Orlando's Outlook: 100-day report card


Bottom Line Savvy traders who successfully employed a “Buy the Election, Sell the State of the Union” strategy pocketed a handsome 15% gain in the S&P 500 over four months, as markets enthusiastically embraced the reflation trade associated with the expected implementation of the Trump administration’s pro-growth fiscal policies. But the past seven weeks, Trump’s early stumbles over immigration, health-care reform and the border-adjustment tax (BAT) have caused investors to rethink their optimism. Equities have slogged through a dreary 3% decline, while the VIX spiked from 11 to 16, 10-year Treasury yields plunged from 2.65% to 2.16% and gold rose 8% to nearly $1,300 per troy ounce. Is this recent defensive rotation overdone in light of good first-quarter earnings, and recent positives such as Justice Neil Gorsuch’s confirmation to the Supreme Court, Trump’s China summit and the U.S. military action in Syria and Afghanistan? Or will markets continue to focus on the negatives, such as poor first-quarter GDP and the uncertainty surrounding the French and U.K. elections? With President Trump’s 100-day anniversary coming at month’s end, we believe investors have already fully priced in their pessimism. That should result in stocks rallying back to record highs from current oversold levels.

Tweaking our GDP forecast The fixed-income and equity investment professionals who comprise Federated’s macroeconomic policy committee met Wednesday to discuss the rampant Washington-related pessimism that has swept over investors in recent weeks:

  • Fourth-quarter GDP was recently revised up from 1.9% to a final gain of 2.1% (versus 3.5% in the third quarter), which leaves full-year 2016 GDP unchanged at 1.6%.
  • Retail and auto sales have slowed noticeably, so we are reducing our first-quarter GDP estimate from 1.9% to 1.5%, while the Blue Chip consensus has cut its estimate from 2.2% to 1.4% (within a range of 0.9% to 2.1%). The Bloomberg consensus is now at 1%, and the Atlanta Fed’s widely followed GDPNow model has gutted its estimate from 1.8% on March 1 to 0.5% today. The Department of Commerce will flash first-quarter GDP on April 28.
  • Some of the economic weakness in February and March may be related to delayed tax refunds, winter storm Stella and the late Easter calendar shift, which suggests we may see a second-quarter bounce. So we are raising our estimate for second-quarter GDP to 2.6% from 2.4%, while the Blue Chip consensus raised its estimate to 2.7% from 2.3% (within a range of 2.1% to 3.3%).
  • We’re certainly frustrated with the pace of fiscal-policy change in Washington. Our best-case scenario had been that Congress would approve “Trumponomics” before its summer recess in August—with elements of the proposal possibly retroactive to the beginning of calendar 2017—but that now appears to be too optimistic. As a result, we are trimming our 2.9% GDP estimate for the third quarter down to 2.7%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 1.9% to 2.9%).
  • That legislative delay may well create an economic chilling effect among businesses and consumers, who could wait to make changes to their spending and investing plans until after the new laws have been passed. So we are reducing our estimate for fourth-quarter GDP from 3% to 2.8%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 1.9% to 2.9%).
  • As a result of these tweaks, we’re trimming our full-year 2017 GDP estimate down a tick from 2.4% to 2.3%, while the Blue Chip consensus is ticking its 2.3% estimate down to 2.2% (within a range of 2% to 2.4%).
  • We still expect that Congress will eventually pass Trump’s fiscal policies into law by early 2018, such that trend-line GDP growth of perhaps 3% or so in 2018 and beyond is what the economic trajectory of successful implementation of Trumponomics looks like. But because of the slightly lower base in 2017, we are trimming our full-year 2018 GDP estimate down from 3% to 2.9%. The Blue Chip consensus is keeping its 2.4% estimate for GDP growth in 2018 unchanged (within a range of 2% to 2.9%). We remain high on the Street for 2018.

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

Best profit quarter in five years Corporate revenue and earnings reports for the just-completed first quarter have kicked off this week. It’s still early, as only 87 S&P  companies (representing 17% of the index and 23% of the market cap) have reported thus far, but we are expecting the best quarterly results overall since the fourth quarter of 2011. After seven consecutive negative year-over-year (y/y) quarters through the middle of last year, the earnings recession is officially over. We are now expecting our third consecutive positive quarter, in part because crude oil prices bottomed a year ago.

To date, revenues and earnings are up about 6% and 16% y/y, respectively, with 75% of the reporting companies beating on profits by an average of nearly 6%. While this robust 16% gain is unlikely to hold throughout the entire season, we believe a 10-15% profit gain is a reasonable expectation. Energy, financials, technology and materials should be the stars of the season, and strong first-quarter earnings could spark a rally in stocks from oversold levels.

