Orlando's Outlook: Happy Anniversary


Bottom Line Yesterday marked the 30th anniversary of the ugly Black Monday stock market crash of 1987, in which computer-driven portfolio insurance forced the Dow Jones Industrial Average to plunge nearly 23% in a single day. All in, from the market’s peak on Aug. 25 of that year to its trough less than two months’ later on Oct. 20, the Dow lost nearly 41% of its value.

Investors of a certain age will never forget the gut-wrenching horror we experienced with that waterfall decline. The fear it could happen again continues to haunt us. Ignore that the Dow hit another all-time high yesterday at 23,173—more than 14 times the Black Tuesday bottom of 1,616—and has generated a total return of 2,780% since that fateful day (for a compound annual return of 9.3%). Many still worry the next great stock market crash is lurking right around the corner. That makes this powerful rally of almost 30% we’ve enjoyed since just before the November 2016 election one of the most hated rallies in history.

The contrast in valuation tells a very compelling story. In August 1987, when the crash started to gather steam, stocks were trading at 23.4 times trailing 12-month earnings. But importantly, benchmark 10-year Treasury yields were at 9%, and core CPI inflation year-over-year (y/y) was at 4.3%. By our count, stocks were more than 50% overvalued at that time, so the market’s subsequent 41% correction seems reasonable.

Today, the S&P 500 is trading at about 20.2 times trailing 12-month earnings. But benchmark 10-year Treasury yields are at only 2.3%, and core CPI inflation y/y is at only 1.7%. We have long believed that inflation and interest rates determine the appropriateness of a price/earnings (P/E) ratio. So in our view, the historically low levels of both at present suggest that stocks are significantly undervalued, as P/E’s should be higher than normal.

There’s no question, however, that investors are climbing a steep wall of worry. This has been a very active hurricane season, and the damage wrought by Harvey and Irma has cast a transitory pall on several key economic data points, such as the labor market and retail and auto sales. Putting potentially wonky third-quarter economic and corporate earnings growth data aside, we continue to see strong underlying economic fundamentals and we’re likely to see a nice fourth-quarter bounce, particularly with the rebuilding in Texas and Florida.

Moreover, additional risks abound surrounding geopolitics and the Federal Reserve’s monetary policy and leadership transition. If Washington is finally able to get its collective act together and pass reformed fiscal-policy legislation by the end of the first quarter of 2018, we could enjoy a tailwind for faster economic growth.

Tweaking our GDP forecast The fixed-income and equity investment professionals who comprise Federated’s Macro Economic Policy Committee met on Wednesday to evaluate the economic impact of the hurricanes, the synchronized global economic recovery and the status of fiscal and monetary policy in Washington.

  • The Department of Commerce’s final second-quarter GDP number was up a tick to 3.1% from its last estimate versus the only 1.2% growth of the first quarter.
  • While the devastation from Harvey and Irma certainly will hurt third-quarter economic growth, stronger manufacturing and consumer-spending trends will more than offset it. As a result, we’re moving our 2.4% GDP estimate for the third quarter up a tick to 2.5%, while the Blue Chip consensus is cutting its estimate from 2.7% to 2.4% (within a range of 1.8% to 2.9%). Commerce will flash third-quarter GDP on Oct. 27.
  • As we enter the fourth quarter, the rebuilding effort from Harvey and Irma will commence, adding to expected strength from holiday spending and manufacturing. So we are raising our fourth-quarter GDP estimate from 2.9% to 3%, while the Blue Chip consensus is raising its estimate up a tick to 2.6% (within a range of 2.1% to 3.2%).
  • We are not changing our full-year 2017 GDP estimate of 2.2%, but the Blue Chip consensus has raised its estimate up a tick to 2.2% (within a very narrow range of 2.1% to 2.2%).
  • Largely due to political self-preservation, we continue to believe the Trump administration and the Republicans in Congress will successfully draft much-needed fiscal-policy reform in the fourth quarter and pass it into law in the first quarter of 2018. Combined with rebuilding efforts from Harvey and Irma, we are raising our full-year 2018 GDP estimate from 2.8% to 2.9%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 2.1% to 2.8%).
  • With second-quarter 2017 GDP growth now final, this is when we typically begin to populate our quarterly estimates for 2018:
    • First quarter 2018: Federated at 2.9%, Blue Chip consensus at 2.3% (within a range of 1.7% to 2.9%)
    • Second quarter 2018: Federated at 3%, Blue Chip consensus at 2.4% (within a range of 1.9% to 3.1%)
    • Third quarter 2018: Federated at 2.7%, Blue Chip consensus at 2.3% (within a range of 1.9% to 2.8%)
    • Fourth quarter 2018: Federated at 2.7%, Blue Chip consensus at 2.2% (within a range of 1.7% to 2.7%)

