Weekly Update: These are the facts

01-19-2018

So much for the Wall of Worry; I believe this is the year of euphoria. Leading indicators are at a record high, small business sentiment is at its second-highest level ever, unemployment is three ticks away from its lowest level since the 1960s, consumer and CFO confidence is soaring, manufacturing and housing are improving, and GDP is on a 3% growth pace. Economies elsewhere also are on the rise—the share of expanding PMIs is a whopping 90%, well above the long-term average of 72%. At the Powell-led Fed, monetary policy appears to be targeting the stock market as much as the economy. With the post-tax-reform prod of 100% expensing and higher after-tax returns on investment, businesses seem set to ramp up capital expenditures (capex), a missing link in this recovery; consensus capex guidance is at a 3-year high. This all suggests little risk of a recession over the next 12 or even 24 months. It could be just the opposite—a boom could be unfolding, abetted by tax reform that in coming weeks will put more money in the pockets of the vast majority of Americans and more cash into the coffers of corporations. Wall Street analysts keep bumping up earnings forecasts, with 2018’s projected per-share growth now topping 12%. The upward revisions have been driven by Financials and Energy, two high-beta, cyclical sectors that perform best in a strong economy. Even the debt backdrop is favorable—household debt to total assets is at mid-1980s levels, and U.S. corporate debt as a ratio of profits is as low as it was in the late ’60s. Get ready for animal spirits to take off!

On the other hand, despite the strong start to the year and a rising-rate environment, investors continue to shift money out of equity funds and into bond funds. Why are they still nervous? Maybe inflation. I get asked about this a lot in my travels. I’ve been pooh-poohing this worry for years. But if we don’t get inflation this year, we never will. Annualized wage growth over the past six months has crept up to a 2.7% pace. The New York Fed’s measure of underlying consumer inflation has jumped to almost 3%, its highest level since 2006. The concern isn’t so much runaway inflation rather than modest acceleration, which could unsettle the disinflation/deflationary investment culture in the post-crisis era. Easy money has allowed quite a few weak hands to remain in the game, making it difficult for good companies to gain share and investors to tell the difference. If the Fed were to take a faster rate-hike path and bond vigilantes were to re-price the 10-year yield, the correction everyone kept anticipating last year could come. The S&P 500, which went all of 2017 without a 5% pullback, has never had back-to-back years with corrections of less than 6%. Of the nine years before 2017 with corrections of 6% or less, the following year saw bigger sell-offs and significantly smaller gains. That said, the S&P has never experienced negative returns in a year after which it set at least 56 new highs—and 2017 saw 66 record highs, second most to 1995’s 82. How well stocks do this year hinges on whether, and for how long, the recovery can remain in its current sweet spot. If the array of potential challenges results in an overdue, gut-checking correction, it could represent a great buying opportunity in this ongoing secular bull.

A chronically surprising economy drove 2017’s spectacular run, but there may not be a lot of juice left. Citigroup’s economic surprise index has rarely been higher, lowering the potential for more upside surprises. So what will drive the market? It won’t be financial liquidity, which after soaring on extraordinary Fed stimulus has now modestly contracted for three quarters. It could, as we’ve noted, be earnings. It could be continued low volatility—the macro backdrop resembles the mid-’90s and mid-’00s, similar eras of a restrained VIX. Or it may be momentum, which tends to come into play in the mid-to-late stages of a cycle. The percentage of S&P names trading above their 65-day moving averages is closing in on 80%, an historical point of momentum confirmation where excess returns tend to be above average. The percentage of S&P stocks trading above their median estimate topped 25% in December, a rarity that historically has presaged significant market gains six to 12 months out. Worries about the flattening yield curve seem premature; data suggest equity markets tend to deliver excellent returns when the spread between 10-year and 2-year Treasury yields declines below 50 basis points to zero. We’re just now flirting with the 50-point level. Moreover, a secular top for the broader stock indexes generally occurs 20 months after a yield-curve inversion, in which short rates exceed long rates. At the current schedule, that potential headwind is a mid-2020 event at the earliest. So … long live the Wall of Worry? The Wall of Worry is dead!

Positives

Housing solid January’s builder confidence dipped as expected but held near a 13-year high. December residential building permits also slipped off an upwardly revised November but were just off their 11-year cycle peak. Starts, on the other hand, fell sharply, led by single-family homes. But it’s not unusual to get some seasonal blips in construction during the winter months. For the year, starts were their highest since 2007.

Euphoria watch Bloomberg’s weekly gauge rose to its highest level in almost 18 years, lifting its 52-week average to a 15-year high. However, Michigan's preliminary take on January sentiment unexpectedly slipped to a 6-month low, although it was still relatively upbeat, with consumers' longer-term expectations reaching a 2-year high. The index has tended to be the laggard of the main consumer optimism gauges over the past 12 months, as the others have been unusually strong.

Capex watch The equipment leasing & finance industry confidence index rose to a record high, in part on strengthening demand for loans and leases to fund capex. Capex plans in the Empire survey, where the services component rose to its second-best level since October 2007, also hit a multiyear high.

Negatives

Manufacturing moderates The Philly Fed gauge reversed most of December’s spike, and the pattern was similar for New York’s Empire. Both were still robust, just less so. Meanwhile, headline December industrial production surged, with the year-over-year rate rising the most in seven years in part on utility output. But the manufacturing component barely rose, and this week’s Beige Book (more below) cited only “modest’’ manufacturing improvement.

Blah Beige Book Contrary to a lot of the recent economic data, the regular report from the Fed’s 12 districts was hardly effusive, reflecting a December-early January economy that was expanding at a “modest-to-moderate’’ pace. The relatively subdued report downgraded its prior view on job growth, was blasé about holiday sales and said supply shortages were constraining housing.

Consumer watch Despite their relatively positive view of the economy, consumers may not spend as much this year as consensus seems to think. This morning's Michigan sentiment report gave a hint of such as buying plans for big-ticket items slipped. Among the headwinds consumers face: tougher credit conditions, rising energy prices and depleted savings following 2017’s end-of-the-year splurge.

What else

‘Swamp’ food Cowen & Co. says it’s not an overstatement to say nearly every major Republican economic policy priority from the past decade made it into the final tax bill in some form. Provisions included Obamacare individual mandate repeal; a less-generous chained CPI that will reduce future inflation adjustments to tax rates; oil drilling in the Arctic National Wildlife Refuge; and enough unintended consequences and drafting errors to keep the “Swamp” busy another 31 years, which represents the period between this legislation and 1986’s sweeping tax-reform bill.

What about the deficit? A lingering concern for 2019 and beyond: even before passage of the tax bill, the U.S. budget deficit has been rising, which is odd for a time in the cycle when it would typically be shrinking given improving growth and more economic activity. Federal debt to GDP now stands above 100%, a level last seen in World War II (although historically low yields have kept the cost of that debt relative to GDP at multi-decade lows).

A contrarian positive for Utilities Everyone seems convinced U.S. bond yields have nowhere to go but up, a condition that tactically often suggests a peak in 10-year yields, which generally is good for returns in Utilities. With utility ETF flows at liquidation extremes—the most overweight sector in Barron’s 2018 outlook piece was Financials and the biggest underweight was Utilities—the beat-up sector could be due for a near-term rebound.

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