Orlando's Outlook: Beware the Ides of March


Bottom Line After a powerful 15% rally in the S&P 500 over the past four months, with a concomitant increase in benchmark 10-year Treasury yields from 1.75% to 2.60%, all eyes now turn to Washington. The prospect of corporate and personal tax cuts, deregulation, repatriation and more infrastructure and defense spending has sent confidence data and sentiment surveys soaring since the election. And while the labor market has certainly been strong the past two months, some of the other hard data has been mixed, such as a widening trade deficit, softer auto sales and personal spending, and a decline in core capital-goods shipments.

Which brings us to the Federal Reserve and its policy-setting meeting that concludes tomorrow, on the Ides of March. Numerous Fed officials have assured us over the past fortnight that a rate hike this week is a very real possibility, pointing to their successful stewardship of the dual mandate—a solid labor market and rising inflation. But in our view, two other significant issues remain unspoken. First, how unappetizing will the fiscal-policy sausage-making be for President Trump and Congress this spring and summer? Moreover, Europe could be a slow-motion train wreck over the next six months, with the U.K. expected to trigger Brexit soon and key elections upcoming in the Netherlands, France, Germany and perhaps Italy.

Amid that uncertainty, will the Fed change its monetary-policy course, and if so, how? And how might financial markets respond? In our view, the Fed will seize upon its available window and hike rates tomorrow before investors become more broadly concerned about whether “Trumponomics” actually passes into law or who wins the upcoming European elections. But given the tug-of-war between strong “soft” data and less firm “hard” data, might a less-accommodative monetary policy stance from the Fed choke off near-term economic growth? Only time will tell which is the right policy choice. Et tu, Janet?

Modest changes to our GDP forecast The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met last week to discuss the state of the economy post-election, the prospect and timing of President Trump’s fiscal policies receiving congressional approval and the Fed’s monetary-policy response mechanism.

  • Fourth-quarter 2016 GDP was unrevised at 1.9% (versus 3.5% in the third quarter), and the final revision is scheduled for Thursday, March 30. That leaves full-year 2016 GDP unchanged at 1.6%.
  • Several key first-quarter metrics have slowed in recent weeks, such as the widening trade deficit and a decline in core capital-good shipments. So we are lowering our first-quarter GDP estimate to 1.9% from 2%, while the Blue Chip consensus remains unchanged at 2.2% (within a range of 1.9% to 2.7%). But the Atlanta Fed’s widely-followed “GDPNow” model cut its estimate sharply, from 2.7% to 1.2% over the past month.
  • We’re frustrated that President Trump’s new cabinet has not yet been fully assembled, which may delay the administration’s work with the Republican Congress to draft legislation to cut tax rates and reduce regulations. That delay may well create an economic chilling effect among businesses and consumers, who may wait to spend and invest until after the new legislation has been passed. So we’re trimming our estimate for second quarter GDP to 2.4% from 2.5%, while the Blue Chip consensus remains unchanged at 2.3% (within a range of 1.8% to 2.7%).
  • Our best-case scenario is that Congress approves “Trumponomics” before the summer recess in August, with elements of the proposal possibly retroactive to the beginning of calendar 2017. This may begin to have a positive impact on economic growth during the last third or so of 2017. To be conservative from a timing standpoint, however, we are trimming our 3% GDP estimate by a tick for the third quarter to 2.9%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 1.9% to 3%).
  • We expect “Trumponomics” to pass into law before year-end, so we are keeping our estimate for fourth quarter GDP unchanged at 3%, while the Blue Chip consensus is bumping its estimate up a tick from 2.3% to 2.4% (within a range of 1.8% to 2.9%).
  • Because of the tweaks we made to the first three quarters, we’re trimming our full-year 2017 GDP estimate a tick from 2.5% to 2.4%, while the Blue Chip consensus is not changing its 2.3% estimate (within a range of 2.1% to 2.6%).
  • We are keeping our full-year 2018 GDP estimate unchanged at 3%. Because of the timing uncertainty of when Congress actually passes Trump’s fiscal policies into law during 2017, we believe that trend-line GDP growth of 3% in 2018 is what a full-year economic trajectory for successful implementation of “Trumponomics” might look like. That’s a sizable boost from the 2% run rate in the U.S. over the past seven years. In sharp contrast, the Blue Chip consensus did not change its much more conservative 2.4% estimate for GDP growth in 2018 (within a range of 2% to 2.9%). Bottom line, we are high on the street.

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

Shift to three rate hikes in 2017 We now expect the Fed to hike rates by a quarter point at this week’s meeting and then twice more over the course of 2017. Looking at its dual mandate, the labor market has certainly strengthened and inflation is grinding higher. Additionally, we believe that the Fed is concerned about whether President Trump’s fiscal policy plans will spark faster economic growth and inflation, which may prompt it to hike more quickly to stay ahead of the curve. We also expect the Fed to begin to unwind its $4.5 trillion balance sheet before the end of calendar 2017, which we expect will be Janet Yellen’s last as Fed chair.

Inflation starting to rise The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—has been mired at 1.7% on an annualized year-over-year (y/y) basis over the past six months through January 2017, remaining below the Fed’s 2% inflation target. But the core y/y retail consumer price inflation (CPI) index (which strips out food and energy) rose from 2.1% in October and November to 2.2% in December and 2.3% in January 2017, matching its highest reading in four years. However, y/y, the core wholesale producer price inflation (PPI) index (which strips out food, energy and trade) slipped from 1.8% in November to 1.7% in December and 1.6% in January 2017. Wage inflation has been rising, however, reaching 2.8% in February 2017, a trend we expect to continue.

