Weekly Update: It's annual review time!

02-17-2017

Back to California for a week of meetings in Orange County, San Francisco and Marin County. In Orange County I offered my thoughts as to why inflation is not a big worry—millions of boomers who must keep working because their portfolios aren’t ready for retirement (more below), many more millions of millennials vying for jobs, machines taking away a whole middle class of jobs and affecting more and more industries, and disappearing global employee barriers. Government reports citing the lowest unemployment rate since before the Great Recession come with the realization that the definition of “job” has changed, Entrepreneur magazine says, referencing a report from Harvard and Princeton economists that found nearly all of the recovery’s job growth has been the result of alternative careers, freelancing, small home/office businesses and the “gig economy.” This suggests there’s more labor slack than official numbers indicate, perhaps buying the Fed time before it really tightens the screws. Every recession since 1950 has been triggered by a tightening Fed. 100%—tough to fight those odds. And what could trigger a faster Fed? Inflation that surprises. Fed Chair Yellen, arguably the most dovish Fed governor ever, sounded some hawkish notes in her testimony before Congress this week, raising the odds of a move next month. But the market still sees June as most likely, with May as a potential compromise. Yellen also reiterated recent comments from other Fed governors indicating the central bank could start to unwind its $4.5+ trillion balance sheet this year, sending the risk-free rate higher even if the target funds rate holds.

What else might prompt quicker Fed action? Tax cuts that aren’t paid for. Washington Analysis says Trump’s economic advisers are gaining leeway over political advisors; both National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin are skeptical about the border-adjustment tax (BAT) idea favored by House leaders and White House advisor Steve Bannon. Senate Republican leaders are trying to secure Trump’s endorsement for a more conventional tax-cut package, driven by desires to get it done and provide stimulus more quickly. This could prove to be a problem for deficit-minded House members, although one way to address their concerns is to sunset the tax-law changes after 10 years. Of course, the lesson learned from the Bush tax cuts is that, once cut, it is hard for a future Congress to revert back entirely to the old rates. Republicans extoll that, even though the Bush tax cuts were passed under reconciliation and expired, 90-95% of them eventually were made permanent. Whatever is done, with Democrats smelling blood over the ongoing Russian furor, it’s unlikely any tax cuts will become effective before Jan. 1, 2018 (though some Washington observers maintain it will be retroactive), meaning the markets perhaps shouldn’t count on any micro or macro benefits from tax reform for another year and a half. Dudack Research expects tax reform eventually will lift earnings that already are on an upward trajectory by an additional 8-10%. Guidance during the Q4 season was notably optimistic, Bank of America says, a break from what is typical as management often uses the January-February reporting season to set a lower bar for the year. This time around, the word “optimistic’’’ was used by managements in a record 51% of the earnings calls, based on Bank of America data going back to 2003.

A faster Fed and/or higher rates could lead to a hostile market environment that year-to-date has been extremely tame. In dropping below 11 last month, the VIX hit lows last seen in 2014 and before that, the eve of the financial crisis in 2007. The S&P 500 has gone more than 40 consecutive sessions without a +/-1% intraday range—the longest run in at least 35 years—while the tech-oriented Nasdaq 100 already has had 18 closing highs so far this year, compared to 17 for all of 2016. All of this suggests a sell-off is inevitable, perhaps very soon. Ned Davis Research this week reduced its equity overweight in its models, while both JPMorgan and Goldman Sachs are calling for increased stock volatility ahead. Elevated economic policy uncertainty under the Trump administration will likely create “winners” and “losers,’’ Goldman Sachs says, with stock performance increasingly driven by such idiosyncratic factors as sensitivity to wage inflation. The return of high stock-return dispersion should prove more conducive to active managers capable of generating alpha through skillful stock picking and security selection, it says. I consider my most important task in my weekly to sniff out the next economic recession for my readers and in recent months to sniff out the worry at the other end of the spectrum—inflation. I challenged my Orange County group, “You tell me where inflation will come from.” The response from one advisor, “wage hikes.” From your lips to my boss’s ears ….

