[UNLOCKED] Market Edges: Week of 10/15/2017

Editor's Note: This is a complimentary edition of our newly launched weekly newsletter Market Edges, contextualizing key market and economic data within big picture macro trends. CLICK HERE to get a free month.

The Latest on U.S. Growth Accelerating

This past week’s U.S. economic data almost perfectly matched the Hedgeye economic outlook. Consumer Confidence hit a 13-year high, Retail Sales came in strong, the hurricane-related pop in Jobless Claims dissipated and even readings on inflation (like the CPI and PPI) confirmed our nuanced view for a short-term boost in consumer prices before inflation resumes its downward descent. We’ll tackle all this at the top of this week’s Market Edges.

If you want to dig a little deeper on our Macro team's process, we've produced a special video for our Sector Spotlight section. In it, Senior Macro analyst Darius Dale describes precisely “How We Model the U.S. Economy” and the impact it has on our investment conclusions. We strongly recommend you watch this short video.

Food for thought: While we’ve been bullish on U.S. stocks throughout 2017, we believe there’s reason to be cautious heading into 2018. In What the Media Missed below, we highlight why the outlook for corporate profits gets increasingly difficult. Meanwhile, the bearish data points are piling up abroad. In Italy, the economic outlook looks increasingly bleak. Read Around the World for more on the cyclical as well as secular headwinds facing Italian GDP.

WEEKLY ASSET ALLOCATION

(EDITOR'S NOTE: TACRM (Tactical Asset Class Rotation Model) asset allocation signals are generated using our highly quantitative risk management system that relies on mean variance optimization techniques to attempt to produce superior risk-adjusted returns in a diversified global portfolio on an ex-ante basis. CLICK HERE to get a FREE month of Market Edges and learn more about this week's TACRM update.)

CLIENT TALKING POINTS

Consumer Confidence Hits 13-Year High!

1. Consumer Confidence Surging

The University of Michigan’s Consumer Sentiment index registered a preliminary October reading of 101.1 on Friday. This was the highest confidence reading since the start of 2004. The trend in consumer confidence suggests further upside for household consumption and bolsters our outlook for U.S. growth accelerating.

2. Inflation (Temporarily) Rising

The headline Consumer Price Index got an energy-related juicing rising for the fourth consecutive month to 2.23%. Core inflation (ex-Energy) remained flat at 1.7% for the fifth straight month. Similarly, the Producer Price Index rose +20 basis points to a new 68-month high at +2.6% year-over-year while Core PPI (ex Food & Energy) also accelerated to a 65-month high at +2.2% year-over-year. 

Note: We expect this Reflation Trade to dissipate in the coming months as inflationary comps get increasingly tough.

3. Jobless Claims & Hurricanes

The impact of hurricane Harvey, Irma and Maria on Initial Jobless Claims appears to have dissipated. Initial claims fell -15k to 243k from 258k week-over-week. The prior week's number was revised down by -2k from 260k. Meanwhile, the 4-week rolling average of seasonally-adjusted claims fell -9.5k week-over-week to 257.5k. The chart below shows the spike in claims for Texas, Florida and Puerto Rico and the resulting dissipation.

Chart of the Week

A Brief Update on Strong U.S. Retail Sales

Consumer spending makes up 70% of the U.S. economy. In other words, get consumption right and you get the direction of the U.S. economy right. That’s why Retail Sales data is so critical. This component contributes about 25% to total GDP.

Headline Retail Sales hit +1.6% month-over-month and accelerated to +4.4% year-over-year for the month of September (versus 3.5% in the prior month). As expected, Hurricane Harvey replacement demand drove unit auto sales +15% month-over-month (+4.6% year-over-year) to 18.47 million units (see the Chart of the Week below). Gas/energy price inflation drove nominal gas station sales higher. Auto’s and Gas Stations make up 30% of total Retail Sales. 

It wasn’t all hurricane-related distortion. The Retail Sales Control Group (which excludes Food, Autos, Gas & Building Materials) were +0.4% month-over-month, holding flat at +3.2% year-over-year.

All-in-all, it was a strong September as the positive weather related distortion benefited the headline and amplified the underlying trend in Retail Sales. Expect this to be a boon for Q3 U.S. GDP.

Top 5 Stats

Sector Spotlight

How We Model the US Economy

Our Growth, Inflation, Policy (GIP) model is “the hallmark of our fundamental research process,” says Hedgeye Senior Macro analyst Darius Dale in the video below. Due to popular demand for a primer on the topic, we’ve produced a special video as part of our “Understanding” video series.  

We find two factors to be most consequential for forecasting future financial market returns: economic growth and inflation. We track both on a year-over-year rate of change basis to better understand the big picture then ask the fundamental question: Is growth and inflation heating up or cooling down?