Treasury yields and dollar rise Benchmark 10-year Treasury yields rose from 1.75% before the election to 2.60% now due to expectations of stronger economic growth and higher levels of inflation from the successful implementation of “Trumponomics.” Over the course of 2017, we expect yields to rise further, perhaps revisiting 2013’s “Taper Tantrum” peak of 3%.

In addition, stronger U.S. economic growth and the prospect of a tighter monetary policy have driven the value of the dollar almost 9% higher versus the euro since the election, from 1.13 to 1.04. But thus far in 2017, the dollar has remained in a relatively tight trading range of 1.04 to 1.08 versus the euro. A stronger dollar could hurt commodity prices and impair the earnings prospects of large-cap, U.S.-based multinational companies, whose exports account for half or more of their business. We expect the dollar to resume its rally against the euro later this year—perhaps approaching parity at some point—which should result in continued strong performance from U.S.-based small-cap stocks as a hedge.

Earnings growth replaces recession With two consecutive good quarters, the earnings recession appears to be over. The S&P suffered through eight consecutive negative y/y comparisons through the second quarter of 2016. But in the fourth quarter of 2016, companies reported healthy y/y gains of 4.2% for revenues and 5.5% for corporate profits, as the energy drag of the past two years has ended.

Labor market strengthening For the second consecutive month, nonfarm payrolls were much stronger than expected, with 235,000 new jobs added in February and a positive revision of 11,000 jobs to 238,000 in January. Important labor-market leading indicators told the story, with a very strong ADP report on private hiring (at 298,000 new jobs) in February, a 3-year high, and a new 44-year record-low in initial weekly unemployment claims (at 223,000 for the week ended Feb. 25).

Aside from the strong headline gains in nonfarm payrolls, February’s report was healthy across the board, with a surge of 447,000 jobs in household employment, strong gains in construction and manufacturing of 58,000 and 28,000 jobs, respectively, an increase in the participation rate to 63% and a decline in the unemployment (U-3) and underemployment (U-6) rates to 4.7% and 9.2%, respectively.

Consumer confidence continues to go vertical Since the election, there has been a palpable surge in confidence:

  • Michigan Consumer Sentiment Index rose to a 12-year high of 98.5 with its final January 2017 reading, up from a 2-year low of 87.2 in October.
  • Conference Board’s Consumer Confidence Index soared to a 16-year high of 114.8 in February 2017, 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 6-year high of 63.6 in February 2017, after plummeting to a 6-year low of 52.4 in August.
  • NAHB’s housing market builder-confidence index (HMI) leapt to an 11-year high of 69 in December, up sharply from 59 in August.
  • The National Federation of Independent Business (NFIB) small-business optimism index rose to 105.9 in January 2017 (a 12-year high), up sharply from a cycle trough of 94.1 in September 2016, and held near that high at 105.3 in February.

Christmas sales better than expected Retail sales in January were much stronger than expected—with sharply positive revisions for December—collectively helping to deliver a holiday shopping season whose powerful 4.6% pace of y/y growth was surprisingly twice as bright this year as last. What happened? We were forecasting moderate holiday-spending growth of 3-3.5%, in the wake of a modest 2.6% y/y increase in Back-to-School (BTS) spending. But the shocking election results on Nov. 8 led to a surge in business and consumer confidence. That and a burgeoning wealth effect from stock prices that have soared to record highs combined to boost animal spirits, prompting consumers to open their pocketbooks and enjoy their best Christmas in five years.

Autos stuck in neutral Total auto sales were flat month-over-month (m/m) in February 2017 at 17.5 million annualized units, down from December’s 10-year cycle high of 18.3 million annualized units sold. So a very promotional December, with a large volume of subprime auto loans, is settling into the slowest pace of auto sales in six months. However, 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 stable in the 16-18 million unit level.

Is seasonal pause in housing over? While housing-market momentum has been strong, thanks to low mortgage rates, a solid labor market, rising wages and increased household formations, we saw some choppiness in December due to the recent spike in interest rates and seasonality. But we expect a solid housing market to resume come spring. New-home sales, which are an important housing leading indicator, rose 3.7% in January 2017, and existing sales rose on a m/m basis 3.3% in January 2017 to 5.69 million annualized units, a 10-year high. While housing starts declined 2.6% in January 2017, building permits rose 4.6% to 1.285 million annualized units, an 11-year cycle high. Pricing has begun to re-accelerate, with the lagging Case-Shiller index up 5.6% y/y in December.

Manufacturing confidence strong Since the election, most manufacturing confidence metrics 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 into growth mode (above 50) in each of the past six months, with a 3-year high of 57.7 in February 2017.
  • Empire regional manufacturing index rose from -5.5 in October to a 2-year high of 18.7 in February.
  • Philadelphia regional manufacturing index spiked from -2.9 in July to a 33-year high of 43.3 in February.
  • Kansas City regional manufacturing index leapt from -5 in July to a 6-year high of 14 in February.
  • Richmond regional manufacturing index rose from -11 in August to 17 in February.
  • Dallas regional manufacturing index improved from -4.8 in August to a 10-year high of 24.5 in February.
  • Chicago regional manufacturing index improved from 51.6 in August to 57.4 in February.

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 and by $46.2 billion in the fourth quarter. Now that inventories have been rightsized, we are in the early stages of an inventory rebuilding cycle in 2017, which rising energy prices should help. While factory orders and durable goods orders both rose in January, core capital goods shipments actually declined modestly.