Orlando's Outlook: Goldilocks revisited

12-01-2017

Bottom Line With third-quarter GDP revised up to a strong gain of 3.3% and with corporate profits during this period rising 8% year-over-year (y/y), we have clearly dodged an economic bullet from hurricanes Harvey and Irma. So economic growth over the past nine months is now running at its best pace in three years, inflation is finally starting to perk up and corporate profits haven’t been this solid in six years.

Most of the business and consumer confidence metrics we monitor are sitting at or near multiyear cycle highs, the unemployment rate (U-3) at 4.1% is down to a 17-year low and the S&P 500 has rallied 27% over the past 13 months to a series of record highs to reflect all of these positive developments.

Moreover, the Federal Reserve’s leadership transition from Janet Yellen to Jay Powell appears to be going smoothly, and Washington is finally getting close on a comprehensive tax reform package that has the potential to help generate sustainable trend-line economic growth of perhaps 3% or so over the next two years, with the possible risk of recession on the horizon no earlier than 2020. Yet, against this admittedly positive backdrop, many investors are apoplectic, worried that the next stock market crash is right around the proverbial corner, making this one of the most hated rallies in history. So for bullish investors, we advise staying the course and enjoying the climb up that steep wall of worry.

Modest adjustments to our GDP forecasts The equity and fixed-income investment professionals who comprise Federated’s Macro Economic Policy Committee met yesterday to discuss the synchronized global economic recovery and the direction of fiscal and monetary policy in Washington:

  • Last Wednesday, the Department of Commerce revised up third-quarter GDP to 3.3% from its flash estimate of 3%, due to slightly better trends in housing, corporate capex, inventory accumulation, government spending and net trade. The final revision will be released on Dec. 21.
  • The rebuilding effort from Harvey and Irma has begun, and we’re expecting a strong holiday spending season, which should help to offset any concerns about weaker trade. So we are raising our fourth-quarter GDP estimate from 3% to 3.2%, while the Blue Chip consensus is ticking its estimate up to 2.7% (within a range of 2.4% to 3.2%).
  • The government’s positive revision to third-quarter GDP and the increase in our own fourth-quarter estimate prompt us to raise our full-year 2017 GDP estimate from 2.2% to 2.3%, while the Blue Chip consensus remains unchanged at 2.2% (within a very narrow range of 2.2% to 2.3%).
  • While it now appears that tax reform will be completed shortly, we are concerned about another brutal winter and Commerce’s typical seasonal issues impacting the first quarter of 2018. So we are lowering our GDP estimate from 2.9% to 2.7%, while the Blue Chip consensus remains unchanged at 2.3% (within a range of 1.8% to 2.9%)
  • The operating leverage on the economy from completed tax reform will begin to manifest itself in the second quarter of 2018. So we are raising our GDP estimate by a tick to 3.1%, while the Blue Chip consensus remains unchanged at 2.4% (within a range of 2% to 3%).
  • Our third quarter of 2018 GDP estimate remains unchanged at 2.7%, and the Blue Chip consensus also remains unchanged at 2.3% (within a range of 1.9% to 2.8%).
  • Our fourth quarter of 2018 GDP estimate similarly remains unchanged at 2.7%, and the Blue Chip consensus remains unchanged at 2.2% (within a range of 1.8% to 2.7%).
  • Largely due to the aforementioned baseline increases to GDP in the second half of 2017, we are ticking up our full-year 2018 GDP estimate from 2.9% to 3%, while the Blue Chip consensus has similarly increased its estimate from 2.4% to 2.5% (within a range of 2.2% to 2.9%). 

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

Labor market rebounds in October After hurricanes Harvey and Irma, the jobs market recovered to its strongest payroll levels in a year, although the headline flash of only 261,000 nonfarm jobs added was disappointing on the surface. When we add back the positive revision of 90,000 jobs from August and September, the adjusted gain of 351,000 jobs is actually better that expected. Moreover, manufacturing hiring leapt in October to a gain of 24,000 jobs, and the unemployment rate and labor-impairment rate (U-6) both fell to 4.1% and 7.9%, respectively, which are cycle lows that go back to 2000 and 2006.