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

Third-quarter earnings will be impacted by the hurricanes While the first half of 2017 boasted the strongest U.S. corporate-earnings growth in six years with double-digit y/y gains, Harvey and Irma likely will sap some near-term momentum in the third quarter due to massive losses by insurance companies. At the start of the third quarter, FactSet was forecasting y/y EPS gains of 7.5%. It cut that to a 4.2% increase at the end of the quarter and reduced it again to a muted 2.8% just before the EPS reports started a week ago. That’s too pessimistic, in our view. We think a 6-9% y/y gain is more likely. Earnings season is just getting underway, with only 60 companies having reported thus far (12% of total and 17.6% of the S&P’s market cap). Revenues are up 6.7% y/y, with 45% of companies beating by an average of 1.2%. EPS are up 11.6% y/y, with 77% of companies beating by an average of 5.1%. Tech, materials and health care are the early stars.

Hurricanes distort jobs Harvey and Irma wrought havoc on the September labor report, with the government’s establishment survey showing an outright loss of 33,000 jobs—the first such decline in job creation since 2010. The BLS said that 1.47 million people were unable to get to work last month due to the bad weather—the most in any month since January 1996—compared with a typical September in which only 80,000 employees can’t get to work because of weather issues. But there were some pockets of strength: the household survey rebounded to a gain of 906,000 jobs in September from August’s loss of 74,000; the unemployment rate (U-3) based upon the household survey fell to a 16-year low of 4.2%; the labor impairment rate (U-6) dropped to a 10-year low of 8.3%; and the labor force participation rate rose to a 3-year high of 63.1%.

Mixed bag for inflation The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—has fallen from 1.9% on an annualized y/y basis in January and February 2017 to 1.3% in August, so it’s clearly moving in the wrong direction from the Fed’s oft-stated and aspirational 2% core inflation target. But nominal inflation has begun to perk up. Nominal wholesale producer price inflation (PPI) rose 0.4% month-over-month (m/m) in September, from a rise of 0.2% in August and a decline of 0.1% in July. Similarly, core PPI (which strips out food, energy and trade) rose 2.1% y/y in September, from 1.9% in both July and August. Nominal retail consumer price index (CPI) inflation has steadily increased from a decline of (0.3%) m/m in March to a recent gain of 0.5% in September. But core CPI (which strips out just food and energy prices) has been mired at a 1.7% y/y increase for the last five months through September, down from 2.3% in January 2017, which had matched its highest reading in four years. Wage growth has been a bright spot, rising 2.9% y/y in September, up from 2.7% in August and 2.5% in July, matching last December’s 8-year cycle high.

Autos rebound This is all about the hurricanes. Total auto sales fell 4% m/m in August 2017 to 16.03 million annualized units (a 3-year low), versus 16.69 million annualized units sold in July. That put August 12.4% below December 2016’s 10-year cycle high of 18.29 million annualized units sold. But businesses and consumers needed to quickly replace their cars and light trucks damaged by the storms, which sparked a powerful 15.2% m/m unit sales surge in September 2017 to 18.47 million annualized units, a new 31-year cycle high and the largest monthly increase since 2005. We saw similar hurricane-related snap-backs in car sales with Katrina in 2005 and Sandy in 2012.

Retail recovery After a dreadful 0.1% m/m nominal decline in August, retail sales enjoyed a powerful 1.6% nominal surge in September—its largest m/m gain since March 2015—due to hurricane-related bounces in retail gasoline sales, autos and building materials. In addition, July and August results were revised higher across the board. So with a strong September now in the books, this recent retail-sales strength salvages the important Back-to-School (BTS) season, whose sales rose a solid 3.9% on a y/y basis, marking the best period in three years. That gives us some confidence holiday sales could rise 3.5-4.5%.

