Weekly Update: Drastic conditions call for drastic measures

06-09-2017

I took a few “staycation” days this week, which in my condition ended up being quite expensive. However, I did speak at Pittsburgh’s fabulous historic train-station-turned-restaurant before a group of fiduciaries. They voiced many concerns about the market, ranging from proper asset allocation to geopolitical risk. The U.K. election may have added to those concerns, as it didn’t go as Prime Minister Theresa May had hoped. Her Tory party secured 316 parliament seats, down 12 and short of the 326 required for an outright majority (i.e., the U.K. now has a “hung Parliament”). The election outcome creates more uncertainty for the British government and Brexit process, but non-U.K. equities really don’t “care” about what happened yesterday. At my Pittsburgh meeting, I described my view that risks, of course, always abound, but we can only get our arms around what we know. What do we know? As of Thursday’s market close, the S&P 500 is up 8.69% year-to-date, but the trailing operating P/E is up only 57 basis points. S&P year-over-year (y/y) sales growth has climbed to 3.7%, its highest level since March 2013. Much of the rebound has come from a less negative contribution from the energy sector. But ex-energy, sales are up 4.5% versus a year ago, the fastest pace since October 2013. Furthermore, there are few indications that the earnings rebound to date is of the low quality that has preceded previous major tops. However, without economic acceleration, the earnings rebound may disappear in late 2017 and 2018, bringing multiples to the forefront again.

What is most notable about the S&P’s rise is the index’s resiliency in light of the twin headwinds from Treasuries and crude oil. Payrolls drove 10-year Treasury yields to their 200-day moving average and the lowest close for 2017. Over the last 50 years, the 10-year yield has been a decent predictor of forward GDP, so lower Treasury yields and oil prices must be a sign that the economy is about to rollover. Or are they? Trend and credit are among the most supportive factors of the current market (the trend model is outright bullish, while Baa spreads versus Treasuries and BBB versus BB spreads are contracting). The four criteria needed to make the bond bear case simply haven’t been fulfilled: yields haven’t risen, inflation risks have receded (except for the unemployment gap), supply hasn’t meaningfully increased and demand for bonds hasn’t weakened. For a time, after the presidential election through the end of 2016, investors sold bond funds and ETFs. But they have returned with a vengeance this year, especially in the taxable space. The curve is collapsing across the board and yields are approaching important support levels established last year. For now, the weight of the evidence supports the equity bulls. 

Still, the overall consumer credit cycle is turning down Millennials are a big part of this, as they struggle with student debt. Student loans currently account for more than 10% of all U.S. household debt, more than triple the 3.3% share of 2003, according to data from the New York Fed. Moreover, a nationwide survey of 24,000 renters by apartmentlist.com found that while 80% of Millennials would like to buy a home, 68% have less than $1,000 saved and 44% have saved nothing at all. The y/y growth in existing single-family home sales has contracted from 15.7% last November to 1.6% in April, while growth in building permits for new single-family homes—a forward-looking proxy for housing starts—has fallen from over 13% in February to 6.9% in April. These anomalies point to a stark new reality: the environment for new housing is going through a paradigm shift that is turning the country into a nation of renters, which could weigh down future economic growth and the value of the dollar. At my Pittsburgh meeting, my host shared his biggest worry: that “President Trump gets nothing done.” Indeed, for the first time since the U.S. election, economists surveyed by the Wall Street Journal are concerned that the economy could wind up doing worse than expected. The day-long Comey testimony in Washington has been described as a “circus.” Even as some in the media called the proceedings “devastating,” among other superlatives, the market was trading to another all-time high. Neither the House nor the Senate is remotely closer to ousting Trump, based on what transpired yesterday. Assuming Trump can refrain from outrageous tweets, he even has a chance to solidify his support within the GOP. Most Republicans will stick with him, because they don't dare to repudiate the Trump base. So back in Pittsburgh, on my stay-at-home days off, I wandered in an auto dealership and left with a “sporty” vehicle. It’s a “sporty” car (two doors, four seats…but it’s tight back there!), not a “sports” car, because the latter would be the behavior of someone suffering a mid-life crisis, which I clearly am not. Cruising around in my black and red beauty, I am staving off that crisis. Nice giddy-up.

