The Days Ahead: Get set for a heavy week of politics.
Headlines this week were the U.K. snap election, elections in France and the slow fuse of the “hard vs. soft” economic data debate. We can deal with the first quickly. The decision to hold an election was opportunistic in a system of fixed term governments. The opposition is in disarray and Prime Minister May will strengthen her hand in the upcoming Brexit negotiations. She will almost certainly win. The opposition Labour party is fighting its cause from the left, not the center. Curiously they voted for the election so, yes, Jim, turkeys do vote for Christmas. The Tories are campaigning under the inspirational banner of “Strong and stable leadership in the national interest” which as catch phrases go lacks some punch. Anyway, add another election to the European roster this year.
Meanwhile at home, it was mostly quiet in U.S. stocks with a continuation of the 2% trading range we’ve seen since mid-February. Corporate earnings were mostly in line. What surprised us was Goldman Sachs (GS), which showed a big drop in trading and earnings (but less in earnings per share). The shares are unchanged from 10 years ago. The other was IBM whose quarterly income peaked four years ago and share price has underperformed the S&P 500 by 50% for five years. Why single these out? Because both are heavy Dow Jones Industrial (the index we hate) components and were expected to do well in the reflation trade.
1. Two hits, three misses: The U.S. economy has yet to hit its stride from the expected post-election gains. Housing sales and industrial production (IP) did better than estimates. House sales and manufacturing did worse. The Fed’s beige book was all rather subdued. They used the words “modest” and “weak” 136 times compared to 107 times in January. Which was not the way it was meant to go. Of these, we would point to the IP numbers.
The line to look at is the green line, which is straight manufacturing and excludes volatile stuff like utilities and mining. It hooked down in March and is a classic case where strong readings in sentiment a few months ago should have panned out by now. They haven’t. It's another reason that the Atlanta GDP Now forecasts sit at 0.5%. They were over 3% six weeks ago. That, in turn, partly explains the bond market, which has held its gains over the last few weeks and trades at 2.2% down from 2.6% in March. The price gains alone from a 10-Year Treasury are 3% in the last three months. Put all this together and i) we’re buyers of the high-quality end of the U.S. bond market and ii) don't expect any rushed action from the Fed.
2. Meanwhile in Europe: The data is upbeat. We saw Eurozone construction up 7%, consumer sentiment up, various PMIs higher and CPI unchanged, which means the ECB will continue QE. Europe’s current account also increased sharply. Germany is now the world’s largest creditor and surplus country, having overtaken China in 2016. Now you don't invest in economies just because they have a current account surplus…it’s no more than a measure of excess savings. But it does explain the strength of the Euro, which we expect to remain strong, and the improvement of Europe’s hard hit economies.
Of course all eyes are on the French elections, which will go to a second round. For all the volume over the politics, French stocks and bonds have held up well.
Stocks are up over 5% year to date and 8% to a U.S. investor. Bond yields have risen this year from 0.6% to 1.0% but most of that change took place in January. Financial markets for one seem untroubled by the outcome or, more likely, reason that a pro-business Macron will emerge the winner on May 7th.
3. People are worried that U.S. equities are overvalued: This has been a constant for months and received more attention on Friday when Paul Tudor Jones, a one-time hedge fund manager, flashed a variation of a chart we use from time to time. Here’s our version:
Jones looked at the black line and said, because it’s higher than it was and approaching 2001 levels, the market is overvalued. All it does is take the value of the U.S. market and divide it by the value of the economy. It’s obtuse. The value of the market is a balance sheet item and GDP is an income item. Stocks are not the sum of the economy. Nor are they representative of the economy. The value of Facebook, Google, Hewlett-Packard and Apple are 11 times larger than the GDP of Santa Clara County but that doesn't mean much because they sell and operate everywhere. It’s the same for U.S. stocks and GDP.
We're the first to admit that the market is no bargain (here) and there is no one, none, zero, predicative metric which will tell you that the market is overvalued or undervalued. But we would point to the earnings yield relative to inflation and BAA corporates, the yield and the earnings outlook, and state that stocks are nowhere close to bubble territory. And that’s why we keep to the quality and dividend growth end of the market.
4. But the CR is a worry: Yes, the Continuing Resolution vote. You know, the one that keeps the government open, is up next Friday April 28th. That could come with a new healthcare vote, or not. Or more talk of fiscal and tax changes. Unlikely. Bonds will trade nervously this week.
--Christian Thwaites, Brouwer & Janachowski, LLC
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