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The Days Ahead: Inflation number and the tail end of earnings.  

One Minute Summary A run of not-so-great economic news but there were good reasons for most of them. The trade deficit narrowed a bit, which lends support to the arguments that lower import demand would follow from the unusually high levels after the hurricanes last fall. The ISM Manufacturing and non-Manufacturing indexes both fell and, worryingly, in the employment sections of the reports. It just seems that employers are very unwilling to start hiring in big numbers. The core (PCE) inflation numbers inched towards 2.0% but there’s a big base effect going on from low hospital services (now up 7%) and energy prices (now up 8%) this time last year.

The Fed met and acknowledged slightly higher inflation but slower growth. There was no press meeting but we feel they must be twitchy about trade tensions and some slower growth in the world economy. We'll know more the next time they hold a press conference in mid-June. We feel the Fed will be fine with a few months of the core PCE at 2% and will wait until late summer for any signs of lasting inflation. We think inflation will remain low, which is why we like bonds at these levels.

Stocks were mixed but had a big Friday. Apple had a monster week announcing another $100bn share repurchase and a 16% increase in the dividend. It rose 12% in the week and it's now worth $900bn. U.S. stocks are up 1.6% this year but there’s no momentum or theme. Nearly all U.S. and foreign markets are around plus or minus 1.5% so far. The only outlier is China, which is trying to solve some of its own trade issues.

1.     How about those new jobs?  Not as well as expected. Non-farm payrolls came in at 164,000. Most people were expecting closer to 200,000. But the prior month was revised up. Here’s the chart: 

We're less focused on the absolute numbers these days and more on the hourly earnings and labor force participation. Why? Well, the reported unemployment numbers are about as low as they can go but that alone doesn't mean there is full employment or wage pressure just around the corner. Hourly earnings rose 2.6% (the lower line in the above chart). Given that non-core inflation is only just below that, it means real earnings are flat. And average weekly hours worked was unchanged. Participation slipped a bit.

All in all, nothing for markets to run on in any direction.

2.     Are U.S. stocks expensive? About 6% less than they were a few months ago. What we've had is a run of very strong earnings. The blended earnings growth in Q1 was 24% and that's the highest since 2013. The energy sector grew earnings by 93%. They're still important to the economy at 6% of the S&P 500 but with 10% and 8% of the S&P 500’s sales and earnings.

Here’s an important chart we look at:

It shows the earnings yield of the S&P 500 at 6.3%. We then reduce that number by the level of inflation. The higher that lower black line, the cheaper the stock market relative to inflation and bonds. Right now it’s cheaper than it was for most of 2017 but not as cheap as it was in the 2012-2015 period.

No one stock market measure is infallible, of course, more’s the pity. But we think the market is adjusting to the gradual rate rise as well as the less than stellar global macro news.

3.     How’s the Treasury doing? Meh. So, every year the Treasury tells the markets how much it’s going to borrow. The amount is basically refinancing of maturing debt and raising of new debt. Early estimates are for $950bn in 2018.

This should be fairly straightforward except the forecasts of what the budget deficit varies by who’s doing the talking. A few weeks ago, we highlighted the CBO’s estimates and they had a chart showing the deficit like this:

But the Treasury recently put out deficit estimates and their graph looks like this:

They both agree the number was about 3.5% for 2017 but then, you know, they kind of take different roads. Basically, the Treasury says growth will rip along at 3% and more and raise lots of tax revenues with no recession and the CBO says, er, probably not. The CBO is a pretty independent, bi-partisan and objective body. Steven Mnuchin runs the U.S. Treasury.

So we’re dealing with a bit of a movable number here and the markets were surprised when the Treasury announced they would only borrow $75bn in Q2 compared to an estimate of $176bn a few months ago and $488bn borrowed in Q1. So that was a bad day for Treasury bears and the 10-Year Treasury rallied some 10bp (or up 1.5% in price).

Does this mean tax receipts are in great shape and the deficit okay? No. The Treasury prefunded some of its needs and April brings in a lot of tax payments, so we don't get to sound the all clear. It demonstrates the seasonality of Treasury bonds (and therefore the bond market). They tend to be weak in the first quarter of the year. Why?

  1. Inflation tends to come early in the year. If businesses raise prices, they’ll get it done as soon as they can.
  2. Japanese investors repatriate dollars by selling Treasuries ahead of the end of the fiscal year in March.
  3. High refunding needs ahead of tax deadlines (h/t David Ader, IFI Research).

Anyway, with all this, we would expect the 10-Year Treasury to stay well below 3% in the near term, despite the expected Fed hiking in June. So, we’re okay with the level and sentiment in the bond market right now.

Bottom Line: We don't expect any break out from the range bound market we've had for three months. We'd be worried about another round of big and leveraged M&A activity (looking at you T-Mobile/Sprint). That tends to typify late cycle activity.  We'll probably look to reduce portfolio volatility again soon.

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All charts from Factset unless otherwise noted.