'Who needs 'em!'
That’s what a feisty millennial advisor I met in Chicago said about my generation! More about that later. I spent several days in the Windy City this week, meeting with advisor and end-client groups, with time to visit my beloved daughter Anne. An advisor was concerned about inflation heating up, as he sees help-wanted signs at every light manufacturing concern in his suburb. Truly the job market is tight (more below), but the Amazon effect, in which technology is reducing costs to consumers (Uber, Dollar Shave Club, shopping for nearly everything on Prime, etc.) looks disinflationary if not deflationary (also more below). At a client event, a lady worried that local businesses are being shuttered in Amazon’s wake, while another worried that the cutting of regulations could go too far, setting us up for another financial crisis. The slippery slope is a definite possibility, but perhaps a worry for another day. Equities have cheapened considerably year-to-date, reflecting ever-increasing forward earnings estimates and the headwinds of rising rates, worries about a more aggressive Fed, trade tensions, geopolitical risk and late-cycle concerns. But the S&P 500 P/E still remains above the implied multiple for investment-grade (IG) bonds based on historical patterns, suggesting either IG yields or the S&P P/E need to rise considerably. Given the economy’s cumulative slack (see next paragraph), the latter may be more likely. With the consensus forward 2019 earnings estimate at $176, if the S&P P/E were to rise 5 points to the current implied investment-grade P/E of 20.6, this would suggest 3,626 on the S&P—a 32% upside!
Defined as the difference between actual and potential GDP, “cumulative slack’’ since 2008 is the highest on record. Evercore ISI says this helps explain why inflation has been and may continue to be restrained, and why bond yields have struggled to move up in any significant way on an historical and real basis. This week, yields declined all over (except for Italy), fed by an Italian government crisis that sent jitters through Europe’s southern periphery and European banks. Even before the dust-up that raised talk about a potential Italexit, the European Central Bank (ECB) has been stymied from normalizing monetary policy. Recent data suggest growth in Europe is slowing, with eurozone inflation up only 1.2% year-over-year (y/y), well below the ECB’s 2% target. The core rate is significantly lower, languishing most of the past four years below 1%. This has been an added drag on U.S. bond yields, which in normal times would see the 10-year Treasury trading around the growth rate of nominal GDP—about 4-4.5% currently. Instead, it is back below 3% because comparable German and Japanese yields are close to zero. While corporate credit spreads remain tight as a drum and upward earnings revisions as a percentage of all earnings revisions are still above 60%, flows into bond mutual funds and ETFs are dwarfing flows into equity vehicles. (The term “dwarfing” is, in actuality, mathematically impossible—there have been net outflows from equity market mutual funds and ETFs year-to-date and since the start of 2017.) This straps another restraint on bond yields.
Short-term equity market pullbacks are likely to be shallow and short-lived amid an improving intermediate-term backdrop for a growing list of sectors and groups. Long-term uptrends remain intact for most markets and sectors, with sentiment indicators remaining depressed (and as such, supportive) and the start of summer helping volatility to continue to subside. The improvement in corporate cash is feeding merger activity, adding to market momentum. Thomson Reuters computes that mergers have reached $2 trillion to date and are on pace to surpass 2015’s all-time annual record of $4.7 trillion. For the S&P, the 20-day low support is at 2,595 and 65-day high resistance is at 2,802. A break in either direction would take the market out of its 4-month trading range, with upside breakout the more likely at this juncture. Back in Chicago, I found most of the conversations circled back to the millennial generation. Two advisor partners refreshingly reported that they serve these young investors, who they find very willing to invest but in a conservative way, avoiding debt. As for the title of my weekly, it was inspired by a young advisor of wealthy clients who, when discussing the concentration of wealth among baby boomers, said that he wants the “young money.… I’m going for the next generation.” As for baby boomers (of which I am obviously one, gulp), “Who needs 'em!” That comment set me up for my evening’s lament and reminded me of a local taxi driver’s comment earlier that day. When I asked if I could turn off the back seat mini TV that kept playing the same loop of nonsense over and over, he said he’d be thankful if I quieted that noise which he must hear ad nauseam every day. “It makes me just want to go home and get a glass of whiskey.” Wine for me.
