Orlando's Outlook: Summer rally stalls
Bottom line From the bottom of the market on June 4, stocks have enjoyed a powerful summer rally, with the S&P 500 surging by nearly 13% to a four-year high earlier this week at 1,426.68, consistent with the "Sell in May, Buy in June" thesis we laid out at that time. During this same time, benchmark 10-year Treasury yields have soared from a record low of 1.38% to 1.83%, while the VIX fear index has plunged from nearly 28 to a five-year low at 13.32. To be sure, economic fundamentals have strengthened over the past two months, highlighted by positive retail sales in July for the first time in four months, a strong rebound in the Leading Economic Indicators (LEI) in July from negative June levels, a continued spike in the housing-market index to a five-year high, a doubling in nonfarm payrolls in July from putrid second-quarter levels, and a positive turn in consumer confidence. But we remain concerned about the summer spike in commodity prices—particularly agricultural and energy products—and whether those changes will negatively impact business and consumer spending as they eventually work their way through the inflation pipeline.
In addition, we fully concede that investor psychology has been upbeat in anticipation of positive central-bank activity both here and abroad, which has likely contributed to the equity-market rally. But we are only cautiously optimistic, with important speeches by Fed Chairman Bernanke and European Central Bank (ECB) President Draghi scheduled for Aug. 31 and Sept. 1 in Jackson Hole, the next ECB meeting coming up on Sept. 6, the key German court ruling on Sept. 12, and the two-day FOMC meeting on Sept. 12-13. Consequently, any investor disappointment could stall the summer rally temporarily, with a healthy pullback of perhaps 3-5% in coming weeks. But we would view any weakness as an attractive buying opportunity, as we remain comfortable with our full-year target of 1,450.
Retail sales rebound in July Consumer spending was much stronger than expected last month, with nominal retail sales rising by 0.8%, compared with consensus expectations for a more muted gain of only 0.3%. In contrast, retail-sales results for April, May and June were all negative for the first time since the fall of 2008, at the height of the financial crisis. We had hoped that the important back-to-school season in August and September would show a strong rebound, so we’re certainly encouraged by July's across-the-board strength, and our optimism remains intact. Consumers have amassed some dry powder by boosting their personal savings rate up to 4.4% in June—its highest level in a year—while lower energy prices and interest rates have helped to create some additional spending capacity. In addition, rising equity and housing prices have helped to spark a renewed wealth effect. Because consumer spending accounts for 70% of GDP, a continuation of this positive retail-sales trend will clearly boost third-quarter GDP.
LEI rises in July The index of Leading Economic Indicators (LEI) leapt by a surprisingly strong 0.4% in July, rebounding from a disappointing decline of 0.4% in June, the index's second negative reading over the previous three months. Building permits, jobless claims, interest-rate spreads, and stock prices were the strongest of the index's 10 components, while ISM new orders and consumer expectations were the most negative components. This positive LEI rebound suggests that GDP growth will strengthen in this year's second half.
Positive surprise for July nonfarm payrolls After a dismal second quarter, in which the average monthly employment gain was only 73,000 jobs, job creation began to firm in July, posting its strongest month since February with a well-above-consensus print of 163,000 nonfarm jobs. We’re still well below the 252,000 monthly average set during December, January and February, but July results were more than double June’s gain of 64,000 jobs and the second-quarter average, which suggests that job creation may be slowly getting back on track.
Housing continues to rise from the ashes The National Association of Home Builders' (NAHB) housing market index (HMI), which is a measure of builder confidence, spiked to a five-year high of 37 in August from just 14 last September. This index had peaked at 70 in July 2005 and troughed at 8 in January 2009. Mortgage interest rates are near record lows, affordability is at record highs, household formations are rising, new-home inventories are at record lows, housing permits and starts are rising, mortgage delinquencies are falling, and pricing is starting to firm, all of which suggests to us that the housing industry is finally starting to slowly come off its trough.
Consumer confidence perking up The Conference Board's consumer confidence index rose in July for the first time since February, to 65.9 versus 62.7 in June. The preliminary August reading for the Thomson Reuters/University of Michigan consumer sentiment index increased to 73.6, its highest reading since May, when it hit a four-year high. Continued improvement in consumer confidence and sentiment should spark more robust consumer spending trends.
But the economic news is not universally positive, as we remain concerned about commodity-price spikes and their potentially delayed impact on inflation and economic activity.
Energy roundtrip After a 45%, five-month surge from $77 per 42-gallon barrel last October to $111 in early March, crude oil prices (West Texas Intermediate) completed a volatile roundtrip, plummeting by 30% back to $77 per barrel by the end of June. Over this time, the national average price for a gallon of unleaded gasoline fell by 16% from $3.95 to almost $3.30. But since the imposition of the Iranian oil embargo on July 1, WTI has soared by 25% back to $98 per barrel, with gasoline reversing by 12% back to $3.73 per gallon, with perhaps more room to run to the upside. Because higher energy prices serve as a tax hike for businesses and consumers, this could hamper stronger spending and economic growth in the second half of 2012.
Ag commodities remain volatile Agricultural commodities are soaring due to the worst drought conditions in half a century in the Midwest. Since mid June, corn has soared by nearly 70% to $8.50 per bushel, wheat has surged by more than 45%, and soy beans have risen by 40%. If weather conditions don't improve soon, then these sharply higher prices could begin to work their way through the inflation pipeline over the next several quarters, impacting prices for packaged food as well as beef, chicken and pork.
No impact yet on inflation data From a timing standpoint, the recent commodity-price spikes have not yet begun to seep into inflation, which is running at relatively well-behaved levels of 2.5% and 2.1%, respectively, for the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI) through July on a core year-over-year basis. The core Personal Consumption Expenditure (PCE) index—the Federal Reserve's preferred measure of inflation—is running at 1.8% year-over-year through June, which remains comfortably within the Fed’s 1.0% to 2.0% target range. But the nominal month-over-month PPI data posted a sharp 0.3% increase in July, so inflationary pressures may assert themselves in coming months, as this spark in wholesale inflation begins to inevitably work its way through the pipeline.