Last week was really something. The stock market hit new record highs, with the S&P 500 finally closing above 2,000 for the first time ever. And we also learned GDP growth surged 4.2% in Q2 thanks to big upward revisions in business spending.
The U.S. will be closed on Monday for Labour Day. However, we have a stacked line-up of top-shelf economic reports coming our way.
Here’s your Monday Scouting Report:
Europe: In recent weeks, we’ve heard nothing but bad news out of the eurozone economy. Growth has stalled and inflation is approaching zero. All of this puts increasing amounts of pressure for the European Central Bank to act when it meets on Thursday. Indeed, ECB President Mario Draghi recently said, “We stand ready to adjust our policy stance further.”
However, the consensus is for the ECB to make no change in its policy, which includes a main refinancing rate of 0.15%, a marginal lending facility rate of 0.4%, and a deposit facility rate of -0.1%.
Nomura’s Nick Matthews is one of the few ECB watchers who expects to see some tweaks. “We expect the ECB to cut all key interest rates by 10bp on 4 September (60% probability) or by October at the latest, taking the refi rate down to 0.05% and the deposit rate to -0.20%,” he said. “…Mr Draghi also increased expectations of a launch of ABS purchases at Jackson Hole (by noting that its preparation “is fast moving forward” and purchases would “meaningfully contribute to diversifying the channels for [the ECB] to generate liquidity”). As a result we formalised as part of our baseline that the ECB will announce and launch an ABS purchase programme by December at the latest, while we cannot exclude (pre-) announcement of such a programme at the September meeting.”
ABS is short for asset-backed securities. ABS purchases means that the ECB would be stimulating the credit markets by buying bonds, which boosts liquidity and keeps rates low. We commonly hear this referred to as quantitative easing, or QE.
- MONDAY: Labour Day Holiday, U.S. Markets Closed
- Markit U.S. Manufacturing PMI (Tues): Economists estimate this index of manufacturing slipped to 57.9 in August from a preliminary estimate of 58.0 and a July print of 55.8. “Overall, with job hiring gathering momentum and input buying expanding at the sharpest pace for at least seven years, it seems US manufacturers are increasingly confident that the recovery is firmly back on track and are gearing up for a sustained rebound in production schedules over the months ahead,” said Markit’s Tim Moore.
- ISM Manufacturing (Tues): Economists estimate ISM’s manufacturing index declined to 57.0 in August from 57.1 in July. “We look for August manufacturing activity to grow at a slower pace, as (ISM-adjusted) readings on the Philly Fed and Empire State surveys both declined a few points,” said Credit Agricole’s Michael Carey. “Other regional surveys were mixed while the preliminary August Markit PMI posted an increase.”
- Construction Spending (Tues): Economists estimate spending jumped 1.0% in July, recovering some of the 1.8% decline in June. “The big swing owes to state and local spending which plunged 5.2% in June,” said Bank of America Merrill Lynch economists. “That said, private nonresidential construction spending was down 1.6% in June while residential dropped 0.3%. We expect residential investment to recover given the recent sharp gain in housing starts and our expectation of greater renovation spending. We also look for a partial reversal in nonresidential construction spending.”
- Vehicle Sales (Wed): Analysts estimate auto sales climbed to an annualized rate of 16.6 million in August, up from 16.4 million in July. ” The new vehicle market has been a notable economic bright spot this year,” said Citi’s Peter D’Antonio. “However, while our forecast is for another strong sales month (and we expect a similar result in September), the contribution to GDP growth from auto sales is likely to be much smaller in the third quarter than in the second. In the second quarter, a 0.8 million unit sales increase contributed 0.4 percentage point to GDP growth. Our forecast would put unit sales roughly unchanged in the third quarter.”
- Factory Orders (Wed): Economists estimate orders jumped 11.0% in July. “Durable goods orders surged 22.6% m/m in July, due to a large increase in aircraft orders, which should push overall factory orders to a large gain; we expect nondurable goods orders to be unchanged on the month,” said Barclays economists.
- Beige Book (Wed): The Federal Reserve will publish its collection of economic anecdotes at 2 p.m. ET. Here’s Credit Suisse: “Wednesday’s Beige Book may provide real-world anecdotes to supplement the better economic data reported recently. Any observations from business contacts related to wage growth or pricing power also would be of interest. There is a good chance either the Philadelphia or Dallas Federal Reserve Bank put together the Beige Book this time around.”
- ADP Employment Change (Thurs): Economists estimate 225,000 private payrolls were added in August. “Initial jobless claims and employment data from the Empire and Philly Fed manufacturing surveys were supportive of a trend-like month for hiring,” said Bank of America Merrill Lynch economists. “Looking at as-reported ADP and BLS private payroll growth, the two series have an absolute average gap of 25,000 over the past six months. Our forecasts of 225,000 for ADP and 230,000 for BLS private payrolls are consistent with this pattern.”
