Weekly Update: If everybody's euphoric on Main Street, then ...

06-15-2018

What’s up with Wall Street? Unemployment is at 1960s’ lows. There are more job openings than people seeking work. CEOs and consumers have rarely been as bullish. Inflation is under control. The dollar is doing well. Earnings are on pace to grow more than 20% this year. And Q2 GDP growth forecasts are hovering above 4%. Yet after nearly six years of P/E multiple expansion, multiples are contracting (more below) as investors appear to be looking past the positives to a recession that one day will come. This week’s quarter-point hike and signal from the Fed that two more are likely this year appears to have added to those fears. The spread on the 2/10-year Treasury yield curve is its narrowest since the global financial crisis, and the current Fed policy path suggests a potential inversion as early as late next year. Every time the yield curve has inverted, a recession has followed. We all know that. But we also know that it typically takes a year or longer for a recession to come after the curve inverts. And during this period, the market historically has racked up significant gains—an average 15% over 12 months the last six times the 2-to-10 curve hit zero. And after outright inversion, the S&P 500 has rallied an average 29% to the equity peak. Moreover, after the last two years (1984 and 1994) that saw a flat to range-bound market against a backdrop of strong earnings, economic growth and P/E compression, the market gained 26% and 35%, respectively, the following year. So why all the worry?

Solid. That’s how the Fed described the economy this week, for all the reasons mentioned above, to justify a slightly more hawkish tone. It’s not so much the 2018 rate forecast that some found worrisome but the 2019/2020 dots that seemed to imply the Fed will keep raising rates even after the yield curve inverts, pushing short rates above the so-called neutral rate, a sort of demarcation line between accommodative and restrictive policy. With the European Central Bank also saying this week that it will end monthly quantitative-easing asset purchases by year-end, the percentage of global central banks in easing cycles has now fallen from late 2017’s peak to a 6½-year low. The soaking up of all this emergency global liquidity potentially represents the biggest secular headwind for the equity rally, albeit not an immediate one. More troubling to nervous nellies is the possibility of a Fed policy mistake—a dogmatic allegiance to an upward rate path in the absence of any hard evidence inflation is on the verge of breaking out. While Powell suggested he’s puzzled why long bond yields are so low, many believe it’s because inflation will stay low indefinitely on the rise of artificial intelligence, aging global demographics and other structural forces. The worry is the Fed appears set to go against a market that is betting heavily that inflation will stay lower for longer.

This morning's trade-related sell-off notwithstanding, the intermediate-term backdrop for equities continues to improve on expanding breadth. A short-term pullback may come on resistance at 2,800 on the S&P, but pullbacks are likely to be relatively shallow and short-lived amid a string of new record highs in the NYSE advance/decline line, the Russell 2000 and the Nasdaq. Even large-capitalization stocks are participating, with all the popular indexes trading above key moving averages. Small-caps are at or near highs in most sectors, IPO performance—an important gauge of liquidity conditions—is particularly strong and sentiment indicators are neither bearish nor bullish. So while this market may be late cycle, it’s still far from end of cycle (to use a baseball reference, a whole lot can happen in the final three innings including extra innings). Speaking of, I visited Seattle this week and went with clients to a Mariners game. I very much enjoyed the company but have always found this sport mind-numbingly boring. Whenever I go with the Mister, who wants to see the final pitch of every game, I dread the prospect of extra innings. But in the market, extra innings are a feature of secular bulls, which can last up to 20 years. At my annual visit to Phoenix, my local adviser friend reminds me most people enjoy three secular bulls in their lifetimes. One when they’re young and have no money, one when they’re old and about to die, and one that we’re in the middle of right now. Why can’t we please just enjoy it???

