Orlando's Outlook: Round trip

06-09-2017

Bottom Line From tepid pre-election levels last summer and fall, several of the key economic metrics that we follow closely—such as inflation, employment, consumer confidence and manufacturing—have round-tripped, enjoying powerful post-election surges, only to see many of them come back down-to-earth over the past few months.

Benchmark 10-year Treasury yields, for example, soared from 1.75% just prior to the election to 2.63% in mid-March and back down to support at 2.15% earlier this week. This powerful flight-to-safety rally over the past three months reflects investor concerns about the surprise of the snap election in the U.K. that resulted in Prime Minister Theresa May’s party losing its parliamentary majority, former FBI director Jim Comey’s testimony in Congress, and the European Central Bank (ECB) meeting, along with next week’s Federal Reserve (Fed) policy-setting meeting, the weakness in wage and inflation data over the past few months, and a growing lack of confidence that any structural fiscal-policy reforms will happen either later this year or early next year.

Yet, the S&P 500 is up 17% from the U.S. election in November to record highs earlier this week, reflecting the best quarterly earnings in five years, a positive underlying fundamental trend that appears sustainable over the course of 2017. So what will it be? Is the bond market’s pessimism about slowing inflation and a lack of progress in Washington correct? Or is our optimism about Washington eventually getting its legislative act together prescient? We continue to believe that stocks will grind up toward our 2,500 year-end target.

Adjusting our GDP forecast The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met on Wednesday to discuss the recent reversal in several key economic data points, as well as the legislative chaos in Washington:

The Department of Commerce revised first-quarter GDP up from its disappointing flash of 0.7% to 1.2% due to better consumer, corporate and government spending. It will release the final first-quarter revision on June 29, and we expect that GDP could drift up toward 1.5%.

With the delayed tax refunds, winter storm Stella, and the late Easter/Passover calendar shift now behind us, we’re expecting an economic bounce. So we’re raising our estimate for second quarter GDP from 2.6% to 3%, while the Blue Chip consensus similarly raised its estimate from 2.7% to 3.1% (within a range of 2.4% to 3.7%).

We remain disappointed by the noise in Washington. President Trump has burned so much political capital in his first few months that it is impeding his ability to orchestrate much-needed fiscal-policy change, such as personal and corporate tax reform, health-care reform, repatriation, deregulation and more infrastructure and defense spending. As a result, our best-case scenario of Congress passing meaningful legislation before its summer recess in August now appears to be too optimistic. Consequently, we are ticking our 2.7% GDP estimate for the third quarter down to 2.6%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 1.9% to 3%).

We are already seeing in the labor market that legislative delay is creating an economic chilling effect among businesses and consumers, who could wait to change to their spending and investing plans until after the new tax laws have passed. So we are reducing our estimate for fourth quarter GDP from 2.8% to 2.6%, while the Blue Chip consensus has lowered its estimate from 2.4% to 2.3% (within a range of 1.8% to 2.9%).

Our full-year 2017 GDP estimate remains unchanged at 2.3%, while the Blue Chip consensus remains unchanged at 2.2% (within a range of 1.9% to 2.3%).

We remain optimistic that the Republicans in Congress—focused on their own political self-preservation—will eventually pass President Trump’s fiscal policies into law by early 2018, which should help to generate trend-line GDP growth of perhaps 3% or so longer term. But because of the slightly lower base in the second half of 2017, we are trimming our full-year 2018 GDP estimate down from 2.9% to 2.7%, while the Blue Chip consensus is keeping its 2.4% estimate for GDP growth in 2018 unchanged (within a range of 2% to 2.9%).

Federated’s macroeconomic policy committee also made the following investment observations:

Inflation moving in the wrong direction The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—has fallen from 1.8% on an annualized year-over-year (y/y) basis in each of the three months through February 2017, to 1.6% in March and 1.5% in April, well below the Fed’s 2% inflation target. Moreover, the trends on core readings for wholesale and retail inflation have been mixed. Core wholesale producer price inflation (PPI), which strips out food, energy and trade, spiked to 2.1% in April from 1.7% in March. The intermediate-term trend for PPI had been steady in the 1.6% to 1.8% range over the previous five months, so we need to gauge the sustainability of April’s elevated reading. But the core nominal retail consumer price index (CPI) inflation, which strips out just food and energy prices, slipped to a 1.9% increase in April, from 2.3% in January 2017, which had matched its highest reading in four years. Similarly, average hourly earnings growth has slowed from 2.9% (y/y) in December 2016 to 2.5% in both April and May.

