Weekly Update: Late cycle, late schmycle

07-27-2018

This week’s U.S.-European Union (EU) “deal” to make an ultimate deal builds on negotiating dynamics Trump appears to be using to get Western allies to gang up on China. While TrendMacro sees near-term risks (as do we, as I’ll discuss in next week’s missive), it thinks China’s fragility in the face of credit risks and capital flight ultimately will force it to strike an agreement, spawning an outbreak of market exuberance. Because it represents 2.1% of the S&P 500 market cap, Facebook’s disappointing guidance dampened the U.S.-EU relief rally but didn’t seem to undermine prevailing positive momentum. The NYSE closing TICK—the net of NYSE stocks closing higher or lower than the previous day’s close—has been signaling oversold conditions for more than two weeks, a condition that’s almost certain to force sideline cash into the market. Other technical factors also are supportive. For one, the market is not as narrow as it seems—breaking down the Russell 1000 into market-cap quintiles (the first being the largest stocks, the fifth the smallest), Strategas Research found quintiles 2, 3 and 4 have outperformed this year. Moreover, the gap between daily highs and lows on NYSE stocks is its smallest since December, reducing investor fears of suffering from a quick and sharp loss when entering a position.

On the other hand, seasonality and declining correlations reflect a bifurcated tape, in which there’s money to be made on both sides (long and short). Given the calendar, Strategas Research believes performance is likely to be more rotational (money moving from group to group) than broad-based (fresh money lifting all groups). Historically, August in the second year of the 4-year presidential cycle is the worst month of the cycle, with a significant up-move typically coming closer to the midterm elections into year-end. Enthusiasm is above normal—the percent of market cap represented by money-losing companies is at 2.5%, vs. the usual 1% (the more confident they are, the more tolerant investors are of losses). This is more a cautionary note than a flashing red sign: the money-losing market-cap peak was 6%, reached in early 2000 just before the tech bubble burst. Fundamentals remain strong. Outside of housing’s deceleration, the economy is humming (more below). And Q2 earnings are on pace to rise 25%, just shy of Q1. Again, a cautionary note. Forward guidance is buttressing the view that Q1 was the earnings peak; historically, the market is weaker six months after peak earnings.

With the expansion a year away from becoming the longest in U.S. history, Goldman Sachs studied other countries where growth cycles have lasted more than 10 years (Australia from 1992 to the present; the U.K., 1992-2008; Canada, 1992-2008; and Japan, 1975-1992). It found similar advantageous factors exist in the U.S.: a relatively flat Phillips curve (the relationship between inflation and unemployment), strengthened financial regulation and a lack of financial imbalances. In the past three U.S. expansions, the late-cycle phase lasted 2-4 years, indicating the next recession could be as far out as 2021. With core inflation having fallen short of the Fed’s 2% target for 10 years, policymakers likely will continue to emphasize symmetry around the target and not fret about periodic moves above it. What could lengthen the cycle? Increasing labor force participation, rising productivity and a strong dollar. Recent data reflect improvement in the first two, and despite some weakness of late, the dollar has strengthened significantly this year. All of this is important for investors as past performance suggests getting out early can be costly. While timing the move from late to end cycle is impossible, in the last three cycles, the equity market’s median cumulative late-cycle return was 42%! Late cycle, late schmycle.

Positives

  • GDP jumps The initial Q2 estimate came in at a 4.1% annualized pace, a sliver below estimates but the first 4%+ print in almost four years. Consumer and nonresidential business investment helped drive the improvement, rising at a respective 4% and 7.3% clip. Q1 GDP also was revised up two ticks to 2.2%.
  • Manufacturing accelerates The Markit PMI rose again in July to well above its expansion average, while regional Kansas City and Richmond Fed gauges and the Chicago Fed’s national survey also reflected strength. Unfilled orders—fuel for future activity—continued to rise.
  • Capex climbing Core capital goods orders—a capital expenditures (capex) proxy—rose a healthy 0.6% in June and were revised up for May from an initially estimated decline of 0.2% to a gain of 0.7%. As noted above, increased capex was a key contributor to Q2 GDP growth. This bodes well for future productivity.

Negatives

  • Housing slump worsens Existing home sales fell a fifth time in six months and June new home sales hit an 8-month low. Culprits include tight supply and affordability, the latter hurt by rising mortgage rates and housing prices that have increased faster than personal income the past 12 months.
  • If we’re ever going to get inflation, this would be the year The Q2 GDP price gauge shot up 3% year-over-year, while July manufacturing cost burdens jumped in Markit’s initial survey. Respondents said steel and aluminum tariffs were pushing up raw material prices. Service companies voiced similar complaints.
  • Tariffs hit trade The trade gap widened more than in expected, as May’s race to ship goods before tariffs kicked in eased in June, causing exports to fall off. Trade for the quarter was still a big positive to Q2 GDP, although future revisions as a result of June’s trade figures could trim the improvement.

What else

But I want to be a grandma Birth rates fell at a record rate last year, possibly as skyrocketing childcare costs and financial insecurity deter millennials from having children. Given the global sweep of the women’s movement, birth rates should keep falling, creating demographic drag. “The relationship between gender equality and fertility is very strong,’’ said University of Maryland sociologist Philip Cohen. “There are no high-fertility countries that are gender equal.”

Losing plastic straws probably won’t be enough University of Georgia scientists warn that 111 million cumulative tons of plastic are likely to accumulate around the world by 2030, largely a result of China’s decision to bar imports of 24 types of waste. Prior to the ban, initiated this year, China bought up over half of the scrap material exported from the U.S. and, since 1992, accounted for roughly 45% of global plastic waste imports.

You go, girls! When Mexico’s new Congress assembles Dec. 1, women will make up 49% of the lower House and 51% of the Senate. In Mexico City, residents elected their first female mayor. And among the 89 million Mexicans who registered to vote in this year’s election, 51.9% were female, one of the highest turnouts ever. Women the world over are making political gains, bolstered by research showing they have the same or better credentials than male candidates. Once in office, they also are more productive with fewer absences.

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