Orlando's Outlook: Second wind?


Bottom Line We began to identify some patches of economic weakness in the second quarter, as autos and housing appeared to (at least) temporarily plateau in December and March, respectively, while many of the Fed’s regional indices began to slide from their cycle highs in February and March. But the economy appears to have caught a second wind in June, as several key economic metrics that we monitor closely have strengthened in recent weeks, including the labor market and the ISM manufacturing index. In addition, the Empire and Chicago regional Fed indices have rebounded to 3-year cycle highs, and the leading economic indicators (LEI) keep chugging along to a new 58-year high.

True, inflation is softer than the Fed would like, but Fed Chair Janet Yellen assured Congress in her semi-annual Humphrey-Hawkins testimony this week that she wouldn’t rush to tighten monetary policy if the data wasn’t there to support it. And while the ongoing, self-inflicted chaos in Washington has put a lid on hope that pro-growth structural fiscal policy reforms will be enacted soon, the second-quarter corporate-reporting season kicks off this week, and we’re expecting another solid period for revenue and earnings growth.

As a result, the S&P 500, which had consolidated its powerful 17% gains since the election by drifting down by some 2% over the past three weeks, appears to have caught a second wind itself and is pushing back up toward record highs. Meanwhile, benchmark 10-year Treasury yields have risen from support at 2.13% in mid-June back up to 2.39% last week, before rallying again in recent days. All in, we’re sticking to our guns that the S&P will grind up towards our 2,500 year-end target.

Tweaking our GDP forecast The fixed-income and equity investment professionals who comprise Federated’s macroeconomic policy committee met on Wednesday to discuss the improvement in several key economic data points, both here and abroad: 

  • The Commerce Department revised first-quarter GDP up from its disappointing flash of 0.7% to 1.2% to a final revision of 1.4%, close to our 1.5% forecast. 
  • The Commerce Department will flash its second-quarter GDP on Friday, July 28, along with benchmark revisions for the past several years. Due to the recent weakness in autos, housing and inventories, we’re ticking our estimate down to 2.9% from 3.0%, while the Blue Chip consensus lowered its estimate from 3.1% to 2.8% (within a range of 2.3% to 3.2%). The Bloomberg consensus is now at 2.5%, and the Atlanta Fed gutted its widely followed GDPNow forecast from 4.3% initially to 2.6%.
  • We remain frustrated by the chaos in Washington and its impact on Congress’ ability to pass meaningful legislation before its summer recess in August, which they’re now threatening to shorten or delay. So we’re ticking our 2.6% GDP estimate for the third quarter down to 2.5%, while the Blue Chip consensus is ticking their estimate up from 2.4% to 2.5% (within a range of 1.9% to 3.0%).
  • This ongoing delay in legislative progress is resulting in an economic chilling effect among businesses and consumers, who are pushing their hiring, spending and investing plans out until after the new tax laws have passed. So we are ticking our fourth quarter GDP estimate down from 2.6% to 2.5%, while the Blue Chip consensus remains unchanged at 2.3% (within a range of 1.8% to 2.8%).
  • 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 2.1% to 2.4%).
  • We continue to believe the Trump administration and the Republicans in Congress—either by positive legislative momentum or sheer desperation—eventually will pass much-needed fiscal policy reforms into law by early 2018, which should boost trend-line GDP growth to perhaps 3% or so longer term. Our full-year 2018 GDP estimate remains unchanged at 2.7%, while the Blue Chip consensus is unchanged at 2.4% (within a range of 2.0% to 2.8%).

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

Inflation drifting lower 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, 1.5% in April and 1.4% in May. Clearly, it’s moving in the wrong direction, in light of the Fed’s oft-stated 2.0% core inflation target. In fact, this was a key discussion point at this week’s two-day semiannual Humphrey-Hawkins testimony for Yellen before the House Financial Services committee on Wednesday and the Senate Banking committee today. 

