On the Road to Nowhere

“And it’s very far away, but it’s growing day by day.” Talking Heads, Road to Nowhere

Listen, for the stock market is telling you something. A year ago, the kind of GDP and employment cost data that last week comprised would surely have caused the market to rally on what would inevitably have been labeled “Goldilocks” data – that is, not too hot, not too cold. With second-quarter GDP coming in at 2.3% (first estimate, more details below), it would have been a perfect parlay – better than the first quarter’s rate of 0.6% (upward revision, and no longer negative) and so progress of a sort, yet still leaving us with about 1.5% growth in the first half. The Fed can’t possibly raise rates now, ergo buy equities!

Two things have changed in the intervening year, one being that the Fed did end its quantitative easing program (QE) last year and has constantly talked of “policy normalization” (i.e., getting off the zero-rate policy and initiating an increase in the federal funds rate) all of this year. It’s been a persistent message, to the point that the July Fed meeting was considered good for stocks on the grounds that the FOMC (monetary policy committee) didn’t actually raise rates, even though hardly anyone expected it to do so.

A second big difference is earnings. As of Friday, the “blended” growth rate for second-quarter S&P 500 earnings was a decline of 1.3% (FactSet), the blend being 354 actual reports combined with a balance of estimated numbers still to come. A year ago, the growth rate for the second quarter was 10.2%. The latter figure may have been boosted by the weather rebound and stock buybacks, but bulls could still crow about double-digit earnings growth. It’s a long way from that 10.2% to the roughly breakeven rate the S&P 500 companies are on course to achieve this time.

Maybe if earnings were better, the Fed-can’t-move theory would have led to a more convincing rally than last week’s blip, one largely based on the usual two-day Fed bounce and some end-of-month positioning (the averages were roughly flat on the month coming into the last four days). As it stands, though, the market is telling you that it’s concerned about earnings and most of all it thinks a rate increase is coming – but doesn’t rally care all that much.

How can such a Fed-obsessed market not care about a coming rate increase, you may wonder, and the first answer is sheer fatigue. The Fed’s message that it wants to normalize (raise rates) has been steady this year. The flirtatious hints about maybe waiting another year or two to move that were so frequent in years past have been absent. We’ve also gotten a steady diet of hints and nods that the Fed will move quite slowly in little increments, ostensibly being data-dependent but also accomplishing the more important tasks of a) not frightening Mr. Market; and b) not catching the blame for the looming end of the business cycle.

The second answer is that the market itself is starting to have doubts about growth. How could it not, with first-half GDP growth at 1.5% and S&P 500 earnings growth on course to finish at barely 1%, if that. Energy has become the whipping boy for all that is wrong with spending and earnings and the sector is certainly dragging down broad measures, but the end of most cycles begins with one or two sectors being singled out as the only real problem. I cannot in good faith make the argument that rising energy prices should extend the U.S. business cycle.

Oddly enough, I would be less worried about the market going into August if last week’s bounce had not taken place. The first half of August is often beset by dramatic price drops of several percent that are then forgotten as the second half of the month has its usual vacation rally towards Labor Day. Had prices not bounced last week, I would have said the oversold condition of the market would probably limit the early August downside risk.

That prop has been removed, opening the door to an August downdraft that might be a bit worse than usual, given the punk earnings season, Fed-fatigue and doubts about global growth (can you say, “China?”). I have long thought that the market peak for this cycle rated to come this fall (as a probabilistic guess rather than odds-on bet) and I’m not ready to abandon that scenario quite yet, but I’m having a harder time coming up with a recipe that gets us there. Maybe the Fed won’t move in September after all, though ultimately that would entail more economic weakness in the interim. At some point, though, weakness has to matter, even to the stock market.

The Economic Beat

The report of the week was the initial estimate of second-quarter GDP, with its sobering revisions and news. It will probably find itself being revised down the road, but by how much and in which direction?

The news of a 2.3% real (inflation-adjusted) growth rate (annualized and seasonally adjusted) for the quarter met few expectations. The consensus estimates ranged from 2.5% to 2.9%, while the Atlanta Fed’s real-time tracker had it at 2.4%. The number released was certainly at the low end of the scale, and the report showed plenty of weakness throughout: Investment spending weakened, gross domestic purchases weakened (though personal spending increased, something not reflected in store reports). Exports grew and imports decreased, however, giving the number a lift. Weakness in oil is partly responsible for the decline in investment spending, but that is not a reason to dismiss it: every recession begins with weakness in one prominent area.

