Weekly Update: Blinded by the light

10-13-2017

I started my week in Denver, where I saw my first snow of the season. Three inches, but it was no match for the blinding sunshine that dried it up in the street in no time. At a client event in beautiful Boulder, the feisty group had very (!) many concerns, to include quantitative tapering’s likely effect on the bond market, how to find “safe” income, “defense spending is a waste of money,” China’s bubble in web-based stocks, “what else can we worry about besides Fed tightening” and “what are your views on ETFs (Oh, I have views!)" Just as I witnessed last week in California, the most relaxed attendees were longtime owners of FANG stocks (Facebook, Amazon, Netflix & Google). It was a fun 2-hour meeting, though it was exhausting—I blame my (too) high-heeled, though fabulous (everyone agreed!) shoes. 

Everyone is focused on S&P 500 forward earnings in the $138-143 range for 2018, with potential tax reform adding $5 to $15 more. But what jumps out to Yardeni Research are sales. They’re projected to rise 5% after climbing an estimated 5.8% this year, and to remain strong and broad-based. There isn’t much sign of worrisome investor euphoria—the latest weekly AAII sentiment poll found investors neutral—the technicals are continuing to favor stocks. Dudack Research’s proprietary volume oscillator has been signaling overbought conditions for more than a week, a bullish sign as it is viewed as confirming the new highs. The credit backdrop also is supportive, with the spread between high-yield and investment-grade bond yields hitting a fresh low this week. Strategas Research notes more than 35% of the S&P is up 20%+ this year, so it’s not just the FANGs. Investors looking for reasons to be cautious may want to consider that S&P earnings estimates assume operating margins will continue to expand from current record levels. In addition, the standard deviation on daily S&P returns is lower than in all but two years of its 90-year history—1964 and 1965, the two years before the 17-year secular bull peaked in 1966. And margin debt is at a record $551 billion, almost double what it was at the 2000 bubble peak. On the other hand, this year’s March-April 2.8% setback was the second-smallest intra-year drawdown on record, undercut only by 1995’s 2.5% dip—a 1-week, December affair that marred a near linear annual gain of 34.1% in a year of minimal volatility (sound familiar?), marking the beginning of a spectacular 5-year bull run. Globally, equity markets have regained momentum and altitude, with nearly a third of MSCI World Index stocks and close to two-thirds of market total return indexes at or within 5% of record highs.


What could go wrong? Tax reform. A 9-page blueprint is a far cry from actual changes in the 70K-page tax code. The last good-faith effort on tax reform was House Ways and Means Chairman Dave Camp's 2014 draft, which included a 200-page summary. Tax reform is as much a math exercise as a political exercise, Cowen & Co. says, and last month’s vague guideline left all the detail, math and specifics to Congress. The so-called Big Six group of lawmakers working on a plan literally stopped short of simple arithmetic not because they do not know how to add, but because the political pain is in subtraction. Further sowing the seeds of doubt for tax cuts are recent polls. Pew Research said about half of Americans believe taxes should be raised a lot or a little on large businesses and corporations; only a quarter said they should be lowered. And a new Politico-Harvard poll found only 1 in 5 adults agree lowering taxes should be a major focus this fall. Even among GOP voters, tax-reform support was muted. Far more were interested in continuing the battle to repeal Obamacare. On that front, President Trump this week took more action aimed at undermining the Affordable Care Act exchanges, but at a cost of further souring relations between Republicans and Democrats and reducing odds of a bipartisan compromise…. Last week’s missive “Greed” got some feedback. An advisor in New Jersey surveys his clients and unlike the totally bullish seniors I met in California, they remain cautious. “No one is bullish,” he reports. My Phoenix advisor friend, who has correctly been “crazy bullish,” writes: “Not you but most every speaker that comes to our office focuses on the impending correction. This has seemingly been the case for 5 years or more—not the impending rise.” Now, that’s the Wall of Worry stuff I prefer. In the back half of the week, blinding sunlight again greeted me, this time in Tampa. Am I in heaven? Indeed, if I died and went to heaven and landed the strategist job, my audience surely would be like that before whom I spoke at the Women’s Symposium in Tampa. I’ve met many terrific male advisors. But here’s to the innumerable awesome women advisors out there!