Conventional inflation trends for core wholesale and retail inflation haven’t been any better. Core wholesale producer price inflation (PPI), which strips out food, energy and trade, spiked to 2.1% in April and May from 1.6% in January, but June slipped back to a 2.0% increase. Core nominal retail consumer price index (CPI) inflation, which strips out just food and energy prices, fell to a 1.7% increase in May from 2.3% in January 2017, which had matched its highest reading in four years. June’s report, due out tomorrow, is expected at the same 1.7% rate. Similarly, wage growth has slowed from 2.9% on y/y basis in December 2016 to 2.5% in June. 

Fed’s second-half plans With regard to the Fed’s monetary-policy plans in the second-half of 2017, our base case is that it will hike interest rates once more this year, perhaps in December, with some initial modest balance-sheet shrinkage starting in September. Waiting until December for the next rate hike provides the Fed with some additional time to see if sub-trend inflation begins to rise.  

With Chair Yellen’s term set to expire at the beginning of February 2018, her legacy-management focus may include starting to roll off some maturing Treasuries and mortgage-backed securities to start the shrinking process from a record $4.5 trillion 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 $2.5-3 trillion over the next five years or so. Yellen may use her upcoming keynote speech at the Fed’s annual monetary policy symposium in Jackson Hole, Wyo., in late August to provide investors with some details on her multiyear plan.

Treasuries volatile Benchmark 10-year Treasury yields declined from 2.63% in mid-March to 2.13% in June, appearing to hold critical long-term technical support at about the 2.15% level. From that trough, yields backed up to nearly 2.40% last week, but have since rallied to 2.35% currently. Over the second half of 2017, then, benchmark 10s could rise from 7-month lows at 2.15% in June up to about 2.65% later this year, and perhaps retrace the “Taper-Tantrum” peak from 2013 of about 3.00%, perhaps by the end of 2018.

German bunds are now yielding 58 basis points, having dropped as low as negative 15 basis points in September 2016, and are pushing their 18-month highs. Japanese JGB yields are now yielding an 18-month high of 8 basis points, having dropped to as low as negative 30 basis points in July 2016. These low foreign yields had exerted considerable downward pressure on U.S. yields, but that pressure appears to be dissipating as economic growth is perking up in both Europe and Japan.    

We’re expecting good second-quarter earnings The first quarter of 2017 enjoyed the best corporate-profit results in five years here in the U.S., with a 15% y/y increase, and Europe experienced its best quarter in seven years. Economically sensitive categories here, such as energy, financials, materials and technology, were the stars of the season.  Corporate results for the second quarter will kick off this week, and we’re expecting a similarly solid quarter. While FactSet expects 6-7% y/y earnings gains, we believe that a somewhat stronger quarter with perhaps 10-13% gains may be more likely.

The labor market strengthened in June Shrugging off a disappointing ADP report of only 158,000 jobs and elevated survey-week initial weekly jobless claims of 242,000, nonfarm payrolls rose a much stronger-than-expected 222,000, along with sharply positive revisions of 47,000 for April and May combined. Moreover, the household survey enjoyed a powerful bounce in June to 245,000 from a loss of 233,000 jobs in May, while hours worked at 34.5 and the participation rate at 62.8% both ticked up last month. 

So looking at the first six months of 2017, it’s now clear that March was an aberration, with a weather-impaired gain of only 50,000 jobs because of winter-storm Stella. But the other five months collectively produced average payroll growth of a solid 206,000 jobs per month, which suggests that employment trends remain healthy. The official rate of unemployment (U-3) ticked up in June to 4.4% from a 16-year low of 4.3% in May, while the labor impairment rate (U-6) rose to 8.6% in June from a near-decade low of 8.4% in May. In addition, JOLTS hit an all-time high of 5.967 million job openings in April, while May posted the best-ever ratio of voluntary quits to firings. 

Consumers pause Consumers clearly recovered from the delayed tax refunds, winter storm Stella and the late Easter and Passover holidays to enjoy the strongest March and April retail sales combined (“Mapril”) in five years. But retail sales in May surprisingly declined 0.3% on a month-over-month (m/m) basis, their largest drop since the start of 2016, and “control” results were flat. Although weak auto and retail gasoline sales aren’t helping, consumers hunkered down in May and perhaps June (also to be flashed today) to raise some dry powder ahead of the important “Back-to-School” season, which we believe will be solid starting in July. As a result of less spending relative to solid income gains over the first five months of 2017, the personal savings rate rose to a 2017 high of 5.5% in May, although that’s still below last August’s three-year high of 6.0%.

