Weekly Update: Fantastic tax cuts would be so much fun!

03-24-2017

“The correction is happening now!” says the media. In fact, most of the “news” this week was devoted to analyses of Tuesday’s sell-off and the “end of the Trump trade’’ amid drama over repeal-and-replace. An up-and-down vote scheduled for this afternoon was postponed as House leaders realized they didn't have the votes. For his part, President Trump signaled he's ready to move on to other issues that he and the market really care about. The post-election rally never was about the Affordable Care Act or just tax reform. It has been about the potential for one of the most pro-business administrations in history. Regardless of health-care’s fate, a cut in the corporate tax rate is still likely, and that’s likely to boost earnings significantly when it happens. Meanwhile, deregulation may have a more immediate positive effect on earnings—and animal spirits. Evercore ISI estimates the average level of optimism, i.e., animal spirits for consumers, homebuilders, small businesses and CEOs, to be near a record high. On Capitol Hill, our sources think Senate Majority Leader Mitch McConnell and House Speaker Paul Ryan are eager to move on, as well, with a deal that combines tax reform for corporations with tax relief for individuals. Cowen & Co. says it would be paid for and compliant with the Senate reconciliation rules, specifically the Byrd Rule that states anything passed in reconciliation must be deficit-neutral (offset/paid for) or the underlying legislation sunsets after 10 years. Given how the calendar has been so delayed, this would likely be seen as a significant win and quite strong finish to 2017, with most of the pro-growth components and structural, permanent reform of the corporate tax code in place ... and a fiscal cliff 10 years down the road for someone else to deal with.

What is truly important for the market is earnings. Thomson Reuter/IBES says the final tally on Q4 2016 should show year-over-year (y/y) S&P 500 earnings up 7.8%. Just as important, ex-energy earnings growth is forecast to reach 7.9%, which means the energy sector no longer is projected to be a drag. Despite recent weakness (more below), crude oil is up 19% y/y, a big positive for energy earnings in this year’s first quarter. Q1 to date has seen 78 negative earnings-per-share (EPS) preannouncements vs. 28 that were positive, Bank of America says. It puts the negative/positive (N/P) ratio at 2.8, well below where it was at this same point in time a year ago and in line with the long-term N/P ratio of 2.7. Q4 2016 also saw sales rise 4% y/y, the most since 2014, on broad-based improvement (only 1 of 11 sectors—telecom—reported negative growth). Encouragingly, quarterly y/y capital expenditures (capex) returned to positive territory and ex-energy grew at the highest rate since early 2012. Furthermore, earnings quality continues to improve. While corporations' official outlooks were nothing to write home about, commentary on earnings calls was notably optimistic. A count of mentions of the word "better" vs. "worse" or "weaker" was its highest in 7 years, and the word "optimistic" was used on a record 52% of calls, the highest since Bank of America began collecting such data in 2003. Optimism could translate into further positive revisions.

This week’s early sell-off and a nearly 3% pullback overall since the S&P hit a record high of 2,401 in intraday trading on March 1 isn’t really surprise—and in many ways, is welcome. Until Tuesday, the S&P had gone 109 days without a 1% decline, a day short of the 110-day streak in 1995. There have only been 8 instances of a longer run, with the record being 184 days set all the way back in 1963. This made Tuesday stand out, but it really was no big deal. Nothing really happened to trigger it. If the market’s rally since early last year was driven by lots of bad things not happening, maybe the sell-off was nothing more than profit-taking. ISI says the technical backdrop for risk-taking remains in an outstanding position, with post-Fed meeting price action reinforcing the idea that we remain in the sweet spot of a positive macro feedback loop within which stocks can flourish and weakness in yields, the dollar and oil no longer should be viewed as destabilizing. Moreover, several indicators suggest bulls are growing increasingly nervous. The combination of a strong market and cautious sentiment make chances of a double-digit correction over the next month low, says Ned Davis Research. Trump on Tuesday night expressed hope ahead of Thursday’s expected vote, but notably said he was looking forward to cutting taxes. “We’re doing well … I think we’re going to have some great surprises. I hope that it’s going to all work out. Then we immediately start on the tax cuts, and they’re going to be really fantastic, and I am looking forward to that one. That one’s going to be fun.”

