Weekly Update: Shall we discuss politics or shoes?

05-25-2018

This was a big week of travel in Northern Nevada and California, with stops in Reno, Roseville, Santa Rosa (home of Peanuts creator Charles Schulz, with statues of the characters throughout the city), Sacramento, Walnut Creek, San Rafael (in Marin County, one of the wealthiest in the U.S.), and Oakland. Reno welcomed us with an arched sign above the road—The Biggest Little City in the World. Thanks to its zero state income tax, it is enjoying a tech boom as Google, Apple and Tesla, among others, have big facilities there. All of Apple’s cash is managed in Reno. Indeed, Californians are flocking here to live and work, resulting in help-wanted signs everywhere and homes being built on every bit of available space. An advisor welcomed my national perspective, as “We live in a bubble here.” Interestingly, in numerous meetings, advisors wanted to discuss politics. In response to my remark about the tax bill’s positive effect on stocks, an advisor replied, “Arrgh, taxes!” And the group turned to an all-out discussion about politics. Another advisor complained about California’s taxes, even as the state is “broke” and has allowed a growing homeless population to change the face of San Francisco. As in my last visit here, the widening divide between the haves and the have-nots remains a sad conundrum. This, in the same week that Bernie Sanders has taken on Amazon, which until now had been taking blows from President Trump.

This week marked the fifth anniversary of the start of the taper tantrum, when then-Fed Chair Bernanke hinted at an upcoming reduction in stimulus, spawning a mini-panic that saw long yields spike. Meanwhile, it was 6½ years ago this week that Italy was on the brink with its 10-year yield over 7.25%, and we’re only a few months away from the 10th anniversary of the Lehman Brothers collapse. So, dear reader, what are you worried about now? Inflation? If we’re ever going to get it, this would be the year. But the latest numbers show most measures struggling to reach and stay above 2%—a level the Fed this week suggested it wouldn’t mind exceeding for a bit to lift almost buried inflation expectations (more below). Recession? The data suggest we’re in the midst of a strong quarter for GDP growth, with the area under the Treasury yield curve telling us the U.S. economy is accelerating and likely to continue to pick up speed this year. A flattening yield curve? The spread between the 10-year Treasury yield and the federal funds target rate is no flatter today than it was in February 2016, immediately after the first Fed tightening. That is, despite five rate hikes since, the 10-year fed-funds yield curve has remained essentially unchanged and is steeper than 43% of the time compared to the last 30 years and a long way from inversion. As for the more popular 10- to 2-year Treasury curve, it still has a ways to go to reach zero and even when it does, history suggests investors should expect considerable upside. When this curve hit zero in '68, '73, '78, '88, '98 and '05, the S&P 500 rallied in each instance by an average of 15% over 12 months. And after outright inversion, the S&P rallied an average 29% to the equity peak.

To be sure, this is a quirky market. Since the correction low on Feb. 8, leadership has come from a disparate combination of S&P sectors: an inflation play (Energy), two growth plays (Technology and Consumer Discretionary), and two traditional defensive sectors (Utilities and Real Estate). Leadership among small-cap stocks shows a similar character, and there’s been a lot of new highs and new lows. Sustained rallies have been lacking. On the other hand, the Russell 2000 recorded an all-time high earlier in the week, a sign the broader market is outperforming larger-cap issues. The NYSE cumulative advance/decline line made a new record high on Monday, indicative of good internal market breadth. And the overall technical backdrop is tilting bullish, suggesting the current trading range is a healthy pause in a longer-term up cycle. Earnings also are very supportive—Thomson IBES says they’re running 6.7% above estimates, more than double the 3.1% long-term average surprise factor seen since 1994 and significantly above the 5.2% surprise factor recorded over the past four quarters. Its earnings growth estimate for Q2 is a healthy 19.8% year-over-year (y/y). During my westward sweep, I spoke at two women’s events. Young and old women were in attendance—they were fierce, independent, jovial and in sync with my message. Discussing the possibility of wage inflation, I asked one group, “If I should ever get a raise, what do you suppose I will buy?” A shout from the audience, “Shoes!” Yes! Then we debated shoes vs. real estate as an investment. We don’t have to agree on everything.

