Weekly Update: Tough act to follow

04-28-2017

I hopped in my car this week to tool around Ohio (Cincinnati and Cleveland) and Pennsylvania (Warren and Erie). First stop, Cincinnati, where several large advisor meetings had us debating the prospect of wage inflation, which I maintained is largely missing outside of low-paying industries and those affected by immigrant visa troubles. Here are 2 headlines from that day: “U.S. holiday spots from Cape Cod to Aspen feel labor market squeeze due to visa cap” (Bloomberg); “In Vermont, a virtual-reality startup had to leave the state because it couldn't find workers” (Wall Street Journal). This morning’s Employment Cost Index suggested some wage pressures may be building (more below), although that has yet to translate over to hourly earnings or inflation. The story is somewhat similar in the hard vs. soft data—sentiment indicators among businesses and individuals remain very robust (more below), but the objective data such as today’s initial take on Q1 GDP and consumer spending (more below) aren’t yet reflecting that. It could be it’s just a matter of time—a view the markets seem to be taking. Stock prices jumped early this week and the Nasdaq hit a series of new highs even as Democrats hinted they would stall any proposed spending bill, a judge blocked part of Trump’s executive order on sanctuary city funding, Canada was hit with new tariffs on dairy and lumber trade, and the Turkish air force attacked in Iraq and Syria. This clearly suggests that, at this moment, good earnings, expectations for faster growth and tax-relief hopes are more important to the financial markets than domestic and international politics.

Earnings have been particularly strong, especially the top line. With nearly two-thirds of the S&P 500 market cap having reported, earnings-per-share (EPS) is on pace to rise 15.1% and sales beats are tracking at their highest level in 5 years. Credit Suisse says of S&P companies that changed guidance, 82% raised their outlooks, with management optimism during earnings calls at record levels and mentions of the word "better" relative to "worse" or "weaker" at levels last seen in late 2010. All of this has analysts raising full-year EPS forecasts, which is highly unusual during Q1. Analysts typically cut early and raise forecasts later, near year-end. Thomson Reuters says the expected earnings improvement has dropped the forward P/E to a very reasonable 17.4, close to its historical average. This is bullish, as is the improving technical backdrop—the NYSE cumulative advance/decline is at a confirming high while Dudack Research’s favorite volume/momentum indicator suggests little evidence of overbought conditions. This morning’s disappointing Q1 GDP already was baked into the market; the focus is on the subsequent quarters where trends look more favorable even without any Trump stimulus. The Philly Fed State Coincident Indexes, for example, show growth accelerating and broadening across states—activity increased in 45 in March at the fastest average pace in more than 5 years—and rising at a 2.9% year-over-year (y/y) rate for the U.S. overall. Regional Fed gauges (more below) also are signaling accelerating expansion.

Potential tax cuts could be icing on the cake. The correct way to think about the opening pitch—slashing the corporate tax rate to 15% and lowering and simplifying individual taxes from 7 to 3 brackets—is that Trump is laying down a marker much like President Bush did in 2003. Bush asked for a lot and ended up with a compromise of 15% dividend and capital gains tax rates—a big victory as it reversed the 25-year decline in dividend-paying companies. Those tax cuts boosted GDP from 2% to over 3%, an outcome Trump’s team also is seeking, causing tax revenues to come in above the Congressional Budget Office/Joint Committee on Taxation forecasts. If enough members of Congress see this may be the case with the new proposed tax changes, a hybrid plan that is mostly paid for but increases the deficit somewhat should gain steam on Capitol Hill, Ned Davis Research says. It estimates cutting the headline rate to 15% could boost after-tax S&P earnings nearly 14%. Back on the road, the concerns were more basic. At a lovely winery near Erie where I spoke, an advisor insisted “all his clients want is income!” Another investor took umbrage with my use of the word entitlement when referring to Social Security. This is not the first time I have been chastised that “it is my money, money that I paid into it.” Agreed! Let’s not argue semantics, and we went to get a glass of wine. I also learned a new word in Erie: “Muppers,’’ a yinzer way of saying, “I’m up here from Pittsburgh.” In Cleveland, as I waited my turn to speak to a large group of about 200 retirees, the musical entertainment was the Dean Martin and Frank Sinatra show. Pretty good. Several guests joked with me that I had a tough act to follow. What! After my talk a gentleman waited in line—he wanted to see my shoes—which he said were only surpassed by my speech. Tough act to follow, ha!