Positives

The U.S. spring housing market is the hottest it's been in a decade That’s according to CNBC, with Realtors reporting strong traffic despite rising mortgage rates. Insufficient housing stock relative to demand appears to be the main deterrent, as rising rates seem to be encouraging fence-sitters to act before rates rise further. This was evident in February new home sales, which jumped again to a 7-month high. Existing sales slipped for the second time in 3 months, in part on the aforementioned supply issue, but both the 6-month and 12-month average sales rates rose again to their highest levels since at least September 2007—a sign of a sustained upward trend.

Where are we in the economic cycle? The Cass Freight shipments and expenditures indexes rebounded strongly in February to levels above a year ago, indicating positive momentum in freight activity and overall economic growth. On a 3-month basis, the Chicago Fed’s national activity index rose to a level historically consistent with above-trend growth, while the Kansas City Fed’s PMI joined other regional gauges of manufacturing activity at multiyear highs, jumping 6 points in March. This morning’s durable goods report for February was mixed, with new orders jumping well above expectations but ex-transportation, coming in slightly below. However, core capital goods shipments, which factor into GDP and are a key indicator for capex, rose 1%, more than offsetting January’s dip. And unfilled core capex orders rose a third straight month.

Where are we in the economic cycle? A rash of indicators point to accelerating global growth. These include the OECD leading indicator for member and nonmember countries, up a 10th straight month with the share of individual countries in expansion the highest since July 2011; the global manufacturing PMI, at its best level since May 2011 with new orders at a 3-year high on the fastest growth in export orders in nearly 6 years; and multiyear highs in the current conditions component of the Sentix Global Economic Conditions Index and Citigroup’s Economic Surprise Indexes for developed and emerging markets.

Negatives

Where are we in the economic cycle? One outlier to the week’s relatively positive economic news was Markit’s flash reading of March activity. While still firmly positive, the composite index and both the services and manufacturing components came in below expectations at 6-month lows, reflecting one confounding issue—the continuing gap between so-called “soft’’ data, i.e., leading indicators, surveys, etc., and “hard’’ data, actual measurements of current activity. The latter has the Atlanta Fed forecasting just 1% real growth in Q1, well below consensus.

Oil Watch The last time oil prices were at these levels, in late October, the markets were doubting OPEC’s conviction to the Algiers agreement cutting and capping production. A garbled message at a recent meeting of industry leaders once again has led to a loss of confidence in OPEC and the Saudi commitment to the deal, spawning a liquidation of longs and an even bigger growth in short positions. Oil prices are in sensitive technical territory with plenty of positioning risk to retest sub-$45 levels. However, markets outside of energy don’t seem to care, seasonality remains strong and for now the current decline continues to look a lot like the previous 2, both of which ultimately resolved themselves at higher levels.

Infrastructure funding gap In its quadrennial report card on the nation’s infrastructure, the American Society of Civil Engineers (ASCE) gave the U.S. a cumulative grade of D+, unchanged from 2013, which means infrastructure remains in “poor to fair condition and mostly below standard, with many elements approaching the end of their service life.” It estimates infrastructure spending needs to increase by $3.32 trillion over the next decade to address deficiencies. Of this, $1.88 trillion is currently funded, leaving a $1.44 trillion funding gap. Without fixes, ASCE estimates the infrastructure gap will cause significant losses to the national economy over the next decade, including over $7 trillion in business sales, nearly $4 trillion in GDP and 2.5 million jobs.

What else

What goes around, comes around Thanks to Harry Reid, who in 2013 triggered the so-called nuclear option eliminating filibusters on nominees, Trump should have the ability to remake the Judiciary in his own image. The same goes for the Federal Reserve. Why? He only needs to reach 51-vote thresholds to appoint what could be as many as 1/2 of all the appellate seats in the country, Cowen & Co. says. There currently are 124 federal judgeships to fill, including 19 on federal appellate courts. But due largely to the age of many federal judges, the White House expects as many as 100 other appellate vacancies will emerge over the next 4 years.

So long, NIRP? When the rest of the world was in a race to depreciate their currency the fastest, the negative interest-rate policies (NIRP) had some affect. But the Institutional Strategist notes that with China and the U.S. both raising rates and the European Central Bank beginning to signal it’s ready to take baby steps away from extraordinary stimulus, bubbles are going to begin to pop. The first to go may very well be the NIRP holdouts.

Retirement savings funding gap The proportion of workers who say they will need $1 million or more to retire has risen to 37%, compared with 19% a decade ago, according to the latest Retirement Confidence Survey from the Employee Benefit Research Institute. However, only a fifth of workers say they have saved at least $250,000.