Weekly Update: Who's your guru?

07-14-2017

This week I headed out West for travel in and around Seattle. The weather was perfect, the streets were crowded and we were greeted by some “cranky’’ pedestrian fingers as we raced to find parking and make a meeting. On the elevator ride to the 49th floor of a center city skyscraper, the alarm sounded for an evacuation—no issue, not on our floor. But our floor’s number did come up during our meeting, where the loud speaker suggested that I make my way to the steps in these heels! I will talk as loud as I have too to spread the good word. Advisor discussions centered on confusion as to where we are in the market cycle, where to invest if everything looks expensive and whether a significant sell-off is imminent. We all agreed a pullback stemming from D.C./Russia headlines would be a great buying opportunity. Of course, if everyone agrees, a pullback if it comes likely will be shallow, quick or both. There is another type of correction, though; a correction in time. Dudack Research notes sector rotation is a classic characteristic of a trading-range market, and we have been in a trading range since early June’s first test of 2,450 on the S&P 500. It continues to find resistance at that level, getting within a fraction this week on Fed Chair Yellen’s dovish Humphrey-Hawkins testimony. Yellen made clear the Fed expects to tighten very slowly given stubbornly low inflation and suggested rates don’t need to rise much further to reach a neutral policy stance. She mentioned low inflation numerous times, insisting that it is “temporary.”

Until recently, inflation was concentrated in shelter and medical expenses. However, shelter, by far the largest component of CPI, has rolled over. But even core prices ex-shelter are decelerating on plunging wireless prices and substantial moderation in medical services and education prices. Wage pressures remain non-existent. Average hourly earnings rose at a below-consensus 2.5% rate in June, well under a normal 4% rate for this stage of a cycle, and May’s increase was revised down to 2.4%. In Seattle, where they are phasing in a minimum-wage increase to $15 an hour, a study found that the second phase taking the minimum from $11 to $13 an hour resulted in a 9% reduction in working hours, causing some lower-wage workers to see their monthly income drop by $125. Indeed, even though the jobless rate is 30 basis points below the historical non-accelerating inflation rate of unemployment, there’s little sign wage inflation is about to take off. This undercuts arguably the biggest threat to the market since the financial crisis—a wage spike that could force faster policy normalization. Although the Fed has lifted its target range four times already, it’s still a very low 1-1.25%, and the real funds rate is still below zero. The target rate would need to rise another 200 to 300 basis points just to be in the ballpark with tightening that ended past expansions. Yellen’s comments indicate that won’t happen on her watch. Similarly, the modest plan the Fed laid out with specificity for when it starts to pare its balance sheet suggests that liquidity is not at risk—not with money supply relative to GDP 10 percentage points higher than at any time in 60 years!

With the market well supported by earnings and fundamentals, equity valuations should be strong enough to withstand rising rates for quite a while. The S&P’s dividend yield of 1.9% and trailing operating earnings yield of 5.1% provide a combined expected return of 7%, very favorable relative to current respective yields just north of 1% and 2.30-2.40% on 3-month and 10-year Treasuries. As the Q2 reporting season kicks off, industry analysts are expecting a fourth-straight quarter of higher earnings per-share. Forward S&P earnings hit record highs last week. But, at a 17.4 forward P/E, the market is not cheap relative to the 13-year high of 17.8 in early March, the 15-month low of 14.9 in January 2016 and the post-Lehman-meltdown low of 9.3 in October 2008. But it remains well below July 1999’s record high of 25.7 and margins have improved over 60 basis points since late 2016. Most of that comes from energy, but ex-energy margins remain in a 3.5-year trading range, near record highs. Significantly higher margins from here would require a major event, like a tax cut. But with recession odds low, crippling margin compression does not appear to be a near-term risk. My last meeting was a client event at a charming winery in a Seattle suburb. The amiable crowd had lots of fascinating questions, some of which tested my diplomacy. “What will the market reaction be if that president of ours starts a ‘fantastic war?’ ” Whoa! She turned heads with that one. Then, an unprecedented question. “What market gurus do you listen to?” Excuse me, I’m the guru!

