Weekly Update: I envision a perennial tan in 2028

04-27-2018

This travel week was one of contradictions, starting in progressive upstate New York (Rochester, Ithaca and Syracuse) and ending in conservative Bowling Green, Ky., U.S. Sen. Rand Paul’s hometown. At a Rochester client event, there was disbelief that the lower-income cohort really did benefit from the tax bill. Later, at a women’s client event in Ithaca, no one was shy: “All your talk is about making money, but what about discussing how we can help the planet?” “I appreciate your enthusiasm, but (uh-oh) you didn’t mention how this president lifted the national debt by $1 trillion in one year.” And another, “only corporations got the tax cut.” And, in a Rochester repeat, disbelief that the average guy really did get a tax cut. But, excellent ladies! I met an 82-year-old resident of a retirement community who runs two not-for-profit enterprises from her apartment and a veteran social worker who described opioid victims that she works with every day. Advisors in Syracuse were trying to make sense of the volatility in the face of strong Q1 earnings. One noted recent recessions were precipitated by rising oil prices, which are flirting with $70 per barrel. With the average pump price jumping to $2.78 from a low of $1.70 in February 2016, filling up a crossover, truck or minivan once again is getting expensive. In response to the observation that the biggest percentage decrease in individual taxes from the new law goes to those earning $20K-$50K a year, an advisor in Syracuse noted the extra $40/week or so is being eaten by the increased costs of filling the tank.

Q1 consensus earnings forecasts continue to increase. On April 4, Thomson Reuters’ year-over-year (y/y) growth estimate was 18.4%. On April 11, it was 18.6%. On April 18, it was 19.2%. This week it hit 21.1% and is trending up. It is not just the size of earnings beats that is impressive but the sheer volume: with roughly a third of S&P 500 market cap having reported, 80% of S&P companies have topped earnings-per-share (EPS) estimates, the highest rate in 20 years, and earnings are beating by 9.3%. This compares to 68% and 4.7%, respectively, over the past three years. The strength of Q1 earnings favors the bulls, with the narrative remaining pretty much the same—strong valuation support at the low-end of the S&P range (2,550-2,600), with breaks above 2,800 difficult without more confidence in the cycle duration (which will determine if P/E multiple expansion can occur). Renaissance Macro said most of the evidence it reviews suggests fears of a cyclical peak are overdone, exacerbated by nervous longs who are using good news as a source of liquidity to sell into. Cyclical peak talk exploded Monday when it was reported that Caterpillar claimed Q1 represented the peak of the cycle, rattling investors who felt such a big-global name must have unique insight into global growth and the health of the overall economy. The only problem, according to many who actually listened to management’s call, is its “high-water mark’’ comment wasn’t meant to suggest the company thinks the economic cycle has peaked.

It didn’t help that the widely disseminated “cyclical peak” interpretation came as market confidence already was shaken by the 10-year Treasury’s breach of 3%. This is getting a lot of attention because it hasn't traded above 3% since January 2014. But spreads relative to yields on comparable government bonds in the U.K., Germany and Japan are their widest in at least 10 years, making the 10-year Treasury attractive and likely tempering further moves up. Dudack Research believes the S&P may be range-bound for the first half of the year, with support at the 200-day moving average and resistance at the January high. Future demand for Treasuries is likely a key reason why long-term interest rates are going up—the net supply of Treasuries is projected to double over the coming 18 months to meet the demands of a growing deficit that’s forecast to top and stay above $1 trillion for years. Government outlays historically have averaged 20.2% of GDP but are now projected to reach an average 22.4% of GDP in the next decade as revenues hold relatively steady at 17.5% of GDP. This would push the ratio of federal debt to GDP from 76.5% in 2017 to 96.2% in 2028, the highest in post-WWII history. Social Security and Medicare currently account for nearly 40% of government outlays, and the Congressional Budget Office estimates their share will reach 46.8% by 2028 if nothing changes. Three percent, schmee-percent. The real trouble lies well into the future…nasty…although by 2028, I’ll be elsewhere.