Fed to hike next week Our base case remains that the Fed will hike interest rates three times over the course of 2017—March, June and perhaps September—with some initial balance-sheet shrinkage in December. With Chair Janet Yellen’s term set to expire at the end of January 2018, her legacy-management focus may include directing the Fed to start rolling off some maturing Treasuries—perhaps at an estimated pace of about $100 billion per quarter. This would start the shrinking process from a record $4.5 trillion in holdings at present, up from less than $1 trillion when the Great Recession hit in 2007. The longer-term goal might be to shrink the balance sheet to about $2.5 trillion over the next five years.

Treasury yields fall Benchmark 10-year Treasury yields plumbed technical support at 7-month lows of 2.15% earlier this week in a flight to safety, despite the Fed’s seeming indifference to slower inflation trends in its quest to systematically withdraw monetary policy accommodation. Near term, we expect that Treasuries could remain within a relatively tight 2% to 2.3% trading range. But over the course of 2017, 10’s could begin to rise back up to 2.60% to 2.65%, and eventually retrace the “Taper-Tantrum” peak from 2013 of 3%, perhaps by the end of 2018.

Strong quarterly earnings results Corporate profits in the first quarter of 2017 were the best in five years in the U.S., and the best in eight years in Europe. So after seven consecutive negative y/y quarters through the second quarter of 2016 (due to the collapse in energy prices), the earnings recession is officially over. Revenues and earnings per share in the first quarter of 2017 rose 8% and 15% y/y, respectively, with 76% of the companies beating by an average of about 5%. Profit margins rose by about 6% and share buybacks added about 2%. Energy, financials, materials and technology were the stars of the season, which helped to spark a 5% rally in stocks from oversold levels at Easter to record highs in early June.

Mixed picture for the labor market The official unemployment rate (U-3) ticked down to a 16-year low of 4.3% in May, while the labor impairment rate (U-6) fell to near-decade low of 8.4%. But both of these metrics declined for the wrong reasons, as nonfarm and private payrolls were much weaker than expected—with sizable downward revisions in March and April—while the household survey, retail, manufacturing and government hiring were all negative. Nonfarm payrolls added a disappointing 138,000 jobs in May and, combined with March’s weather-impaired final gain of only 50,000 jobs, the last three months averaged only 121,000—the slowest pace in five years—and nearly half the robust pace of 224,000 in January and February.

But continued strength in the ADP report and the initial weekly jobless claims, which are important leading indicators, suggests that May’s labor-market weakness is transitory. ADP added 253,000 jobs in May, which was much stronger than consensus expectations, and the continued healthy pace in hires by small and midsized firms suggests that the labor market and the U.S. economy remain in solid shape. New initial weekly unemployment claims in the survey week that ended May 13 hit 233,000, just above the 44-year cycle low of only 227,000 set in February. In addition, April’s Job Openings and Labor Turnover Summary (JOLTS) hit an all-time high of a larger-than-expected 6.044 million job openings.

Solid ‘Mapril’ April retail sales rose 0.4%, which was their best month-over-month (m/m) growth since January, although it was a smaller-than-expected rebound from softer March and February results. Those two prior months were both revised higher, however, as consumers recovered from the delayed tax refunds, Winter storm Stella and the late Easter and Passover holidays that plagued first-quarter results. Average total retail and food-service sales for the 2-month holiday period of March and April 2017 rose a healthy 4.6% y/y, the best “Mapril” in five years (since 2012’s robust 5.6% gain). This year’s increase was nearly double the 2.4% y/y gains in both 2016 and 2015, and roughly even with 2014’s 4.5% increase. What’s interesting is that retail sales for Christmas 2016 (the combined sales of November and December 2016 and January 2017, compared with the comparable year-ago period) also enjoyed a 5-year high, which suggests that the consumer has maintained a level of consistency. The personal savings rate rose to 5.3% in April from 4.5% in December 2016, so there should be plenty of dry powder to fuel a constructive Back-to-School season starting in July.

