Nearing the Finish Line

“You never know what is enough unless you know what is more than enough.” – William Blake

My, what a sell-off on Friday. Market skeptic though I may be, however, it was only a sign of increased volatility, not of the apocalypse (that will come later). For now, we are still in a topping pattern that I don’t believe has peaked yet for this cycle.

So why the selling, you may wonder, but to be fair, there was no one smoking gun. Certainly one can cite the backdrop of a negative earnings quarter (probably down about 1%-2% for the S&P 500), along with the missing magic potion of QE. China’s decision to put some speed bumps in front of its equity market bubbles was tough on sentiment, and the options dealers (Friday was expiration) were making a killing on S&P calls getting crushed. And as I have so often said in the past, one might also have asked why the market had been going up last week in the first place – mostly weakish economic releases that played up to hopes of delays in the Fed’s first nudge to interest rates, not the strongest of platforms.

There was even an ill-informed column in a national business paper that shall remain nameless, claiming the Fed has already slowed the economy by virtue of its tightening talk throwing brakes on the economy. Puh-leez – don’t they know better than to print watering hole laments from lower Manhattan, or dark-corner whispers about conspiracies? I will give you three quick reasons why it is so wrong, the first being that credit markets are booming. Financial conditions aren’t tight, unless you make the claim that a stock market that doesn’t move relentlessly higher is a sign of tightness.

Second, if you’re trying to blame allegedly tightening financial conditions for the first quarter, then please explain how it was that a negative first quarter of 2014 followed right on the heels of a 30% gain in the 2013 stock market. Third, and most importantly, the business cycle is going to end whether the Fed raises rates or not, a theme I will repeat over and over this year for the very simple reason that we are getting near the end of the current cycle.

I don’t know that this cycle will end before the Fed raises rates, but I believe it to be reasonably probable that the central bank can slip in at least one or two rounds before it starts to contract. The bank won’t be able to get rates high enough to provide the Fed with much of a safety cushion going into the next downturn, as Janet Yellen & Co. will discover, but even the ability to cut by 200 basis points – which the bank will almost certainly not have – can’t stop a contraction. Monetary policy is a cushion in downturns, not some reality transmogrifier out of Calvin and Hobbes.

Mundane realities won’t stop the Street from blaming the bank for the long fall from sky-high valuation levels (but not as high as the tech bubble, so nothing to worry about, sayeth the typical trader) to the concrete below. The reason for that long (and destructive) fall is the Street’s foolishness in chasing prices to ridiculous heights, but it will blame the Fed for that too, even as it took credit for all the “great performance” that preceded the fall. It’s just the nature of the beast.

But we can return to the ins and outs of the days of reckoning at a later date. For now, I fully expect that the stock market will complete its usual first-quarter earnings rally, even if said earnings are negative on balance, first because the bar is set low enough, second because options expiration is behind us, and third everyone expects the market to go up over the next two weeks, thus putting a damper on the urge to sell. Weak earnings are not a good springboard for further rallies, so I expect yet another pullback sometime in May-June, but the market’s mainstay is Fed policy and will remain so for the foreseeable future. The trend is your friend, until the end.

The Economic Beat

The report of the week had to be March retail sales, though it offered next to nothing in the way of surprise. The overall increase of 0.9% missed consensus estimates for an increase of 1.0%-1.1%; sales excluding autos were up 0.4% against consensus for a tenth or two higher, and sales excluding both autos and gas were up 0.5%, beating consensus by a tenth, but only because sales for the prior month were revised a tenth downward (overall sales and sales excluding auto each benefited from a revision of a tenth higher).

The market seemed somewhat disappointed by the results, though they did reinforce the popular notion that the Fed would have to remain on hold at least until September, if not longer. Despite the noise from the seasonal adjustment factors, though, it doesn’t appear as if the underlying trend of sales growth has changed at all in recent months. There has been a small moderation in the year-over-year growth rates – the first quarter was up 2.1% – but nothing remarkable for this late in the economic cycle. The twelve-month growth rate has remained quite stable at around 4% for the last eighteen months.

One thing that has changed, certainly, is the value of gasoline sales, with year-to-date sales running over 20% lower than a year ago. Some categories have benefited, like food (+3.0%) and especially dining out (+9.0%), but falling gas prices only influence the mix of spending dollars, not the total. For the latter, either income or credit growth needs to expand. I’ll say it again – cheaper gas isn’t like a tax cut. Here in Massachusetts, soaring electric rates (about +40% year-on-year, believe it or not) have offset lower gas prices in the monthly tally.

The manufacturing sector finished the quarter on a feeble note, reviving debates over how much the weather was responsible. Record snowfalls in the Northeast were certainly a factor, as was the port strike in California. But so were heavy inventories. The truth is that it isn’t unusual for any given quarter to have an unusual episode or two of something, episodes that usually balance out over time. For example, the second and third quarters of 2014 were free of excessive heat waves and a problematic hurricane season, “unusual” positive factors that contributed to above-trend quarters. The second and third quarters of this year ought to see a rebound as well, but probably weaker than in 2014 – the first quarter wasn’t as much of a dip, and last summer’s nicely benign weather may not repeat itself. The net of it will very likely be that 2015′s annual growth is about the same as 2014.

So, for example, anyone familiar with the Philadelphia Fed’s business survey would have known that last fall’s very high readings (over 60) in the six-month outlook did not promise glowing conditions over the next six months, but an impending decrease in activity as stuffed order books dwindled in response to high stock levels. Sure enough, the latest reading on Thursday showed an activity index of 7.5 (zero is neutral), little changed from the previous month’s result of 5.0 and with new orders unchanged. Shipments and backlog declined for the second month in a row, as did prices paid.

The New York Fed April manufacturing survey was roughly unchanged – even slightly negative, at (-1.2) – with new orders declining, though shipments increased. The March industrial production index showed a sharp drop of (-0.6%), leaving the first quarter negative and a year-on-year growth rate of only 2.0%. The latest month was dragged down by a big decline in utility output as the weather improved, but nearly every other category was negative too. The year-on-year rate in manufacturing that had been above 4% last fall slipped back down to 2.4%. Yes, it was a weak quarter, but activity will probably pick up over the new few months (he said again), aided by better weather and in time an inventory rebuild stage. Then the business cycle will end anyway, and it won’t be four or five years from now. When it does, Europe is going down too, QE or no QE.

On the housing side, activity was also muted. The homebuilder sentiment index moved back up to 56, but the rate of starts and permits for March was below expectations The Beige Book from the Fed reported the usual “modest to moderate” mix, while sentiment indicators eased to still-high levels. Thanks to falling energy prices, the consumer price index is unchanged from a year ago, while the producer index is actually down by 0.8%. The ex-food and energy readings were 1.8% for CPI and 0.9% for PPI; the market did not like the former (the Fed is closer to raising rates) but was happy with the former.

While I don’t trust the accuracy of Chinese data, readers know I do believe their direction. The latest figures for China’s retail sales, industrial production and GDP (7.0%) were all below consensus and at the lowest levels in years. The Shanghai market reacted by going crazy in anticipation of more stimulus, so the Chinese authorities first put on trading limits Friday (markets tanked) and then cut the reserve rate over the weekend (markets rebounded). It’s crazy.

Next week is a quiet week, with the most notable reports being existing home sales Wednesday, new home sales on Thursday and durable goods on Friday.