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The Days Ahead: Congress back at work.
A big week for numbers. GDP was revised up for Q2 but that’s old news by now and we all expected a rebound after Q1. That pattern of a slow start to the year, a good two quarters and then slack towards the end of the year has run for years now. The commentary practically writes itself. The gap between soft data (“I’m feeling confident”) and hard data (“I’m doing stuff”) seems to continue. On the hard side, commercial construction was down 6% from May’s high and manufacturing construction was down 15% YOY. These two components are about a third of non-residential construction. Total construction of both residential and everything else is a $1.2 trillion industry or 6% of GDP. So, pretty important. Pending home sales fell too. On the soft side, consumer confidence improved and the ISM Manufacturing survey bounced.
The relentless news from Houston hung over markets. We discussed it earlier in the week and don't have a lot to add. Gas prices in Texas are, predictably, at about $3.00 compared to an average of $2.25 for the last three months. The hit to spending will follow. We expect weekly jobless claims to spike. Right now they're running at 236,000. But in the weeks after Katrina in 2005, claims jumped 33% to 424,000 and after Sandy in 2012, by 20% to 446,000. Even that will understate the economic loss, as only 1.5% of unemployed are eligible for employment insurance. And if they're not eligible they won't file.
In all this, bonds rallied. The 10-Year Treasury at one point yielded 2.09%, its lowest level this year.
1. Personal Income
We’ve been banging on about weak wage and income numbers for a while. The Fed, of course, looks at the unemployment rate and core inflation, as defined by PCE (Personal Consumption Expenditure). The target is 2%, which they've missed for years, and came in at 1.4% for July… its lowest all year.
The reason we harp on this is that we simply don't see any meaningful increases in personal income. The problem is that income includes earned income (so wages and employer benefits) and unearned income (so rental, dividend, interest and inventory valuations). So, the headline number can look good but we think there is a world of difference between wage growth and whether a portfolio kicks off more income. In the jargon, the marginal propensity to spend is likely higher for wage earners than for investors and landlords.
As for income increases, which would you prefer?
A. Your employer gives you a pay increase of 2%
B. Your employer does not change your pay but inflation falls 2%
C. Your employer increases your hours by 2%
They all have the same real effect on your pocket book but our guess is that you’ll only be really happy with #1.
Anyway, here's private sector wages, adjusted for inflation, with annual growth of wages at 2.5% (nominal!). The wage numbers look good from 2010 to 2013 but that coincided with very low inflation. Nominal changes were minimal. It’s the #2 example.
It also shows the annual change in savings. The number is pretty volatile and was $510bn in July, down from nearly $800bn a year ago. Outlays, or spending, can of course get a boost from people running down savings and, if they feel confident about the future, then that is exactly what they'll do.
We don't think this a pretty picture. Slow private sector wage growth at a time of supposedly near inflationary levels of unemployment (if you're a NAIRU, Philips curve fan) seems, ya know, uninspiring.
2. Oh brother, where art thou?
The new job numbers came in and disappointed. Non-farm payrolls were 156,000, well below expectations. The survey was before Harvey. August is typically a tough month. Something to do with the seasonals. The circles show August for the last five years. 2017 was no exception.
The big industry winners were tech and the losers were hospitality and leisure. That's a nice change because the latter work 26 hours a week for $402 and the former 36 hours for $1,391. But overall hourly earnings (the bottom line) increased at a low 2.5%.
Earlier in the week the core inflation numbers came out and, yep, once again, well below target.
We'll stick with our position that the Fed will probably increase rates in December because they've more or less said they would and they like to follow through. The balance-sheet reduction will be a non-event. Some parts of the credit markets will bid up mortgages but the Treasury part will diminish slowly. There is no sense of urgency with PCE at 1.4%.
3. And the winners are…
Last month saw tech and utilities vied for best performing sector. Both were up nearly 3.5%, compared to the S&P 500 of 0.3%. Here's the chart for the last two years:
Together the two sectors account for 28% of the S&P 500, with tech the biggest sector by far at 25%. It’s really the story of growth at high price (the tech sector sells at a 30% premium to the rest of the market) and interest rates, which utilities broadly track. For us, it's a vindication of a mix of seemingly pedestrian investments with more exciting themes. Note the above chart shows utilities outperforming the S&P 500 in the last two years. It’s the same for the last 10, 15 and 20 years.
We've also mentioned that 2017 has not been the year for Small Caps, after a large outperformance in 2016. Part of this is tied to the promised tax changes and overseas economies. The first hasn't happened. The second has. The S&P 500 has a tax rate of 17% compared to the small cap S&P 600 of 28%. So any tax changes will benefit small companies much more than large. On the other side, S&P 500 companies have around 30% of their sales from overseas while small companies have around 18%, and even that is weighted by a small sample. So if either of these themes turn, we expect small companies to perform well.
“It seems as if there is no president in the U.S.,” Risto Murto, chief executive officer of Varma Mutual Pension Insurance Co., said in an interview in Helsinki on Wednesday. “If I look at what is the moral and practical power, there is no longer a traditional president.”
That's a quote from someone who runs a Finnish $50bn pension fund. They're running down their U.S. stock position. We don't quite agree but it does show that U.S. capital markets are in an extended holding pattern. Something might break in the next month or two, probably to the upside.
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--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.