Weekly Update: Rarely do politics matter for the markets

09-28-2018

I crisscrossed the country again this week, attending what have become annual events in Denver and Tampa. My first talk, with financial advisors at Coors Field, came before cocktails and the contender Rockies game. Then off to Tampa, presenting to a large group of women advisors. Maybe it was because I see these people every year, or maybe because these are fun gatherings and fabulous venues, but other than idle talk about the many political stories of the week, nothing anybody said or asked really stuck out. The window does appear to be closing on a seasonal correction, with stocks grinding to new highs and high-yield bonds breaking out relative to Treasuries. The technical backdrop is noncommittal: last week’s S&P 500 and Dow records were not accompanied by new highs in the NYSE advance/decline line. With the Fed sticking to the gradual rate-hike script (more below), the biggest test before earnings season gets underway most likely will come from trade. Trade disputes are common, and markets and prices tend to quickly adjust. Guggenheim says productivity-enhancing technology increasingly is offsetting the comparative advantages of cheap-labor countries, accelerating a trend from global supply chains toward production that resides closer to final demand. Further, a Goldman Sachs study of 150 years of trade tensions suggests higher tariffs only modestly impact growth and prices. No, as discussed here in recent weeks, it is not tariffs to worry about, but a full-blown, breaking-apart-global-supply-chains, fully protectionist trade war.

The strong economy continues to translate into excellent earnings growth, with the bulk of the gains coming from basic business success—not the tax cuts. To be sure, the huge tax cut jump-started 2018 earnings and represents “money in the bank’’ for Q3 and Q4 earnings, as well. But sales growth was the primary driver of Q2 earnings and appears to be rising at a double-digit rate across a majority of sectors, lifting year-over-year (y/y) operating margins and the growth rate from business operations. Wall Street analysts are projecting earnings growth of 21% and 17.7%, respectively, for the final two quarters of the year. This is helping hold down forward valuations—the forward P/E multiple for the S&P still resides 3% below its upper bound since prior to the presidential election and after last winter’s correction. I was asked about the market’s valuation in Denver. I’ve argued that while stocks are not cheap, they aren’t nearly as rich as government bonds. Still, it should be said that the median trailing P/E stands at a post-war high of 21.1, more than 50% higher than where it was in 2000!

The biggest change in the Fed’s statement was the removal of the characterization that “monetary policy remains accommodative.” Nevertheless, Fed Chair Powell insisted there was no change in the path of policy and that the policy remains in line with expectations. He added the phrase’s “useful life” was over, downplaying the significance of its removal. This was always going to be a complex meeting to interpret, with many moving parts and confusion as to whether the decision to drop “accommodative” should be read dovish, hawkish or neither. The phrase’s removal implies the fed funds target rate is approaching neutral, and that the Fed needs to have a solid reason for tightening above neutral, i.e., for actively restraining the economy. Recessions have often followed previous instances when the Fed did so, and the Fed is very well aware of it. The fact that policy is getting closer to neutral means the Fed will be more cautious and slower than it has been so far. This is equity-market friendly. Interestingly, despite the present improvement in growth and inflation, there was no upgrade to the average "longer-run" equilibrium funds rate in the statement, suggesting no improvement in hopes for an end to "secular stagnation." From Cornerstone Macro’s perspective, this implies that while the short end of the yield curve will continue to rise as the Fed hikes more, the long end should settle not too far from current levels. Finally, Fed Chair Powell emphasized that politics don’t matter for monetary policy-making. And only rarely do they matter for the markets.

Positives

  • A confident nation Conference Board consumer confidence hit an 18-year high in September, led by a jump in expectations as the job outlook rose to its highest level since January 2004. Michigan’s final take on September consumer sentiment dipped off the initial read but still topped the triple-digit mark for just the third time since January 2004. CEO confidence also slipped in Q3 but remained just off a 7-year high, with respondents to the Business Roundtable survey revising up their GDP growth forecasts.
  • No recession in sight The Chicago Fed National Activity Index remained at a level associated with above-trend growth, Markit and Richmond Fed estimates of September manufacturing accelerated and the Chicago PMI slipped but was still strongly expansionary. The Fed revised up its forecast for growth this year, which held at 4.2% rate in the final estimate for Q2.
  • Counting on capex An unexpected jump in August durable goods orders masked a 0.5% decline in core capital goods orders, reversing the prior month’s trend. However, at 9%+, y/y growth in capital expenditures (capex) remains strong. It’s expected the tax cut will provide a supply-side boost by encouraging more capex, leading to increased productivity that allows for higher wages without inflation.

Negatives

  • Services slip Markit’s flash services PMI fell to a 1½-year low, with speculation Hurricane Florence may have played a role as businesses shut down ahead of the storm—a view reinforced by a plunge in the Richmond Fed’s services gauge for that region. Still, it marked the fourth straight monthly decline in the Markit index, indicating broader issues may be at work. That said, activity easily remained expansionary.
  • Housing continues to moderate August new home sales rose as expected, but the prior months were revised sharply down. Both the Case-Shiller and FHFA price gauges moderated, and pending sales fell a fourth straight month and more than expected, prompting the National Association of Realtors to forecast a decline in sales for the year. It blamed inadequate supply, with what’s left over too pricey and picked over to tempt buyers.
  • Trade isn’t helping The trade gap widened further in August, assuring trade will be a drag for Q3 GDP, as exports plunged on China’s refusal to buy soybeans in retaliation for higher U.S. tariffs. Import growth also slowed, in part on a decline in capital goods, a negative sign for business investment.

What else

Six weeks to midterms Markets historically approach elections with caution, with muted returns and a more defensive tilt. However, that uncertainty quickly dissipates, with robust returns following. Also, going back to 1935, periods with a Republican White House and partial or full Republican control of Congress have been associated with double-digit market returns. A Republican White House and Democratic Congress, a less common occurrence, has been associated with more modest returns.

Tax-cut myth The political argument is the tax cut was a waste with nearly all the money going to share repurchases. But the data clearly refutes this. Buybacks and dividends are growing just a tad faster than the increase in U.S. market cap, with companies repatriating about $465 billion year-to-date and receiving another $40-$45 billion from the corporate tax cut. Of that $500 billion, buybacks are up $125 billion—about a quarter of the total.

A worry in the wings One of the most troubling longer-term trends is the wealth-to-income ratio, which currently is at all-time highs. Notably, this ratio has significantly surpassed levels reached just prior to the technology bubble of the late 1990s and the 2008-09 global financial crisis.

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