Positives

Fed sounds a dovish note Minutes from early May’s policy-setting meeting indicate a modest inflation overshoot isn't just likely but would be welcomed by the Fed. “It was also noted that a temporary period of inflation modestly above 2% would be consistent with the [FOMC’s] symmetric inflation objective.” The “it was also noted” phrase strongly suggests Chair Powell pronounced those words. There were indications that while a June rate hike is likely, the Fed may be nearer than many think to a neutral rate.

Where are we in the economic cycle? Markit U.S. PMIs showed private sector growth strengthening, with services rising the most and manufacturing near a 3-year high. Elsewhere, April durable goods ex-volatile aircraft and defense climbed a healthy 1%, the Philly Fed’s U.S. Coincident Index rose the most since November 2016, the Chicago Fed’s National Activity Index on a 3-month basis hit its second-highest level since May 2010, Richmond and Kansas City indexes were surprisingly robust, and truck tonnage and freight shipments jumped, the latter to near a 11-year high.

Why rising gasoline prices aren’t a big deal—yet So far there's not been a “hue and cry” about prices approaching $3 a gallon. That’s partly because consumer spending on gasoline relative to disposable personal income is close to a record low. Part of the explanation is automobiles are more efficient (better gas mileage and electric), and because gas prices first hit $3 almost 15 years ago. Michigan sentiment slipped but remained high, with no mention of any worries about gas prices.

Negatives

Home sales soften New and existing home sales fell in April, the latter for the first time in three months, as tight supplies and rising mortgage rates took a bite. New home sales still remain in an uptrend near October 2007 levels. With prices rising and mortgage rates at 4-year highs, buyers have been rushing to lock in before rates move further up—the average home last month sold and closed in an extremely fast 36 days. In Reno’s very hot housing market, homes are selling as fast as they can be built. And the real estate ladies table in Northern California said existing home buyers there are competing feverishly to bid higher prices than asked.

If we’re ever going to get inflation, this would be the year Input costs in April’s Markit PMI reports picked up at the quickest rate since July 2013, led by metals (especially steel) and oil-related inputs. Manufacturing prices continued to rise at the fastest pace since June 2011. The Cass Freight survey also noted that demand is exceeding capacity in most modes of transportation, leading to greater pricing power for shippers and a risk of higher inflation in the broader economy. Higher oil prices bear watching—they nearly hit $73/barrel earlier this week before pulling back—but their correlation with core PCE has fallen from 70% from 1973 to 1999 to less than 20% currently, lessening oil’s impact.

No more global synchronized recovery? Unlike robust readings in the U.S., this week’s global PMIs sent a different message, broadly decelerating across Europe, Asia and South America. This slowing in the rest of the world is a big reason why the U.S. dollar has experienced upward pressure of late.

What else

Why not us too, mate? If this U.S. expansion lasts through next year, which most expect, it would be the longest on record. This will cause many to think about Australia’s current expansion, which is 25 years and counting. The U.S. is no Australia, true. But its long expansion is worth noting. Inflation in Australia since 1992 has averaged just 2.5% per year, which helps explain its expansion’s longevity. Fed staff currently estimates that core PCE inflation will be near the 2% objective over the next several years.

Don’t blame bond yields Many investors espouse the view that higher rates are the cause of 2018’s volatility and weaker equity performance—since the beginning of the year, 10-year Treasury yields have increased some 60 basis points while the S&P is up less than 2%. But the data clearly contradict this assertion, as the market has been outperforming on days when interest rates rise relative to down-rate days. Credit Suisse believes equities will continue to reward higher yields up until the point where the 10-year reaches 3.5%.

Active getting its mojo 60% of large-cap active managers are running ahead of their benchmarks this year, Bank of America says, putting actively managed funds on track for their best year since at least 2003. The outperformance has nothing to do with rates, volatility or correlations. It’s because the market is getting messier. The easy money is over—most of what mattered until 2016 was QE and the Fed. Today, with tightening, trade friction and tax reform, it’s getting more complicated and nuanced, making company analysis more important than it has been for a long time.

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