Weekly Update: It's the dog days of August—last chance to chill

08-17-2018

Last week I traveled through laid-back North Carolina—Asheville, Hickory, Charlotte, Raleigh. In exclusively advisor meetings, numerous questions arose over and over again: how to invest in cannabis (always ended up with just buy Big Tobacco, which will pay a fabulous yield while we await national legality). There were many worries about debt buildup, particularly corporate debt. Ned Davis suggests these fears are overblown as total liabilities net of cash remain on a downtrend relative to net worth. Will the midterms mean anything to the markets? I get this comment often, and believe that, gridlock or no, this administration blew all its ammo on a massive tax cut. The worries were close to home. There was nothing about Turkey, emerging-market (EM) contagion or the strong dollar. With the typical vacuum of news, liquidity and attendance the final weeks of August, the market seems noncommittal, rallying on perceived positives (China trade talks, earnings) and selling off on perceived negatives (Turkey, dollar strength). It would not be unreasonable to expect seasonal weakness—the market’s strong start to Q3 is a historical anomaly—with S&P 500 support in the 2,785-2,800 area. And don’t forget the historical tendency of a politically driven summertime correction leading up to the midterms.

If everyone's underestimating Turkey (more below), there should be more signs of credit market stress and that just hasn’t been the case. To be sure, dollar strength is a risk to earnings, with the negative implications a major topic in Q2 earnings calls. That said, the consensus estimate for Q2 S&P earnings-per-share has surged $8 in just four weeks to $161, up 27% year-over-year (y/y)—more than Q1’s 25%+. The consensus for Q2 S&P revenues has moved up to a very strong 11% y/y. And S&P earnings for Q3 are expected to post another 25% y/y increase! The outperformance this year of the Russell 2000 to the S&P makes clear markets are worried about the potential impact of growing trade tensions. But earnings and revenues of the top 50 companies with the biggest exposure to foreign sales have actually grown faster than both the S&P as a whole and companies with no foreign sales at all. Strategas Research reports more than 80% of companies queried by the University of Chicago have stated that tariffs, announced and threatened, have not affected their capital spending plans. It believes, as do we at Federated, that a renaissance in capital spending has begun that will lead to higher productivity growth, wages and corporate profits while keeping unit labor costs comparatively low. If it holds, this theory would strongly suggest we are not late in the business cycle at all.

“Will you explain to me why we need to worry about Turkey and keep it simple please,’’ was a question I received late this week at a Pittsburgh client event. Some view the 1997-98 Asian crisis as an analogue for Turkey contagion. EM stocks were hammered (-60%) back then, but S&P weakness was short-lived and proved to be an important buying opportunity. The 1994-95 Mexican debt crisis behaved similarly. At present, EM sovereign risk isn’t uniform either—China’s credit default swap market has remained relatively benign over recent weeks. Deutsche Bank says an overview of Turkish debt finds Turkey's short-term borrowing position isn’t as vulnerable as some suggest, and its share of global trade and linkages to other EM countries isn’t all that big. The bigger hammer on the EM may be the dollar’s breakout. EM equities’ sharp swing from 16% outperformance in 2017 to 11% underperformance so far this year is mostly explained by the turns in the dollar (down 7% in 2017, up 6% this year). Country-specific EM stories such as Turkey’s are always more likely to materialize when dollar strength puts pressure on EM assets. The Institutional Strategist posits the Trump administration’s crackdown on Turkey, said to be aimed at freeing the release of a captive American pastor, really reflects frustration over Turkey’s desire to buy Russian-made missile systems; Russia is where the true risks lie. Earlier this week, I spoke at a women’s event at a vineyard in a Boston suburb (these ladies events always make me feel bonded to my gender. I must shout-out to the Queen, Aretha, whose 1967 masterpiece “Respect” started me on my path to “fierce’’ as a young girl). Might have been the scenery, the company, the paired tastings or all three, but the mood was light. No worries in this group. Our host advisor, dubbing the event Women, Wealth & Wine, offered a tasting from her signature bottle with a caption that read, “... and the queen lived happily ever after in her own damn castle with her own money and took care of her own finances.” Perhaps I can work this into the next argument I have with the Mister.

Positives

  • The economy’s got Big Mo July retail sales rose at their fastest y/y pace in six years, industrial production climbed at its fastest y/y rate in 6½ years and Conference Board leading indicators jumped. The Empire PMI for New York was strong, too, and while the Philly Fed reading moderated, its future activity component jumped, reflecting strengthening optimism.
  • Consumers and businesses very confident NFIB optimism hit a 35-year high and the weekly Bloomberg consumer confidence gauge hit a 17-year high. Preliminary August Michigan sentiment unexpectedly fell to an 11-month low but remained consistent with above-average GDP growth.
  • Inflation worries may be overblown Q2 productivity rose 2.9%, its fastest pace in more than three years, as output surged and hours worked moderated. The y/y increase was a more modest 1.3% but still up considerably from recent quarters. Notably, unit labor costs fell, indicating limited pressure on core PCE.

Negatives

  • Housing still softening August homebuilder confidence slipped to near a 1-year low, mortgage purchase applications slowed and y/y housing starts through July fell 1.4%. On a positive note, permits have perked up and are now running 4.2% above the year-ago pace, with single-family activity leading the increase.
  • If we’re ever going to get inflation, this would be the year Led by fuel, import prices rose at their fastest y/y pace in 6½ years in July. However, y/y export prices eased on plunging agricultural inflation as foreign tariffs on a range of commodities cut into demand. Although inflation expectations didn’t change, worries about rising home and durable goods prices drove the dip in August Michigan sentiment.
  • Q2 GDP growth may get a trim June business inventory growth was less than expected and retail sales for the month were revised down, indicating Q2’s initial 4.1% print may be lowered when the second estimate is released later this month. However, early data suggest Q3 growth may surprise to the upside.

What else

Gold can’t work when the dollar is strengthening Gold hit 15-month lows and has not provided any safety over recent weeks (or this year). It’s worth noting that during the EM crises in 1994-95 (Mexican debt) and 1997-98 (Asia), gold also failed to provide any meaningful defensive advantage.

Small is beautiful Small-cap earnings growth is at a 7-year high and is beating large caps for the first time since 2016. One reason: small caps tend to see fewer downward revisions than large caps as the dollar strengthens. Another: domestic-oriented small caps tend to be insulated from trade battles.

Rising rates hit Uncle Sam The federal budget deficit is on track to hit a 6-year high and to surpass $1 trillion in the coming fiscal year. A major culprit? Rising interest rates. Net interest payments represents the biggest year-to-date increase in outlays, up 21.4% on a y/y trend basis, the fastest pace since October 2006. We’ll be hearing “$1 trillion” a lot in the foreseeable future.

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