Last week we stepped through all of the components of economic output and talked about the setup for positive surprises. Keep in mind, the economy is running at near a 3% pace already. And if Trumponomics is just in the early stages of materializing in the data on consumption, investment, government spending and exports, then we may be in for a big growth number.
On Friday we talked about the exports (i.e. the trade) component. On that note, the media was stirring over the combative tone from G7 events over the weekend. What I heard was the potential for big movement (i.e. gains on U.S. exports, which will drive gains in GDP). Trump went in and proposed taking down all trade barriers. That’s negotiating from an extreme. And that typically brings about movement. Quickly, trade partners were discussing “reducing” barriers.
With hotter than expected growth coming, how will that effect Fed policy?
We will soon see. The Fed meets this week. They continue their path of normalizing rates. They’ve hiked once in 2015, once in 2016, three times in 2017 and once, thus far, this year. The market is nearly fully pricing in a second hike for the year on Wednesday. And expectations are for another hike in September. We’ll see this week if they’re adjusting uptheir growth forecasts.
As for the rate path: Remember, Powell is a Trump appointee, and from what we’ve heard from him thus far, he sounds like someone that’s not going to risk chipping away at the recovery by jumping ahead with overly aggressive rate hikes. Unlike the last regime, he will likely take a “whites of inflation’s eyes” approach.
We’ve talked the past couple of days about economic growth and the likelihood that we’re just beginning to see the positive surprises from Trumponomics materialize in the economic data.
Yesterday we talked about the consumption component of GDP. Today, we’ll take a look at investment.
Businesses invest when they’re confident about the outlook. And that was anything but the case for the decade following the global financial crisis.
Why? Because the politicians spent their time playing politics in Washington, instead of addressing an economy that was in desperate need of fiscal stimulus and structural change. Instead, they swung the regulatory pendulum too far in the opposite direction. And they played political football with debt and deficits, instead of acting to restore growth and stability. They stifled growth, just as the Fed was desperately throwing everything at the economy to keep it going. And it was all coming to a head by mid-2016 when global interest rates started turning negative.
But with the election came optimism. There was at least a chance of a return of good economic times (not just domestically but globally). We had a President with an aggressive economic stimulus plan, and a Congress in place to approve it. With that, small business optimism popped and has soared to record highs.
And companies are now investing again. Capital goods orders (the chart below) are nearing record highs again.
Get this: An ISM survey shows businesses were forecasting just 2.7% capital spending growth for 2018 when they were asked back in December. When they were asked again last month, they revised that number UP to 10.1% growth. A big positive surprise coming down the pike.
Again, as with the consumption picture we talked about yesterday, not only is the back drop solid, but we have stimulus that is still in the early stages of feeding through the economy, which is setting the table forpositive surprises in the economic data as we head toward the second half of the year.
And with that, we finally have the pieces in place for the aggressive bounce back in growth that is characteristic of post-recession recoveries. And that should continue to fuel stocks.
On Friday, we talked about the building momentum in the economy. We’ve already had huge positive surprises in corporate earnings for the first quarter. And we’re probably just beginning to see the positive surprises on economic data roll in.
Remember, despite the execution success on Trumponomics over the past year (deregulation, repatriation, tax cuts and $400 billion in new government spending approved), the Fed is still expecting growth to come in well below trend (3%), at 2.7%. That’s just 20 basis points higher than they projected prior to the execution of massive tax cuts in late December.
The good news: Positive surprises are fuel for confidence and fuel for stocks.
Remember, we’ve yet to have a return of ‘animal spirits’–a level of trust and confidence in the economy that fuels more aggressive hiring, spending and investing. We should see this reflected in wage growth. Wage growth has been the missing piece of the economic recovery puzzle.
On that note, we’re now near the best wage growth in nine years, and that tax rate cut is still in the early stages of working through the economy.
