Despite all the CEO meetings, fiscal promises and tweets, the government still faces enormous constraints, including financial (very little fiscal capacity), logistical (Senate math) and ideological (deficit hawks), and this will eventually deflate the present political optimism bubble. That being said, the growth/earnings backdrop remains supportive. After last week in Vancouver, where one of my meetings was completely devoted to political discussion, this week’s chill trip to the Sunshine State was a welcome break. Still, in the car heading to the Fort Myers airport and anticipating snow in Pittsburgh (it came), I told my Naples driver that I want some of his spectacular weather. His response, “Just let Trump know, he will fix that.”

Positives

Many signs of a tightening labor market Led by fewer respondents saying “jobs are hard to get,’’ January’s Employment Trends Index rose 2.4% year-over-year (y/y), suggesting jobs may be accelerating. Elsewhere, the SHRM/LINE survey showed recruiting difficulty rose in services, leading to higher compensation growth; the Fed’s Labor Market Conditions Index rebounded and has now been positive eight straight months; December’s JOLTS report showed job openings at record highs and the number of unemployed per job opening near its May 2001 low; and jobless claims remain at a 43-year low. Despite all of this, wage growth remains surprisingly subdued (more below).

Where are we in this economic cycle? The OECD U.S. composite leading indicator rose a fifth straight month, indicating gradual improvement in the near-term growth outlook. Y/y, the index was positive for the first time since January 2015 and the annualized 6-month rate of change rose the most since August 2013, suggesting strengthening growth momentum. Robust readings this week on initial February Michigan sentiment and Bloomberg consumer comfort indicate consumers remain in a very good mood.

Subdued wages give Fed flexibility The uptrend in wage growth observed since 2014 is slowing, not only average hourly earnings but also the Atlanta Fed wage-growth measures, unit labor costs and wages across the income distribution, Deutsche Bank observes. This is a puzzle given most other labor market indicators are signaling we are at full employment. On the plus side for markets, this slowdown in wage growth allows Fed policymakers to remain dovish, which is bullish for equities and credit spreads.

Negatives

Trade gap hits 4-year high Despite narrowing more than expected in December, the nation’s trade deficit totaled $502.3 billion last year, its highest level since 2012. The biggest jump in exports in more than four years drove December’s shrinkage, with capital goods rising their most since 1994. The trade gap is expected to trim 1.7 points off Q4 GDP and to be a focus for the new Trump administration as it seeks to narrow the gap. For the year, the trade gap did shrink with our two biggest markets, China (5% to $347 billion) and the European Union (nearly 5% to $146 billion). It rose 8% with Mexico to $63 billion.

Deficit Watch The federal budget deficit rose again in January and now stands at $587 billion on a 12-month rolling basis, up 44% after bottoming at $405 billion a year ago. With tax revenue declining and spending rising on a y/y basis, the growing red ink may limit how far policymakers go on infrastructure spending, one of the Big 3 Trump pillars (along with tax reform and deregulation). Republican leaders already are pushing for “revenue neutral” tax reform to keep the deficit from growing. It’s not clear the Trump administration shares the same commitment.

Where are we in this economic cycle? Consumer bankruptcies posted consecutive increases for the first time since 2010, up 5.4% in January y/y on top of December’s 4.5% y/y increase, according to the American Bankruptcy Institute (ABI). “As interest rates increase and the cost of borrowing rises, more debt-burdened consumers and businesses may seek the financial shelter of bankruptcy,” the ABI said.

What else

Watch what Trump does, not says The Trump administration's reaction to the Iran missile launch in many ways is a return to longtime American foreign policy tenets, reversing the departure that was Obama's detente policies, Medley Global Advisors says. Trump is keeping up criticism of the Iran nuclear deal as "the worst" ever made but didn’t move to rip it up Day One, a sign the deal with all its imperfections will not be thoughtlessly abrogated. Traditional American alliances in the Middle East, led by the Saudis and Israel, are poised to improve. Defense Secretary Mattis went on a "reassurance tour" in Asia that hit all the right notes with historic allies in South Korea and Japan. As for Australia, national security sources say Trump’s blunt and undiplomatic phone call may have been a calculated signal to adversaries (re: China) that he is a tough b--------d (hombre!). D.C. foreign policy chatterati even wonder if that was the reason the White House leaked news of the embarrassing exchange in the first place.

Taking on ‘stagulation’ The Competitive Research Institute estimates that nearly 10% of GDP is associated with the cost of federal regulation and intervention, prompting investment banking firm Jeffries to coin the term “stagulation,” a combination of stagnation and regulation. It believes part of the strength in the market since Trump’s election is a result of optimism around the deregulation theme.

Republican Sweep In looking at S&P performance after presidential party upheavals since 1933, Jeffries found that while returns tend to be erratic, the first year often features outperformance, averaging 11% (price only). Further, when taking a look at the entire first term, returns showed a compounded average annual growth of 11.5%.