Positives

Bullish businesses Anticipating pro-growth/business-friendly policies under Trump, the NFIB small business optimism index has spiked 11 points since October to a 13-year high. The increase is reminiscent of comparable leaps in 1980 when business owners started to anticipate a Ronald Reagan victory and in 1982-83 when Fed Chairman Paul Volcker lowered interest rates to revive the economy. Small businesses represent a major portion of the economy, accounting for 4 of every 10 private-sector workers. In another survey reflecting rising confidence, the Real Estate Roundtable Index jumped well above the break-even 50 level for the first time in a year. Also helping sentiment is a strengthening economy, further bolstered this morning by an above-consensus increase in January’s leading indicators, which rose the most in 2 years.

Happy holidays, after all January retail sales beat consensus and on a year-over-year (y/y) basis rose at their fastest pace since November 2014. Combined with a sizeable upward revision to December, the report put a bow on a solid holiday season that initially appeared to be lagging. It now appears the post-election surge in consumer sentiment carried over to spending as the calendar turned to a new year.

Manufacturing momentum Excluding a weather-related drop in utility output and a sales-driven softening in vehicle output, core industrial production rose in January by the most since November 2014, with manufacturing up a fourth time in 5 months. Inventories are supportive as the inventory-to-sales ratio fell to a 2-year low, and February is off to a good start, with New York’s Empire gauge jumping to its highest level since September 2014 and the Philly Fed index surging to its highest level since 1984, led by increases in new orders and shipments.

Negatives

Inflation Watch January’s headline CPI rose the most in nearly 4 years, lifting the y/y rate to 2.5%, its fastest pace since March 2012. Energy prices drove the increase although the core rate (ex-food and energy) also jumped the most since March 2006. While volatile energy, apparel and airfare increases are unlikely to be sustained at January’s pace, pipeline price pressures continue to build, with January’s PPI rising at its fastest y/y rate in 2½ years. Over half of the increase was due to surging energy prices, which are likely to moderate given crude oil seems to be settling after soaring 57% y/y. Rising inflation is a drag for workers, eroding the buyer power of already subpar wage increases; real average hourly earnings fell 0.5% last month (my boss could help a little bit here), the most since August 2012.

Housing mixed The NAHB sentiment index fell a second straight month on declines in buyers’ traffic, future sales expectations and current sales. Despite the drop-off from December’s post-crisis high, the gauge still reflects healthy builder optimism, a view supported by January’s report on housing starts and permits. Single-family starts rose again and are now up more than 6% y/y, while single-family permits slipped but were still up 11% y/y. The more volatile multifamily activity saw January starts fall and permits rise. One concern is the impact of rising mortgage rates and home prices on prospective buyers—the Housing Opportunity Index fell in Q4 to 59.9%, its lowest level since Q3 2008 and below the 61.9% historical average of affordability to median-income families.

My boss can also help here Among people ages 45 to 65, 27% have no retirement savings, 22% have less than $100,000 in retirement savings and 78% expect to cut spending upon retirement, according to a survey by Ipsos and USA Today. Although payroll, real estate and market values have recovered, former salary levels have not returned for many workers.

What else

‘All aboard!’ President Trump is talking as though every bit of America’s infrastructure is on the brink of collapse, and watching what was happening to the Oroville Dam in California where I was this week suggests he may not be exaggerating all that much. Trump often refers to the country’s “obsolete” infrastructure for trains, roads and planes, and in his recent meeting with Japanese Prime Minister Shinzo Abe, talked passionately about the need for high-speed rail. This is an issue California has been working on for decades; perhaps it can be a potential project on which liberals and Trump can work together?

Herbal Tea Party Cowen & Co. notes that GOP congressmen are being overrun at district meetings and town halls from vocal anti-Trump protests on everything from Obamacare ("Make America Sick Again") and immigration to Betsy DeVos and Nordstrom-ghazi. And many of these are in Trump districts. These could be examples of the beginning of the left’s own Tea Party. The ACLU says it raised $24 million the weekend of the immigration executive order, nearly 6 times its yearly online average.

Get me some Botox and I’m good to go for years Women's career trajectories are more closely mirroring men's, including an increasing tendency to work full-time into their 60s and 70s, according to studies of census, earnings and retirement data. About 30% of women ages 65 to 69 are working, double the rate from the late 1980s, with more highly educated women likely to stay in the workforce longer.