Don’t underestimate the value of confidence in the outlook (and the return of “animal spirits”) to drive economic growth higher than the number crunchers in Washington can imagine. Remember, these are the same experts that couldn’t project the credit bubble, and didn’t project the sluggish ten years that have followed.
Remember, while we’re in the second longest post-War economic expansion, we’ve yet to have the aggressive bounceback in growth that is characteristic of post-recession recoveries. We now have the pieces in place to finally get it.
So, as we’ve discussed throughout the year, the backdrop continues to get better and better for stocks.
We have a lot of geopolitical noise surrounding markets.
Let’s step through them:
1) Yesterday, we discussed the Trump trade threats with China:
How is it playing out?
We have an economy that is leading the global economic recovery. China wants and needs to be part of it. Trump’s bark, with the credibility to bite, is creating movement. It’s creating compliance. That’s becoming a very positive catalyst for global economy and for geopolitical stability (the exact opposite of what the experts have predicted these tactics would produce).
2) We’ve talked about the shock-risk developing in Europe. A coalition government forming in Italy, with an “Italy first” approach to the social and economic agenda, has created some flight of Italian bond market capital toward safety. This has people skittish about another blowup threat of the euro zone.
How is it playing out?
The last time Italy was on default/blow up watch, the 10 year yields were 7% (unsustainable levels). At those levels, the ECB had to intervene.
This recent move in the Italian bond markets leaves yields at just 2.4% …
This looks like Grexit, Brexit and the Trump election. It creates leverage for the third largest economy in the European Union (excluding Britain). In this case, we may see it result in a loosening of fiscal constraints in the European Union – and an EU wide fiscal stimulus plan to follow the lead of the U.S.
3) The North Korean nuclear threat …
How is it playing out?
Eight months ago, North Korea launched a missile over Japan. Markets barely budged, and the world continued to turn. Now, we’ve quickly gone from an imminent threat to potential denuclearization. And now a meeting has been cancelled. With that, on the continuum of this relationship, I’d say it’s closer to its best point, rather than its worst.
Bottom line, these risks should do little to stop the momentum of the economy and the stock market.
Over the past two Friday’s we’ve stepped events and conditions that have built the case that that “all-clear” signal has been given for stocks.
We are 91% through S&P 500 earnings for Q1 and the positive surprises have continued to roll in, on both earnings growth and revenue growth. Q1 GDP growth had a positive surprise, to reflect an economy that is running very close to 3% over the past three quarters. The important FAANG stocks all beat on earnings and beat on revenues for Q1. And the big jobs report last Friday did NOT come with a hot wage growth number, which keeps the inflation outlook tame.
Now we have very compelling technical confirmation that a resumption of the big secular bull trend for stocks is resuming. This correction has given everyone a long time to get on board. But it looks like the train is leaving the station.
Here’s a look at the S&P 500 ….
This bull trend in stocks from the oil-price crash induced lows of 2016 remains intact. The trendline tested and held three times in this recent correction, as did the 200-day moving average. And yesterday we had a big break of this trendline that represents this correction of the past three months. This has been textbook technical confirmation of a price correction within a strong bull trend.
Here’s the Dow chart we looked at on Wednesday …
And here’s the latest as we end the week, as the momentum from that trend break continues …
U.S. stocks are being valued right at the long-term P/E, at about 16 times forward earnings. Stocks in the UK, Germany and Japan are all trading closer to 13 times forward earnings. That’s cheap relative to long-term averages, and especially cheap (including U.S. stocks), in ultra-low interest rate environments. For perspective, Japanese stocks are recovering back toward the highest levels in more than 25 years, yet the forward P/E on Japanese stocks is closer to the lowest levels over the period. Stocks are cheap, and this correction has been a gift to get all of the onlookers on board.
Stocks have a huge influence on sentiment. And sentiment has a huge influence on economic activity.
With that, for the better part of the past four months, we’ve discussed the technical correction we’ve seen in stocks. And we’ve waited patiently for a catalyst to end the correction and resume the long-term bull trend for the stock market.