Positives

More signs of labor strength The number of hires in May rose the most in seven years to their second-highest level since 2006, while the voluntary quit rate jumped to its second-highest level since 2001, the latest JOLTS report shows. The Conference Board’s Employment Trends Index slipped for the first time in 10 months but remained at levels that suggest strong job growth and accelerating wages in coming months, with July hiring rates projected to rise for both manufacturing and services.

More signs of manufacturing pickup Industrial production rose an above-consensus 0.4% in June, and May also was revised up a tick. Mining led the gains, but manufacturing also rose on increased vehicle and technology equipment activity. Separately, business inventories reversed April’s decline and rose in May, a sign of rising business confidence.

Recession watch The Fed’s Beige Book reported activity expanded across all districts in June and that a majority of districts remain positive about the outlook, with most experiencing higher consumer spending despite pockets of weakness in auto sales. Most districts also reported expanding mid-to-late June manufacturing activity. Globally, the OECD’s composite leading indicators pointed to stable though somewhat softer growth momentum.

Negatives

Inflation watch June capped one of CPI’s weakest 4-month stretches in 60 years, as core prices rose only 0.1% a third straight month after declining 0.1% in March. This left the year-over-year (y/y) core rate at 1.7%. Headline CPI was even worse, up 1.6% y/y following no change in June. On the producer side, y/y core PPI moderated again while a separate gauge of pipeline pressures was flat on a headline basis and up slightly on a core basis, continuing recent deceleration. The reports only served to reinforce the market’s lower-for-longer Fed view.

Consumers won’t help Q2 GDP Retail sales have been weak but the market wasn’t expecting June’s actual across-the-board declines, as the headline, sales-ex autos, sales ex-autos & gas and control group sales (sales ex- autos, food services, building materials and gas stations that are feed directly into the GDP report) all fell. A lone bright spot: sales at non-store retailers rose 0.4%, reflecting e-commerce’s ascending importance.

Small business, consumer moods dim While still holding on to most of its post-election surge, the NFIB’s optimism index slipped for the fourth time in five months in June on concerns fading prospects for swift fiscal stimulus and deregulation. However, plans for productivity-enhancing capital spending rose to a 10-year high. Michigan’s first read on July consumer sentiment also fell back to its lowest level since November on softening expectations.

What else

It’s no wonder everyone is looking for a correction The 255 days since the 5% post-Brexit correction is the longest stretch without such a pullback in over 20 years. And it’s not just in the U.S. A notable feature of the world economy now is the dearth of major shocks; an absence of sectoral booms and bust; a lack of volatility regarding interest rates, exchange rates, and commodity and equity prices. One expected major catalyst that has not emerged, Credit Suisse observes: U.S. fiscal stimulus, which remains a positive but diminishing, possibility.

They say Trump is not a quitter but … There’s a growing buzz in the lobbying community about Mike Pence's prodigious fundraising and schmoozing with top officials from the financial, defense and manufacturing sectors. He’s raising money for his own political action committee—an unprecedented development for a vice president this early in his tenure. IESB says sources believe he’s concerned Donald Trump will be so battered by the Russian scandal that he won't run in 2020. There's a growing realization in Washington that a scandal that now involves Trump's inner circle won't go away and may even intensify. Pence is very popular among congressional Republicans and would be among the front-runners in an extremely crowded field if Trump does not run.

Hey, I’m a lady and a fine tipper A survey of more than 1,000 American adults by Princeton Survey Research Associates International finds men, Republicans and Northeasterners are the best tippers, leaving a median 20%. That compared with a median 16% for women and 15% for Democrats and Southerners. Those who pay with credit left more—a median 20% vs. 15% for those who pay in cash. And while roughly half of people tip between 16-20%, a fifth of those polled admitted to occasionally stiffing the wait staff.