When I die, I think I shall reincarnate ...
As a southern lady. Traveling this week throughout Virginia, with nonstop meetings in Suffolk, Virginia Beach, Richmond, Reston and Tysons Corner, gentlemen were aplenty. Seems everyone is polite here, with greetings from advisors, clients, people on the street, people in the elevator, etc. I could get used to being a member of “The Club” in Richmond, where fried oysters on a cracker and ham biscuits are always served, bow ties are common and the accent is m ’mm, m ’mm, m ’mm. Common concerns voiced along the way included: valuations (“Aren’t you worried that valuations are too high?” “What is the true P/E?”); inflation/yields (“How do we really know what inflation is?” “Once we get to 3%, won’t we quickly go to 3.5%?”); and bear watches (“I’ve only received one call from a concerned client. I am sure that not enough pain has been felt.” “Aren’t you worried that everyone is bullish?” “My clients are asking when is the crash?”). There were frequent jabs at millennials, as well: (“My child was born in 1981, and if you want to [tick] him off, call him a millennial.” “There aren’t as many loser GenXers as loser millennials and boomers.” (Hahahahaha!)) Even as the 10-year Treasury is a bad day or two away from 3%, we’re still seeing the yield curve flatten, as the short end continues to rise relatively faster in anticipation of faster Fed tightening. But this morning’s semi-annual policy report to Congress had a dovish tone, suggesting little need for more than three hikes in 2018 amid what policymakers still consider a benign inflation outlook.
Still, the consensus narrative continues to see rates rising, presenting a headwind for stocks. But equities historically have responded positively to rising rates until yields hit a threshold—5-6% in the 1991–2014 period, possibly 3.5% now. But 3.5% hardly should be viewed as a cliff given it’s not really a competitive threat to the S&P 500 and its respective earnings yield of 5.8%. Further, the ongoing domination of growth—growth stocks are outperforming value stocks by 5 percentage points year-to-date—is inconsistent with runaway inflation/yields. The S&P is trading at an attractive 17.3 times this year’s consensus earnings estimate and 15.7 times next year’s—a strong counter to those who believe there’s significant downside risk in the market. Dudack Research surmises the fear of higher rates may be because many of today’s investors have never owned stocks in a rising-rate environment as interest rates have been in a secular downtrend since 1982, or 36 years! Fear of the unknown is understandable. But even with the 10-year inching toward 3%, real interest rates (10-year minus inflation) are 70 basis points, well below the long-term average of 200 basis points and the typical level at the height of a Fed tightening cycle. To be sure, as Rhino Trading Partners puts it, a 3% yield may be hanging like a Sword of Damocles over risky assets. But is 3% really a big deal? Since 1954, higher interest rates have equaled a higher P/E when the 10-year yield was below 4%. Are you prepared to say this time is different? Simplistically, a move from current levels to about 4% could be driven by 100 basis-point increases in either inflation or real rates, but core inflation appears anchored and a move of 100 basis points in any 12-month period happens less than 10% of the time.
The technical condition of the market is mixed. The rebound off the Feb. 8 bottom was so quick and strong that many investors believe the correction process might be complete; however, history suggests that after a panic sell-off, a multi-month trading range materializes. The S&P keeps stalling near its closely-watched 50-day moving average, failing to maintain its morning strength as afternoon selling has been stronger, at least through Thursday of this week. Breadth off the recent lows has been anemic, and intraday reversals aren’t comforting. Importantly, marginal credits (lower quality investment-grade) and high-yield spreads vs. Treasuries are contained. This suggests a potential retest of the low in coming weeks, not a crash. Or given the constructive earnings backdrop, perhaps a correction in time—stocks sort of hang around in a tight range, setting up for nice back-half of the year if inflation concerns wane. I thoroughly enjoyed my travel this week among southern gentlemen, many of whom reported no sightings of Nancy Pelosi. But the ladies, too, were spectacular. Top advisors, each with a great sense of humor and style; I want to be each one’s BFF! There was much discussion this week about the 10-year bond yield, the seemingly inevitable rise to 3%, and the likely S&P pullback at that time. Want to worry about 3%? Not my Tysons Corner lady advisor, who remarked that she is “not worried about anything. Probably a benefit of getting older.” Amen, girlfriend.