That catalyst, we anticipated, would be first quarter data (namely earnings and GDP growth). Indeed, that data has confirmed that fiscal stimulus is stoking the economy – shifting it into a higher growth gear than what we’ve seen coming out of the global financial crisis.
Let’s take a look at how this has played out, and the important technical break we’ve had today in the Dow that further supports that the correction is over.
As you can see, we put in the low of this technical correction in the Dow the day after the first quarter ended. And we’ve since seen Q1 earnings roll in, with record positive earnings surprises, record margins and the hottest revenue growth we’ve seen in a long time. Toward the end of April, we had our first look at Q1 GDP growth. That too beat expectations and showed an economy that is growing at 2.875% over the past three quarters — closing in on that big 3% trend-growth level.
Along the way, we’ve tested the 200-day moving average (the purple line) and held. And today, we get a break of this big trendline from the highs of January.
And this beak in stocks comes with the 10-year yield back at 3%, and with oil above $70. While some have seen these levels as a risk to growth, they are rather reflecting a stronger economy, with surging demand.
Crude oil crossed the $70 mark today, and with new sanctions to be placed on Iran, likely tomorrow, $100 oil is looking very possible.
We’ve talked a lot about oil prices over the past couple of years. In early 2016, we talked about the price crash that was induced by OPEC as an effort to crush the competitive U.S. shale industry.
While they nearly succeeded, these oil producing countries nearly killed their own economies in the process. So, in effort to drive oil prices higher, to salvage oil revenues, they flipped the switch in late 2016, cutting production for the first time since 2008. And they did so, in a market that was already undersupplied.
In my January 12th note, we revisited Leigh Goehring’s call for $100 oil. Goehring is one of the best research-driven commodities investors. And has been calling for triple-digit oil prices–this year! He predicted a surge in global oil demand (which has happened) and a drawdown on supplies (which has been happening at “the fastest rate ever experienced”). He said that with the OPEC production cuts from November 2016, we’re “traveling down the same road” as 2006, which drove oil prices to $147 a barrel by 2008.
Below is the chart of oil. A break of $70 is putting the price of oil very close to the levels that it collapsed from that Thanksgiving Day evening back in 2014. That was when OPEC announced that it opted NOT to cut production, despite an oversupply and plunging prices.
At the end of last week, I said “it looks like the all-clear signal has been given to stocks.”
Well, we had some more discomfort to deal with this week, but that statement probably has more validity today than it did last Friday.
With that, let’s review the events and conditions of the past two weeks, that build the case for that all-clear signal.
As of last Friday, more than half of first quarter corporate earnings were in, with record level positive surprises in both earnings and revenues (that has continued). And we got our first look at first quarter GDP, which came in at 2.3%, better than expected, and putting the economy on a 2.875% pace over the past three quarters.
What about interest rates? After all, the hot wage growth number back in February kicked the stock market correction into gear. The move in the 10-year yield above 3% last week started validating the fears that rising interest rates could quicken and maybe choke off the recovery. But last week, we also heard from the ECB and BOJ, both of which committed to QE, which serves as an anchor on global rates (i.e. keeps our rates in check).
Fast forward a few days, and we’ve now heard from the last but most important tech giant: Apple. Like the other FAANG stocks, Apple also beat on earnings and on revenues.
Still, stocks have continued to trade counter to the fundamentals. And we’ve been waiting for the bounce and recovery to pick up the pace. What else can we check off the list on this correction timeline? How about another test of the 200-day moving average, just to shake out the weak hands? We got that yesterday.
Yesterday, in the true form of a market that is bottoming, we had a sharp slide in stocks, through the 200-day moving average, and then a very aggressive bounce to finish in positive territory, and on the highs of the day. That took us to this morning, where we had another jobs report. Perhaps this makes a nice bookend to the February jobs report. This time, no big surprises. The wage growth number was tame. And stocks continued to soar, following through on yesterday’s big reversal off the 200-day moving average.
