Orlando's Outlook: Negative momentum in Washington


Bottom Line In the immediate aftermath of President Trump’s well-received State of the Union speech in Washington on Feb. 28, the month of March roared in like a bull the very next day, with stocks spiking to record highs. But over the past three weeks, a wave of bearish pessimism has swept over Wall Street as concerns have risen about choppy legislative efforts to repeal the Affordable Care Act (ACA) and replace it with the American Health Care Act (AHCA). Investors muse that if Congress—and a seemingly fractured Republican majority—is unable to fix health care now, then perhaps Judge Neil Gorsuch won’t make it onto the Supreme Court and maybe the key economic pillars of “Trumponomics,” such as tax reform, deregulation and repatriation, won’t pass muster.

As a result, the S&P 500 has slipped nearly 3% over the past three weeks, the small-cap Russell 2000 has fallen almost 6%, crude oil has corrected more than 13%, the dollar has lost about 3% of its value to the euro and benchmark 10-year Treasury yields have dropped from 2.63% to 2.37% in a sharp flight-to-safety rally just over the past 10 days.

Frankly, it would not have been our first choice to do health-care reform, which we view as much more contentious, before tax reform, which has broad bipartisan support. The reason is that it could drain Trump of much-needed political capital at a point in time when he should be building positive momentum to pass the rest of his fiscal-policy agenda. Instead, investors fear that a health-care failure now could spark a negative domino effect that knocks down “Trumponomics.”

While our contrarian view is that the ACA repeal and replace will eventually succeed, this very public display is precisely the sort of unappetizing legislative sausage-making that we feared. Investors are fixated on Trump, House Speaker Paul Ryan and other Republican moderates in Congress as they engage in a ferocious tug-of-war with the far-right Freedom Caucus. Across the aisle, meanwhile, instead of working to help strike a more productive compromise between fiscal prudence and social responsibility, Democrats are threatening filibusters. Our tax dollars at work.

We prefer to take a few steps back from this legislative scrum and look at the economic forest rather than the congressional trees. To that point, the economy is a lot firmer today than prior to the election. Witness the improvement we have seen recently in manufacturing. We expect that pace to accelerate, eventually resulting in stronger corporate-earnings growth and higher share prices.

Inventory cycle back on a restocking upswing From bloated inventory additions of $112.8 billion and $113.5 billion in the first and second quarters of 2015, respectively, businesses gutted their pace of inventory accumulation over the next year to an actual reduction of $9.5 billion in the second quarter of 2016. That represents the trough of the current cycle. That sharp inventory reduction coincided with several quarters of decidedly below-trend-line GDP growth: notably muted gains of only 0.9% in the fourth quarter of 2015, 0.8% in the first quarter of 2016 and 1.4% in the second quarter of 2016. But with inventory levels liquidated and right-sized, companies began to restock, by $7.1 billion in the third quarter of 2016 and by a post-election surge of $46.2 billion in the fourth quarter. So it appears we are in the early stages of an inventory rebuilding cycle in 2017, which the recovery in energy prices should help to sustain. Trump’s structural fiscal-policy reforms, if enacted, should facilitate more potent economic growth and increased manufacturing activity.

ISM manufacturing index rebounds The manufacturing ISM index had fallen into contraction territory for the first time in six months at 49.4 in August 2016, a 6-year low, suggesting that the manufacturing economy was downshifting toward recession. But it rebounded strongly back into growth mode (above 50) in each of the past six months, with a 3-year high of 57.7 in February 2017. Since the election, manufacturers have begun to anticipate the implementation of more business-friendly government policies that should boost economic activity.

Manufacturing hiring soars This sharp rebound in the ISM manufacturing index coincided with a surge in nonfarm payroll hiring in this sector. Manufacturing added 28,000 jobs in February 2017 (a 3-year high), after adding 11,000 new jobs in January and 18,000 in December 2016. This sector has been recovering steadily from negative levels over the previous six months: manufactured had lost 17,000 jobs in August 2016, 12,000 in September and 5,000 in October, and it was unchanged in November. In the ADP private payroll survey, factories added 32,000 workers in February 2017, the most in nearly five years.

Manufacturing confidence strong Since the election, all of the Federal Reserve’s regional manufacturing indices that we monitor closely have soared:

  • Empire rose from a -5.5 in October 2016 to a 2-year high of 18.7 in February 2017.
  • Philadelphia spiked from -2.9 in July 2016 to a 33-year high of 43.3 in February 2017.
  • Kansas City leapt from -5 in July 2016 to a 6-year high of 14 in February 2017.
  • Richmond increased from -11 in August 2016 to a 7-year high of 17 in February 2017.
  • Dallas jumped from -4.8 in August 2016 to a 10-year high of 24.5 in February 2017.
  • Chicago improved from 51.6 in August 2016 to a 2-year high at 57.4 in February 2017.

Durables and capital goods strengthen The Department of Commerce reported this morning that durable and capital goods orders and shipments enjoyed a strong February, as civilian aircraft orders surged for the second consecutive month. Digging into the weeds:

  • Nominal durable goods (items meant to last at least three years) orders rose a stronger-than-expected 1.7% on a month-over-month basis in February 2017, after an upwardly revised gain of 2.3% in January.
  • Core durable goods orders ex-transports rose 0.4% in February versus a 0.2% gain in January and a stronger 0.9% increase in December 2016, marking the sixth consecutive month of gains for this metric.
  • Capital goods orders nondefense ex-air slipped -0.1% in February, after an upwardly revised 0.1% gain in January and stronger gains of 0.8% in December 2016 and 1.7% in November.
  • Capital goods shipments nondefense ex-air (which feeds directly into the quarterly GDP report) soared a much stronger-than-expected 1% in February, after declining -0.3% in January 2017. But it rose 1.7% in December and 0.7% in November. This metric has now risen in five of the past seven months, with an annualized growth rate of 8.8% over the past quarter.

Economic chilling effect? So the manufacturing sector appears to be making a positive contribution to GDP growth in the first quarter of 2017 to date, a trend which we believe could accelerate over the balance of 2017 and into 2018, as Trump’s structural fiscal-policy reforms are passed into law.

But therein lies a concern. Businesses and investors universally recognize that lower tax rates, deregulation, repatriation, the immediate expensing of capital investments and more infrastructure and defense spending will boost both manufacturing activity and the broader economy. But if there’s some question as to the timing of when—or perhaps even if—Congress approves Trump’s economic proposals, then businesses may hold back until they’re confident about it. Financial markets hate uncertainty, of course, so continued congressional intransigence could introduce some unwanted volatility near term.