Signs of stronger growth The Conference Board index of leading indicators jumped in January on broad improvement and has risen 3.8% over the past six months, the biggest gain since April 2011. On a year-over-year (y/y) basis, it’s up 6.2%, well above the 2.2% gain per annum historically. Separately, Ned Davis Research’s proprietary leading indicator rose at its fastest pace since April 2011, and Evercore ISI saw similar improvement in its own gauge.
More signs of stronger growth Markit’s initial gauge of February manufacturing activity hit its highest level since September 2014, while the companion services measure rose the most in three years to a 6-month high. Regionally, the Kansas City Fed’s composite index unexpectedly increased, with the component of future activity reaching a record high. Elsewhere, the Cass Freight monthly report said (y/y) shipments advanced at their fastest pace since March 2011, the American Truck Associations’ monthly survey reflected similar momentum and the Architecture Billings Index hit an 11-year high.
If we’re ever going to get inflation, this would be the year, although … Assuming West Texas Intermediate crude prices stabilize in the $55-$65 range, monthly energy inflation should decelerate in the months ahead, likely causing other inflation measures to moderate as well.
If we’re ever going get inflation, this would be the year Existing sales in January posted their biggest decline in nearly a year, surprising expectations for a rebound after December’s decline and lowering the annual sales rate to a 4-month low. On a y/y basis, sales fell the most since August 2014. The National Association of Realtors attributed the downturn to a "glaring inventory shortage" that is pushing up prices at the same time mortgage rates are rising.
If we’re ever going to get inflation, this would be the year This week’s Fed minutes revealed policymakers are weighing research that found many industries never lowered wages during the crisis and thus felt little pressure to raise them as the economy recovered and unemployment fell. Instead, they’re letting inflation and productivity growth bring real wages closer to their equilibrium level. As this process nears completion, wage inflation could take off. Tight labor markets clearly are an issue for small business owners, who for the first time ever in the NFIB’s monthly survey said labor quality was the No. 1 issue they faced. Separately, Evercore ISI’s proprietary survey of wage pressures rose to a record high this month (data beginning 2008).
Global growth slowing? Led by Germany and France, the flash PMIs in Europe moderated this month, dropping the eurozone PMI to a 3-month low vs. an expected increase. However, the individual and eurozone composite numbers were still very robust on an absolute basis. Across the Pacific, Japan’s flash manufacturing PMI also slipped slightly. Monthly data can be choppy but this bears watching.
This was discussed extensively in our Virginia advisor meetings When looking at flows of non-U.S. investors into/out of U.S. assets, there was a startling lack of demand for U.S. Treasuries in 2017 and a massive $329 billion outflow in 2016. The Institutional Strategist says this is becoming a problem as the combination of a growing U.S. budget deficit and additions to Treasury supply via the Fed's quantitative tapering (QT) will require finding new buyers. Assuming the laws of economics/markets have not been repealed, either rates have to go up enough to attract buyers or the Fed has to give up on QT and perhaps even return to quantitative easing.
The robot invasion heads to the Far East Advances have made robots so dexterous that they’re now invading garment industry factory floors, knitting sweaters and sewing pockets—work historically the bailiwick of humans. A study quoted by the Wall Street Journal said up to 80% of garment, textile and apparel jobs may be at risk in Asia, eliminating a key source of income in emerging nations. The World Bank’s lead Bangladesh economist told the newspaper that, “It’s a social time bomb.” And it’s a problem that may arrive sooner than expected.
I haven’t had my annual review yet At numerous stops this week, we discussed the lack of wage increases. Many found it curious that lots of companies used their tax windfall from the new lower corporate tax rate on one-time bonuses rather than wage hikes. After a large advisor meeting in Richmond, one gentleman remarked that he hadn’t received his raise yet; his three colleagues joked, “We did.’’