Positives

Sentiment unexpectedly soars The University of Michigan’s initial take on October sentiment blew through consensus, surging to its highest reading in 13 years. Among the factors lifting consumers’ moods: nearly full employment and wages that are starting to move higher. Both the expectations and current condition components jumped, while inflation expectations eased. Survey administrators said their findings suggest consumers aren’t euphoric, but are happy with their situation, feeling that it’s about as good as it can get.

Retail sales ex-storms surprise While the headline increase for September jumped (albeit a tick less than expected) on post-hurricane auto replacement and gas sales, sales excluding those two big items were up a solid 0.5%. So-called control sales, which also ex-out restaurants (which had a good month) and building materials (ditto), increased 0.4%, double consensus. The report marks a strong finish for the third quarter and, as also reflected by Michigan sentiment, suggests consumer momentum heading into the holiday sales season.

Where are we in the economic cycle? The global OECD composite leading indicator rose an 18th straight month to its highest level in nearly three years, indicating global economic conditions should remain robust. This came as the IMF raised global growth forecasts for 2017 and 2018, citing improvements in the eurozone, Japan and emerging markets. Global PMI data also suggest continued above-trend expansion, with the composite index expanding at its fastest pace since March 2015 and manufacturing at its highest level since May 2011—global industrial production is up 3.7% from a year ago, its best growth rate since early 2014. Elsewhere, the Citigroup economic surprise and the Sentix global expectations indexes hit 5-month and 7-month highs, respectively.

Negatives

Small business optimism dims a bit The NFIB gauge fell by the most in two years to its lowest level since last November, when it spiked following the Republican election sweep. The recent hurricanes were a factor, suggesting some of the decline is likely to be reversed in the coming months. The discussion of possible tax reform by year-end also could have a positive impact. But the decline was driven by sizeable drops in the outlook for expansion and real sales growth as well as a pullback in capital expenditure plans. An offsetting buildup in inventories suggests owners may think the current lull will pass.

Inflation watch September’s core PPI rose at its fastest rate in five years, suggesting pipeline pressures may be building even as this morning’s CPI report was devoid of such. This followed last week’s spike in hourly pay, a sign wage growth may be set to break out. While this week’s JOLTS report showed job openings slipping in August, they remained near a record high, with many components pointing to some of the tightest labor market conditions in a generation. With unemployment claims indicating the jobless rate could fall to a 49-year low of 3.5% over the next year, the Conference Board expects “more wage pressures in the months ahead," potentially pushing the average hourly earnings growth rate to 3% annualized.

Widening divide The Fed’s 2017 Survey of Consumer Finances showed the wealth share of the bottom 90% of families fell by a third over the past 28 years to 22.8% in 2016, while the wealth share of the top 1% rose from just below 30% to 38.6% over the same time period.  Moreover, the wealth share of the bottom 90% fell more precipitously after 2007, underscoring how benefits from post-crisis policies largely accrued to a narrow segment of the population. If the stock market continues to advance to new records—and is accompanied by tax rate cuts whose benefits mainly flow to the rich—it should exacerbate the disparity of wealth even further, likely adding to social unrest and political divisiveness.

What else

‘Lowflation’ could make for a flattening yield curve This week’s minutes from the September Fed meeting indicated a growing number of policymakers think inflation may be affected by more than transitory factors. Cornerstone Macro says this suggests an already gradual pace of tightening may end with a neutral rate of just 2% in this cycle—only 75-to-100 basis points above current levels. This setup implies that the yield curve is likely to continue to flatten and could become completely flat or even slightly inverted by the end of next year or early 2019. Inverted curves historically have been associated with pending recessions, although such inversions have tended to come when rates across the curve were significantly higher than current levels.

Scarier than Halloween $8 trillion of global debt—17% of all outstanding debt—is trading at negative interest rates. When will this bubble burst? Deutsche Bank says it will happen when we begin to see inflation in the U.S., spurring the Fed to tighten more and faster, causing global rates to rise in tandem. The good news is that consensus doesn’t expect U.S. core inflation to move higher until mid-2018 or so; the bad news is that the $8 trillion in negative-yielding debt shows investors don’t believe we will ever see inflation again. Once inflation does start to move higher, then checking out from Hotel Easy Money will be a lot more difficult than checking in.

If I come back, it must be without these heels One-third of those who retire end up coming back to the labor market and taking another job, Deutsche Bank says. This reverse retirement rate is higher for workers in the lowest and the highest income quintile. Retirees either come back because they need more income (lowest income quintile) or they come back because the opportunity costs of staying at home are too high (highest income quintile).

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