Negatives include the household survey losing 484,000 jobs in October, after adding 906,000 jobs in September; wage growth was flat for October and grew only 2.4% on a y/y basis, down sharply from a 2.8% increase in September; the average private work week for all employees remained unchanged for the fourth consecutive month at 34.4 hours; and the labor force participation rate plummeted to 62.7% in October from a 3-year high of 63.1% in September (its 38-year cycle low of 62.4% was in October 2014).

Third-quarter earnings better than expected Combined with strong double-digit first-half gains, corporate profits are running at their best pace in six years, due to a 3% surge in productivity and a well-behaved 0.5% increase in unit labor costs during the third quarter. While FactSet was forecasting a muted 2.8% y/y increase in the third quarter, earnings per share actually rose 8.1%, with 70% of S&P companies beating consensus estimates by an average of 5.7%. Because revenues rose 5.8%, it was a surprisingly high-quality quarter, with tech, energy and materials the strongest categories.

Oil on a tear Crude (WTI) prices have risen 40% over the past five months, from an oversold $42 per barrel in mid-June to a recent peak of $59, due to better global supply and demand balance, a relatively weaker U.S. dollar, new geopolitical risks, and the temporary reduction of about 25-30% of refinery capacity in the Gulf of Mexico due to Harvey. In addition, OPEC and non-OPEC producers agreed yesterday to extend their production cuts of 1.8 million barrels a day from March 2018 through the end of next year. We continue to believe that Saudi Arabia and Russia are motivated to keep crude prices elevated ($60), in advance of the planned Aramco IPO in the second half of 2018 and Russian President Vladimir Putin’s bid for re-election in March/April 2018.

Inflation finally starting to perk up The core personal consumption expenditures (PCE) index (the Fed’s preferred measure of inflation) had fallen steadily from 1.9% on an annualized y/y basis in January and February 2017, to a trough of 1.3% in August, approaching its cycle low (1.25%) set in July 2015. But September and October have ticked up to 1.4%, so we’re finally starting to move in the right direction towards the Fed’s 2% core inflation target.

Core wholesale producer price inflation (PPI), which strips out food, energy and trade, rose back up to a 2.3% y/y gain in October from 2.1% in September and from 1.9% in both July and August. Core retail consumer price index (CPI) inflation, which strips out just food and energy prices, ticked up to a 1.8% gain in October from a 1.7% increase for the previous five months through September. That’s down from 2.3% in January 2017, which had matched its highest reading in four years.

Fed’s leadership transition underway Janet Yellen’s term as chair will expire in early February 2018 (with Jay Powell likely replacing her), and she also will leave the board of governors. Powell’s confirmation hearing in the Senate on Tuesday appeared to go well, and we expect he will be confirmed. In a lot of ways, Powell appears to be a near-perfect candidate. He shares Yellen’s dovish view on monetary policy and appears to share Trump’s desire to tweak regulatory overreach back toward the center. Vice chair Stan Fischer already retired eight months early in October, and he also needs to be replaced. So with three board seats and a vice chair still open, leadership transition continues to represents a market risk. Trump nominated Marvin Goodfriend on Wednesday for one of the open governor posts, and the Senate recently confirmed Randy Quarles for Dan Tarullo’s opening.

Treasury yields stable After benchmark 10-year Treasury yields rose from an overbought 2.01% in early September (marking the lowest levels since the election in November 2016) to an oversold 2.46% in late October, they have been relatively stable in the 2.30-2.40% range over the past two months. We still believe they will eventually retrace the “Taper-Tantrum” peak from 2013 of about 3% over time.

We still expect the Fed to hike interest rates by another quarter point in two weeks, with perhaps two more hikes coming in 2018. While any 2019-2020 hikes are aspirational and data dependent under new Fed Chair Powell, the terminal value of the fed funds rate will likely peak at perhaps 2.50% to 3% over the next few years.

