Weekly Update: Calling it as they see it in Minneapolis

06-27-2018

[Editor’s note: With early starts by some to celebrate the upcoming July 4 holiday-shortened week, we’re getting this week’s missive out early and will be back to normal with our regular weekly on July 6. Happy Fourth of July!]

I traveled in Minneapolis and its suburbs this week and encountered mostly dubious advisors, some whose comments took me aback. With gloriously moderate temps and mostly sunny skies, my local colleague suggests it may be the weather that’s getting them riled up??? Worries centered on debt and the deficit, trade wars, slowing growth and a shrinking Fed balance sheet (“Surely that will lead to rising bond yields!”) Challenging my bullish view, one advisor asked, “After strong earnings growth this year, what will we do for an encore in 2019?” In several discussions, advisors wanted to know my thoughts on regional investing. I said I’ve been Team U.S.A. for years and particularly prefer to “stay home’’ these days. While the U.S has the world’s largest trade deficit, its exports and imports are relatively small compared to their importance to the economies of our major trading partners. That might be partly because our partners got used to exporting more and more to the U.S., thanks to our lack of significant trade barriers. It’s also worth noting that despite this sideways market, the Russell Microcap Index (the smallest stocks in the Russell 2000) hit fresh relative highs vs. the S&P 500 this week, perhaps for domestic small caps’ insulation from global concerns. Meanwhile, this year’s tax cuts are providing a big offset to negative trade protectionism consequences—so far. It may be investors aren’t fully appreciating the positive impact this fiscal stimulus is and will continue to have for consumers and corporations.

Still, the advisors I met were not impressed with the tax cut. They’re worried about paying for it, as am I, but that’s a worry for another day. The risk remains to the upside for earnings as S&P forward earnings continue to rise faster than forward revenues. To be sure, nobody wins a trade war, but using respective stock markets as a measuring stick, President Trump has lost much less than his adversaries. EAFE, Europe and emerging-market indexes all broke below first-half trading ranges this week, reversing uptrends that began in 2016. FBN Securities surmises the president has concluded that with the U.S. economy standing above all others, he’s holding the best hand, with the rewriting of the tax code and  historically low unemployment giving him plenty of outs. Fed Chair Powell also could choose to slow his pace toward normalization if he believes the recovery is threatened (more below). This week’s reports (more below) belie any reasons to fret, as does Bloomberg’s consumer comfort gauge, which hit a level last reached when real GDP was growing 4.5% year-over-year (y/y). Cornerstone Macro says watch for three things to know if the trade showdown is starting to hurt. No. 1: dollar weakness—the U.S. trade-weighted dollar so far has had its biggest year-to-date percentage increase in at least 30 years. No 2: signs of financial strains in Asia supply chain countries such as Malaysia and Taiwan. And No. 3: any erosion in U.S. business confidence. It has remained elevated despite increasing anecdotes of trade concerns by CEOs around the country.

Monday’s sell-off had a lot to do with an unwinding momentum/FAANG trade (Facebook, Amazon, Apple, Netflix and Google). With tech trading 20% above its 200-day moving average, there’s room for additional corrective risk. But negative breadth and volume wasn’t as nearly pronounced as in the earlier innings of this correction (i.e., February and April), and Monday’s close represented the exact midpoint between the all-time S&P high of 2,872 on Jan. 26 and the correction low 2,532 on Feb. 9. With high-yield outperforming, 10-year Treasury yields steady and inflation expectations stable, this suggests trade tensions are having a larger impact on risk appetites than the overall economy, even though it appears investors still think volatility will decline over the near term and trade risk will be fleeting. Remember, it’s rare for the market to make much progress in the first three quarters of midterm election years, especially during the summer. The gains tend to be back-end loaded. Technicals put support at 2,677 (20-day low line), followed by 2,664 (200-day average) and 2,595 (the May 3 low). The pullback dropped the forward P/E multiple to nearly 16 (15.9 has represented bulletproof protection for the blue chip index since Brexit), and excluding outsized tech, the multiple is below 15.5. The dubious Minneapolis advisors raised their eyebrows at the 20 P/E we show for our 3,100 year-end target based off consensus $155 earnings for the year (a figure I maintain is actually low, even though the underlying growth trend of earnings this cycle has been about half its historical level). Barraging me with questions, one dubious advisor even quizzed me as to how many firms made up the consensus. Yes, the Minnesotans I met spoke their minds! Introduced to an advisor studying my bio, his first comment to me was: “Looks like you’ve been around and around and around the block.” Hey, I’m doing the best I can over here!!!

