Economic Commentary - Dave's Top Ten
4 March 2005
Merrill Lynch
This research product summarizes the 10 major macro themes of the past week as a
prelude to our weekly publication the Market Economist.
1. Given the stronger than expected momentum we are seeing, we made some upward
revisions to our GDP and earnings forecast for 2005, especially for the next two
quarters. First, we’ve upgraded Q1 GDP to 4.3% growth from 3.2%. A good chunk of
this reflects a 4% consumer instead of the 3% we were initially expecting. But the
biggest change to our first-quarter view is in the same component that provided the
upside surprise in the fourth quarter revision which is capex – we now see it at 14% at
annual rate instead of the slowdown to 3% we had been expecting following the end to
the bonus deprecation allowance but last week’s capital goods data were so strong that
they pretty well bake in the cake another double-digit quarter for business spending, and
this will be the ninth quarter in a row in which capex growth has outstripped consumer
spending growth in what seems to be real underlying long-term theme here.
2. For the second quarter, we have also revised GDP up to 3.5% from 3%, but our
leading indicators still tell us to expect little better than a 3% growth pattern for
the second half of the year, but that is still an upgrade from 2.7% before. For all of
2005, we now have 3.7% growth which is up from our earlier forecast of 3.2% and I
believe that now actually puts us in a rare position of being above the 3.6% consensus
view. As for 2006, we left GDP growth intact at 3.3%.
3. Now all of this has a big bearing on earnings: we can see based on what is coming in
for the fourth quarter that S&P 500 operating EPS for all of 2004 will come in
around $68, above our prior estimate of $66.70, and that would represent a 24.3%
increase on an annual basis, the fastest growth rate since 1993. Since the momentum
heading into 2005 was stronger than we had envisioned, we are taking up our 2005 EPS
forecast by $2.75 – from $69.50 to $72.25, which is up 6.3% on a year-over-year basis
(that compares to our earlier forecast of 4.2% EPS growth.) Since we kept our 2006 GDP
growth forecast of 3.3%, we did the same for earnings and maintained our 6% growth
view for operating EPS but the LEVEL is going to be much higher as a result of the
higher starting point we’re at – so the LEVEL of operating EPS for 2006 comes to $76.75
which is a $3.25 upward adjustment from our previous estimate of $73.50. And what this
means is that the stock market right now is trading at a 15.8x forward multiple based on
our 2006 earnings estimate which in the context of a 5.8% yield on a long-term BBBrated
corporate bond gives equities a slight edge over fixed-income from a relative
valuation standpoint, at least based on our earnings estimates.
4. This pattern is what makes us nervous about the bond market all of a sudden, and
it’s more rooted in technicals than fundamentals. The June/03 low of 3.1% was
followed by an interim high of 4.6% in Sept/03. Then the next low of 3.7% in March/04
was followed by a move to 4.9% in May/04. The Feb 9th/05 low of 4% failed to take out
the nearby low in yield of 3.99 pct in Oct/04 and yet the 10-year yield yesterday blasted
through the Dec/04 nearby high of 4.33%. Next Fibonacci retracement level is
reportedly at the 4.42% area. Bottom line though is that these interim selloffs can be
severe (look at the past two – 100 bps+) and quick (three months). Sad to say – this
selloff is barely a month and 37 bps old. Better buying opportunities likely loom ahead.
5. Less of a ‘conundrum’: Mr. Greenspan said this week that long-term rates represent
less of a “conundrum” now that they have risen to 4.38% – a whole 25 bps separated a
conundrum from a non-conundrum. Bottom line is that the Fed Chairman didn’t want to
see long-term rates break below 4% and touch off a mortgage refi craze and reinforce
the housing bubble – a little bit different than the mantra at Humphrey-Hawkins time
that he wanted long-term rates to move higher and act as a source of economic restraint.
He went on to say that short-term rates usually lead to an increase in long-term rates and
the only time they don’t is typically when the Fed has moved sufficiently to dampen
inflation expectations – not exactly bond-bearish commentary.
6. Oil now above $53/bbl for the first time in four months – up 25% YTD and up 45%
from a year ago (even with the DoE data showing that crude oil inventories rose 2.4
million barrels last week – more than double the consensus – to 299.4 mln barrels, the
highest since July.) Given the lags, those that think that we have remotely seen the peak
impact on GDP growth are dreaming in Technicolor (as an aside, how does this
influence the so-called “monetary conditions index” that is supposedly so
accommodative?). This, along with the lagged impact of the flattening yield curve will
hit home in the second half of the year when GDP growth will struggle to do better than
3% SAAR from the current 4%+ trend.
