Weekly Update: How's your summer going?

07-20-2018

Despite July’s strong start, equity market sentiment is very apathetic, with neither bulls nor bears exhibiting significant conviction. Bulls point to favorable momentum (breaking above 2,800 on the S&P 500), solid earnings, reasonable valuations (about a 16 P/E on forecasted S&P earnings for 2019) and a possible cessation of trade risks. Bears cite thin market leadership (super-cap tech still doing too much work), a strong dollar, the absence of any U.S.-China trade clarity and the inability of P/E multiples to expand meaningfully from current levels given late-cycle/peakish earnings. Peak earnings worries should be taken with a grain of salt as long as earnings remain robust—up 26%+ in Q1 and on track to rise 23.6% in Q2, assuming a typical beat rate the rest of the reporting season. Bank of America notes that, since 1960, short- and medium-term S&P returns always have been positive following peak quarterly earnings growth. Moreover, earnings surprises so far in Q2 have been driven by the top-line, a rare and potentially positive development as long as growth continues to be robust in this year’s back half. Since 1990, 90% of earnings surprises have been driven by margins, which are coming under pressure as input costs rise (more below).

A trade war-induced slowdown may be the most important downside risk to rates, equities and the dollar in coming months, in part because of uncertainty over how trade volumes and prices may react to tariffs. No one really knows how much demand may fall when prices of solar panels, cars and soybeans move higher, Deutsche Bank opines. Nor does anyone really know the elasticity of demand or supply of the thousands of products on the tariff list. It’s confusing for U.S. trading partners, too. The South China Morning Post reported that China is setting up an alliance of 20 top Chinese think tanks to come up with better policy advice as it looks for ways to improve its analysis of U.S. affairs and avert a trade war. According to the newspaper, “the tit-for-tat trade war has forced Beijing to try and understand what is happening inside the Trump administration. However, it has struggled to find clues to the U.S. president’s intentions.” The 10% duties on an additional $200 billion of Chinese goods would come as that country’s economy appears to be slowing. It grew at a 6.7% rate in Q2, matching the slowest pace since 2016. The fear is if the new tariffs are enacted in September, they would shave another three-tenths or more off GDP growth, putting it at its lowest level since after the 1989 Tiananmen Square crackdown, when the world’s major economies sanctioned Beijing for its response to the pro-democracy movement. China’s leading industrials are almost completely reliant on imports for high-end chips and other crucial components.

Volatility is likely to remain restrained, as the lack of a meaningful market response to negative headlines arising from the trade disputes suggests all the bad news related to negotiations is known to investors. The price range on S&P futures is narrow (within a 33-point range), with the quieter tape giving comfort to portfolio managers to add to risk without fear of suffering a sharp and painful loss. Indeed, the S&P has garnered nearly 300% of its aggregate gain since 2009 in such calm environments. A favorable domestic macroeconomic backdrop also helps. Initial jobless claims are their lowest since just after Neil Armstrong walked on the moon 49 years ago today, yet wage increases remain restrained and nowhere near levels that could add an uncomfortable boost to inflation. This buttresses the argument that there’s no need for the Fed to act with haste. Manufacturing momentum appears to be building, with the Philly Fed’s monthly survey (more below) the latest regional report to surprise to the upside. Industrial production rebounded in May, rising for the fourth time in five months (more below) and lifting capacity utilization to a 3-year high. All of this is supportive of lofty profit projections for the next several quarters, putting downward pressure on multiples and allowing this rally to stretch its legs as we roll through the summer. Me? I’m preparing to go on vacay, so I expect my already pleasant summer is about to get even better.

Positives

Consumers are spending June retail sales rose an in-line 0.5%, but with big upward revisions to the prior two months, sales for the quarter advanced at a 7.9% annualized rate, four times Q1’s pace. The results prompted the Atlanta Fed to raise its Q2 GDP growth estimate, due next Friday, to 4.5%. June’s spurt was driven by vehicle sales, although there were other big gainers. Health and personal care sales increased the most since March 2004, while combined with an even stronger May, restaurants and bars sales had their best two months in 24 years.

Manufacturing accelerates June industrial production rebounded and advanced at a 6% annual rate in Q2, its third straight quarterly increase and almost triple Q1’s 2.4% pace. Manufacturing, which accounts for about three-quarters of production, saw output jump on the biggest increase in vehicle production in nearly three years. However, a key driver was a bounce back from May’s sharp drop-off, when an oft-mentioned fire in a truck supplies plant disrupted a lot of May industrial data. Excluding that impact, industrial production was still up 3.8% year-over-year (y/y), with manufacturers adding workers at their fastest pace in 20 years.

Where are we in the economic cycle? June leading indicators rose more than expected to another new high in the 58-year series, even though May’s slight increase was revised to no change, ending the Conference Board’s consecutive streak of monthly increases at 20. June’s increase reflected broad-based improvement, with only building permits (more below) a drag. The biggest driver came from new manufacturing orders.

Negatives

If we’re ever going to get inflation, this would be the year The Fed’s Beige Book found input costs continuing to trend higher as tariffs—mentioned 89 times in year-to-date Beige Book reports vs. an average 20 times a year since 1996—started to bite. Thursday’s Philly Fed report, which came in much stronger than expected on expanding and unfilled orders, had the sharpest rise in input costs since July 2008. The prices-paid component surged to near its highest level on record while the selling prices rose by a smaller amount, causing the 6-month outlook to fall to a 2-year low on concerns about margins.

A few cracks in housing June starts sank the most in 1½ years to a 9-month low, and the prior two months also were revised down, causing the 6- and 12-month averages to decline as well. Notably, single-family starts fell the most this year and permits shrank a third straight month. While both series tend to be volatile, the falloff pushed y/y momentum for starts and permits into negative territory. Mortgage purchase activity also slipped but remained positive y/y, while builder confidence held at a 10-month low but was still expansionary.

Where are we in the economic cycle? OECD leading indicators suggest the pace of economic activity for the next six months will be unchanged to marginally slower. Among the reasons: moderating Chinese growth, a European soft patch, emerging markets irritation and possibly a Q3 letdown in the U.S. after an expected big GDP number for Q2.

What else

This isn’t your S&P CEO According to a recent study by Fundera, 86.3% of small business owners said they take a salary of less than $100K per year; 30.1% said they don’t pay themselves at all. Of those who do take a salary, most put theirs in range of $20-$50K per year.

Two economists walk into a bar … The president’s Council of Economic Advisers projects economic growth will accelerate to above 3% y/y, on average, through the next decade, boosted by Trump’s economic agenda. In contrast, Fed officials are expecting real GDP growth to slow over the next three years to 2.8%, 2.4% and 2%, respectively, and to just 1.8% over the long-term.

What does ‘For now’ mean? Those two words, uttered by Fed Chair Jerome Powell in this week’s biannual testimony before Congress, left many wondering if it was a signal the Fed may be willing to ease off its tightening path. Futures are pricing in just two more hikes next year vs. the three in the Fed’s dot plot, indicating investors may think Powell will be flexible and let the data and geopolitical events dictate the central bank’s actions. That said, futures suggest this year’s two additional hikes are baked in the cake.

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