Consumer confidence remains strong:

  • Leading Economic Indicators (LEI) had been positive for 12 consecutive months, reaching a new 58-year cycle high in August before dipping in September on temporary hurricane impacts to jobless claims and building permits.
  • Michigan Consumer Sentiment Index spiked to a 13-year high of 101.1 in October 2017, up from a 2-year low of 87.2 last October.
  • Conference Board’s Consumer Confidence Index soared to a 16-year high of 124.9 in March 2017, up from a 3-month low of 100.8 in October 2016, but it has since eased to 119.8 in September.
  • The National Federation of Independent Business (NFIB) small-business optimism index roared to a 12-year high of 105.9 in January 2017, up sharply from a cycle trough of 94.1 in September 2016, but it has since slipped to 103 in September, perhaps due to hurricane damage to small businesses.

Round trip for Treasury yields Benchmark 10-year Treasury yields plunged from 2.39% in early July in a flight-to-safety rally to an overbought 2.01% in early September (marking the lowest levels since the election last November). But over the last six weeks, yields soared back up to 2.40% in early October and have settled at 2.31%. Over the next few quarters, then, benchmark 10’s could continue to rise above their current 2.40% resistance to about 2.60%. They may eventually retrace the “Taper Tantrum” peak from 2013 of about 3%, perhaps in early 2019.

Fed uncertainty remains Coming out of its mid-September policy meeting, the Fed expects to hike interest rates once more in December, with perhaps three more in 2018, two more in 2019 and one more in 2020. While its projections for 2018 and beyond are somewhat data dependent, the terminal value of the fed funds rate will peak at perhaps 2.5% to 3% over the next few years. The Fed also began to shrink its $4.5 trillion balance sheet in October, rolling off $10 billion in maturing Treasury and MBS obligations each month, a level they will increase by $10 billion each quarter over the next year. By the end of 2018, it will be rolling off $50 billion per month. At that pace, the Fed will have whittled its balance sheet down to $2.5 to $3 trillion by the end of 2020, which could represent the new “normal” level. But with Chair Janet Yellen’s term set to expire in February 2018, vice chair Stanley Fischer recent retirement and two board seats still open, leadership transition represents a market risk.

Manufacturing remains a bright spot The ISM manufacturing index soared to a 13-year high of 60.8 in September 2017, up sharply from a contraction reading of 49.4 in August 2016. The trade deficit fell a larger-than-expected 2.7% m/m in August 2017 to an 11-month low of -$42.2 billion. Core capital goods shipments rose for the seventh consecutive month by 1.1% m/m in August. Finally, the Empire regional Fed index roared to an 8-year cycle high of 30.2 in October, and the Richmond Fed index rose to a 7-year high of 19 in September.

Inventory restocking cycle reaccelerates Inventory accumulation had slowed sharply to only $1.2 billion in the first quarter of 2017, down from $63.1 billion in the fourth quarter of 2016. But the second quarter picked up the pace to $5.5 billion. Factory orders enjoyed a stronger-than-expected 1.2% m/m rebound in August, and core readings (which exclude volatile transportation orders) have now risen for three consecutive months. Wholesale inventories have risen four months in a row and in six of the past seven months, increasing a strong 0.9% m/m in August, and wholesale trade sales surged 1.7%. Finally, business inventories enjoyed a solid 0.7% m/m gain in August, posting a fourth consecutive positive month.

Housing momentum continues to slow Despite low mortgage rates and rising wages, pending monthly home sales through August have been negative for five of the past six months, declining 2.6% m/m in August. New-home sales (an important housing leading indicator, because they are calculated when a contract is signed, typically several months before closing) fell 3.4% in August, and are now down 12% from March’s cycle highs. Existing home sales (a lagging indicator calculated when a purchase contract actually closes), which now account for 90% of total home sales, fell 1.7% m/m in August to a 1-year low before turning up 0.7% in September. Housing starts and permits (important leading indicators) have fallen 16% and 7%, respectively, from their recent peaks through September.

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