Weekly Update: This is going to be a big problem in 6 months

03-09-2018

Do you know how many times in the last five years have I heard or read that wage inflation is going to be a big problem—with certainty and soon! I have refused to make such prognostications because I can’t read the future! But I can observe, and we have seen jobs growing steadily throughout the whole cycle without serious wage inflation that might precipitate a Fed policy error. Further, while bond market pessimism is its highest since the financial crisis, with the 10-year Treasury close to support levels and a Powell-led Fed expected to continue on the modest tightening path, there’s really no sign of demand destruction that would suggest a bond bear market is at hand. Banks, households and foreigners are still buying—January flows into bond funds and ETFs topped $43 billion in January, the second-biggest month on record. And with the exception of one bad week since, money continues to flow into these funds. Strong stock-market performance over the past year has encouraged portfolio rebalancing, adding to demand. The bias on yields may be up, but it looks to be a very slow grind with yields close to major resistance—2013's taper tantrum peak at 3% and a secular downtrend near 3.2%. If long-term interest rates settle into a trading range, then bond proxy stocks—the only sectors not to have rebounded—should stop weighing on breadth as these higher-yielding stocks come back in favor. The question is whether this lessens the relative appeal of technology stocks, the main driver of the market’s up-move in the Trump era. By definition big tech represents longer-duration growth stocks whose valuations should be affected by rising rates. But an Empirical Research study found today’s tech growth stocks are generating far higher cash-flow margins than their predecessors at previous market peaks, muting the impact of higher rates. Something for everyone.

The market has yet to see extreme pessimism, which would confirm the recent retest of early February’s low. The longer the market goes without a breadth thrust, i.e., a broad move across sectors, the more likely it may be vulnerable to another leg down, Ned Davis says. But if one comes, the downside risk should be limited to the 200-day moving averages in the popular indexes, as the 50-day moving average already has been breached. With equities already discounting 2018 earnings growth, the next catalyst for an advance is unlikely to materialize prior to the Q1 or Q2 earnings seasons. Stock buybacks could represent a significant tailwind, with S&P 500 companies on pace for a record $800 billion in gross share purchases in 2018 vs. $530 billion last year. There could be further upside if companies increase gross payout ratios to levels similar to late in the last cycle, when they returned over 100% of profits to shareholders (vs. 83% now). Companies tend to accelerate buyback programs during market sell-offs, which are more likely with the return of volatility. Buybacks are expected to be overwhelmingly funded with cash, aided by the new tax law that slashed the headline corporate tax rate. JP Morgan estimates cash repatriation alone could contribute $200 billion to buybacks this year.

So, what could we worry about? Trade is a visceral issue for President Trump and remains his policy North Star. There is no macro issue that has been so definitive and consistent in his decades of public life—Trump views trade through a zero-sum prism of winners and losers. Section 301, which rarely has been used since the 1995 creation of the World Trade Organization (WTO), packs a serious punch and essentially gives the president unilateral power on a host of remedial trade actions (quotas, tariffs, etc.). This week’s announcement on steel and aluminum was more limited than some had feared, possibly because Trump has made the market the barometer of his success and uncertainty over what he may do reignited volatility in the past week. But his administration is continuing with a nearly year-long investigation into potential theft of U.S. company intellectual property by China that reportedly is measured in the trillions, not billions, of dollars. A report due soon could trigger massive Chinese retaliation and cause an uproar at the WTO, an organization not held in particularly high regard within this White House. Cowen & Co. says the rumor around D.C. is the U.S. initially may seek to impose $1 trillion of tariffs that would require a 200% across-the-board tax on Chinese imports, a level even Trump is likely to think is too much. Still, getting “tough’’ with China is one of the few areas of bipartisanship and would play very well with Trump’s base. Anyway, at this writing, the market is cheering an extraordinary jobs report for this late in the cycle even as wage growth has slipped vs. last month’s correction-inducing figure. But bond yields are rising! Could this be “it?’’ You want to call the secular bear in bonds? Many have done it. Not me—I can’t read the future.

