Weekly Update: My delightful colleague dropped me off at the airport and went for barbecue

05-11-2018

I traveled this week to Kansas, aka “Tornado Alley,’’ with stops in Overland Park (which boasts the highest per-capita income in the country), Kansas City (known as the city of fountains with more fountains than Rome) and Topeka. The economy here is doing pretty well—the K.C. Fed’s labor market indicator is near March 2007 highs and its momentum component is near all-time highs. My last meeting was a large client event for ladies only, my favorite kind of group! The subject was active versus passive investing, and the ladies’ comments were fascinating. One was concerned with algorithmic trading. Another wondered if millennials are the ones investing in silly smart beta ETFs, which use alternative index construction rules instead of typical cap-weighted index strategies. A third asked if it’s too late to invest with Warren Buffett. We were a room of aging lady boomers with a lot of lingering worries. It’s been 91 days since the Feb. 8 low, making this the third-longest period between a correction end date and a so-called breadth thrust—an upside move marked by significant volume and participation. Based on the 16 past corrections in cyclical bulls since 1946, this suggests either a breadth thrust is unlikely or the lows have not been made for the current correction. For non-breadth thrusts, the median gain from the end of the 10% correction to the next cyclical bear market has been 21.3% over six months. By comparison, in breadth-thrust cases, the median gain has been 56.3% gain over 22 months. In other words, non-breadth-thrust rallies tend to be significantly shallower and shorter.

Many have argued that as long as the Fed is raising short-term interest rates, long bonds likely will move higher. It is true that in the first few quarters of a tightening cycle, long and short rates tend to rise. But long-term bond yields usually peak and decline several months—even quarters—before the Fed’s focus shifts from curtailing inflationary pressures to supporting economic growth. So it bears watching the global PMI, a favorite indicator among some. It has declined three of the past four months, largely because of the eurozone, where prospects have been sagging all year. We could be staring at a synchronized global slowdown if this trend continues, with significant implications for bond yields. Still, while the flattening yield spread between the 2- and 10-year Treasuries has been spawning recession talk, the spread between the 10-year and comparable Treasury Inflation-Protected Securities is showing mounting inflationary expectations, which makes sense only if the economy is about to overheat, not contract. Meanwhile, the spread between high-yield and 10-year Treasury bonds remains remarkably subdued at around 325 basis points. The message: there’s no credit crunch or recession signal in these spreads. This is a new environment for most money managers, who have grown used to dealing with declining yields during the nearly 40-year secular bond bull. Treasuries continue to trade in a tight range, with resistance on the 10-year currently around 3.06% (incidentally, if it pierces 3.35%, it will break the long-term downtrend). Treasury yields remain well supported by the Fed’s policy of normalizing rates, the stability of the dollar and lingering global concerns tied to Italy, Brexit and Argentina.

Q1 earnings were more consistent with mid than late cycle. With almost 90% of the S&P 500 having reported, bottom-up Q1 earnings per share surged to $37.98, 5% above analysts' expectations at the start of season, the biggest beat in three years. Almost 60% beat on sales and earnings, the highest since at least 2000. It’s not all tax reform—Q1 earnings growth is tracking at a whopping 23% year-over-year (y/y), but less than half of that is from tax reform. At 13%, pre-tax profit growth is coming in well ahead of expectations, and S&P sales ex-Financials are up 9%. Even on raised numbers, U.S. companies still think analysts are too low, with upward-to-downward guidance at a record high. Since tax reform was not priced in January’s highs, Q1’s gains have beaten down P/E multiples. Based on 12-month trailing operating earnings and 12-month forward estimates, the S&P is trading at respective multiples of 19.2 and 15.4, well below December levels. This indicates the current trading range of 2,550-2,700 is building underlying value in equities, with an intermediate up-leg likely. Characteristics of the next leg will be important for the longevity of the bull market (breadth, thrust, momentum, etc.). Even if the market’s in late cycle as some suggest, cycles can last awhile…. Meanwhile, it was a quick trip to Kansas. Too quick for me, as I never got a chance to sample any barbecue.

Positives

Capex on the rise The latest ISM semiannual forecast sees capital expenditures (capex) gaining steam in this year’s second half. May respondents project 2018 manufacturing and services capex to rise 10.1% and 6.8% y/y, respectively, up from 2.7% and 3.8% y/y just six months ago. The NFIB survey (more below) also shows actual and expected capex continuing to climb. S&P constituents increased capex more than 21% during Q1, nearly triple Q4 2017, as accelerating demand tightened capacity, especially for Tech companies.

Small businesses still very optimistic The NFIB monthly gauge ticked up in April and remains in line with 2004-2005, when real GDP growth was around 4%. The earnings trend jumped to its highest level since data began in 1974. But fewer firms thought now was a good time to expand as the economic outlook fell to its lowest point since November 2016, reflecting worries about finding and retaining good workers (more below).

If we’re ever going to get inflation, this would be the year Consumer prices edged up less than expected in April, largely on gasoline’s spike. Producer prices also were subdued. Y/y, core PPI and CPI still topped 2%, with the latter exhibiting signs of picking up—median core CPI, a measure of underlying trends that focuses on price changes in the middle of surveyed items, rose 2.6% y/y, the most since January 2009. Core PPI softened, as did import prices. The reports indicate inflationary pressures generally remain contained.

Negatives

If we’re ever going to get inflation, this would be the year The latest JOLTS report found job openings at their highest level since the data series was initiated in December 2000, while the number of unemployed per job opening and number of available labor per job opening were at record lows. NFIB openings held at 2000 highs, although hiring plans slumped as 50% of those surveyed said they could find few or no qualified applicants. Services firms are confronting similar difficulties—nearly 2/3 of ISM respondents say they’re struggling to find skilled workers. The Conference Board, whose April Employment Trends Index rose 4.9% y/y, projects significant labor-market tightening over the next 12 months, adding to wage pressures.

Cautious consumers Bloomberg’s weekly consumer comfort index continues to slide from expansion highs, while initial Michigan sentiment for May held steady vs. Econoday expectations for a tick up. March consumer credit also came in at the low end of expectations, led by another drop in the revolving component that includes credit card usage. With consumer spending failing to keep pace with sentiment this year, this suggests Q2 spending may get off to a slow start.

Inventories may trim Q1 GDP upon revision Wholesale inventories rose well below consensus in March, and the previous month also was revised lower. Sales, on the other hand, rose, keeping the inventory-sales ratio at a 6-month high, boding well for a potential build in the current quarter.

What else

Stagnant wages? Not real-ly Divided by the PCE index, average hourly earnings are at record highs—up 0.6% y/y in March, 9.6% since 2008 and 17.5% since 2000, according to Yardeni Research. The reason: wage gains, as small as they may seem nominally, have been outpacing even smaller price increases, causing real wages to keep rising and keeping workers from pushing for even bigger raises.

An arresting development The latest National Longitudinal Survey of Youth, a representative sample of approximately 9,000 youths, found a third of 25-year-olds have been arrested at some point in their life. This is important because as also noted recently by Richmond Fed President Barkin, more and more employers are relaxing their stance on arrest records, felonies and drug testing amid a tightening labor market (see above).

Political watch The consensus in Washington is that the Trump administration is falling apart, yet the president’s approval rating has broken out to the upside. Not coincidentally, Trump’s recent strength is correlated to the recent move higher in the dollar, consistent with the historical relationship. This bears watching as the president’s approval rating has historically correlated with the number of lost House seats in the first midterm election.

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