Positives

Consumers doing what they are supposed to do—shop! May retail sales jumped the most in eight months and double expectations, lifting year-over-year (y/y) sales growth to a 5.2% annual pace. The increase has personal consumption expenditures on track to add 2.5 points to real GDP growth—the Atlanta Fed’s GDPNow annualized forecast for Q2 is now 4.8%. With the Bloomberg Consumer Comfort index rising the most in four months and preliminary June Michigan consumer sentiment at a 3-month high, spending momentum is likely to continue.

Businesses are ecstatic The share reporting higher minus lower earnings is the highest on record dating to 1974, May’s NFIB survey found. The percent viewing taxes as their most important problem held at April’s record low, while the 3-month average of those who feel government regulation is their biggest headache dropped to an 8-year low. The Duke/CFO Magazine Business Outlook Survey for Q1 found individual company optimism near an 11-year high, earnings expectations for the next 12 months at a 4-year high and hiring plans at a 14-year high. The surveys were reassuring that economic activity in the second half will be stronger than the first half.

Where are we in the economic cycle? Year-to-date business fixed investment growth has been solid, driven by equipment. Information processing equipment and software have been standouts, while ex-energy structures investment growth has been tepid. These dynamics are the opposite of typical late-cycle patterns; historically, a cyclical peak is characterized by equipment investment rolling over even as structures investment growth accelerates. Also this week, New York’s Empire gauge jumped while industrial production fell, largely because of a fire at a key parts plant that severely disrupted the truck-assembly supply chain.

Negatives

If ever we’re going to get inflation, this would be the year Led by goods inflation exacerbated by new steel and aluminum tariffs, PPI rose in May by the most in four months, pushing the y/y increase to 3.1%, the fastest since December 2011. Core PPI rose a steadier 2.4% y/y but maintained its upward trend as pipeline price pressures strengthened and personal consumption PPI accelerated. May’s headline and core CPI increases were a respective 2.8% and 2.2% y/y, while both import and export prices jumped at the fastest annual pace since 2011.

Again, if we’re ever going to get inflation, this would be the year A slew of indicators show the U.S. experiencing the tightest labor market since 1969, causing a notable pickup in worker compensation. Average hourly earnings for production and nonsupervisory workers rose at their fastest pace since June 2009, the quarterly Employment Cost Index increased the most since Q3 2008 and Duke/CFO Magazine inflation expectations for company products surged 3.8% y/y, the highest in a decade.

Multiples contracting After rising nearly six years, providing a strong tailwind to equity returns, P/Es have been contracting since February. One would have to go all the way back to 2011 to see the last time P/Es contracted in a material way, leaving the market with flat, narrow and volatile returns. Of the 83% gain in the S&P between 2012 and 2017, nearly two-thirds of the return came from P/E expansion, not earnings. Gulp.

What else

Trump! Trump! Trump! Gallup says President Trump commands the second-highest “own party” approval rating of any president at the 500-day mark since World War II, behind only President George W. Bush after 9/11. Trump-backed candidates won closely watched races in Tuesday’s primary races, defeating more moderate Republicans. Polls continue to show a narrowing Democratic lead heading into midterms, with Dems still in sight of recapturing the House and Republicans on track to actually add to their Senate majority.

Amazon! Amazon! Amazon! Seattle leaders repealed a planned tax on large companies in the face of mounting pressure from Amazon, Starbucks and other big local businesses. It’s estimated the $275 per employee tax would have raised more than $20 million for affordable housing in this booming economy (the two richest people in the world live within blocks of each other in the Bellevue suburb), where soaring home prices have created a huge homeless problem.

Mariners! Mariners! Mariners! Seattle’s baseball team has quite a winning streak going on. On Thursday, a day after the Mariners swept a series against the Los Angeles Angels on a come-from-behind victory, I was treated to a showdown between two of this year’s three most-winning teams (Mariners vs. Red Sox—the other team is the Yankees). My advisor companion said it was a pitchers’ duel. Whatever. News commentators said the team is making baseball fun. Perhaps I suffer from having the Pirates for my home team.

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