Cyclical Adjustments

“Content makes poor men rich; Discontent makes rich men poor.” – Benjamin Franklin, Poor Richard’s Almanack

Well, we keep grinding higher. The list of reasons is familiar, starting with the obsession over the Fed’s stance towards monetary policy, with the latter widely and incorrectly believed to be the prime causal agent of recession and prosperity. Last week’s slate of weak economic releases (see below) gave a bit of fresh life to the familiar parlor game of guessing the timing of the Fed’s next move, with the edge towards those guessing later than sooner. The consensus has shifted into September and is speculating more and more on December.

It’s all late-cycle stuff, from the chatter about the slow economy – is it really slowing, maybe it’s just a bump in the road, don’t worry things will get better in the fourth quarter, no a recession is about to start, there is no recession at all on the horizon. Usually at this point in the cycle, with unemployment down below 5.5%, interest rates would be higher and the markets might be speculating about whether the central bank was about to stop raising rates, or even begin to cut them. This time we are still gnawing over whether the too-timid FOMC might begin to raise them

Some traders don’t really believe that the Fed can keep the business cycle going forever with ZIRP. Within this smaller, quiet group are those content to trade on the belief that so long as the majority buys into the notion of no recession without rate hikes, nothing really bad can happen. Others take the view that the financial markets won’t correct unless and until the Fed raises rates, or there is incontrovertible evidence of recession, perhaps a deep one. Certainly the economy and profits have mattered little to the markets in recent times. TINA (There Is No Alternative), anyone?

Trading is also being helped this year by the winding down of the earnings season. As more big companies emerge from the quiet periods surrounding an earnings release, they are free to resume buying back stock. Given the size of many of the announcements and the pressure on corporate management to prop up prices during the dying stages of the bull, it seems likely that they have been pretty busy.

More volatility is the near-term condition I am most certain about, so while I do expect (with only modest conviction) that the market grinds higher into the fall, it also seems likely to me that it will come with more swoops and dips. The period between mid-May and mid-June is often a weak one for the markets, and once the post-season buying starts to dry up, we could head right back to 2000 again on the S&P 500 (many CFOs will want to keep some buying powder around for the end of the quarter, when pressure tends to mount). Then the usual second-quarter earnings rally, though a somewhat less predictable affair than the one in April, might take us up back to where we are now. The Fed might well blink again in September and we end up around the 2250 level that many (including yours truly) think is the region to start selling. The market may of course blow right past that level, but that doesn’t mean I won’t be selling all the way.

It might also come to pass that new Fed vice-chair Stanley Fischer has his way and there is a June rate hike after all, a possibility perversely more likely if the stock market were to keep climbing steadily higher. I wouldn’t expect the markets to come apart in the wake of such a move, partly because rate hikes have been in the air too long and partly because equities hardly ever roll over after the first tightening. The textbook reaction is a knee-jerk sell-off followed by bold new highs. It ought to be noted that such reactions have usually been accompanied by a better economic and earnings environment, but the market may choose to accept a relatively low unemployment rate as foundation enough. Second quarter growth should prove better than the first, the third quarter better than the second and that may be enough for the marching band to play on. I’ve certainly seen flimsier pretexts in the past.

Near term, the market could well keep alternating between sudden dips followed by determined recoveries in our Fed-obsessed environment, driven by an economy that is not quite weak enough to truly scare financial markets, yet not quite strong enough either for the FOMC to find the nerve to start raising rates. So far as the latter is concerned, I don’t see the economy to be at all strong enough that the Fed will actually need to raise rates to begin the process of checking over-speculative behavior. The issue is that the business cycle will end anyway, with the Fed having not much else besides restarting QE in its kit bag. I wrote on Seeking Alpha last week that the time to keep buying the dips is past, and that conclusion is still intact.

