Eyes Wide Shut

“There are apparent disconnects between the positive assessment of economic prospects reflected in market valuations and forecasts for the real economy.” – OECD Interim Outlook, March 2017

So why did markets ease last week, after a six-week fun run for equities (including eight of the last nine?). The answer may lie partly in the question, as such prolonged streaks of green are not common in equity-land. Part of the answer must surely therefore be technical – equities have become increasingly overbought, to near-nosebleed levels, making the situation ripe for some kind of pause. Some of the answer may also be in the erratic signals coming out of the administration, or the firmer signals coming from the Fed that a rate increase at the coming meeting is almost certain.

Friday’s release of the February jobs report would seem to make the last thought a virtual certainty. The surprisingly good number of 235,000 jobs (seasonally adjusted, or SA) easily beat consensus for 190K-200K, and the unemployment rate ticked back down to 4.7%. The Fed was even heard to hint that we might be near full employment, which ordinarily means the event would have happened at least a year ago. The jobs number may have been weather-aided (see below), but the new administration lost no time taking credit for the good news.

Another interesting development last week – little heeded by markets – was the OECD’s assessment that markets have run ahead of both the global economy and its outlook in its Global Interim Outlook released last week. The Fed aside, outlooks by economic bodies rarely get attention on Wall Street (where more sophisticated analysis like “the trend is your friend” usually prevails), so I would not attribute last week’s very mild pullback to the OECD. I mention it more as something to think about and of course, consonant with what I have been saying for many weeks now as prices march higher on little more than the conviction that things will get better, despite the lack of hard evidence.

Most traders will not bother to read the OECD report, and even if they believed it would pay it little heed. Conventional Street wisdom is that macroeconomic forecasts should not be listened to unless they predict better times, and even the latter projections can be short on staying power. One certainly does not trade against the trend based on such frivolities.

In his book The Big Short, journalist Michael Lewis detailed how arduous the road was for the early bettors against the mortgage bubble. Despite an abundance of hard data that things were going badly, the majority conviction that the mortgage meltdown was little more than a bout of indigestion was not shaken until the very end – not until the bankruptcy of Lehman Brothers rubbed everyone’s face in it. At that point the U.S. had been in recession for nine months, though very few on the Street would admit it.

We don’t have a credit bubble the size of the mortgage bubble this time around, thank God, but that absence doesn’t mean that the business cycle can’t end anyway, tax cuts and deregulation notwithstanding (neither could stop the recessions that began shortly after Bush and Reagan took office). It’s ending in slow motion, the way cycles always do, before speeding up at the very end.

Valuations are extraordinarily rich, but not really – just ask an asset manager, who certainly doesn’t want you to take out any of your money. You must stay the course. Of course, despite last week’s mild losses, equities remain short-term overbought and extremely overbought on both and intermediate and long-term basis, but no worries, we’ll just shake it off and seize the opportunity afforded by the brief pause to march every higher. Just close your eyes and buy, it’s really so much easier that way.

The Economic Beat

So how much did weather affect the February report? We’ll get to that after we review the good parts of the data. To begin with, the headline number of 235,000 (235K) was well ahead of consensus for 200K (though not so much after the eye-popping ADP private-sector estimate of 298K two days earlier). The good news was echoed in the household survey, where a 447K number caught up a few months of little or no change. At 58K, construction was the second-biggest contributor, and that doesn’t often happen.

Average hourly earnings were up 2.8%, while average weekly earnings are up 2.5%, both numbers representing an improvement and possibly a mix issue as well, with better-paying goods-producing jobs up 95K overall while retail suffered a loss of 26K (SA). The diffusion numbers (breadth of hiring) for both total private and manufacturing were in the low to mid-60s, quite an improvement over year-ago readings, especially in manufacturing (65.4 vs. 48.1). The unemployment rate fell to 4.7% vs. a year-ago 4.9%, the participation rate edged back up to 60% and the not-in-labor-force category fell, though it is still above year-ago levels.

It’s difficult to pick out the weather effects with much confidence, though unseasonably warm temperatures and below-average snowfall undoubtedly helped, particularly in construction. Warm weather probably also helped in mining, but may have been a drag in retail help, where doubtless a lot of winter clothes went unsold – and a lot of disappointing brick-and-mortar fourth-quarter earnings results also led to cost-cutting. I saw estimates of 35-70K, and analysts at the Brookings Institute suggested it may have been 25K, and that warm weather has inflated the January-February count overall. Jobless claims were very low in February, though they have since seen a small pick-up.

Higher petroleum prices are sure to have contributed as well, an effect that may disappear if the current bout of weakness persists. My own inference is that warm winters always boost employment, though the exact effects are nearly impossible to distill. More important that is that weather effects are transitory, and January-February’s gain may end up in give-backs down the road this spring. Overall it was a good but not great report, and there is no real evidence that the overall trend of softening employment growth has changed at all. We got a little boost from weather and energy, so much the better (especially for those people drawing the checks!), but calling it something more permanent isn’t warranted.

Some of the weather-and-oil oil trend can be seen in the January wholesale sales report. Though monthly sales were down 0.1% (seasonally adjusted), they were up a whopping 8.4% year-on-year, the best such result since February 2012. But half of the increase can be directly attributed to oil and the change in oil prices. Related categories like chemicals and agriculture also posted strong increases, while lumber and electrical sales were similarly very strong. So were motor vehicle sales, which always benefit from warm weather and increased construction. Most categories were up year-on-year, so it was a good report, but weather and energy prices can’t be counted on, and the inventory-to-sales ratio, while below a year ago, is still quite high for January at 1.29.

The rise in oil prices has also been driving import-export prices, with import prices now up 4.6% year-on-year through February and export prices up 3.1%. That’s quite a reversal from the last few years of negative comps. Energy inflation has a way of feeding through the price chain, but the recent weakness in oil prices may signal an impending pause.

Factory orders, whose key components are largely known from the monthly durable goods report that precedes it every month, were up 1.2% (SA) in January, principally due to aircraft orders. Excluding transportation, orders were up 0.3%, while capital goods remain soft: trailing-twelve-month (TTM) sales are down 5.1% (NSA), the fifth month in a row they have been down over 5%. The international trade balance worsened as expected, presenting a potential drag to first-quarter GDP.

The week coming up will fittingly center on Wednesday, being also the center of the workweek. At 8:30 we are due to get February retail sales, which should have benefited from the warmer February weather (ski shops in the Northeast may feel differently), though auto sales may hold down the total. At 2PM, we will have the FOMC monetary policy statement, which in months divisible by 3 (like March) feature updated staff forecasts and a press conference with chair Janet Yellen.

That’s not all for Wednesday, as the homebuilder sentiment survey, consumer price index (CPI) and New York Fed regional manufacturing survey are all slated for release. Barring an outlier, only the CPI is likely to get much attention, as the market begins to pay more attention to prices and the Fed’s thoughts therein. The producer price index is the day before.

Thursday will bring housing starts, the Philadelphia Fed survey, the labor turnover report (JOLTS) and a blizzard of Fed commentary, I am sure. Friday has February industrial production, which apart from utility output should benefit from the mild weather. It’s also a quadruple expiration day, so between the Fed on Wednesday and expiration Friday, we might get a bit more market volatility than we’ve seen in the back half of the week. It would certainly be difficult to see less.