Real growth was adjusted downward for the last four years, from an average rate of 2.3% to an average rate of only 2%, notably with 2011 (1.6%) and 2013 (1.5%) now below the 2% line. It’s worth taking a minute to stop and think about some of the implications of that news – one, that the decision of former Fed chairman Ben Bernanke to institute a program of quantitative easing (QE) in August of 2011 now looks more justified than ever.

A second plain conclusion is how little GDP and the economy truly matter to the stock market: the S&P 500 rose over 30% in 2013, now reported to be the weakest year of the recovery for growth (though 2015 could still overtake it).

Despite the upward revision to the first quarter, first reported as falling 2.5% and now sporting a 0.6% growth rate, four-quarter nominal GDP (that is, the twelve months ending June 30) fell to 3.3% from 3 9%. That could be revised of course, and the rate does oscillate around a central tendency of about 3.8%, however, a falling four-quarter rate this late in the cycle is more cause for concern than it might have been two years ago: the current quarter marks eight years since the last cycle stopped growing.

Thursday’s GDP report was definitely weaker than expected, apart from the upward revision to Q1, but Friday’s release of the employment cost index (ECI) for the second quarter of 2015 may have shaken the markets just as much. It bears repeating that it too is a number subject to revision, though the first quarter’s release did go unrevised. The quarterly rate was 0.2% in the face of expectations for an increase of 0.6%, and the year-on-year rate fell to a low of 2% (from 2.6% in Q1), the kind of number usually only seen in recessionary times. Most of the minimal growth came from the public sector.

Economic growth has slowed but it hasn’t disappeared, as regional surveys showed. The Chicago purchasing index surged back up to a surprising 54.7 (50 expected) from the previous month’s 49.4 (50=neutral). It was only the second expansionary reading in the last six months, possibly influenced by generous seasonal adjustments for auto production, but it was echoed by the Richmond Fed survey, which similarly moved up from 6 to 13 (neutral=0), and even the energy-centric Dallas index, which moved up from (-7) to (-4.6). Keep in mind that the surveys do not measure the level of activity, only the directional sentiment.

Consumer surveys do not get much attention in this space for the simple reason that they correlate best with recent stock prices, something I hardly need to be told about, and worst with future spending. However, the large drop in the Conference Board measure (99.8 to 90.9) and the small drop in the University of Michigan measure (93.3 to 93.1, but an increase was expected) did catch my eye for the negative readings on employment. Long-time readers know that I believe that the jobs market entered the peak phase of its cycle last August, and that the cycle usually lasts from six to eighteen months with a median of about a year. Data from the first half of this year sustained that view, indicating a strong job market whose growth rate was nevertheless showing some sign of waning. The declines in the sentiment measures might be an early signal that the peak is indeed waning, or it may only be a signal that consumers were unhappy with their quarterly 401k statements, but it bears watching.

New orders for durable goods continued an unhappy trend in June, namely being the sixth month in a row that year-year comparisons were negative in the cap-ex category. Monthly orders were up 3.4% all-in for the month, but are down 2.8% so far this year. Many argue with a straight face that all the economy needs is higher oil prices and a weaker dollar and we’ll be fine, a parlay that has not shone in the past.

The FOMC meeting produced little in the way of fireworks, with no press conference and a statement that seemed more terse than ever. Many are taking it as a sign that the committee will move in September, an outcome I lean to as well. The Fed needs to give itself some room before the cycle is over and is running out of time, but a weak jobs report for July or August could leave it boxed in.

Next week is an important one, being not only the first week of an often tumultuous month, but bringing many important releases, most prominently the jobs report on Friday. The consensus is for a range of 210,000-220,000, and I don’t think anyone will be surprised by a number that is 10,000 higher or lower than June, currently at 223K (and subject to revision). The weekly claims data isn’t suggesting any weakness, but some of the sentiment data is, albeit in a mild way and one that may be more reflective of August than July.

The week will kick off with personal income and spending on Monday, followed by the ISM manufacturing survey and monthly construction spending. The latter is prone to such wide revisions that one should really only lean on the first revision, rather than the first estimate. Factory orders are on Tuesday, international trade on Wednesday (with a clue to current GDP) along with the ADP payroll report and the ISM non-manufacturing survey. Auto sales and some chain store sales for July will come out during the week, but Redbook data indicated another soft month at the local store.