The Economic Beat

The report of the week was April retail sales that were not merely disappointing, but not good either. If one looks past the month-to-month weakness of no gain (seasonally adjusted) in the rate of sales where consensus had looked for an increase of 0.2%, there is some disturbing softness. Despite the upward March revision (0.9% to 1.1%) that seemed to offset the April weakness, year-to-date sales are only up 1.9%. More alarming is the year-over-year change in March-April sales combined (unadjusted), which eliminates the Easter effect and has historically been a reasonably good indicator of annual sales growth. The increase was only 1.4%, the weakest since 2009 (when it was negative during the recession), and uncomfortably similar to the 1.3% increase of 2008, when we were already in a recession that virtually no one would acknowledge.

We can talk about the weather, energy, port strikes and whatever other “one-off” factors are responsible, but last year’s March-April combined added up to a much bigger 3.8% year-on-year growth. I can think of excuses too, one being that after a winter (2015) that was tough but not as tough as the prior year, there is also less of a rebound. That explanation doesn’t do enough to close the gap, though, not without some wild-eyed faith. A simple attempt at normalizing the data suggests that last year’s rebound effect could have amped the year-year change by 50-100 basis points, implying that the underlying “true” trend might be closer to 3% in 2014 and 2% in 2015, instead of 3.8% and 1.4% respectively. It might even be closer to 2.2%-2.4% in 2015. That would still suggest a trend like 2007 (2.6%), when the economy was in its last year of expansion in the business cycle.

Something else rebounded too, namely gasoline prices and related spending. The big surge in pump prices is probably responsible for the sudden drop-off in consumer sentiment as measured by the University of Michigan survey. I don’t consider these sentiment surveys to be especially useful indicators, but the big miss (about 88 instead of about 95) did get a lot of media attention. The New York Fed survey reported a bit of a miss as well with a reading of 3.09 versus expectations for 5.0. That’s hardly worth talking about but that the results were soft overall and echoed the April industrial production report, which at (-0.3%) showed a fifth consecutive month of contraction. April was supposed to see the first stage of the rebound, yet the New York survey was a tad weaker still for May. Year-on-year manufacturing growth, over 4% last year on the strength of the summer rebound, has since fallen to 2.3%.

Throw in the inflation data and the picture of weakness deepens. Producer prices fell 0.4% in April, taking the year-year change to (-1.3%). Energy is the main culprit, but weakness is still evident in the 0.7% annual increase when food and energy are excluded. Export prices fell even further (-0.7%), import prices fell steeply as well (-0.3%) and the year-on-year totals now stand at the alarming levels of (-6.3%) for exports and (-10.7%) for imports. One can argue that oil prices distort the extent of demand weakness, but the data certainly do not reflect demand strength.

The best showing of the week was in the lagging indicator of employment. Weekly jobless claims are at 15-year lows, though the relative position is distorted by the lower percentage of insured workers in the general population. The claims strength was somewhat offset by the labor turnover report (JOLTS) for March that showed an unexpected drop in job openings, though hiring remained steady. It might well be monthly noise.

I still expect conditions in the second and third quarters to improve from the first, now estimated to be negative in GDP terms, perhaps by as much as 1%. The energy sector bite has come first, as noted in this space before, before other manufacturing that stands to benefit from cheaper energy can start to establish a more solid expansion. That said, the second quarter is not off to a very good start. As usual, the stock market likes that overall because of the implications for soft monetary policy, but monetary policy doesn’t fix everything. We’ll see a little bit more about what the Fed thinks about policy on Wednesday, when the latest monetary policy meeting (FOMC) minutes are released. The bank certainly won’t address the policy limitations issue however, and the stock market will be almost exclusively focused on (obsessed with) with the question of more or less dovishness.

Housing is slated to be the other main story of the week, with the housing market sentiment index on Monday, housing starts on Tuesday, and existing home sales on Thursday. The Philadelphia Fed survey that is usually two days later than New York (last Friday) isn’t released until Thursday, and the consumer price index that usually follows the producer price index (last Thursday) by two days isn’t until Friday. Bond markets should close early in the U.S. on Friday the 22nd and equity volume will be light as traders disappear for the holiday weekend (Memorial Day in the U.S. being Monday the 25th).