With all of this, it looks like “the all-clear signal has been given to stocks.”
We’re getting into the heart of Q1 earnings now, with about a quarter of the companies in the S&P 500 now in, and many more reporting this week. And we’ll get the first look at Q1 GDP this Friday.
Remember, as we went through the price correction in stocks, we’ve been waiting for the data to “prove it” to the market that fiscal stimulus and structural reform are indeed fueling a return to trend growth.
On that note, the performance of companies in Q1 have NOT disappointed. As of Friday, 80% of the S&P 500 companies that have reported have beat earnings estimates. And 72% have beat revenue estimates.
Now we have the build up to the big Q1 GDP number at the end of this week. We were already heading into the first quarter, with the economy growing at better than 3% for the second half of 2017. And then the fire was fed with the tax bill.
So what are the expectations going into the GDP report?
The Atlanta Fed attempts to mimic the model used by the BEA on their GDP forecast. They are looking for 2% for Q1 growth. And as you can see in their chart above, the forecasted number has been on a dramatic slide as we’ve seen more and more economic data through the period. More importantly, Reuters has the consensus view of economists at 2%.
The New York Fed’s model is predicting 2.9% growth (closer to that important trend growth level).
As with earnings, a low bar to hop over tends to be very good for stocks. And at a 2% consensus, we’re setting up for a positive surprise on GDP.
As we’ve discussed, despite the move higher in global rates over the past week, and the coming break of the 3% barrier in the 10-year yield, it will be hard to dispute the signal of economic strength and robustness from the combination of a huge earnings season and a positive surprise in GDP. If we get it, that should kick the stock market recovery into another gear.
Yields continue to grind higher toward 3%. That has put some pressure on stocks, despite what continues to be a phenomenal earnings season. This creates another dip to buy.
Yesterday, we talked about a reason that people feel less good about stocks, with yields heading toward 3%. [Concern #1] It conjures up memories of the “taper tantrum” of 2013-2014. Yields soared, and stocks had a series of slides.
My rebuttal: The domestic and global economies are fundamentally stronger and much more stable. But maybe most importantly, the economy (still) isn’t left to stand on its own two feet, to survive (or die) in a normalizing interest rate environment. We have fiscal stimulus doing a lot of heavy lifting.
Let’s look at a couple of other reasons people are concerned about stocks as yields climb:
[Concern #2] Maybe this is the beginning of a sharp run higher in market interest rates — like 3% quickly becomes 4%?
My Rebuttal: Very unlikely given the global inflation picture, but more unlikely with the Bank of Japan still buying up global assets in unlimited amounts (Treasuries among them, through a variety of instruments). They can/and are controlling the pace, for the benefit of stimulating their own economy and for the benefit of stimulating and maintaining stability in, the global economy.
[Concern #3] I hear the chatter about how a 3% 10-year note suddenly creates a high appetite for Treasuries over stocks at this point, especially from a risk-reward perspective (i.e. people are selling stocks in favor of capturing that scrumptious 3% yield).
My Rebuttal: In this post-crisis environment, a rise toward 3% promotes the exact opposite behavior. If you are willing to lend for 10-years locked in at a paltry rate, you are forgoing what is almost certainly going to be a higher rate decade than the past decade. If you need to exit, you’re going to find the price of your bonds (very likely) dramatically lower down the road. Coming out of a zero-interest rate world, bond prices are going lower/not higher.
Remember this chart …
The bond market has become a high risk-low reward investment. Meanwhile, with earnings set to grow more than 20% this year, and stock prices already down 7% from the highs of the year, we have a P/E on stocks that continues to slide lower and lower, making stocks cheaper and cheaper. That makes stocks a far superior risk/reward investment, relative to bonds – especially with the prospects of the first big bounce back in economic growth we’ve seen since the Great Recession.