Positives

Ongoing earnings recovery Looking at global markets, today’s P/E decline can be best explained not by a falling P, but a rising E, as earnings breadth has continued to improve. In addition, today’s market breadth is decisively bullish. And globally, the pace of economic improvement has slowed, but 88% of the indices are above 50 while 84% have positive year-to-year momentum. An ongoing earnings recovery will not only keep valuations in check, but allow them to improve, as the E rises faster than the record-setting P.

Factory orders trend strong While factory orders modestly declined 0.2% in April, down for the first time in five months, they matched consensus. But March numbers were revised up to 1% from 0.2% and y/y factory orders were up 6%, the most since September 2014, led by non-durables (largely reflecting the rebound in oil prices). Durable goods orders were up a smaller 4.2% y/y, indicating a modest pickup in factory activity. Nondurable goods orders also rose 0.4%, led by apparel and food products.

Jobs outlook promising The Employment Trends Index (ETI) rose 0.7% in May, and was up 6.4% y/y, the most since January 2015, as labor market trends continued to improve, despite a relatively soft May employment report. Seven of the eight ETI components made positive contributions, led by fewer workers saying "jobs hard to get." Based on this report, the Conference Board expects "solid job growth over the summer" that is "fast enough to continue tightening the labor market." The ETI trend also suggests a pickup in real GDP growth in Q2 and early Q3.

Negatives

Non-manufacturing pullbacks In May, three of the four components in the Institute of Supply Management (ISM) Non-Manufacturing Index declined, led by a 5.5-point slide in new orders, the most in nine months. Among other indicators, export orders plunged 11.0 points, the most since November 2008, to 54.5, a 4-month low, indicating notably weaker demand from abroad. The Prices Index plunged 8.4 points, the most since September 2009, to 49.2, indicating a return to falling input prices for the first time after 13 consecutive months of increasing. Still, the employment index shot up a record-matching 6.4 points to 57.8, its highest reading since July 2015.

Too slow in Europe? On Thursday, the ECB changed its forward guidance, but only to a modest degree, suggesting that the monetary policy outlook remains dovish. Inflation surveys and expectations, suggest that while deflation fears appear to be long gone, any major upside seems unlikely in the near term. Why has inflation, chiefly the core rate, remained stubbornly low? One big reason is that despite a decline in the unemployment rate, wages continue to grow at a slow pace. In fact, average hourly earnings, up 1.6% y/y, are growing at only half the 3% annual pace of 2000 to 2007.

Too fast for Asia? Unanswered questions about U.S. fiscal stimulus and China's rapidly expanding borrowing are putting the future of Asia's economy in doubt, according to the International Monetary Fund. If the Federal Reserve raises interest rates faster than markets expect, the value of the dollar and the debt burden of Asian economies with much dollar-denominated debt could increase, says IMF Deputy Managing Director Mitsuhiro Furusawa.

What else

U.S. political watch The Gallup Poll on Presidential Approval showed 41% approval for Trump as of May 26. While this may be good fodder for discussion on political opinion TV shows, the markets shrug it off. When looking at historical results since 1959, presidential disapproval has not hurt stocks unless the reading falls to 35% or below.

U.K. political watch Political commentators are unanimous in calling the U.K. vote a giant setback for May, who called the election from a position of great political strength but saw a 20-point-type margin fade over the course of a campaign that May hoped would give her a Brexit mandate but ended up marred by errors and dominated more by domestic and security issues. The U.K. likely faces a prolonged period of uncertainty that may only be resolved by another election, as May could face a leadership challenge. A weaker U.K. government—whether led by May or far-left Labour leader Jeremy Corbyn—may struggle to conduct and conclude Brexit negotiations on which the clock is already running.

A meticulous old lady was driving my trade-in There’s a strong market for used cars. The Manheim Used Vehicle Value Index surged 2.6% in May, the most since October 2010, reaching a record high of 127.9. On a y/y basis, prices rose 2.8 percent, the fastest since October 2015. This suggests that inventories are well-managed and demand is solid for now. Still, wholesale prices will likely come under downward pressure, especially since the new vehicle inventory-to-sales ratio is currently near its highest level since the last recession. (Hey, I’ve done my part!)