Weekly Update: Like watching paint dry

06-15-2017

I had a break from the road this week, which gave me an opportunity to witness pandemonium in the streets of Pittsburgh as we celebrated our back-to-back Stanley Cup Champion Penguins with a midweek ticker-tape parade. Just like last year’s parade, it was very hot! (I wonder if it will be hot again next year?) It was a brief diversion from much of the week’s unpleasant national news, which investors can’t seem to tune out. It’s as though there’s been more attention paid to Washington than fundamentals. Both the ISM manufacturing and nonmanufacturing indexes, which tend to be leading indicators of growth, have strengthened on a 12-month average basis, indicating a firming trend. Similarly, businesses remain upbeat about the economic outlook, with the CEO Confidence Index rising in the first quarter to its highest level since the second quarter of 2004. Also, the NFIB Small Business Optimism Index was unchanged in May, following a record surge after the election, and is now near its highest level since 2004. And the current level of the Conference Board’s Consumer Confidence Index is historically consistent with above-trend economic expansion. As the last of corporate earnings reports trickle in, Thomson Reuters estimates the S&P 500’s first-quarter earnings results should be 15.4% above EPS seen a year earlier, which would be the best quarterly performance since the third quarter of 2011. And in a reversal to the pattern seen for many quarters, S&P’s earnings estimates have been rising. Consensus estimates are calling for S&P operating EPS growth to accelerate to 26% in the fourth quarter. The positive trend has not only kept the S&P above its 200-day moving average, but the 200-day itself has continued to rise. Most topping processes include failed rallies, during which upside momentum is lost, eventually leading to a declining 200-day. But if there is one message from the first half of 2017, it’s don’t fight the tape!

It’s remarkable how strong stocks have been in light of the Treasury rally. Yields on 10-year Treasuries have declined alongside inflation expectations, pushing their spread versus 2-year notes to the smallest since September. Additional rate hikes this year would likely push the yield curve even lower. While recession probability models based solely on the slope of the yield curve point to higher recession risk, the Fed’s policy stance and a measure of the corporate-bond risk premium currently suggest the odds of a recession over the next 12 months are less than 10%. This compares favorably to the 14% of the time the U.S. has been in a recession since 1970. Moreover, there is little or no evidence that traditional cyclical sectors—namely housing, capital expenditure and consumer durables more broadly—are overextended. While the 10-year is doing its best to hold 2.15% support, the yield curve has given back all of its post-election gains. What does the bond market know?

A resolute Fed. Amid this equity and bond tug-of-war, the Fed raised rates and broadly reaffirmed its expectations for ongoing hikes, while also unveiling its balance sheet roll-off plan, despite the third successive weak inflation print. The core personal consumer expenditures (PCE) price index of 1.7% is significantly below the Fed’s stated target of 2%. The Federal Open Market Committee (FOMC) statement noted that inflation has “declined recently” and tweaked the second paragraph to underline that it is “monitoring inflation developments closely.” But it reaffirmed it continues to expect that, with gradual policy adjustments, inflation will stabilize around 2% in the medium term. The dots were unchanged for 2017 and 2018, and point to one more rate hike this year. By announcing the balance-sheet plan now, the Fed makes it clear it wants the option to begin roll-off as early as September. Still, Chair Janet Yellen insists that the unwind will be like “watching paint dry.” The Fed meeting supplied the final significant item of interest on the schedule for the next few months. We may be in store for an incredibly boring summer. Back on the road next week, I will be listening for whether investors remain as certain about rising inflation and a Fed racing to get ahead of the curve as they have been for the last two-and-a-half years. Or will they come to agree with my assessment that looking for inflation is (also) like watching paint dry?

Positives

Consumer confidence steps back, but still robust. The University of Michigan consumer sentiment index fell almost three points to 94.5 in the preliminary June estimate. The drop was broadly based with the current conditions index and the future expectations index both declining compared to the previous month. Generally, consumer sentiment surged in the months immediately following 2016’s presidential elections, but has come off those highs. Although the June report suggests softening in consumer enthusiasm, continued sentiment around current levels should be supportive of consumer spending in the coming months.