Positives

New home sales strong Unlike existing home sales, new home sales are surging, rising nearly 7% in May to a 6-month high and, on a 12-month average basis, running at a 10-year high. Tight inventories, a problem for existing homes (this morning’s report showed pending sales slipping a fourth straight month because of lack of supply), have yet to deter new-home buyers. Price increases remain modest, up a median 1% and average 0.2%, indicating growing demand for lower-priced homes.

Regionals signal acceleration The Dallas Fed’s gauge of service activity posted its second-highest reading since September 2014, with the best company outlook component reading since February 2006. The manufacturing component eased off somewhat but was still solid, with jumps in new orders and employment. The Richmond Fed’s manufacturing and services survey also reflected strengthening activity, with difficulty in finding skilled workers the biggest concern.

Might the Fed back off? Inflationary expectations as reflected in the spread between 10-year yields on the nominal Treasury and Treasury Inflation-Protected Securities remain where they’ve roughly been all year, 2.1%. And a flattening yield curve suggests expectations are closer to zilch than 2.1%. So with the 10-year yield remaining just below 3% even after two quarter-point hikes, might a potential yield-curve inversion unnerve Fed officials, reducing their determination to proceed with 2 more rate hikes this year and 3 in 2019? The Financial Times this week quoted Chair Powell as saying “Changes in trade policy could cause us to have to question the outlook.’’

Negatives

Cracks on the consumer front? Redbook’s weekly measure of same-store sales decelerated a sharp 1.6 points to the slowest growth pace since mid-April, primarily on weaker sales at department and discount stores. However, the ICSC gauge of weekly chain store sales jumped the most in three months, creating uncertainty over whether consumers are pulling back or not. Elsewhere, consumer confidence dipped for the third time in four months, although it remained just off its 18-year high. Expectations were the drag, primarily on uncertainties of what may happen with trade.

Where are we in the U.S. economic cycle? The Chicago Fed’s national activity index unexpectedly fell into negative territory the first time this year, but it appears the drop-off may be a one-off due to the auto-parts assembly fire that’s been rippling through various parts of the manufacturing supply chain. Underlying components stayed consistent with strong economic growth. That fire wreaked havoc on durable goods orders, as well, although unfilled orders expanded again and are at a 4-year high, while revisions to core capital goods turned April’s solid 1% increase into a whopping 2.3% gain.

Where are we in the global economic cycle? This year’s slowdown in factory activity has the eurozone on the verge of a “manufacturing recession,” defined as two quarters of negative growth. Markit’s eurozone PMI hasn’t dropped below 50, but if it does, it would be important to market sentiment and could postpone the European Central Bank’s planned baby steps toward policy normalization, adding another layer of resistance to rising global yields.

What else

‘Heartless Fed’ Strategas Research surmises that the demand for long-dated paper with any yield at all is so strong that the bond market is unable to act as the vigilante on wayward policy choices it once did. It fears that, without any indication of a pause by the Fed in coming months, that role will be filled by the equity market. Strategas says it isn’t too difficult to imagine our current president tweeting his displeasure with the Fed if stocks were to experience a meaningful correction as a result of over-tightening: HEARTLESS JAY POWELL CAUSED CORRECTION. SO SAD. #AUDITTHEFED.

Have you ever heard of ‘Pittsburgh rare?’ Me neither until this week, when I spoke at a Minneapolis restaurant called Pittsburgh Blue at an evening client event. According to Wikipedia, the term started in the various steel mills in and around Pittsburgh, where mill workers needed high calorie food for the heavy work and had only 30 minutes for lunch. With blast furnaces heated to over 2,000°F, they would throw a steak on the side of the furnace, leave it for a few moments and then turn it. The steak was seared but raw inside.

53391 That’s the ZIP code of one of the wealthiest cities in the U.S., the Minneapolis suburb of Wayzata. Houses along “The Lake,” that is Lake Minnetonka (mentioned in one of Prince’s hits, Prince having been a proud Minneapolitan), are owned by executives of numerous Fortune 500 companies headquartered in the area. They include General Mills, Cargill, United Health, Best Buy, Target, Medtronic and United Health. Spectacular homes, some featuring underground tunnels to the lake, were originally built for railroad titans.

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