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Economics: This Week and Last Week. February 21, 2017

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An excerpt from today’s Sevens Report. Subscribe now to get the full report in your inbox before 7am each morning.

Both economic growth and inflation accelerated according to last week’s data, and while the former continues to help support stocks despite a darkening outlook from Washington, the latter also is increasing the likelihood of a more hawkish-than-expected Fed in 2017, and a resumption of the uptrend in interest rates. For now, though, the benefit of the former is outweighing the risk of the latter.

If, however, we do not see any dip in the data between now and early May, I do expect the Fed to hike rates at that May meeting, which would be a marginal hawkish surprise. To boot, if we get a strong Jobs report (out Friday, March 3), then a March rate hike two weeks later isn’t out of the question. Point being, upward pressure is building on interest rates again.

Last Week

Both economic growth and inflation accelerated according to last week’s data.

Looking at last week’s data, it was almost universally strong. Retail Sales, which was the key number last week, handily beat expectations as the headline rose 0.4% vs. (E) 0.1% while the more important “Control” retail sales (which is the best measure of discretionary consumer spending) rose 0.4% vs. (E) 0.3%. Additionally, there were positive revisions to the December data, and clearly the US consumer continues to spend (which is more directly positive for the credit card companies).

Additionally, the first look at February manufacturing data was very strong. Empire Manufacturing beat estimates, rising to 18.7 vs. (E) 7.5, a 2-1/2 year high. However, it was outdone by Philly Fed, which surged to 43.3 vs. (E) 19.3, the highest reading since 1983! Both regional manufacturing surveys are volatile, but clearly they show an uptick in activity, which everyone now expects to be reflected in the national flash PMI.

Even housing data was decent as Housing Starts beat estimates on the headline, while the more important single family starts (the better gauge of the residential real estate market) rose 1.9%. Single family permits, a leading indicator for single family starts, did dip by 2.7%, but even so the important takeaway from this data is that so far, higher interest rates don’t appear to be negatively impacting the residential housing market, and a stable housing market is a key, but underappreciated, ingredient to economic acceleration.

Finally, looking at the Fed, Yellen’s commentary was marginally hawkish, as she was upbeat on the economy, basically saying the nation had achieved full employment and was closing on 2% inflation, and reiterated that a rate hike should be considered at upcoming meetings. None of her comments were new, but the reiteration of them reminds us that the Fed is in a hiking cycle, and the risk is for more hikes… not less.

This Week

The big number this week is the February global flash manufacturing PMI, out Tuesday. With last week’s strong Empire and Philly Surveys, expectations will be pretty elevated for the flash manufacturing PMI, so there is some risk of mild disappointment. On the flip side, if this number is very strong (like Empire and Philly) you will likely see a hawkish reaction out of the markets (dollar/bond yields up) and the expectation for a rate hike before June increases. That, by itself, shouldn’t cause a pullback in stocks, but upward pressure will build on interest rates.

Outside of the flash manufacturing PMIs, the FOMC minutes from the January meeting will be released Wednesday, and investors will parse the comments for any clues as to the likelihood of a March increase. Yet given the amount of political/fiscal uncertainty, and considering the FOMC meeting was before the strong January jobs report and recent acceleration in data, I’d be surprised if the minutes are very hawkish (although given they are dated, I don’t think that not-dovish minutes reduces the chances of a May or even March hike).

Bottom line, the focus will be on the flash manufacturing PMIs, and a good number this week will be supportive for stocks.

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What impact are Trump’s headlines having on markets?

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Trump makes a lot of headlines, but what actually impacts the market?

After impacting the markets with his comment about a forthcoming “phenomenal” tax plan, the markets have been surprisingly unmoved by any of the headlines coming in from Washington D.C.

This week, we’ve seen stocks focusing on the good economic data (retail sales, Empire Manufacturing) and ignoring the political drama (Trump’s Labor Secretary nominee, Andrew Puzder, withdrew yesterday). Earlier this week, the market also remained steady after the news of National Security Administration Michael Flynn’s resignation.

What might Trump do to impact the market? After campaigning with somewhat hostile trade rhetoric, we’ve the realities of global trade soften his tone a bit. For example, he embraced the “One China” policy of governance over Taiwan. Similarly, so far Trump has resisted instructing the Treasury Department to label China a “currency manipulator” in its semi-annual currency report, due out in late March/early April. That would obviously be bad for stocks.