Housing market catches a bounce It’s unclear whether this is just a rebound from hurricane damage, or a more sustainable reacceleration of strength. After three consecutive negative months through September, pending home sales surged 3.5% on a month to month (m/m) basis in October and 1.2% on a y/y basis. New-home sales soared for the second-consecutive month 6.2% in October 2017, at an annualized run rate of 685,000 units sold, which is a new 10-year cycle high. Existing home sales rose on a m/m basis by 2% in October 2017 to 5.48 million annualized units, only 4% below March 2017’s new 10-year high of 5.70 million units.

Housing starts surged 13.7% m/m in October to 1.29 million annualized starts, only 4% from the peak of 1.34 million annualized units in October 2016, a 9-year cycle high. Building permits rose 5.9% in October 2017 to 1.297 million annualized units, just under the peak in January 2017 at 1.3 million annualized units, which was an 11-year cycle high. After peaking at a 12-year cycle high of 71 in March, the HMI builder-confidence index slipped to 64 in July and September, but surprisingly surged to 70 in November, an 8-month high. Pricing has also surprisingly reaccelerated, as the lagging Case-Shiller pricing index increased 6.2% y/y in September versus 5.8% in May, June and July.

Auto rebound eases Businesses and consumers needed to quickly replace their cars and light trucks damaged by Harvey and Irma, which sparked a powerful 15.2% m/m unit sales surge in September to 18.47 million annualized units, a new 31-year cycle high and the largest monthly increase since 2005. But October saw some modest consolidation, with total unit sales slipping 2.7% to an 18 million unit annualized run rate, and we expect similar seepage in November.

Confidence remains solid:

  • Leading Economic Indicator (LEI) has now been positive for 14 consecutive months, soaring 1.2% in October 2017 m/m to 130.4, a new 58-year cycle high.
  • Conference Board’s Consumer Confidence Index soared to a 17-year high of 129.5 in November 2017, up from a 3-month low of 100.8 in October 2016.
  • 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, although it did slip to 98.5 in November.
  • The National Federation of Independent Business (NFIB) small-business optimism index rose sharply 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 eased to 103.8 in October.
     

Getting ready for a good Christmas Although a relatively less important month in between the important Back-to-School (BTS) and holiday seasons, October retail sales were solid, on the heels of a powerful 1.9% 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. So the important BTS season (July, August and September) saw sales rise a solid 4.0% y/y, marking the best period in three years. That gives us some confidence that holiday sales could rise toward the upper end of our 3.5-4.5% estimate, and Black Friday/Cyber Monday sales to start the holiday season appear to have been strong.

Inventory restocking accelerates 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. But the second quarter picked up the pace to $5.5 billion and an upwardly revised $39 billion in the third quarter. Factory orders rose 1.4% m/m in September, after a stronger-than-expected 1.2% rebound in August, marking the third strong month out of the past four. Core readings (which exclude volatile transportation orders) were also solid, rising for the fourth consecutive month by 0.7% in September. But after rising five months in a row and in seven of the past eight months through September, wholesale inventories declined 0.4% in October. Business inventories were breakeven in September, after soaring 0.6% m/m in August, which was their fourth consecutive positive month.

Manufacturing comes off the boil After soaring to a 13-year high of 60.8 in September 2017, which was up sharply from a contraction reading of 49.4 in August 2016, the ISM manufacturing index consolidated to 58.7 in October and to 58.2 in November. Also, the trade deficit rose by a larger-than-expected 1.6% m/m in September 2017 to ($43.5 billion). Although durable goods orders fell 1.2% m/m in October, the more important core capital goods shipments rose for the ninth consecutive month by 0.4% in October. After a soft summer, industrial production (IP) and capacity utilization (CU) are beginning to firm. IP rose 0.9% in October, up from a 0.4% m/m gain in September and a 0.5% decline in August. CU rose in October to 77.02, up from 76.40 in September and an upwardly revised 76.10 in August. Finally, the Richmond Fed index rose to a 24-year cycle high of 30 in November, while Empire, Kansas City, Dallas and Chicago all hit multi-year cycle highs in October.

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