Positives

Remarkable strength this late in the cycle Despite the comments I got this week about higher gas prices offsetting the tax-cut benefits to lower cohorts on the income scale, the Conference Board’s consumer confidence index unexpectedly rose, with all of the improvement concentrated in the low rungs of the income distribution ladder. The increase lifted the index’s 3-month average to its highest level since December 2000. Notably, consumer income expectations were the highest since June 2001. Michigan’s final reading of April sentiment also improved a full point off its initial take, though it was still short of March’s 14-year high.

Remarkable strength this late in the cycle New home sales rose 4% in March, double expectations, boosting the 3-month average to its highest level since November 2007. Wide divergence between median and mean home prices indicated demand was strongest for lower-priced homes, in line with the Conference Board findings that plans to buy a home surged to a record high. Existing home sales also rose above consensus to a 5-month high.

Remarkable strength this late in the cycle The flash manufacturing PMI hit a 4½-year high, led by marked increase in output and new orders. Durable goods orders also were stronger than expected and on a y/y trend basis rose at nearly their fastest pace since October 2014. Elsewhere, the monthly trade deficit unexpectedly shrank the most in nearly three years on increasing exports, led by food and capital goods, while the Kansas City Fed PMI accelerated.

Negatives

If we’re ever going to get inflation, this would be the year This morning’s GDP report showed price pressures perking up, with the core GDP price index advancing at 2.5% annualized pace, the fastest since 2011. The separate Employment Cost Index, which encompasses wages and benefits, rose at 2.7% y/y, a 10-year high. And private-sector pay increased 2.9% y/y, a cycle high.

Q1 GDP slows, but doesn’t it always? In the government’s initial estimate, first-quarter growth slipped to a 2.3% annualized pace vs. Q4’s 2.9%, as consumer spending increased at its slowest annual pace since 2013 and both government and residential spending also eased. The growth still beat consensus, with the underlying data suggesting a pickup is likely the rest of the year. Q1 sluggishness is not unusual—it has been occurring regularly since the early 1990s. It’s thought to be a result of a statistical quirk known as “residual seasonality”—a manifestation of seasonal patterns in data that has already been seasonally adjusted.

Slow start to Q2? Preliminary April data suggests softening economic momentum for a quarter that is expected to experience stronger growth. Many of USB’s real-time growth indicators have been lower this month relative to last, including ISM manufacturing, annualized auto sales, core retail sales and private construction. All still reflect growth, just not as fast.

What else

Debt crisis?! Because of its deteriorating fiscal situation, the probability of a U.S. debt crisis has risen seven percentage points, from a historical average below 9% to around 16%. Because the dollar is a reserve currency, the immediate risk is unlikely but the ongoing fiscal expansion raises questions about where the limits are. With entitlement problems still lurking in the background, Deutsche Bank wonders if investors will continue to buy Treasuries if debt-to-GDP reaches 85% or 100%…or 125%?

My alma mater does cool things Researchers at Carnegie Mellon University have created origami that folds itself. But they aren't stopping with flowers, rabbits or small boats. The researchers inside the Morphing Matter Lab, part of CMU's Human-Computer Interaction Institute, see a future where flat pasta takes shape when it boils, flat satellites unfold in space and furniture, shipped flat, self-assembles in your home or office. Goodbye Ikea directions and that little tool.

I love GOT! But my puppy is my go-to Each year since 2011, the security firm SplashData has released a list of the most commonly used passwords, based on caches of leaked account credentials. The annual list, intended as a reminder of humanity’s poor password practices, always includes predictable entries like “abc123,” “123456” and “letmein.” But one entry, finishing in the top 20 every year, has stood out since the beginning: "dragon." Reasons given for this choice vary, to include the Game of Thrones (GOT) fan, scary creature and “cool.”

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