Orlando's Outlook: Is a retest inevitable?


Bottom Line March has come in loaded for bear, as investors seem hell-bent on orchestrating a technical retest of the 200-day moving average line. That level has successfully served as support from the S&P 500’s recent 12% equity-market plunge, despite healthy readings on both economic growth and inflation.

In February, the S&P suffered its worst month in two years, falling 3.9% and breaking a record-setting stretch in which stocks had risen for 15 consecutive months on a total-return basis. This happened despite the favorable combination of a strong labor market, solid economic and corporate profit growth, cycle highs for consumer confidence, manufacturing and leading indicators, and relatively benign levels of inflation.

What’s the source of this seeming market disconnect? In our view, investors appear to be fixated on new Fed Chairman Jerome Powell’s first biannual Humphrey-Hawkins testimony to Congress this week, Tuesday before the House Financial Services Committee and today before the Senate Banking Committee. While we thought he did fine, some investors remain apoplectic at the possibility he will abandon outgoing head Janet Yellen’s dovish pace of three quarter-point rate hikes last year, and instead substitute four or five hikes this year (maybe sneaking in a half-pointer along the way), with a similar plan for 2019. We disagree, but it appears we are spitting into the wind this week, with stocks down more than 4% over the past three days.

Two critical signposts ahead Next up for investors will be the delayed jobs report on March 9, with particular focus on wage growth. Average hourly earnings rose for the fourth consecutive month in January by a stronger-than-expected year-over-year (y/y) gain of 2.9%, the strongest increase since June 2009. With the tightening labor market and President Trump’s December tax cut, we believe wage growth will approach 4% over the next year or so. And later this month, Powell will chair his first 2-day policy-setting meeting (we still expect a quarter-point hike), which will include a new set of dot plots and his first presser with the media.

We’ve seen this movie before, we know how it ends None of this, of course, is surprising, as we discussed in 2006 and again in 2014, Ben Bernanke and Yellen’s respective first years at the helm of the Fed. Over the course of the Fed’s 100-year history, the market has a tendency to greet the incoming Fed chair with a sharp 10-15% correction due to a lack of initial confidence. That decline tends to reverse itself by the end of that first year.

Fundamentals still matter Several recent key data points suggest the equity market is overreacting to initial Powell-related nervousness:

  • Initial weekly unemployment claims (a leading economic and employment indicator) for the survey week that ended Feb. 24 fell to only 210,000 jobs, a new 49-year cycle low.
  • S&P corporate profits for the fourth quarter are running up 15% y/y, with three quarters of the companies beating consensus estimates by 5%.
  • ISM manufacturing index in February soared to 60.8 (a new 14-year high) from 59.1 in January.
  • Conference Board’s consumer confidence index spiked to 130.8 in February (a new 18-year cycle high) from 124.3 in January.
  • Leading Economic Indicators (LEI) in January leapt 1% to a new 58-year cycle high of 108.1, up from 107.0 in December.
  • Domestic final sales (GDP minus volatile net trade and inventory) grew at 4.3% in the fourth quarter of 2017 on a quarter-over-quarter basis. That’s the fastest growth in domestic demand since the third quarter of 2014 versus 1.9% in the third quarter—much better than the nominal 2.5% GDP print. 

Despite solid economic growth, inflation does not appear to be a problem:

  • Core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, has risen only 1.5% in each of the past three months through January, well below the Fed’s oft-stated 2% core inflation target. 
  • Core retail consumer price index (CPI) inflation (which strips out food and energy prices) was unchanged at a 1.8% y/y gain for the third time in the past four months in January. 

What’s wrong with these numbers? Absolutely nothing. So if the technicians have temporarily seized control of the equity markets over the next three weeks, we suggest deploying dry powder and buying on weakness.

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