Confidence softer, but still solid:    

  • Leading Economic Indicator (LEI) rose by 0.3% in May 2017 on an m/m basis to 127.0, a new 58-year cycle high.     
  • Conference Board’s Consumer Confidence Index soared to a 16-year high of 124.9 in March 2017, up from a three-month low of 100.8 in October 2016, but has since eased to 118.9 in June. 
  • Michigan Consumer Sentiment Index spiked to a 12-year high of 98.5 in January 2017, up from a two-year low of 87.2 in October, but it has since slipped to 95.1 in June. 
  • The National Federation of Independent Business (NFIB) small-business optimism index roared 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 103.6 in June.

Inventory restocking slows sharply 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 has slowed sharply to only $2.6 billion in the first quarter of 2017, which contributed to the poor GDP growth.

Factory orders in April and May declined on an m/m basis, but wholesale inventories enjoyed their largest m/m increase in May in five months. Wholesale trade sales, however, suffered their worst monthly decline in nearly a year, business inventories suffered their first negative month in April in six months, and industrial production and capacity utilization both slowed in May after a strong prior three months.

Auto sales continue to slide They were down 1.2% on an m/m basis in June 2017 to 16.41 million annualized units, versus 16.58 million annualized units sold in May. Importantly, June is now 10.3% below December 2016’s 10-year cycle high of 18.29 million annualized units sold, which was the peak of the current cycle. Inventories are now sitting at an elevated 13-year high, while the pace of auto sales is at a 2-year low.   The average loan term is now at an all-time high of 69.1 months. A flood of vehicles leased in 2014 is hitting the used-car market now, potentially impacting the appetite for new-car sales. As a result, we’re expecting extended furloughs for auto workers to facilitate factory repairs and retooling this summer, to help shrink bloated inventories.   

Housing-market momentum plateaued in March and has begun to soften Despite relatively low mortgage rates, a good labor market and modestly rising wages, the housing market has slowed a bit. Pending home sales have now been negative for three consecutive months and in four of the past five. New-home sales (an important housing leading indicator, because they are calculated when a contract is signed, typically several months before closing) rose by 2.9% in May 2017, at an annualized run rate of 610,000 units sold, but that’s down 5.3% from a 10-year cycle high of 644,000 units in March 2017. Existing home sales (a lagging indicator calculated when a purchase contract actually closes) now account for 90% of total home sales. While they rose 11% on an m/m basis in May 2017 to 5.62 million annualized units, that’s down 1.4% from March’s new 10-year high of 5.70 million units.

Housing starts and permits (important leading indicators) have both slowed in recent months. Housing starts peaked at 1.34 million annualized units in October 2016, a 9-year cycle high, but they’re currently running at only 1.092 million, a nearly 19% decline.  Building permits peaked in January 2017 at 1.3 million annualized units, which was an 11-year cycle high, but they’ve since fallen 10% to 1.168 million. After peaking at a 12-year cycle high of 71 in March, the HMI builder-confidence index has fallen to 67 in June. Pricing has started to slip, too. A lagging indicator, the Case-Shiller pricing index (a rolling three-month average) rose 0.28% on an m/m basis in April, but that’s down from gains of 0.53% in March, 0.66% in February and 0.85% in January.

Manufacturing strengthens The ISM manufacturing index surged to a nearly 3-year high of 57.8 in June 2017, up sharply from a contraction reading of 49.4 in August 2016.  This sector accounts for about 12% of the economy, and the recently weaker dollar, shrinking trade deficit and stronger overseas demand have helped stabilize the manufacturing ISM at a healthy level. The trade deficit shrank 2.3% in May 2017 on an m/m basis to negative $46.5 billion, versus -$47.6 billion in April. Durable and cap goods orders and shipments, after a strong 4-month run through March, slipped in April and May, although we expect a rebound in June. In addition, two of the seven regional Fed indices that we monitor closely (Empire and Chicago) soared to 3-year cycle highs in June.