- Initial Jobless Claims (Thurs): Economists estimate weekly initial claims ticked up to 300,000 from 298,000 a week ago. “Initial claims have hovered around 300k (near pre- recession lows) for the past couple of months and should continue to do so as labour markets tighten,” said Nomura economists.
- Unit Labour Costs (Thurs): Economists estimate labour costs climbed by 0.6% in Q2. “With wage growth now at the forefront of the discussion of monetary policy and inflation, unit labour costs could provide a good indication of underlying inflationary pressures,” said Nomura economists.
- Trade Balance (Thurs): Economists estimate the trade deficit expanded to $US42.4 billion in July. “Sluggish aggregate demand among US trading partners may be constraining marginal US export growth,” said Credit Suisse economists. “We estimate exports were flat in July. Imports may have picked up by a modest 0.2% in July after a cumulative 1.3% decline in May and June, the sharp decline in imported oil prices notwithstanding.”
- Markit Services PMI (Thurs): Economists estimate this index of services activity climbed to 58.7 in in August from a preliminary estimate of 58.5 but down from the July print of 60.8. “The U.S. service sector continues to enjoy a strong growth phase, but the latest survey suggests the recovery has lost some momentum since hitting a post-crisis peak in June,” Markit’s Tim Moore wrote. “Output expanded at the slowest pace for three months in August, while new business growth picked up only slightly from July’s recent low.”
- ISM Non-Manufacturing (Thurs): Economists estimate this index of services fell to 57.6 in August from 58.7 in July. “We look for another very strong non-manufacturing activity reading in August,” said Citi’s D’Antonio who forecasts a 59.0 print. “Early signals such as the regional Fed surveys and the traffic of potential home buyers have strengthened since July.”
- The Jobs Report (Fri): Economists estimate nonfarm payrolls increased by 225,000 in August, driven by a 210,000 gain in private payrolls. The unemployment rate is estimated to have declined to 6.1%. Average hourly earnings are estimated to have increased by 2.1% year-over-year. Here’s Goldman Sachs’ Kris Dawsey: “Employment indicators have strengthened a bit in August vs. July, including the employment components of the available service sector surveys, the Conference Board labour differential, and initial jobless claims. Our preliminary forecast for August payroll job growth is 240k, with the important caveat that we have yet to receive a few key pieces of data for the month, most notably the ISM nonmanufacturing report… With no special factors on weather, strikes, unusual composition in the prior month, fiscal policy issues, or obvious seasonal distortions, we think the August report should be a fairly “clean read” on the likely-strengthening underlying trend. We also anticipate a downtick of one-tenth in the unemployment rate to 6.1%, matching its prior cycle low set two months back. Should the participation rate give up its small July increase, the risk is skewed toward 6.0%, in our view.”
Jesse Livermore, the pseudononymous blogger behind the brilliant Philosophical Economics blog, has a lengthy examination of the cyclically adjusted price-earnings (CAPE) ratio. This is the stock market valuation measure popularised by Nobel laureate Robert Shiller.
“Why is the Shiller CAPE so high?” he asks.
He explains that valuations in general have been higher than usual largely due to elevated earnings per share growth rates, which have been boosted by expanding corporate profit margins.
Livermore believes current conditions will likely allow for very low-singled digit returns in the near-term. Here’s his scenario:
The increase in profit margins is not going to fully hold. Some, but not all, of the profit margin gain will be given back. On this assumption, it becomes harder to defend the market’s current valuation. Importantly, profit margin contraction tends to occur alongside stronger sales growth. In terms of the effect on EPS, stronger sales growth will help to make up for the profit margin that will be lost. However, almost half of all sales growth ends up being inflation — the result of price increases rather than real output increases. With inflation comes lower returns in real terms (the only terms that matter), and also, crucially, a tighter Fed. If the Fed gets tighter, a TTM P/E of 19.3 will be much harder to sustain. The market will therefore have to fight two headwinds at the same time — slow EPS growth due to profit margin contraction and a return drag driven by multiple contraction. Returns on such a scenario will likely be weak.
But they need not be disastrously weak. In a prior piece, I argued that they might end up being 5% or 6% nominal, or 3% or 4% real. Of course, that piece assumed a starting price of 1775. Nine months later, we are already at 2000. The estimated returns have downshifted to 3% or 4% nominal, and 1% or 2% real. Such returns offer almost no premium over the returns on offer in the much-safer fixed income world, and therefore, if any kind of profit margin contraction is coming, then the current market is probably pushing the boundaries of defensible valuation.
For more insight about the middle market, visit mid-marketpulse.com.
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