Geopolitical risk in Europe has re-entered investors’ lexicon:

  • Netherlands’ election results last month with Geert Wilders’ (far right) defeat.
  • French election on Sunday, April 23, with the runoff May 7. The top four candidates are within a point of each other in the polls: Emmanuel Macron (center left); Francois Fillon (center right); Marine Le Pen (far right); and Jean-Luc Melenchon (far left). While we prefer a Macron win, victories by Le Pen or Melenchon would fan investor fears of “Frexit.”
  • Great Britain’s snap election on June 8, and the triggering of the 2-year Brexit negotiating window last month.
  • Germany’s election in October.
  • The potential for a snap election in Italy later this year.

Inflation slips The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—has been steady at 1.8% on an annualized y/y basis in four of the past five months through February 2017, but it remains below the Fed’s 2% inflation target. Conventional inflation trends, however, on core readings for the producer price inflation (PPI) index and the consumer price inflation (CPI) index declined in March 2017. Core y/y wholesale producer price index (PPI) inflation (which strips out food, energy and trade) slipped a tick to 1.7% in March from 1.8% in February, although the trend has remained steady in the 1.6% to 1.8% range over the past five months. But nominal retail CPI inflation surprisingly declined in March for the first time in a year (perhaps due to cellular/wireless-service contracts and lower gasoline prices), and the core y/y CPI (which strips out just food and energy prices) fell from 2.2% in February to 2% in March. That’s down from 2.3% in January 2017, which matched its highest reading in four years. That narrows the typical 0.5% spread between core CPI and core PCE to only 0.2%, which bears watching.

Treasury yields plunge Benchmark 10-year Treasury yields plunged from 2.63% in mid-March to 2.16% this week in a massive flight-to-safety trade related to disappointment over the expected pace, details and timing of implementing Trump’s fiscal-policy plans, as well as geopolitical risk concerns, such as the first round of French elections and this week’s call for a snap election in the U.K. Moreover, German bunds are now yielding 19 basis points, having dropped to a low of -19 basis points last year. Japanese JGB yields are essentially flat, having dropped to as low as -30 basis points last year. These low yields have exerted downward pressure on U.S. yields. Amid this heightened uncertainty, we expect Treasuries could stay anchored within a relatively tight 2% to 2.30% range near term before revisiting 2013’s “Taper Tantrum” peak of perhaps 2.75% to 3% toward year-end.

Fed on less-accommodative path We still expect the Federal Reserve to hike rates three times over the course of 2017—with the remaining two perhaps coming in June and September—as well as some shrinking of the balance sheet starting in the fourth quarter. With Chair Janet Yellen’s term set to expire at the end of January 2018, the Fed may start to allow some maturing mortgage-backed securities (MBS) and Treasuries to roll off, which will start the shrinking process from a record $4.5 trillion at present (up from nearly $900 billon when the Great Recession hit in 2007).

Jobs report whiffs in March Weather played a significant role in March’s much weaker-than-expected payroll report, as nonfarm payrolls rose by only 98,000, roughly half what was expected, with downward revisions totaling 38,000 jobs in January and February. The combination of warmer-than-normal weather during the first two months of the year, and winter storm Stella (which dumped up to two feet of snow in parts of the Mid-Atlantic, Northeast and Midwestern states during the March survey week) may well have collectively reduced March’s job count by an estimated 100,000.

For the week that ended Feb. 25, initial weekly jobless claims (a leading economic and employment indicator) hit a 44-year low of only 227,000. But during the survey week that ended March 18, claims were elevated at 261,000. With Stella now behind us, new jobless claims for the week ended April 8 fell back down to only 234,000, a 5-week low. Other parts of the March labor report also were strong. The ADP report on private hiring (a gain of 263,000 jobs) was the best in more than two years, and the household survey in March surged by 472,000 jobs. Moreover, the unemployment rate (U-3) and underemployment rate (U-6) fell to 10-year lows of 4.5% and 8.9%, respectively. The labor market is healthy and growing strongly, and April results should enjoy a powerful snap back, with the potential for upside revisions in March.

Consumer confidence remains strong Since the election, confidence has surged:

  • Leading Economic Indicator (LEI) rose 0.4% in March 2017 on a month-over-month (m/m) basis to 126.7, which represents an all-time cycle high (dating back 58 years), besting the previous cycle peak of 125.9 in March 2006.
  • Conference Board’s Consumer Confidence Index soared to a 16-year high of 125.6 in March 2017, up from a 3-month low of 100.8 in October 2016.
  • 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. April’s preliminary reading is 98.0.
  • 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. It has since slipped to 104.7 in March.
  • NAHB’s housing market builder-confidence index (HMI) leapt to a near 12-year high of 71 in March, up sharply from 59 in August, although it slipped to 68 in April, perhaps due to Washington-related uncertainty.