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Stock Market Update: 7/11/2016

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Stocks surged last week thanks almost entirely to the post-jobs-report Friday rally. The S&P 500 rose 1.28% on the week, and is up 4.21% year to date, and now is within a few points of its all-time high.

Despite the gains, the week started with some volatility as the S&P 500 dropped 1% Tuesday following a plunge in European financials stemming from worries about Italian banks and fund redemption halts at British commercial property funds. But, the market acted resilient and stocks rallied during the final hour of trading to close the day down modestly.

A good June ISM Non-Manufacturing PMI helped stocks rally Tuesday as markets ignored more weakness in European bank stocks (an important European bank index broke to multi-year lows), and the S&P 500 rallied and recouped almost all of the Tuesday declines. Thursday stocks basically drifted sideways ahead of the jobs report, as a drop in oil to one-month lows helped offset more positive economic data (good jobless claims) and a good earnings report from PEP.

Then, stocks exploded higher Friday as the blowout jobs report combined with a lack of selling in bonds and no rally in the dollar created a short squeeze higher that built on itself throughout the trading day amidst low volumes. Stocks moved steadily higher throughout the morning and afternoon, and traded to multi-month highs, closing just below the all-time high.

Trading Color

Cyclical sectors outperformed last week, but that was due almost entirely to Friday’s big rally, which came on low volumes and consisted of faster money managers chasing stocks higher via higher-beta cyclicals. Not to pooh-pooh the rally, but it didn’t come on strong volumes or with a lot of conviction.

From an internals standpoint, easily the biggest question facing advisors and investors over the next few weeks will be whether we see a large rotation out of defensive/yield-oriented sectors (utilities, staples, REITs) and into cyclicals (banks, materials, consumer discretionary). There certainly was some of that on Friday as cyclical sectors did outperform, but it was not nearly as big as it could have been given how “overbought” most people think utilities/staples and REITs currently are.

In fact, we were actually relatively impressed with the performance of consumer staples (XLP/FXG) on Friday, as given their recent outperformance we could have easily seen outright declines in both those sectors following that strong jobs report. To that point, there will be a lot written about a potential massive rotation out of defensive sectors and into growth over the coming weeks, but until we see a material break lower in the belly and long-end of the Treasury curve, the income provided by staples, utilities, REITs and other defensive sectors will remain critical to outperforming in a choppy market.

On the charts, the S&P 500 broke through several levels of resistance and nearly notched a new intra-day high—2134 is now the next near-term resistance level while support sits lower at 2100.

Bottom Line

Two and a half weeks ago the S&P 500 plunged temporarily below 2000 on Brexit fears, but in less than three weeks the market totally recouped those losses and traded to near-18-month highs. Yet despite all this whipsaw activity, the outlook for stocks has remained largely unchanged, and the bull and bear arguments remarkably static.

So, despite the rising chorus of optimism (which is largely based on very resilient price action) we remain generally cautious on stocks as fundamentals have not materially improved, and because of that we would not be chasing markets at these levels and would resist adding significant capital into stocks broadly, or re-adjusting allocations into higher-growth/cyclical sectors.

Looking at the bull’s argument, it has been bolstered by strong data so far in June, but with unknown Brexit effects looming, any well-reasoned bull is still solely relying on the $130 2017 S&P 500 EPS to justify allocating new capital to stocks. That’s the same argument we’ve had since April. And, in the meantime, the dollar is higher (which will weigh on earnings in the coming quarters) and oil looks heavy. To boot, if the bulls are right and we see a 17X $130 number, that’s only 2210 on the S&P 500, which is less than 4% from current levels. 2000 (which we hit less than three weeks ago) is now about 6% from current levels, so the risk/reward is not attractive.

Now, to be clear, I’m not advocating shorting stocks or selling everything. This tape is strong and that must be respected. But, from a “what do we do now” allocation standpoint, we are staying relatively unchanged in our proprietary accounts. We are not materially adding more cash to stocks, nor are we rotating out of defensive sectors and into cyclicals like materials or consumer discretionary.

Looking at other assets, the markets continue to send “Caution” signals. Treasury yields remain near all-time lows, the pound remains weak and Brexit is not “over” as an influence, the 10’s-2’s Treasury yield spread hit greater than 10-year lows last week while gold remains elevated and European (especially Italian) banks remain under pressure. Again, the odd man out in this cross asset analysis is US stocks, which are just off all time highs, so either the US stock market is “right” and everything else is wrong, or stocks are simply pricing in a very optimistic scenario right now. Regardless, despite the optimism we remain cautious.