Consumer confidence has eased a bit since its post-election surge:

  • Leading Economic Indicator (LEI) rose 0.3% in April 2017 m/m to 126.9, which represents a 58-year cycle high.
  • Conference Board’s Consumer Confidence Index surged to a downwardly revised 16-year high of 124.9 in March 2017, up from a 3-month low of 100.8 in October 2016, but has since slipped to 117.9 in May.
  • Michigan Consumer Sentiment Index rose to a 12-year high of 98.5 in January 2017, up from a 2-year low of 87.2 in October, although it has since slipped to 97.1 in May.
  • The National Federation of Independent Business (NFIB) small-business optimism index soared to 105.9 in January 2017 (a 12-year high), up sharply from a cycle trough of 94.1 in September 2016, although it declined to 104.5 in April.

Autos rolling downhill Total auto sales slipped m/m in May 2017 to 16.58 million annualized units, down 1.4% from April’s 16.8 million unit level and 9.3% below December 2016’s 10-year cycle high of 18.3 million annualized units sold. Inventories are now sitting at an elevated 13-year high, the pace of auto sales is at a 2-year low, and the average loan term is now at an all-time high of 69.1 months. Concerned about slowing sales and a shift to driverless technology, auto companies are laying off workers to free up capital for more aggressive research and development. Ford recently announced reducing its white-collar work force 10%, or about 20,000 workers.

Housing plateau? Housing-market momentum may have peaked, despite relatively low mortgage rates, a good labor market and modestly rising wages, as pending sales have been negative in three of the past four months. New-home sales (a leading indicator) fell 11.4% in April 2017, at an annualized rate of 569,000 units sold, down from a 10-year cycle high of 642,000 units in March 2017. Existing home sales (a lagging indicator that accounts for about 90% of total home sales) fell m/m 2.3% in April 2017 to 5.57 million annualized units, down from March’s new 10-year high of 5.7 million.

Housing starts and permits (important leading indicators) both declined about 2.5% in April to 1.172 million and 1.229 million annualized units, respectively. The 9-year cycle high for starts of 1.34 million annualized units was set in October 2016 and the 11-year cycle peak for permits of 1.30 million units was set in in January 2017. The builder-confidence index, which had fallen to 68 in April after peaking at a 12-year cycle high of 71 in March, rebounded to 70 in May. Pricing has remained firm, as the lagging Case-Shiller pricing index (a rolling 3-month average) increased 5.89% y/y in March, 5.85% in February, 5.67% in January and 5.43% in December. Mortgage delinquencies declined to 4.71% in the first quarter of 2017 (after peaking at 10.06% in 2010), and foreclosures continued to grind lower to 1.39%, down from a cycle peak of 4.64% in 2010.

Inventory restocking slows Bloated inventory levels in 2015 and early 2016 contributed to slower GDP growth, as companies sharply reduced inventory accumulation from their cycle peak at the addition of $113.5 billion in the second quarter of 2015. But they actually cut inventory by $9.5 billion in the second quarter of 2016, which cleared the decks and allowed companies to begin rebuilding their inventories again, which they did by adding $7.1 billion in the third quarter of 2016 and $49.6 billion in last year’s fourth quarter. But inventory accumulation slowed to only $4.3 billion in the first quarter of 2017. Factory orders and wholesale inventories declined m/m in April, although industrial production and capacity utilization have strengthened over the past three months.

Manufacturing mixed The trade deficit rose 5.1% in April 2017 m/m to a 3-month high of $47.6 billion, and nominal and core durable goods orders declined in April, although core capital good shipments have risen in four of the past five months. The ISM manufacturing index, however, slipped to 54.9 in May 2017 from a reading of 57.7 in February, its highest since August 2014.

In addition, most manufacturing confidence metrics have retreated from their post-election spikes:

  • Empire regional manufacturing index rose from -5.5 in October 2016 to a 2-year high of 18.7 in February, but has since fallen to -1 in May.
  • Philadelphia regional manufacturing index spiked from -2.9 in July 2016 to a 33-year high of 43.3 in February, but it has declined to 38.8 in April.
  • Kansas City regional manufacturing index leapt from -5 in July 2016 to a six-year high of 20 in March, but has pulled back to 8 in May.
  • Richmond regional manufacturing index rose from -11 in August 2016 to a 13-year high of 22 in March, but plunged back to 1 in May.
  • Dallas regional manufacturing index improved from -4.8 in August 2016 to a 10-year high of 24.5 in February, although it declined to 17.2 in May.
  • Milwaukee’s Marquette ISM manufacturing survey rose from 47.46 in October 2016 to 61.77 in March, but it eased back to 57.22 in May.

The exception is the Chicago regional manufacturing index, which improved from 51.6 in August 2016 to a 2-year high of 59.4 in May.