Retail sales winter slump After enjoying their best Christmas in five years, consumers shut their pocketbooks in the ensuing winter months. Nominal retail sales declined on a m/m basis in both March and February, with sluggish auto, gasoline and building materials sales. But the calendar shift of a late Easter this year (April 16), delayed tax refunds and winter storm Stella (March 14) also may have contributed to a poor March, pushing spring sales into April, which we believe will be relatively robust. Importantly, the control results for March, which strip out autos, gas, building materials and food service, were better than expected with a solid 0.5% gain in March versus a -0.2% decline in February.

Autos stall Total auto sales fell on a m/m basis in March 2017 to 16.5 million annualized units, down 5.4% from February’s 17.5 million unit level and nearly 10% below December 2016’s 10-year cycle high of 18.3 million cars sold, which now appears to be the peak of the current cycle. A very promotional December, with a large volume of subprime auto loans, likely pulled some first-quarter sales into year-end 2016. Winter storm Stella in mid-March likely hurt last month’s sales, too. So inventories are now sitting at an 8-year high, and the pace of auto sales at a 2-year low.

Inventory restocking cycle has resumed Bloated inventory levels in 2015, which peaked at the addition of $113.5 billion in the second quarter of 2015, contributed to slower GDP growth the last two years, as companies sharply reduced their pace of inventory accumulation. But they actually cut inventory by $9.5 billion in the second quarter of 2016, which marked the trough of the cycle, and started to add to it by $7.1 billion in the third quarter of 2016 and $49.6 billion in last year’s fourth quarter. Now that inventories have finally been right-sized, we appear to be in the early stages of an inventory rebuilding cycle in 2017, which would boost GDP growth. To that point, factory orders have recovered strongly over the past three months through February, wholesale inventories have now been positive three of the past four months and business inventories rose in each of the past four months.

Spring housing season should be strong Due to low mortgage rates, a solid labor market, rising wages and increased household formations, we expect housing to reverse its seasonal winter softness this spring. New-home sales (an important housing leading indicator) rose 6.1% in February 2017, at an annualized run rate of 592,000 units sold, a seven-month high. Existing home sales (which now account for about 90% of total home sales) rose on a m/m basis 4.4% in March 2017 to a stronger-than-expected 5.71 million annualized units, a new 10-year cycle high.

Pricing has been accelerating, as the lagging Case-Shiller pricing index increased 5.7% y/y in January versus 5.5% in December, 5.1% in November and 4.9% in October of 2016. Housing starts (an important housing leading indicator) declined 6.8% in March 2017 to 1.215 million annualized units, perhaps due to Stella, down from a new 9-year cycle high of 1.34 million annualized units in October 2016. But building permits (also a leading indicator) rose 3.6% m/m to 1.26 million annualized units in March 2017, down from 1.293 million annualized units in January, a new 11-year cycle high.

Manufacturing confidence peaking? Since the election, most manufacturing confidence metrics have soared, but they may be peaking:

  • ISM manufacturing index slipped to 57.2 in March 2017 from a reading of 57.7 in February, its highest since August 2014. After falling into contraction territory for the first time in six months at 49.4 in August 2016, the ISM manufacturing index has bounced back into growth territory (above 50) in each of the past seven months.
  • Empire regional manufacturing index rose from -5.5 in October 2016 to a 2-year high of 18.7 in February. But it has since slipped to 5.2 in April.
  • Philadelphia regional manufacturing index spiked from -2.9 in July 2016 to a 33-year high of 43.3 in February, but it fell to 22 in April.
  • Kansas City regional manufacturing index leapt from -5 in July 2016 to a 6-year high of 20 in March.
  • Richmond regional manufacturing index rose from -11 in August 2016 to a 13-year high of 22 in March.
  • Dallas regional manufacturing index improved from -4.8 in August 2016 to a 10-year high of 24.5 in February, although March fell to 16.9.
  • Chicago regional manufacturing index improved from 51.6 in August 2016 to a 2-year high of 57.7 in March.
  • Milwaukee Purchasers Manufacturing Index was temporarily suspended in April 2016, but the Marquette ISM manufacturing survey returned an initial reading of 47.46 in October 2016, which has subsequently soared to 61.77 in March 2017.

The trade deficit fell 9.6% in February 2017 on a m/m basis to a 4-month low of -$43.6 billion, and core capital good shipments have risen in three of the past four months, both of which will help to stabilize first-quarter GDP.