It turns out the US consumer is still doing fine.
This was thrown into doubt last week as the peak season for big-box retail earnings started on a sour note. Macy’s lowered its earnings guidance for the year with some bleak commentary, while JC Penney whiffed on sales and slashed full-year projections. Their shares fell with Gap, Nordstrom, and others that missed expectations.
But the Census Bureau’s retail sales data Friday brought some relief when it showed a 1.3% jump in April — the most in a year.
If it’s so bad for big-box retailers, how come retail sales were so strong? “That juxtaposition is a useful reminder that publicly-traded corporations account for a minority of economic activity in the US, and only the Census data are structured to get a read-through of sales irrespective of legal organizational form,” said JPMorgan’s Michael Feroli in a client note.
So, brace for more ugly retail earnings this week, but don’t get carried away.
- Fears about the consumer were overblown: After an economic slowdown in the first quarter followed by some of the bleakest commentary we’ve heard from retailers in a while, Friday’s retail sales report became an all-important reading on consumer spending. And it did not disappoint. “The rebound in growth in the second quarter looks solid,” wrote Diane Swonk at DS Economics. “This, coupled with a warming trend in inflation, will allow Fed officials to feel more comfortable with another rate hike … I think the Fed should move in June, but probably cannot, given the shock that would be to markets.” If weak retail earnings were the source of consumer concern, then that would be ignoring non-store (mostly online) retailers, who accounted for over 40% of last month’s increase per the Census Bureau. But the reality check is that wages are still largely going nowhere, even though average hourly earnings crept up in recent months. For Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, that’s the one catalyst that would lift consumer spending even higher.
- Negative rates are still on the table: However, they will only be used in the US in an extreme scenario. Federal Reserve chair Janet Yellen repeated this in a written response to a question from US Rep. Brad Sherman (D-California.) She said (emphasis ours), “By some accounts, these policies appear to have provided additional policy accommodation. As I have noted previously, we certainly are trying to learn as much as we can from the experience of other countries. That said, while I would not completely rule out the use of negative interest rates in some future very adverse scenario, policymakers would need to consider a wide range of issues before employing this tool in the United States, including the potential for unintended consequences.” It’s still unclear whether the Fed has the legal authority to use negative rates like its counterparts in Europe and Japan, as a 2010 Fed-staff memo indicated.
- Empire State Manufacturing (Mon.): The latest index of manufacturing activity in New York is expected to slow to 6.50 in May from 9.56 in the prior month. That would be a decline from the highest level in 15 months. Here’s RBC: “Empire should remain firmly in positive terrain as underlying detail (namely orders relative to inventories) continues to suggest good momentum for activity.”
- NAHB Housing Market Index (Mon.): The index of sentiment from the National Association of Homebuilders is expected at 59. RBC said, “We think NAHB is poised for some upside as well, given firm housing demand suggested by mortgage app activity.”
- Housing Starts and Building Permits: (Tues.): Housing starts are expected to rise 3.3% month-on-month at a seasonally adjusted annual rate of 1.125 million. Building Permits are forecast to increase 5.4% at a seasonally adjusted annual rate of 1.134 million. Here’s Bank of America Merrill Lynch: “Housing data can be very choppy and the large decline in March single family starts appears to be mostly payback from a robust February. As a result, we anticipate only modest recovery.”
- Consumer Price Index (Tues.): The gauge of inflation is expected to show a 0.4% rise in April from March. Compared to the prior year, CPI is forecast at 1.1%. Excluding volatile food and energy costs, core CPI is expected at 0.2% month-on-month and 2.1% year-on-year. BNP Paribas lists three things supporting their core CPI forecast of 0.15% month-on-month: “(1) improvements in apparel, lodging away from home, and household furnishings & operations prices; (2) slightly better Owners’ Equivalent Rent after softer-than-expected March gain; and (3) limited improvement in medical services prices after soft reading in March.”
- Industrial Production and Capacity Utilization (Tues.): Economists forecast that industrial production rose 0.3% month-on-month in April, following a 0.6% drop reported in the previous month. Capacity utilization is forecast at 75%, and manufacturing production is estimated at 0.3%. “We look for industrial production to advance in April, but for near-term gains to remain modest amid slow growth at home and abroad,” Wells Fargo said.
- FOMC Meeting Minutes (Wed.): Minutes of the Federal Open Market Committee’s April meeting will be released at 2 p.m. ET. RBC thinks they “should continue to show a committee worried more about global developments than constructive US domestic realities. Given recent comments, these are likely to prove quite stale. Even some doves, like Rosengren, have taken a much more balanced approach of late.”
- Initial Jobless Claims (Thur.): Economists estimate that weekly initial jobless claims fell to 275,000. Last week, claims spiked to 294,000, the highest level since late last February.
- Philly Fed Business Outlook (Thur.): Economists forecast that the regional index of business activity jumped to 3 in May after printing at -1.6 in April. Here’s BAML: “While the guts of the survey did confirm that April was a weak month for the Philly Fed district, every expectations component saw a nice improvement suggesting that businesses were optimistic and viewed the deterioration as transitory. Indeed, the stabilisation and upturn in oil prices, pullback in USD, and fading global uncertainty are ample enough reasons to be more positive about the near-term outlook for manufacturing.”
- Existing Home Sales (Fri.): Economists project that existing home sales rose 1% at a seasonally adjusted annual rate of 5.38 million. “Limited inventory on the market continues to hamper the pace of home sales activity,” noted Wells Fargo.
Brace for one more sell-off before the end of the year, Goldman Sachs’ David Kostin advised clients.
In a recent note, Kostin wrote that markets are calmer than they were in the first quarter, demonstrated by the drops in various volatility gauges. After a 12% plunge in January and February, stocks are right about where they were at the start of the year.
The S&P 500 is likely to end the year at 2,100, or 3% above its current level. But in the next few months, we could be looking at another drop of between 5% to 10%.
Not all is bleak, with possible upside arising from the recent trend of positive earnings revisions, as discussed last week, along with the possibilities of investors adding more length and a dovish Fed surprise in June. However, upside/downside risks are not evenly distributed. S&P 500 will likely experience at least one drawdown between now and year-end. We recommend selling upside calls to fund downside protection given the options market prices a below-average probability of a 5%-10% drawdown during the next three months.
He noted the following six risks that are currently dormant, but could easily become tangible scares if investor sentiment suddenly changes:
- The forward P/E multiple of the S&P 500 shows that stock valuations are high, and the most likely future path of equities involves them being lower. The multiple of the index, at 16.7x, ranks in the 86th percentile compared to the last 40 years.
Supply and demand trends suggest downside risk. Investors have bought $23 billion worth of futures positions since the end of March. When there was less investor positioning at the beginning of the year, that served as a bullish argument. But now, Goldman’s sentiment indicator is higher, which is a less bullish sign for the market.
- Corporate buybacks have been a big source of demand, but they may wane in the coming months.
- The Fed may shock with more rate hikes this year than markets are pricing in.
Slowing growth in China would cause investors to re-focus on the prospect of a US recession.
- The upcoming party conventions in July could raise political uncertainty and weigh on the stock market.