The Market Narrative... And Why It"s Wrong

Authored by Steven Englander via Rafiki Capital Management,

When you have a market move such as Monday’s, it always signals that the story the market is buying has changed abruptly. In practical terms, it becomes much easier to tell the market-down-10% story and much harder to tell any market-up-10% story.

The shifts in market thinking:

1)      Maybe underlying growth is not as strong as we thought

2)      Productivity is not coming to the rescue and costs are rising

3)      The Fed is not as friendly as it used to be

4)      The business cycle may not last as long as we thought

Equities hit their peak January 26, the day of the disappointing GDP release. The Bloomberg consensus forecast was 3.0% seasonally adjusted annual rate (SAAR), but many had been looking at econometric forecasts coming out Reserve Banks pointing to growth well over 3%. With employment growth steady, a GDP acceleration into the 3’s would mean productivity growth at or above 1.5% SAAR for a third quarter in a row, a rare event in recent years. In fact, nonfarm productivity growth fell 0.1% SAAR, and unit labor costs rose sharply. At the same time inflation expectations, the GDP deflator, and wages were showing marked increases. This led to discussions of four 2018 hikes by Dallas Fed President Kaplan and the rest is history. 

Think about whether asset markets are happier with inflation persistently below target and Fed stimulus a constant presence -- or with inflation at target and the Fed ‘even-handed’, and which will be the more volatile asset market environment.

Take this together and you have a market that has shifted from a benign narrative of accelerating output/productivity growth raising profits, slowing cost growth and extending the cycle to a new narrative driven by rising inflation/cost pressures and a Fed that is no longer friendly.

Consider the dividend discount model for equity pricing. Slower output/productivity growth and higher costs hit the secular trend in profits, advances the date of the expected expansion end, and raises the discount rate applied to this softer profits path. The approach to target inflation also means that the Fed put is no longer in play, so anticipated volatility rises.

Combine this with breaches of technical levels, choppy price signals, stops being hit and panic -- and you have Monday.   

Why is this pessimistic narrative wrong?

1)      The growth/productivity narrative is being dismissed too quickly. We are likely to see Q4’s lost GDP show up in Q1, or in Q4 revisions. When net exports make such a pronounced negative contribution, the statistical regularity is that the following quarter’s GDP is significantly higher (I think there are arcane GDP accounting reasons for this).  In addition, nonresidential investment has been making a strong contribution, suggesting business optimism that counters the Q4 headline GDP disappointment, and business optimism remains very strong. So the output/productivity growth story may be there – the problem is that we may not know for some months.

2)      The wage fear is overstated. January’s average hourly earnings number was pushed up by a sharp drop in the workweek. As well, the acceleration that spooked investors in overall AHE did not show at all in the data for production and nonsupervisory workers, which are flat and below 2.5% y/y. These are people who punch time clocks and where wages are best measured.  You would expect broad wage inflation to show. There are a couple of other indications that employment of low wage workers was weak in January. Overall, I would want  to see more confirmation before an inflation epidemic is declared.

3)      Not every inflation pickup is a hockey stick. Even in the 1960-80s, the heyday of the conventional Phillips curve, labor market tightness took a long time to show up in inflation. The technical reason is that there are long lags embedded in each step of the inflation process, so a gradual tightening of labor markets produces an even more gradual upward move inflation. So the Fed does not have to panic.

4)      The great unknown is how closely the Fed is targeting 2% and whether bygones are bygones or they intend to make up some of the sub-2% shortfall with a period of 2%+ inflation. This comes up in virtually every discussion of Fed policy. It would be equities positive, USD negative and probably lead to steepening of the yield curve.

5)      The economy may be more robust than we think – insofar as the fear is that the business cycle may end prematurely, as we saw in 1994, there may be more robustness to Fed tightening than we think. Throughout the expansion the economy has been viewed as a fragile flower thsat can not deal with any shocks. The economy"s reaction to additional Fed tightening could be indifference.

Investors have lurched from pricing in an increasingly benign economic and profits outlook to one in which there are far more headwinds. These fears are likely overplayed, but there is no immediate data that would show that the benign story is correct. Real-time economic volatility masks underlying trends, but it doesn’t mean that the trends are not there. Any sign that the supply side is working, either for exogenous reasons or because of tax reform, and the positive scenario is back.