Tight as a drum May jobs surprised at a well-above consensus 223K, with broad-based gains and another drop in the jobless rate to 3.8%, matching its lowest level since Neil Armstrong walked on the moon. Other data this week suggested the gains could continue, as other measures of economic activity, including construction spending and regional and national manufacturing PMIs, accelerated. The data is in line with surveys suggesting a strong Q2 GDP rebound off Q1’s slightly downwardly revised 2.2%.
Confident consumers step up spending The Conference Board index rose in May for the first time in three months to near a 17½-year high. Present situation, current business conditions and job availability components were the best in over 17 years. This bodes well for the markets as consumer confidence tends to fall sharply a year or so before recession, and the opposite is happening now. It also is good for spending, which has recovered from its slow start to the year. Personal expenditures rose the most in five months in April, and March was revised up too, helping lift the Atlanta Fed’s GDPNow forecast for Q2 growth to 4.7%, nearly double Q1’s pace.
If we’re ever going to get inflation, this would be the year Y/y core PCE inflation held below 2% again in April, suggesting higher gasoline prices aren’t having much of an impact yet. The Fed’s Beige Book survey also showed limited price pressures amid moderate growth. Based on data since 1997, Renaissance Macro says there’s an elevated number of workers in the same job reporting no y/y wage change despite an 18-year low in the jobless rate. This would be consistent with 2.5% average hourly earnings growth in the year ahead, although this morning’s jobs report put y/y hourly average earnings at a slightly higher 2.7%.
Home sales slip again A shortage of supply and rising mortgage rates are conspiring to cut into housing’s late-winter momentum, as pending sales plunged 1.3% in April, dropping the y/y decline to 2.1% and foretelling further declines in existing sales when those numbers come out later this month. Housing was on upswing in February and March, but that’s faded with the arrival of the normally robust spring selling season.
Trade war watch The return of U.S. protectionism after a century has led to fears of a trade war, with U.S. tariffs acting as a negative supply shock to the world economy. Barclays estimates a 1% tariff as a share of imports causes global growth to decelerate three-tenths of a point and inflation to rise fourth-tenths of a point. With tit-for-tat retaliation, the effects double. Putting current measures into perspective, this week’s U.S. steel tariffs represent just 0.33% of U.S. imports, even ex-exemptions. The Intellectual Property tariff of 25% on $50 billion of Chinese goods represents just 0.5% of U.S. imports.
Italy watch While a near-term crisis appears to have been averted, the situation in Europe’s third-largest economy bears monitoring. Unlike Greece six years ago, Italy has political parties and potentially a government that is not committed to remaining in the euro. ECB President Draghi’s rescue plan for European banks and Greece had as its basis a euro system not to be tinkered with. There was no risk in that sense as the ECB bought all the bonds necessary to fund EU governments. This new Italian government’s manifesto includes rolling back pension reforms, a flat tax and a budget blow-out. This is a country with the largest debt of euro countries and the fourth-largest in the world.
It’s a global earnings story Earnings upgrades picked up across the continents in May, with the U.S. leading the charge (up 1.6%). Deutsche Bank says Europe and Japan rose the least, with emerging markets falling in the middle and improving off the prior month’s downgrade. Italian earnings were upgraded a seventh straight month, while France, Spain and the U.K. also saw decent upgrades.
When will the piper come for payment? The dirty secret of the U.S. growth model, Bernstein says, is that it relies on either debt growth or asset price bubbles to get anything that resembles decent growth rates. In the ’90s we got an equity bubble that drove wealth and consumption growth. When it burst, the economy was artificially boosted with a housing bubble. And when that burst, we got quantitative easing—a bubble in duration that helped lift prices in other asset classes. Now QE is reversing and so we need a new fix, this time it's debt growth again. And so we have arrived at the Trump tax cut, a large debt-driven piece of pro-cyclical stimulus. The problem with this addiction pattern is that despite all this stimulus, we're getting ever less GDP growth. This is not only a problem of accumulation of liabilities but also a more short-term problem, where the ability to stimulate the economy has dropped.
Do you tip your Uber driver? A new Fed report suggests the gig economy’s significance is vastly overstated, with gig work representing a small share of family income. The activities of three-quarters of gig workers account for 10% or less of their family income. This picture's confirmed when looking at the ride-sharing market, as the 833K total Uber drivers translate into only 100K full-time jobs.