Manufacturing surveys point to expansion. The Empire State manufacturing index surged 20.8 points in June to 19.8 after declining in each of the last three months, and it is now firmly in expansionary territory. Key underlying components generally firmed, with meaningful improvement in the new orders and shipments, though the employment component edged lower. Elsewhere, the Philly Fed manufacturing index declined 11.2 points to 27.6, but the pullback was smaller than consensus expectations, and most key components showed more stability than the headline index.

Soft producer, consumer and import price measures. The Producer Price Index (PPI) was unchanged in May, in line with consensus expectations, as a sharp month-to-month (m/m) rise in the volatile trade services category (1.1%) was offset by softer underlying inflation measures and a drop in energy (-3%) and food (-0.2%) prices. The Consumer Price Index (CPI) slipped 0.1% in May, marking its second decline in the past three months and third consecutive soft print. Energy prices fell 2.7%, down in three of the past four months, led by gasoline. Other notable price declines were seen for new and used vehicles, as well as apparel. Import prices also were weak, falling 0.3% m/m in May, below consensus expectations (-0.1%). Continued softening in prices has the potential to delay additional rate hikes.

Negatives

Dark clouds looming over housing? The NAHB housing market index of homebuilder sentiment fell to 67 in June, coming in lower than consensus expectations. The fall was broad-based across sub-components. The index for buyers’ traffic fell below the 50-mark for the first time in three months, to 49. The expectations for future sales also declined, while the present family sales index inched lower to 73 (previously 75). Additionally, housing starts fell 5.5% m/m in May, against expectations of a solid rebound. Starts have fallen for three consecutive months now, and the trend has weakened steadily since December 2016, particularly for multifamily units.

So much for the ‘Trump bump’? The OECD Composite Leading Indicator (CLI) edged down less than 0.1 point in April to 99.7. Although the index has improved since mid-2016, it has been below 100 for 21 straight months, as economic activity remains short of its historical trend. At 0.9%, the annualized 6-month rate of change of the CLI was the weakest since last November, showing that the initial swell in the outlook following the 2016 election has nearly evaporated. The momentum, nonetheless, is consistent with trend-like economic expansion in the near term.

Industrial production down. Total industrial production was unchanged in May as utilities output rose 0.4% and mining production gained 1.6%. A weather-related surge in utilities output and a continued recovery in mining activity (which includes oil and gas) has masked a soft picture for manufacturing over the last three months. Within manufacturing, where activity in May is slightly below February’s level, the strongest gains have been seen in computers and other high-tech output, while production of consumer goods has outpaced business equipment over the last three months.

What else

Political watch Circa News called 10 prosecutors after former FBI Director James Comey’s testimony and asked them if they saw grounds for obstruction of justice charges. All 10 said no, there was no way that would happen based on what Comey said. If 10 professional lawyers agree on anything, it must be right.

More political watch A fit and trim 70-year-old Mitt Romney hosted his annual gathering of supporters and party leaders last weekend in Deer Valley, Utah—doing nothing to discourage speculation that he's mulling a return to politics. If Utah Sen. Orrin Hatch, 83, decides not to seek re-election to the Senate next year, Romney would be the logical replacement and the near-certain winner, instantly making him a counter-weight to President Trump. If Congress leaves town in early August with no significant accomplishments—and with Trump unable to curb his tweets, needlessly picking fights—the markets may have to conclude, as Mitt Romney undoubtedly has, that Trump is incapable of governing.

Global rates not moving Eight years into the economic recovery, short-term interest rates remain close to their 2009 levels! In fact, 2-year yields in the eurozone and Japan are even lower than in 2009, and their aggregate balance sheets are roughly $4 trillion greater. What makes it all the more remarkable is that economic conditions are much better than they were in 2009.