Weekly Update: Pretty faces

05-18-2018

I crisscrossed the country again this week, only South to North. First stop, New Orleans, which is celebrating its 300-year anniversary and is home to Louis Armstrong and my favorite style of music—jazz. I presented on a panel to a national advisors’ summit on using income-oriented strategies to reduce volatility. I was asked to make the case for dividend stocks, even as the 10-year Treasury yield rose decisively above 3%. Many worry the breach marks a crossing of the Rubicon. Nine of every 10 money managers have only known an environment of secularly declining yields—a downtrend that intersects with 3.25% on the 10-year, with resistance at 3.06%. This is feeding a “this is it!” mentality about a potential secular bond bear. But the slow climb above 3% has been nothing like 2013’s taper tantrum, when the 10-year jumped nearly 140 basis points in four months to just shy of 3%. And monetary policy is far from restrictive—European and Japan central banks are still expanding their balance sheets! Current market expectations see the federal funds target rate gradually reaching 3-3.25%, making for a flat curve in 1-1.5 years. Recessions typically don’t occur until a year or two after an outright yield-curve inversion (short rates above long rates), with the market rallying in the interim.

What drives rates up? Inflation. But for all the talk of resurgent inflation, the numbers of late have softened in the U.S., though economic growth is still solid. Valuations look attractive—the forward P/E multiple for the S&P 500 sits much closer to its pre-Brexit floor (15.9) than its ceiling (17.4)—and technicals have turned favorable. The triangular pattern in the S&P and Dow has broken to the upside, with the S&P above its 100-day moving average and the cumulative advance/decline line setting a new high, a sign of internal market strength. Intermediate-term momentum indicators are incrementally turning up, sentiment indicators are oversold after peaking early this year, overall participation is improving across most sectors and the small-cap Russell 2000 index has set fresh 52-week highs. In addition, the average intraday range for the S&P has narrowed by roughly half this month to levels historically associated with a low probability of a correction. With no scheduled events prior to mid-June’s Fed meeting to disturb this quiet period, the current path of least resistance leads to higher share prices.

This week’s move above 3% in the 10-year came even as the CPI, PPI, PCE and average household earnings have missed consensus expectations. Earlier in 2018, it took stronger-than-expected readings to push bond yields higher, but now it is happening even among stable U.S. data and global inflation that’s been flat for about a year and a half.  Investors tend to have a fear of round numbers (3% in this case). But in reality, a 3.1% bond yield is still historically low, particularly with inflation running at 2.4%. In Bank of America’s annual institutional survey, half of the respondents cited “short-termism” as the biggest threat to investing. It thinks long-term fundamental investing may be the most contrarian opportunity today. In my Behavioral Finance seminar, I describe a newspaper competition that asks contestants to pick out the prettiest face from a hundred photographs, with the prize being awarded to the competitor whose choice most nearly corresponds to the average of the competitors as a whole. It is not a case of choosing which, to the best of one’s judgment, is really the prettiest, nor even what one thinks average opinion would think is the prettiest. It is the third degree—anticipating what average opinion thinks the average opinion is. That’s what stock market investing is like in the short term and right now, “mo” doesn’t think the average investor thinks that the average investor finds dividends so pretty. To which the average baby boomer investor, looking at increasing volatility, innumerable uncertainties and impending retirement (!) may respond, “Huh?”

Positives

Synchronous global growth U.S. and global leading indicators rose again, signaling above-trend growth, while two key regional indicators—Philly Fed and Empire gauges—showed manufacturing activity noticeably accelerating. Notably, Philly Fed new orders hit a 45-year high while the overall index was at a 12-month high. Also, industrial production also rose a third straight month, with business equipment activity up the most in a year.

The consumer is OK April retail sales rose the most this year on a 3-month basis, improving from late 2017/early 2018’s weather-related slump. On a smoothed y/y basis, sales were up 4.6%, a slight uptick in trend from the previous month. The report shows that despite higher gas prices, consumer spending remains robust and continues to run ahead of last year’s pace, bolstered by tax cuts, low unemployment and robust confidence.

Housing’s positives The good news in last month’s drop-off in housing starts and permits (more below) was that the decline was concentrated in multifamily units. Single-family activity posted increases on both fronts, helping builder confidence increase for the first time in 2018 to near a 13-year high.

Negatives

If we’re ever going to get inflation, this would be the year Two risk factors linger over April’s benign inflation reports. The first is crude oil prices, with the technical chart showing no upside resistance prior to $80-85 per barrel. Second, given the size of the nation’s energy sector, higher oil prices could goose growth, adding to inflationary pressures. While higher oil prices also could trim consumer spending, Strategas Research estimates they’d have to average at least $86 for the year to wipe out the tax-cut boost to incomes. Elsewhere, Empire input price pressures hit a 7-year high and Philly Fed selling prices were their highest since 1981.

Housing’s negatives With mortgage rates climbing to near a 7-year high, the Housing Affordability Index slipped in April to a 9-month low while mortgage purchase applications fell a third straight week. Housing starts and permits also declined more than expected in April, although both remain on steady upward trends, with y/y starts up 10.5%, permits up 7.7% and both 6- and 12-month averages as well as housing backlogs at 10-year highs.

It’s premature for the bond market to worry about deficits Even with April’s $214 billion surplus, the largest monthly surplus on record, fiscal year-to-date red ink sits at $385 billion, up 12% from a year earlier. The deficit remains on track to top $1 trillion by 2020 as a result of the recent tax cuts and spending increases. Still, Goldman Sachs estimates this will push the deficit to 5.5% of GDP by 2021, adding just 30 basis points to the 10-year Treasury yield.

What else

Behind the capex boom: tax reform and…China? Based on analysis by the Boston Consulting Group, the savings from producing in China have dropped to basically 0%, reflecting higher wages, higher energy prices and a stronger yuan. That’s one reason why U.S. domestic capital expenditures (capex) relative to cash flow already have turned up. Combined with corporate tax reform and full expensing, capex in the U.S. should continue to increase, causing productivity growth to accelerate to 1.5% y/y, more than double its average growth rate over the past five years.

I want grandchildren! A survey of credit card spending in 14 cities found growth in spending by millennials more than tripled the average 2% increase for everyone—there wasn’t a single city where millennial spending growth didn’t dwarf others, a factor of this cohort (median age 26.5, oldest 37) entering prime income years. Yet even as their economic importance accelerates, millennials don’t seem to be all that eager to start families. U.S. births are at their lowest level since 1987 and the birthrate is at an all-time low, based on records going back more than 100 years.

I finished my week in Harrisburg The capital of my state, it was established in 1812 and named after John Harris, an English immigrant who first landed in Philadelphia with a total fortune of $26K (in 2018 dollars). At first a roving trader, he established a trading post along the river. In 1733, he began to operate a ferry across the Susquehanna River and for more than a half century “Harris’ Ferry” was the funnel through which much of the Scottish, Irish and German migration trickled west. In the same year he acquired two tracks of land adjacent to his ferry, which today is downtown Harrisburg.