Weekly Update: Jimmy, haven't you heard? Inflation is MIA

07-28-2017

I spent part of the week in Virginia, where the unprecedented reduction in the Fed’s balance sheet and what that might mean for bond yields was the only concern voiced (and several times) at an advisor meeting. A stand-pat Fed on Wednesday said it plans to start reducing its $4.5 trillion inventory “relatively soon,” leaving the door open for a likely September launch. The omission of an exact timeline for paring the balance sheet could be viewed as slightly dovish, with the Fed acknowledging recent inflation weakness has prices stabilizing below its 2% target. Central banks all over are keying off low inflation, which is spurring asset prices higher and interest-rate spreads narrower—Baa corporate spreads relative to Treasuries hit a new low this week. Even though inflation is MIA, a range of indicators suggests the global economy is improving and is much stronger than in 2015, making it unlikely that we’ll see another resurgence of deflation fears and rising correlations like we did back then. With 87% of the MSCI ACWI component markets above their 200-day moving averages, the global bull market appears well intact. In the U.S., the NYSE advance/decline line continues to make a series of confirming new highs.

The earnings season to date has been good. Thomson Reuters data show a blended (actuals and estimates) earnings growth rate of 9.1% year-over-year (y/y) so far, with three-quarters of reporting companies beating estimates. Sales growth excluding Energy and Financials is running at a steady 4-5% rate, more than double its pace for most of this cycle, even as capacity utilization and wage rates remain low by historical standards. This bodes well for operating margins. Yet sentiment indicators aren’t suggesting excessive bullishness or optimism, and investors continue to shift money out of stocks and into bonds—$31 billion from equity funds and ETFs and $36 billion into bond funds and ETFs over the past month alone. Hedge funds also have shifted to a defensive position. Ned Davis theorizes this is partly due to the extreme partisan conflict of the past nine years that has made crowd optimism and euphoria difficult. As frustrating as this may be, the historical record since 1984 has shown that the market has thrived under conflict and struggled under “harmony.” On the other hand, Oppenheimer thinks that any temporary weakness likely will be bought, being that it will occur against equity trends that are higher with relatively bullish support (a view we share at Federated).

We are entering a seasonally weak period, with most investors vacationing in August and September. Add to this a lack of catalysts prior to late September’s Fed meeting and October’s debt-ceiling showdown, and a pullback wouldn’t be all that surprising for several reasons. For the first time since 2008, 3- and 6-month Treasury yields have inverted, an historical signal for short-term sell-offs. Positioning for a potential pickup in volatility is non-existent—the most searched term on Google is, “Will XIV always go up?’’ (XIV is an inverse volatility ETF for the VIX). And valuations are bloated—2018’s earnings estimate for the S&P 500 has fallen by nearly $1.25, pushing the forward P/E multiple to just below March’s cyclical peak. Then you have a Fed talking normalization. Like the people I met in Virginia, many investors believe central bank stimulus has been the primary driver of global markets and worry what happens if it’s pared back too quickly. That’s why everyone is watching inflation. The ongoing shakeup in the retail industry is one reason wage growth is so meager—along with leisure/hospitality and education/health, the three fields that represent nearly 4 in 10 workers carry average weekly wages anywhere from 5% to 55% below the average aggregate private-sector weekly earnings. Growth in all three appears to be slowing, adding to downward pressure on wages and prices. Today’s Employment Cost Index report reflected this trend, as costs slowed in the second quarter to a 2.4% y/y rate. Business people around the world no doubt see that McDonald’s has won by cutting prices. Will Jimmy Choo take a lesson here? Probably not. Jimmy, haven’t your heard? Inflation is MIA. Come on, give a girl a break!

Positives

Consumer confidence jumps The Conference Board gauge rose in July for the first time in four months to its second highest level in almost 17 years. Its current level is historically consistent with above-trend growth, boding well for the pace of the expansion in the second half. The present situation had its best reading in 16 years and future expectations also were robust, aided by a jump in home-buying plans. Final Michigan sentiment for the month wasn’t as strong, rising slightly more than expected on strengthening in the current conditions components. Expectations weakened.

More signs of manufacturing pickup A near doubling in volatile aircraft orders drove June’s unexpected surge in durable goods orders, but the headline was better than the details. Core capital goods (nondefense ex-aircraft) actually slipped but, bolstered by a sizeable upward revision to May, rose a third straight quarter, a sign businesses are picking up the spending pace. Elsewhere, the Richmond and Kansas City Fed regional surveys, the Chicago Fed’s national index and Markit’s initial composite index for July all improved on accelerating manufacturing activity.

A weaker dollar’s upside June’s smaller-than-expected trade deficit was driven in part by exports, which rose on both improving overseas economies and a weaker dollar. The improvement should add a few ticks upon revision to Friday’s flash Q2 GDP, which came in as expected at a 2.6% annual growth rate. The weaker dollar also appears to be a factor this earnings season, as the top quintile of companies with the highest international revenue exposure have posted earnings growth that’s 300 basis points above the rest of the market.

Negatives

June home sales disappoint, although … Existing sales fell more than expected and new home sales rose by roughly half consensus, as tight inventories hurt activity and drove up prices. The lack of supply caused the median time new homes were on the market to fall to 3 months, matching the second shortest time on record. Upward sales trends remained positive, barely so for existing homes but very much so for new homes, with 6-month and 12-month averages at 10-year highs.

Recession watch The Philly Fed’s monthly survey of all 50 states found economic activity decelerated in eight and was unchanged in seven, causing Ned Davis’ measure of the breadth of the nation’s recovery to narrow to a 7-year low. The Philly Fed’s companion U.S. coincident measure also showed national activity moderating to a 2.8% y/y pace, well off 2015’s cycle high of 3.8%. Ned Davis said its proprietary model continues to reflect a low probability of recession anytime soon.

Business confidence slips The NEMA Electroindustry Business Conditions Index fell a fourth straight month in July to its lowest level since December, with future conditions dropping to a 10-month low. The cooling is in line with recent deterioration in other business sentiment indexes as it has become clear fiscal stimulus and other policy changes from the Trump administration may be delayed.

What else

Political watch The primary argument for completion of tax relief/tax reform is the GOP cannot possibly be so incompetent as to fail on both health care and taxes. While the premise makes sense, the execution increasingly is in question, Cowen & Co. says. To wit: President Trump is considering replacing Fed Chair Yellen with Gary Cohn, his National Economic Council chief, possibly as early as Thanksgiving. It takes a monumental amount of trust and coordination to get big legislation passed and near perfection to get tax reform done. Cohn is the tip of the spear on Trump’s tax plan; if he leaves the West Wing before it’s done, it’s highly unlikely tax reform gets done this year. It’s not clear how the market would react given that tax reform doesn’t appear to be priced in—not when the companies that would benefit the most are underperforming the S&P more than 600 basis points year-to-date.

Political watch The House is scheduled to leave town Friday for a 5-week break and the Senate will soon follow, leaving the heavy lifting on budget issues until post-Labor Day. There are two huge tasks—Congress has to pass a budget resolution, including crucial instructions on tax reform, and to raise the debt ceiling. Both issues are stalled. The upside for investors: rough policymaking periods historically have been buying opportunities.

Have you ever heard Trump say, ‘I’m sorry’ CNBC reports that certain words and phrases can make a leader look weak or ineffectual. These include saying sorry excessively and using the phrase, "I hope that's OK.”

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