Weekly Update: 'I've seen it rainin' fire in the sky'

09-07-2018

I’ve been reading in numerous places about the “sugar high’’ concern—that the economy and stock market will come crashing down once all the fiscal stimulus via tax cuts and increased government spending ends. This brings to mind my recent visit to Colorado and Pikes Peak, at 14,115 feet, one of the highest points in the Rockies and the inspiration for “God Bless America.” A bucket list item checked off, but a hair-raising ride (featuring an abrupt U-turn by the Jeep in front of us!) with certain death just a foot or two away. We survived and I’m thinking the economy will too. These sugar-high theorists, many of whom never favored the tax cuts in the first place, see the economy slowing significantly in 2020 as the tax-cut effects wear off. But the Congressional Budget Office estimates that 70% percent of the potential fiscal drag that year would come from reduced federal spending, not waning tax cuts. Don’t hold your breath on the spending cuts. They’re supposed to come from sequestration kicking back in, but since 2013, Congress has blocked sequestration every time it’s come up. It’s almost certain it will back off again in 2020, a presidential election year with every member of the House and third of the Senate up for re-election. The sugar-high theory also ignores any resultant change in behavior from the tax cuts. Tax reform is just starting to drive productivity-enhancing capital expenditures (core capital goods orders are surging) and the repatriation of more than $1 trillion of foreign cash. Both developments are long-term bullish and hardly a threat to the economy.

Skeptics suggest the rally that sent most U.S. equity indexes to record highs in August suffers from poor breadth and thin leadership, but that just isn’t the case. Consider that the NYSE cumulative advance-decline line has been setting a series of new highs, most recently on Aug. 27; 62% of S&P 500 components are up year-to-date, 70% are above their 200-day moving averages and 77% are above their 50-day moving averages; and the daily new high list consistently has been above 100, typical of a bull-market advance. Moreover, of the five largest market-cap stocks, only Amazon ranks in the top 50 (!) in terms of performance. Fifteen of the top 50 and six of the top 20 performing S&P components are tech stocks, well within historical precedent, Dudack Research says. The widening disparity between U.S. and rest-of-world equity performance arguably is a worthy worry, but this may be overblown, too. Using the mid-1990s as a relevant roadmap, Strategas Research notes over the course of 1994-95, U.S. stocks held their own during respective 33% and near-20% routs in emerging-market (EM) and European equities. And while the S&P did suffer in the 1997-98 EM crisis, it quickly recovered to new highs. EM credit is a concern but there’s little evidence of contagion. I remain team U.S.A.

Even if Democrats unexpectedly take both houses of Congress in the midterms, Wolfe Research doesn’t expect much in the way of major legislative actions. Many of the hopes that drove markets higher after the 2016 election (tax reform, deregulation) have materialized and will be hard to undo without veto-proof majorities. Gridlock is the likely outcome and the markets love gridlock. Under a Republican president, a split Congress historically has yielded 12% average annual returns. Gridlock also could act as a check on trade policy, reducing that downside risk. To be sure, technical and seasonal factors point to near-term risks. The S&P is at the top of its trend channel, September seasonally has not been a good month (particularly in midterm years) and macro data surprises could turn negative. Geopolitical risks (trade, Mueller, FAANG1 social media scrutiny) are adding to the noise during the corporate news vacuum between earnings seasons. That said, strong seasonal tailwinds that tend to kick in after September shouldn’t be ignored, particularly during midterm elections years. Since 1929, Q4 of midterm years through Q2 of pre-election years have represented the best 9-month stretch of the 4-year U.S. presidential cycle, with bullish tailwinds typically starting in October. The fundamental backdrop remains supportive. We continue to get upward revisions to already strong earnings. GDP, manufacturing and services are accelerating into Q3 (more below). Consumer spending and employment remains robust (more below). In short, the stage is set for new highs into year-end and 2019. No sugar required.

Positives

  • U.S. manufacturing humming along The ISM gauge jumped to a 14-year high in August, with broad improvement across industries and a surge in new orders and production. The companion Markit index wasn’t as robust, slipping to a 9-month low but still at a level indicative of above-average growth.
  • U.S. services humming along In reports that mirrored their manufacturing counterparts, the August nonmanufacturing ISM jumped to near a new cycle high, driven by big increases in new orders and order backlogs, while the companion Markit services index slowed but still signaled above-average growth.
  • U.S. job market humming along August nonfarm jobs came in above expectations, as the labor market continued to reflect broad strength. Notably, wage growth accelerated (more below). ADP payroll growth slowed but remained solid, while jobless claims fell to new 50-year lows.

Negatives

  • Widening trade gap nips at GDP Despite new White House tariffs, imports jumped in July on strong domestic demand and a stronger dollar while exports fell the most since January, mainly because of retaliatory China tariffs. The higher trade deficit, along with slowing vehicle sales (below), prompted the Atlanta Fed to trim its Q3 GDP growth forecast from 4.7% to 4.4%.
  • Vehicle sales slip Slower domestic car and imported truck sales more than offset faster domestic truck and imported car sales, dropping the vehicle sales rate to a low for the year in August. Year-over-year (y/y) sales were up almost 1%. Other consumer spending reports were more upbeat as mortgage purchase applications rose and y/y weekly Redbook sales almost hit a 52-week high.
  • If we’re ever going to get inflation, this would be the year Average hourly earnings unexpectedly jumped last month, supporting Fed tightening plans that include a late-September hike and a second by year-end. August’s 0.4% monthly increase, the biggest this year, pushed the y/y rate to 2.9%, a 9-year high.

What else

It’s too early to worry about recession The San Francisco Fed just published a paper demonstrating the “3-month to 10-year yield curve’’ as the most reliable predictor of recessions. It notes that a recession historically has tended to occur a year or two after the curve inverts, i.e., the 3-month Treasury yield moves above the 10-year. The curve currently is far from inversion, with the spread between the two around 80 basis points.

It’s too early to worry about EM underperformance While EM equity underperformance has only been this bad prior to or during recessions or major debt crises, FundStrat believes the strong dollar is the main reason this time—not some systemic issue or policy mistake. Of the five sectors that account for S&P outperformance—Technology, Industrials, Consumer Discretionary, Financials and Health Care—four represent cyclicals. If EM underperformance is a late-cycle signal, why would U.S. cyclical sectors be driving the outperformance, it asks?

Is Value set to shine? Value has given up its entire 40-years of equity outperformance relative to Growth in the MSCI World Index and in the U.S., has retraced its entire 19-year rally vs. Growth back to 1999—the exact month that Value began a 7-year rally of outperformance. History says expect mean reversion as Value consistently outperforms 76% of the time after such awful 5-year returns.

1FAANG is an acronym for Facebook, Amazon, Apple, Netflix and Google (aka Alphabet) technology stocks.

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