Positives

More signs of housing’s upward trend Residential investment jumped 14% in Q1, the second straight very strong quarter, and March new home sales surprised, rising at their second fastest pace since January 2008 to near a 9-year high on a 12-month average basis. Pending sales—a gauge of existing sales this month and next—pulled back after February’s surge but were still solid. Inventories remain tight, causing Case-Shiller home prices to hit a record high and the FHFA price index to rise the most in nearly a year—an issue in some markets where affordability is becoming problematic. The homeownership rate remains near a 50-year low, another sign of supply shortages.

Regional business sentiment solid Regional Fed surveys in Dallas, Kansas City and Richmond showed manufacturing moderating somewhat but still healthy after a post-election surge, while the Chicago survey that tends to foreshadow the broader ISM gauge that comes out Monday unexpectedly jumped. Services were more of a mixed bag in some of the reports, declining in Texas but jumping in Richmond by the most in nearly 4 years to a near a 2-year high. The readings were indicative of "normalizing" after a big Trump bump to sentiment.

All eyes on capex Despite so-so March durable goods orders, there were several signs of a pickup in capital expenditures (capex) in Q1, led by 3%+ y/y increases in core capital goods orders the past 2 months. Even though it slipped for the first time in 7 months, the monthly NEMA Electroindustry Business Conditions Index held close to its highest level in 12 years, implying a notable acceleration in capex growth in Q2 as respondents said they view the current business environment as broadly positive. And the Q1 GDP report showed nonresidential investment rising at a 9.4% rate, with both structures and equipment showing unusual strength.

Negatives

GDP continues its streak of futility While not unexpected, the initial print of Q1 GDP growth of 0.7%—the slowest in 3 years—marked the ninth out of the previous 10 quarters that GDP has come in below 2.7%. FBN Securities notes this subpar growth streak started with the end of quantitative easing and thinks that balance-sheet reduction, which the Fed says may start before year-end, represents the biggest secular risk for the market.

Consumers are happy; they just aren’t spending April’s Conference Board confidence index slipped but was still at its second-highest level since December 2000, as the post-election run-up in sentiment has been mostly sustained. The Michigan sentiment gauge followed a similar pattern. The current levels historically are consistent with above-trend growth, although we’ve yet to see a marked acceleration in consumer spending. Indeed, Q1 consumption rose at its slowest pace since 2009, according to the flash GDP report, while the March trade balance narrowed on broad-based weakness in imports, led by consumer goods.

It’s too early to worry about wage inflation The Employment Cost Index rose at 2.4% y/y in Q1, its second-strongest showing of this expansion. The surge was split nearly evenly between wages & salaries and benefits. This cost pressure has yet to appear in average hourly earnings or consumer prices.

What else

Political Watch A Pew Research Center poll found very little buyer's remorse among Trump voters—just 7% of Republicans and Republican-leaning independents say he’s performed worse than they expected. Fully 38%—5 times as many—say he has performed better. A new Washington Post-ABC News poll confirms this and actually shows more buyer's remorse for Trump's opponent in the 2016 election, Hillary Clinton. Were the 2016 election held again today, it shows Trump would avenge his popular-vote loss. While just 4% of Trump's supporters say they would back someone else if there was an election redo, 15% of Clinton supporters say they would ditch her.

Political Watch President Trump on Thursday reflected on his first 100 days in office with a wistful look at his life before the White House. "I loved my previous life. I had so many things going," Trump told Reuters in an interview. "This is more work than in my previous life. I thought it would be easier."  He misses driving, feels as if he is in a cocoon and is surprised how hard his new job is.

Millennials again! At every stop during my road trip this week, the subject of millennials came up. “Why won’t they invest?” “Will there be enough of them to pay taxes so the boomers can retire?” “Where will they all work if machines are taking over?” My favorite hotel chain, on a national basis, is moving away from plated room service to “high end boxed meals.” (??!) I asked the gentleman who brought my dinner if this was a cost-cutting move. “No,” I was told, “it is to satisfy the millennials.”