7. Folks just don’t appreciate the lags: all we hear is how all the risk assets carry so well
and how the Fed has really done very little to take the steam out of the markets or the
economy for that matter. But the lags between policy changes and the real economy are
long and variable and guess what? The bond market figures this out early in the game.
We recall all too well in late 1999 and early 2000 how the Fed’s rate hikes were being
stifled by the stimulus provided by a zero cost of capital in technology. The flattening
yield curve was discarded as a relic – it was no longer reliable in forecasting slower
growth since the government was paying down debt, didn’t you know. Good call –
fading the curve (of course, there’s no shortage of excuses for why bond yields have
refused to follow the consensus this time around to the high side – artificial support from
central banks or conspiracy theories that the BLS is purposefully showing low inflation
numbers through hedonics and imputed rent measures). Let’s just keep in mind that the
Fed started to tighten in June/99 and that the average GDP growth rate for the next 4
quarters was 5% SAAR on the nose. Nasdaq didn’t peak till March and the S&P 500 in
May – everything was hunky dory (or was it – why did the long end of the curve peak in
January?). When the lags kicked in from the Fed tightenings, growth in the ensuing 3
quarters averaged 0.5% SAAR (what’s a decimal place between friends?). Of course,
what aided and abetted that slowdown was a bursting of the bubble du jour – as equity
holdings in the household sector asset base surged to 140% of GDP. And guess where
real estate valuation relative to GDP stands today? Try 140%. Déjà vu?
8. Look at what the stock market is telling you about the growth outlook: First, the
S&P 500 is still down 0.1% on the year – all the return has come from the dividend.
Bonds have outperformed stocks by nearly 200 bps YTD and that is not a market
development usually conducive to accelerating economic growth rates down the pike.
And look at the sector performance. The top two sectors are “China plays” – Energy up
22% and Materials up 4%. But the next three sectors on the ladder – the only other ones
that are up on the year – are Utilities (+4.2%), Consumer Staples (+2.3%) and Health
Care (+0.4%). These are the classic defensive sectors that do well when the equity
market is starting to price in some domestic economic softness in coming months. And
look at the sectors that are down year-to-date – all the domestic economic-sensitives:
Tech (-5.3%), consumer cyclicals (-3.8%) and Industrials (-1.3%).
9. The Fed is tightening, the curve is flattening, profit growth is in the process of
peaking and oil prices are firming: And yet the equity market and beta trades look
superb. Sounds a lot like late-99/early-00 – the calm before the storm . And the
economy seems bid too – all the buzz over the chain store sales yesterday. What if we
were to tell you that in Feb/00 and March/00, retail sales surged 1.3% apiece and the y/y
trend was 9% in the former and 10% in the latter. And what if we were to tell you that
as the lags percolated through, y/y retail sales growth was basically cut in half within the
next six months (see below for more on the “lags”). And this was even with the
supposed stimulus at the time from declining bond yields.
10. Yellen is in our camp: San Fran FRB President Yellen listed her concerns and they
were more over the growth outlook than the inflation outlook. Oil, low savings rate,
external trade, fiscal restraint – and she said that the closer the Fed gets to neutral, “the
more carefully the committee will need to consider each successive increase.” (Fed
Governor Gramlich also gave a speech on the need to raise national savings – how you
then get a booming economy, inflation and a bear market in bonds out of that process
remains a bit of a mystery.) Ms. Yellen is not one who is losing sleep over productivity
– a “fairly optimistic view” and believes that the “economy is continuing to reap
productivity gains”. To be sure, the Business Roundtable was bullish on growth but not
bullish on employment – not the mix for a sustained productivity slowdown. She did
say that the funds rate is still “below the lower bound” of what is considered the neutral
range but her tone was such that it seems like we are not that far away. Our Taylor Rule
model, which includes the Fed’s implicit estimates of the output gap, potential growth
and the macro forecast yields a 3.25%-3.50% neutral funds rate. That raised a lot of
eyebrows in London a few weeks ago where many see it at 4%-4.5% but keep in mind
the historical record – the median real funds rate in the past when the output closed (by
definition that is neutral) is 2% – based on a 1.5% core PCE inflation view (the low end
of the Fed’s forecast range) then neutral is around 3.5% and certainly not above 4%
(though of course, if you’re an inflation hawk and shop at Nordstrom and Coach instead
of Family Dollar and Best Buy, your view of where the Fed ends up is quite a bit
different than ours). |
