May Macro Update: Two Watch Outs Are Retail Sales And Employment Growth

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

One concern in recent months had been housing, but revised data shows housing starts breaking above the flattening level that has existed over the past two years. A resumption in growth appears to be starting.

That leaves two watch outs. The first is employment growth, which has been decelerating from over 2% last year to 1.6% now. It's not alarming but it is noteworthy that expansions weaken before they end, and slowing employment growth is a sign of some weakening that bears monitoring.

The second watch out is demand growth. Real retail sales excluding gas is in a decelerating trend. In March, growth was just 2.0% after having grown at more than 4% in 2015. Personal consumption accounts for about 70% of GDP so weakening retail sales bears watching closely.

Overall, the main positives from the recent data are in employment, consumption growth and housing:

• Monthly employment gains have averaged 187,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading.
• Recent compensation growth is among the highest in the past 8 years: 2.6% yoy in 1Q17. 
• Most measures of demand show 2-3% real growth. Real personal consumption growth in 1Q17 was 2.8%.  Real retail sales (including gas) grew 2.7% yoy in March.
• Housing sales grew 16% yoy in March. Starts grew 9% over the past year.
• The core inflation rate is ticking higher but remains near the Fed's 2% target.

The main negatives have been concentrated in the manufacturing sector (which accounts for less than 10% of employment). Note, however, that recent data shows an improvement in manufacturing:

• Core durable goods growth rose 6.4% yoy in March. It was weak during the winter of 2015-16 but has slowly rebounded in recent months. 
• Industrial production rose 1.5% in March, helped by the rebound in mining (oil/gas extraction). The manufacturing component grew 1.0% yoy in March.

Prior macro posts are here.

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Our key message over the past 5 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes. Enlarge any image by clicking on it.

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.


Employment and Wages

The April non-farm payroll was 211,000 new employees minus 6,000 in revisions.  In the past 12 months, the average monthly gain in employment was 187,000. Employment growth is decelerating.

Monthly NFP prints are normally volatile. Since the 1990s, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 79,000 last month, 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.

Better Sales And Profit Growth Are Behind Good 1Q17 Results, Not Financial Engineering

Summary: S&P profits are up 22% yoy. Sales are 7.2% higher. By some measures, profit margins are at new highs. This is in stark contrast from a year ago, when profits had declined by 15% and most investors expected a recession and a new bear market to be underway.

Bearish pundits continue to repeat claims that are more than 20 years old: that "operating earnings" are deviating more than usual from GAAP measurements, and that share reductions (buybacks) are behind most EPS growth. These are both wrong. Continued growth in employment, wages and consumption tell us that corporate financial results should be improving, as they have in fact done.

Where critics have a valid point is valuation: even excluding energy, the S&P is now more highly valued than anytime outside of the 1998-2000 dot com bubble. With economic growth of 4-5% (nominal), it will likely take excessive bullishness among investors to propel S&P price appreciation at a significantly faster rate.

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A little over 60% of the companies in the S&P 500 have released their 1Q17 financial reports. The headline numbers are good. Overall sales are 7.2% higher than a year ago, the best annual rate of growth in more than 6 years. Earnings (GAAP-basis) are 22% higher than a year ago. Profit margins are back to their highs of nearly 10% first reached in 2014.

Before looking at the details of the current reports, it's worth addressing some common misconceptions regularly cited by bearish pundits.

First, are earnings reports meaningfully manipulated? This concern has been echoed by none other than the chief accountant of the SEC, who has complained about non-GAAP earnings numbers being "EBS", or "everything but bad stuff." Enlarge any image by clicking on it.

Weekly Market Summary

Summary: US equities ended the month of April above or near new all-time highs. There are no significant extremes that suggest the trend higher will suddenly end. But the upcoming "summer months" are normally marked by lower price appreciation and larger drawdowns. Into this period, it is notable that SPX's streak without a correction of 5% or more is nearing the longest of the 8 year old bull market.

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US indices closed above or near new all-time highs (ATH) last week. In the past two weeks, SPX has gained 2.4% while NDX and RUT have each gained more than 4%. The set up for these gains was detailed here.

Overall, the trend in equities remains higher, supported by breadth, sentiment, volatility, macro and seasonality. All of that said, the first correction of at least 5% is increasingly likely to take place in the next two months.

Let's recap where markets currently stand as the month of May begins.

Trend: NDX and COMPQ made new ATHs this past week, as did RUT. On a total return basis, SPX is also at a new ATH. The primary trend is higher. After becoming overbought (top panel), the rising 13-ema is normally the approximate first level of support on weakness (green line and arrows). Enlarge any chart by clicking on it.

Fund Managers' Current Asset Allocation - April

Summary: A tailwind for the rally since February 2016 has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.

Fund managers have become more bullish, but not excessively so. Profit expectations are near a 7-year high and global economic growth expectations are near a 2-year high.  However, cash balances at funds remains high, suggesting lingering doubts and fears.

Of note is that allocations to US equities dropped to their lowest level in 9 years in April: this is when US equities typically start to outperform. In contrast, weighting towards Europe and emerging markets have jumped to levels that strongly suggest these regions are likely to underperform.

Fund managers remain stubbornly underweight global bonds due to heightened growth and inflation expectations. Current allocations have often marked a point of capitulation where yields reverse lower and bonds outperform equities.

For the fifth month in a row, the dollar is considered the most overvalued in the past 11 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October 2016 to 4.9% in April. Recall that 5.8% was the highest cash level since November 2001. Cash remained above 5% for almost all of 2016, the longest stretch of elevated cash in the survey's history. Some of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Weekly Market Summary

Summary: A week ago, a number of notable short-term extremes in sentiment, breadth and volatility had been reached, suggesting a rebound in equities was ahead. In the event, US equities gained 1% and both NDX and COMPQ made new ATHs.

But new uptrends are marked by indices impulsing higher as investors quickly reposition and chase price. Momentum quickly becomes overbought. Neither of these has happened, at least not yet. Some clarity from the French elections this weekend could free equities to move higher. Should SPX instead rollover, breaking the recent low on April 13 and head to the 2300 area, it's a good guess that a stronger rebound will follow: there are several indications that short-term investor sentiment has already become too bearish.

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Since reaching an all-time high (ATH) on March 1, SPX has traded sideways in a 3% range. The ATH came on the day of the new president's State of the Union address and also corresponded with bullish sentiment extremes in, for example, the equity-only put/call ratio and the Investors Intelligence survey. Our recent posts have emphasized that these extremes, together with the subsequent loss in price momentum, are most often associated with a mild correction of 3-5%. A return to the 2300 area for SPX appeared to be odds-on. Read more on these points here and here.