Weekly Update: 'Whatever it takes' equals bullish for stocks

09-08-2017

Winter is here (if you are a Game of Thrones fan, you will understand). Last week it was Hurricane Harvey—the costliest ever. This week, it’s Irma—one of the most powerful storms in a century—and the massive Equifax data breach—perhaps the biggest ever. This morning it was the earthquake in Mexico—the biggest in a century. All summer, it’s been North Korea, with another potential missile test coming this weekend. And yet, the major equity indexes are just off record highs even as the 10-year Treasury yield flirts with 2%. Having rallied 10 months without a 3% sell-off—the third-longest such stretch since WW II—the S&P 500 is long overdue. Historically it has seen sharp, short-lived declines—a median of 5.7%, Deutsche Bank says—around domestic and global geopolitical events before recovering quickly and rising significantly three to 12 months out. The magnitude of the decline and speed of the subsequent recovery generally has depended on the economic backdrop, which currently is fairly favorable. Growth appears to be accelerating in the U.S. and overseas. Credit conditions remain solid, with central banks here and abroad hesitant about removing stimulus in anything other than a very gradual fashion—odds of a December Fed hike have declined by half over the past 10 weeks to just over 30%. And earnings have just come off their best first half in six years with positive forward revisions continuing to outpace negative changes.

Because of all of the disasters, the data is about to get very messy. We’ve already seen this in jobless claims, which spiked this week to a 2½-year high. Car sales (below), oil rig activity and various measures of sentiment are sure to follow. While Evercore ISI believes the U.S. economy is in an accelerating trend of 3% real GDP growth—which some economists expect to perk up further as rebuilding gets underway—it’s likely to suffer some short-term pain and lack of clarity while the storm-related one-offs wend their way through the economy. That this comes in a seasonally weak period could add to the possibility of market retrenchment in coming weeks, even though breadth appears to be improving and most broad indexes remain solidly above long-term uptrend lines, having recently tested their 50-day and 100-day moving averages. Investor complacency could be a near-term headwind. The Conference Board asks consumers about their expectations for a drop in stock prices and currently those expectations are quite low. Peaks in consumer confidence, which has surged this year, often have coincided with past peaks in the stock market. People speak about rebuilding after hurricanes and the unknowable binary outcome of North Korea and just see stocks as being better than other assets so they keep buying. Through July, investors were overweight stocks and had a record low allocation to cash, according to a Ned Davis review of $19.1 trillion of stock, bond and cash mutual fund and ETF assets.

This week’s surprise early resignation of Fed Vice Chair Stan Fischer gives President Trump a wide-open field to reshape Fed policy. Four of seven Fed governorships are open and given her Jackson Hole speech, Chair Yellen pretty much signaled she doesn’t expect to be reappointed. The Institutional Strategist (TIS) expects Trump’s new cast of Fed characters will make low interest rates, a weaker dollar and financial deregulation priorities. The stock market and the dollar mean far more to the U.S. economy, with the dollar appearing to be in the early stages of a bear market that could run 7-8 years. This would be very good for exports and work much quicker than trade deals, which take too long and are too cumbersome to make happen before the 2018 midterm elections. It is difficult to see how the Fed starts moving on a balance-sheet unwind now given the damage that already has happened and seems imminent because of the hurricanes. Projected losses to Harvey and Irma already exceed $260 billion, more than half of the combined costs of all hurricanes over the past 50 years, including Katrina ($133 billion), Sandy ($75 billion) and Andrew ($46 billion). What we do know, TIS says, is reconstruction costs will be large, opening the federal checkbook (bullish for stocks). What politician is going to vote against aid for hurricane victims? So the federal budget deficit blowout is just getting underway. Florida Gov. Rick Scott spoke to this point yesterday morning. “I have told our people not to worry about the costs, save lives. So we will, whatever it takes.”

Positives

More signs of stronger growth The ISM nonmanufacturing index rebounded in August on broad-based improvement, consistent with other data indicative of strengthening services consumption. Markit’s final take on services for the month also was strong, with new orders and employment components at 2-year highs. Elsewhere, the Fed’s Beige Book reported expanding activity across districts in mid-summer; the Conference Board’s Employment Trends Index rose at its fastest year-over-year (y/y) since April 2015, implying a near-term pickup in GDP; and July’s pace of export growth accelerated, suggesting trade may be additive to Q3 GDP.

Capex on the rise Ex-transportation, durable goods orders rose in July and, more importantly, nondefense capital goods orders ex-aircraft—core business orders, a proxy for capital expenditures (capex)—increased the most in six months. On a smoothed y/y basis, factory orders are climbing at their fastest pace since March 2012, while the capex orders trend is up 5.2% y/y, the most since June 2012.

Productivity improves The second read of Q2 productivity growth was revised to a significantly higher 1.5% annualized rate as nonfarm business output expanded 4%—a clear improvement from the very slow growth throughout late 2015 and 2016. Still, trend productivity growth remains subdued by historical standards.

Negatives

Harvey adds to auto slowdown Light vehicle sales fell a sixth time in eight months in August, dropping the annual sales rate to a 3½-year low. The decline was exacerbated by Hurricane Harvey’s floods. But even accounting for its impact, the sales rate missed expectations handily, causing the longer-term trend to continue to weaken as sales slid at their fastest pace in seven years on a y/y basis. That said, analysts expect sales to experience a bump in coming months as consumers rush to replace flood-damaged vehicles.

Consumers are spending but …. Consumption accounted for 69.1% of Q2 GDP, one of the highest levels in history. That’s good for the economy but it’s coming as consumers dip into savings and take on debt to pay for it, a worrisome if unsustainable scenario. Consumer credit now stands at a record high, and a recent Harris Poll on behalf of CareerBuilder found “78% of U.S. workers live paycheck to paycheck,” reflecting the low savings rate.

Businesses are watching Washington Investors may have low expectations of Washington, but businessmen and entrepreneurs have remained hopeful since the election. While this week’s debt-ceiling deal kicked the can, key issues including a 2018 fiscal budget and tax reform need to be addressed and the deficit hawks who just got rolled by President Trump may be in no mood to cooperate. Six more months of political wrangling without anything to show would provide little incentive for businesses to boost capex or take other steps to grow their enterprises.

What else

What will Apple do? Next week is its big product launch week, an event where the iPhone forever changed the phone industry. The iPhone officially started as a Steve Jobs-approved project around the end of 2004, but without previous successes like iMac, iPod and iTunes, it would not have happened, 13D Research says. Small teams of dedicated engineers and designers within Apple collaborated and competed over several years in tight secrecy to design, test and build the key features of the iPhone. A team working on a still-experimental hybrid of multi-touch technology and Mac software beat out another team simply focused on an iPod phone.

The elements for a perfect storm Scientists say the clear rise in global air temperatures over the past 140 years—2016 was the warmest in recorded history—has added rocket fuel to the boiling waters that cook up hurricanes in the Atlantic, Caribbean and the Gulf of Mexico, causing an increase in storms with winds in excess of 150 mph and with astonishingly low barometric pressure. IESB says Harvey and Irma already are having dramatic impacts on government policies in ways we could not have foreseen a month ago as recovery, rebuilding and workforce needs trump worries about immigration, budget deficits and debt ceilings.

Don’t get caught up in headline risk An average of more than 10,000 bills and resolutions have been introduced each congressional session over the past 30 years, with roughly only 4% being enacted into law, Cowen & Co. says. This speaks to the panic button investors hit after a particularly onerous piece of legislation is introduced that could negatively affect their sector coverage. Take a deep breath—they rarely become law.

Connect with Linda Duessel on LinkedIn