A Plan for All Seasons

“If it were done when ’tis done, then ’twere well it were done quickly” – William Shakespeare, Macbeth

The European Central Bank (ECB) has spoken, and markets listened. At least they did in Europe, where the German DAX index hit an all-time high and other European indices were in similar territory of multi-year highs, if not more. Though the bank’s move was widely hoped-for, the subsequent plunge in the euro showed that traders had been cautious about assuming too much – after all, ECB President Mario Draghi had been hinting at a quantitative easing (QE) program for months. Meetings came and went without any action beyond “technical preparations,” while analysts pondered the division between the apparent Draghi majority and the reluctant German-led minority. The latter may have held a minority vote, but the majority of the money.

Now we are left to speculate some more. For U.S. investors, the most immediate question is quite naturally what it might mean for our own markets. Friday was but one day of trading, but the fact of a sell-off cutting short a rally of only one day on Draghi’s words could signal a shift that has been talked about for many months now, namely a rotation out of U.S. equities and into European stocks.

The argument for the rotation is partly based on valuation: U.S. stocks are not cheap, with the S&P rising over 40% in the last two years, while the current anemic earnings season is making them even less cheap. European stocks are cheap, or at least some of them have been in recent months, even if Germany isn’t much of a bargain anymore.

Momentum is the other part of the argument for European stocks. While it isn’t clear whether or not the Federal Reserve will indeed raise rates this year, with the argument against any such move getting fresh impetus from lackluster earnings reports, the Fed has indeed ended its own QE and few if any believe it could be revived this year. Meantime the eurozone has just announced the start of its own program, and even though the buying isn’t scheduled to begin until March, well, you know what they say on Wall Street – “if you wait for the move, you’ll miss the move.”

Indeed, a widespread Street sentiment is that QE may not do much if anything for the eurozone economy, but hey, let’s buy the stocks anyway because everyone else will. The pro-US Street bias, combined with its conservative leanings and the EU’s rather dubious economic report card for the last few years, would naturally lead to skepticism about whether things might change. But it goes beyond that, as the EU is not quite the same as the U.S., financially speaking, and there was doubt amongst many economists at Davos, including Larry Summers, about the efficacy of the program.

A key difference is in transmission methods. The Fed’s QE dollars mostly ended up sitting in reserve balances. The much-feared inflation never ensued because the money wasn’t lent out – or not much of it was, not commercially. Most of it seemed to facilitate leveraged lending and equity buying by hedge funds and the like on the days the Fed was in the markets buying bonds. According to St. Louis Fed data, commercial and industrial lending rose from $60 billion in 2010 to $90 billion recently. That’s an increase of 50%, but not remotely near the possibilities of a leveraged expansion (roughly 8 to 1) of the $4 trillion or so the Fed’s balance sheet made possible. Ergo, no inflation, except in financial assets.

Will even financial asset inflation ensue in Europe? It might for a while, if for no other reason than the money river may decide to head in that direction on the wise premise that everyone else will. Whether it can be more than a blip, whether it can survive back-to-back weak earnings quarters in the U.S. (estimates for the first quarter are trending towards zero growth and a possible outright decline), remains to be seen.

For the moment, however, markets could still have a good breeze at their back. The Fed meeting is coming this week, and while the reception hasn’t been as jolly in recent months, any sigh of dovish solicitude for financial conditions should be warmly greeted. Friday brings the first estimate of fourth-quarter GDP, and if it’s near the consensus of 3.5%, it should bring about a fresh round of shouting about Fortress America, even if the numbers are dependent on an inventory boost that is currently reversing and falling import sales. Besides, it’s the first quarter.

Here in New England, we are preparing for a major snowstorm (expect more weather excuses for first quarter earnings) after last week’s major snowstorm about deflated footballs, and the rest of the week’s snow about the upcoming Super Bowl. It should make for an interesting week.

The Economic Beat

The report of the week, as it were, was the ECB QE announcement. From the point of view of economic data releases, nothing really stood out, either with the markets or from my own point of view.

Housing was the main feature of the week. The homebuilder sentiment index was about unchanged at 57, December being initially reported at 57 and then revised upward to 58. The difference is trivial. Sales remained in a positive mode, while traffic fell, perhaps reflecting the change towards more frigid weather.

Although starts showed an above-average bump of 4.5% after falling 4.5% in November, much of the variation can be laid at the door of the weather (November was colder than usual, December warmer) and seasonal adjustments. Permits eased. The monthly starts data is subject to large revisions, but for now 2014 shows an increase of 8.6%, thanks to solid multi-family activity – single-family starts were up a modest 4.9%. 2014 was also the first year since 2007 to see actual starts back up over the one million mark (1.006 million, so a revision could still drag it down). The average since 1970 is 1.46 million, so it’s not quite a reason yet to get out the cake and balloons.

In tune with the modest activity in starts was the December report on existing home sales. This report is also subject to not-insignificant revisions, though not as large as starts, and showed that sales fell 3.1% in 2014 to a rate of 4.93 million. The median sales price increased by 5.8%, about the same as the federal housing agency report on existing sales (5.3%). Some of the new federal proposals should help, but the sector isn’t going to see a full recovery until at least the next business cycle, and possibly longer.

Manufacturing surveys showed a little easing and will probably continue to do so for the next month or two, in part due to a couple of good months in the fall. Wall Street has yet to grasp (out loud) the premise that two good months do not promise the next twelve in a row will be similar, particularly in an era of modest growth. The Kansas City survey reported a result of 3 (zero is neutral) versus 8 the previous month, and the Markit “flash” estimate of national purchasing conditions showed a reading of 53.7 (50 is neutral). In the same vein, the Chicago Fed’s national activity index showed a read of (-0.05) for December (0=neutral), even as November was revised upward to 0.92, quite an elevated reading for that measure. Such spikes, however, have consistently been followed by declines in recent years; the 3-month moving average slowed from 0.54 to a still-respectable 0.39. The index has not been very useful as a leading indicator.

Nor has the leading economic indicator series. The biggest contributor to this measure is the steepness of the yield curve, but that metric has been of no use ever since short-term rates were artificially pegged near zero. It may as well be the data series from China, most of which consist of what is thought to be appropriate rather than real. It was with some amusement that I noted China’s 2014 GDP estimated at 7.3% (the number is never revised, they’re so good at it), with retail sales up 11.9%, industrial production up 7.9%, yet consumer inflation is reported at 1.5% and producer inflation at minus 3.3%! It’s the Chinese miracle, alright.

Next week is the heaviest earnings week of the calendar. The “blended” (reported + estimated) rate fell again last week, to 0.25%, suggesting 4% is the upper limit for actual earnings last quarter and 6% the upper limit on the year. Estimates for this quarter are already down to 0.8%. Since estimates usually fall by several hundred basis points from the beginning of the quarter to the beginning of reporting season, the implication for now is that earnings growth will be zero or less this quarter.

Next week’s highlight is the FOMC statement on Wednesday. After all of the forecast cuts from the World Bank and the IMF, I wouldn’t look for anything hawkish. The committee will have seen two new useful indicators, durable goods orders and new home sales, that will be released to the public on Tuesday. They should have access as well to the first estimate of fourth-quarter GDP, set for release on Friday (along with the employment cost index). The Atlanta Fed’s estimate is at 3.5%.

Other reports of note include the Case-Shiller price index and consumer confidence on Tuesday, pending home sales on Thursday, and the Chicago purchasing survey on Friday.