The Days Ahead: U.S. inflation and start to earnings
One-Minute Summary Stocks were up 2% in the week after a barnstorming first quarter of 13.6%. With all the ballyhoo about record markets, if you compared your portfolio six months ago to now, not much changed. If you got your timing wrong, then it was a very different story. Last year, nearly all asset classes moved down together, except for Treasuries later in the year. This year, it’s been up across the board. This is what a humble 60% Equity/40% bonds looked like in the first quarter, the best level since 1998 and the third best quarter in 30 years.
The market liked the latest on trade talks (“any day now, going well’) which makes us a little wary about how many times the market can rally on the rumor. Most of the economic news was better than expected (U.S. manufacturing) or seems to be touching lows from which they’ll rebound (German manufacturing). European stocks climbed to a seven-month high on expectations trade will improve.
U.S. Treasuries lost some ground but ended the week at 2.5% or just 6bps up on the week. We don't think anything changed that would cause Treasuries to break out of their 2.4% to 2.7% range.
1. How exciting were the jobs numbers? Not very. New jobs came in at 196,000 after February’s weak 20,000 number. The unemployment and underemployment (those who would like to work more but can't) were unchanged. Service jobs (71% of the workforce) increased by 170,000 and 61,000 of those were in healthcare. Now, when the BLS says healthcare, please don't think of nurses, technicians, doctors and EMTs. Most of the jobs are home and community care and office service workers and the point about those jobs are they’re i) part time and ii) pay very little. The average home care worker earns $11 an hour, or 40% of the average, and works 20% less.
Look, we get it. Jobs are jobs. But many jobs just aren't that well paid and pay rises stalled again. The Average Hourly Earnings, which popped by 3% in January, is now down at a 0.1% growth and 3.2% over the year (white line below).
The curious thing about wages is that the NFIB consistently talks about the difficulty of finding workers. If that's the case then you would expect wage increases to start coming through. But they haven’t. If they do start to rise then we’ll see margins compressed and a feed through into inflation. If we don't, then we’ll continue to see the economy eke out 2% growth rate with low productivity.
Either way, these numbers won't have changed the Fed’s mind about holding off on rates.
2. Is the Fed becoming politicized? Not yet. The Fed enjoys a well-earned reputation for independence. A couple of things happened last week, which caused concern. One, the President upped the pressure on the Fed to drop rates and let the “rocket ship” run. The Fed can ignore this. Two, Herman Cain and, two weeks ago, Stephen Moore, were nominated to fill the two vacant spots on the Fed’s Board of Governors. You can read about it here and here but the summary is that both are hacks, ignorant of monetary policy and run an overt political agenda with a history of disastrous calls on the economy, inflation and markets. And they’re not economists.
All of which is true. But taking this one step at a time, we don't think it’s quite as dire. First, there are five permanent members of the FOMC, and only two are economists. The other three are lawyers. Rotating groups of Regional Fed Presidents make up the rest of the ten members for a total of six economists and four non-economists. So the non-economist is not a problem. And there’s an army of highly qualified economists at the Fed if you're a Governor who’s intellectually curious.
Third, just because they're on the board doesn't mean anyone pays attention to them. The Fed statements back in 2008-2009 regularly had two policy dissenters and no one gave them a second thought. Sure, they can take to the airways right after the meetings but that won't change things.
So at this point we’d say the possible outcomes are:
They’re voted down by the Senate (like Nellie Liang and Marvin Goodfriend)
They’re voted in and cause havoc
They’re voted in and marginalized
They're voted in and grow up
The regional governors run the show
People are rightly worried about #2 but we’d put it at less than a 20% probability.
3. What can we expect in earnings season? There is a bit of a ritual in forecasting earnings that goes like this:
Analyst (shows number on paper): I’m putting you down for this.
CFO (sucks teeth): Er, bit high, we had that recall thing.
Analyst (scribbles down a number): Gotcha. This?
CFO (looks out the window)
CFO: That does not look unreasonable.
Three months later:
CFO: We beat estimates
Analyst: Good quarter guys. Solid beat. Trebles all round.
That’s why 75% of companies “beat” earnings because everyone lowballed them to begin with. Anyway this quarter, analysts are busy revising down earnings. According to Factset, they revised them down 7% during the quarter, which means as the quarter progressed, they slowly pushed estimates down. Earnings will still be up year over year but far short of the 20% levels we saw throughout 2018.
That 7% is a big number. Normally it’s more like 4%. It makes us a bit nervous what businesses will say about sales and the rest of the year. And it will probably reduce the number of times we hear “beats”.
Bottom Line: Inflation numbers next week. This is the one measure the Fed has consistently overestimated and got wrong. We're looking closely at the earnings announcements with the big banks all due next week.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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All charts from Factset unless otherwise noted.