Positives

On the one hand, work is a man’s salvation This morning’s 313K print on February nonfarm payrolls and big upward revision to January were much stronger than expected. At the same time, the average hourly earnings number that drew so much consternation last month eased from a downwardly revised 2.8% year-over-year (y/y) rate to 2.6%. And the jobless rate held steady at 4.1% despite the flood of jobs as the labor force growth surged.

Services surprise The ISM nonmanufacturing index posted its third-strongest reading since August 2005, indicating activity remains solid. Combined with the February’s ISM manufacturing gauge, the reports correspond to 3.5% real GDP growth annually. The separate Markit services PMI reached a 6-month high, with respondents citing a sharp upturn in client demand. New orders surged at their fastest pace since March 2015.

Finally, capex appears and likely will extend the cycle In rising to a record high in Q1, the quarterly Duke/CFO Business Outlook Survey said respondents project capital expenditures (capex) will jump 11% over the next 12 months, the most in seven years. Technology spending is forecast to surge a record 9% y/y. Of those who plan to increase capex due to tax reform, 53% said it would be due to the lower tax rate, while 44% said it would be due to the immediate capex expensing provision.

Negatives

On the other hand, if we’re ever going to get inflation, this would be the year February’s robust jobs reports show U.S. unemployment about to decline below 4% even as wage inflation remains below 3%. There has never been a jobless rate below 4% in post-war history without wage inflation of least 3.5%, and it has been extremely rare for wage inflation to be less than 4% once the unemployment rate falls below 4%. Based on its monthly survey, which showed business payrolls expanding above 200K a fourth straight month, ADP described the jobs market as "red hot" and at risk of overheating. The Duke/CFO survey (more above) also showed y/y inflation expectations picking up to 3%, matching their highest level since Q3 2008.

Trump’s not going to like this The trade deficit increased for the fifth straight month in January to its widest level in almost 10 years, with the goods portion reflecting its second-biggest gap on record. On a 12-month total basis, the trade deficit is at its widest since December 2007, led by a record non-petroleum trade gap. The Atlanta Fed’s GDPNow model is projecting the exports gap will carve six-tenths of a point from real Q1 GDP growth.

Slowdown watch With this week’s decision by the European Central Bank to remove “easing bias’’ from its policy and the Bank of Japan signaling it may start pulling back stimulus next spring, the Fed’s Powell faces challenges that went unseen by his predecessor. The threat of coordinated tightening efforts from around the planet should concurrently flatten and drag upward the yield curve; FBN Securities sees the potential for an inversion of 2- and 10-year Treasury yields sometime in mid-2019, a sign that a recession could come in the subsequent year or two.

What else

The stock market’s going to like this The forward P/E differential between small and large companies has virtually closed, making it the most attractive environment for large companies to buy small companies since before the financial crisis. Tax reform also is expected to be a significant tailwind for M&A activity by increasing cash in company coffers and by allowing acquirers in deals structured as asset sales to realize an immediate 100% deduction for acquired assets. There could also be a “reverse inversion” trend, in which foreign companies look to expand in the U.S. to take advantage of the lower corporate tax rate.

Midterm correction watch The market during midterm election years has tended to be weaker than average due to elongated corrections. A typical year includes an early year rally, a spring correction, a weak summer rally, an autumn correction and a year-end rally. The biggest correction during midterm years has been a median of 17% lasting four months. The late January-early February correction was 12% over two weeks.

It’s best for the children if the Mr. and I splurge on ourselves Harvard Business School researchers asked more than 4,000 millionaires to rate how happy they were on a scale of 1 to 10 and found anything above $75K doesn’t seem to have much of an impact on a person’s day-to-day mood. Indeed, less than 13% of millionaires said they could achieve perfect happiness with the amount of money they already have. Interestingly, millionaires who made their wealth on their own were happiest vs. those who inherited it.

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