From there, we get four possible outcomes, each of which is assigned a “quadrant” in our Growth, Inflation, Policy (GIP) model and the typical government response as a result (neutral, hawkish, in-a-box or dovish):

• Growth accelerating, Inflation slowing (QUAD 1);
• Growth accelerating, Inflation accelerating (QUAD 2);
• Growth slowing, Inflation accelerating (QUAD 3);
• Growth slowing, Inflation slowing (QUAD 4)

After building this base of knowledge, we can now select what we like and don’t like based on our historical back-testing of the different asset classes that perform best in each of the four quadrants.

“In QUAD 1, for instance, where growth is accelerating and inflation is slowing, that has historically been really positive for both equity and credit data across all sectors of the U.S. economy,” says Dale in video below. “Whereas when you think about QUAD 4, in which growth and inflation are slowing concomitantly, that has historically actually been quite negative for both equities and credit.”

Get a FREE month of Market Edges to watch this 6-minute video and better understand our Macro research process.

What the Media Missed

MarketWatch: Stock Market Bulls Shouldn’t Sweat Bad Earnings

“Third-quarter earnings season kicked off this week, with investors hoping for signs that the record-highs in major indexes are justified by the level of activity in corporate America,” writes MarketWatch in a recent piece. “The good news is there may be more wiggle room on this score than investors realize.”

Sure, there may be some wiggle room but not much. The reason why has everything to do with the U.S. economic cycle. Here’s why.

Corporate profit growth tracks the broader U.S. economy. U.S. GDP slowed from 1Q 2015 to 2Q 2016. Year-over-year GDP growth fell from 3.8% to 1.2% over that period. At the same time, earnings growth contracted for five straight quarters starting in the second quarter of 2015.

Here’s the key point. As the U.S. economy rebounded off their 2016 lows, S&P 500 earnings snapped back too. Year-over-year earnings growth peaked in Q1 2017 at 14.5%.

While this profit growth has been bullish for equity investors throughout 2017, it also makes for an increasingly tough set-up for earnings heading into 2018. The earnings “comps” – the numbers against which year-over-year growth is measured – get very difficult in the coming quarters.

So what’s this mean for investors?

Remember, the rate of change is what matters for prudent asset allocation. While the most consequential macro factors – economic growth and inflation – will continue to be supportive of equity prices through early 2018, slowing earnings growth suggests investors should be dialing back their bullishness into early 2018. See our proprietary Asset Allocation above for more on that, particularly how it's changed over the last 3 to 6 months.

Hedgeye CEO Keith McCullough puts the key takeaway simply on a recent institutional conference call, “I would not want to be as long as we’ve been, or as aggressively bullish as we’ve been on all stock market pullbacks, ahead of Q1 reporting season in 2018.”

Around the World 

an Awful Outlook for Italy

The International Monetary Fund released its world economic growth projections this past week, painting a largely rosy picture of the world. The report raised its estimate for global growth 10 basis points from its July forecast to 3.6%. The developed world economies – from the U.S. to countries in the Eurozone – all got a boost.  

In the previous edition of Market Edges, we introduced our 4Q Macro Theme “Global Growth #Divergences.” This theme overtly questions the validity of Wall Street’s “synchronized global recovery” narrative. We’re bullish on the U.S. but abroad, in Europe and China, we see slowing growth.

The Italian economic outlook looks particularly awful.

According to our GIP model (explained in this week’s Sector Spotlight section), growth in the country appears to have peaked and will likely trend lower through early 2018. That means Quad 4 (Growth slowing, inflation slowing) for Italy, a setup which has historically been very bad for equity markets.

Italy’s problems are both cyclical and secular in nature, a powerful combo that doesn’t bode well for an economy where the banking sector’s non-performing loans exceed 15 percent of all loans and 20 per cent of gross domestic product.

On the cyclical side, Italy’s household consumption has stalled as you can see on the left hand side of the chart below. The headwinds continue to grow. Most recently, Italian Retail Sales were down -0.5% on a year-over-year basis (versus 0.0% in the month prior). This is really important. Consumption contributes about 60% to Italian GDP.

Meanwhile, on the secular side, Italy’s demographic trends look awful. 

What the chart below shows (on right hand side) is the slowing in Italy’s peak consumer age bracket, the number of 35-54 year olds. At the same time, the country’s “Old-Age Dependency ratio” (the percentage of 65+ year olds over working age Italians) is swelling. In short, policymakers really don't want their country to be in the bottom right hand side of this chart, precisely where Italy is today. The Italian populace is aging and there simply aren’t enough working age Italians to make up for the resulting consumption shortfall.

These slowing demographic trends combined with a cyclical economic contraction suggest a precarius setup for Italian equities.

THE WEEK AHEAD