Entries from July 2017 ↓

The disconnect

RYAN  By Guest Blogger Ryan Lewenza

I’m not sure how I follow up Garth’s recent blog post “The implosion”, but here it goes…

The US equity markets have been rockin’ and rollin’ since the US election in November, with the S&P 500 and Nasdaq up 15% and 21.5%, respectively. While Prez Trump and his administration would like to (and have) take all the credit for these strong gains, the reality is that the rebound in corporate profits has contributed to the gains which we’ve covered in recent posts.

That said, Trump does deserve some of the credit as his pro-growth, pro-business agenda has helped to ignite “animal spirits” among investors. The expectation is that his policies will help to spur growth and inflation thus propelling financial assets higher. The problem as we see it is: 1) does the recent failure by Congress/Trump (sorry Trump but some of this is on you!) to repeal Obamacare diminish the odds that Trump will be able to advance the rest of his pro-growth agenda; and 2) some recent economic data shows a waning of “Trumpflation” resulting in a “disconnect” between the recent equity gains and the incoming economic data. The question then is, how does this “disconnect” get resolved?

US Equity Price Returns Since US Election

Source: Bloomberg, Turner Investments

Trump’s pro-growth agenda of corporate tax reform, deregulation, and infrastructure spending engendered hopes of higher economic growth and inflation. This was seen in an immediate jump in inflation expectations and bond yields. However, some of this “bloom is off the rose” as we’ve seen a deterioration in some important economic indicators.

Yes, key data like nonfarm payrolls and ISM Manufacturing data has remained robust, but we’ve seen a softening in other key economic indicators. For example, below we chart US retail sales Y/Y and CPI which have both rolled over since January. We believe this recent weakness does not dovetail with the strong equity gains seen since Trump won the election, thus making the markets vulnerable to a short-term “air pocket” should economic data continue to disappoint.

Retail Sales and Inflation Are Rolling Over

Source: Bloomberg, Turner Investments

Despite this we remain optimistic about the US economy and equity markets in H2/17 for the following reasons. First, the US economy is notoriously weak in the first quarter with a bounce back typical in the following quarters. For example, since 1985 US GDP has averaged 1.9% in Q1 versus 3.3% and 2.9% for Q2 and Q3, respectively. Second, one of my favourite economic indicators – the Citigroup Economic Surprise Index – is at a level where it typically bottoms and begins to rebound. This great indicator measures whether economic data is coming in above or below economists’ expectations.

Sorry economists, but you often exhibit a “herd mentality”, raising your economic forecasts as data comes in better than expected and vice versa. This index has dropped significantly in recent months capturing the trend of weaker economic data. But I believe economists may now have become too cautious in their outlook and we should start to see economic data coming in above expectations in the coming months. If correct, this positive economic momentum should support stocks in the second half and is why we see more upside in this bull market.

US Citigroup Surprise Index Is About To “Hook Up”

Source: Bloomberg, Turner Investments

Trump or no Trump, we see the US economy continuing to improve. But if the recent equity gains have in part been driven by optimism over Trump’s policies then it makes sense that we could see some unwinding of this if there is a delay in passing his pro-growth policies. Putting my own personal views of Trump aside, I want him to succeed and get some of his key polices passed so that the US economy can get out of second gear and back above 3%+ GDP growth.

I think JP Morgan CEO Jamie Dimon said it perfectly in a recent quarterly earnings call:

“Since the Great Recession, which is now 8 years old, we’ve been growing at 1.5 to 2 percent in spite of stupidity and political gridlock, because the American business sector is powerful and strong. I don’t buy the argument that we’re relegated to this forever. We’re not. If this administration can make breakthroughs in taxes and infrastructure, regulatory reform —we have become one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid s— we have to deal with in this country. And at one point we all have to get our act together or we won’t do what we’re supposed to [do] for the average Americans.”

So President Trump listen to Jamie Dimon’s message, put down your phone and stop tweeting, and instead focus on your agenda, since there’s some good stuff there. If not, this apparent “disconnect” between the strong equity gains and waning economic momentum will get resolved and likely to the downside.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.

The bottom

Besides hockey, guilt and crappy donuts, we’re really good at irony. What better example than houses? When times were hard, jobs scarce and the dollar plopping we blew the mother of all real estate gasbags. Now that the economy rocks, a serious correction threatens to become a crash. Fear of missing out has become a scramble to get out. Greed, then panic. It’s so classic.

In this case, however, the better the economy becomes the tougher it might be for the value of your home. The odds of a second interest rate increase in 2017 shot up dramatically on Friday with the latest data. Markets now expect another quarter-point increase on Wednesday, October 25th.

That will raise the prime rate at the banks to 3.2%, move secured lines of credit to within spitting distance of 4% and increase the cost of variable mortgages. Fixed-rate home loans will likely move higher in the week or two prior, as bond yields plump ahead of the central bank move. By the way, this would mean the Bank of Canada benchmark would have doubled in 2017. With more to come.

By historic standards this is still stupid-cheap money. But real estate is fueled by hormones, perceptions and stirred loins. The last rate hike didn’t cause a flurry of offers by people with cheaper pre-approved mortgages, for example, the way many forecast. Instead, it just scared buyers. They smell risk.

The Toronto market continues to collapse. The latest stats build on the numbers this blog gave you a few days ago. Fugly. Bigly. Overall sales were down 39% in the first two weeks of July, with a 45% crumble in deals for detached houses. Semis dropped 43% and condos 35%. Listings are starting to shrink as owners understand the market’s turning toxic and gamble that conditions will be better in the autumn. They won’t be.

In terms of price, the GTA average is $760,356. In April it was $919,589. That’s a fade of more than $159,000, or 17.31%. The declines have been historic: down 6.2% in May, another 8.1% in June, and 4.2% in just the first two weeks of July. In the last 15 days alone the average house shed $34,000, or enough to buy eight or nine used Kias.

By every definition, this is a sharp, deep and ferocious correction. If it were the stock market under discussion, we’d be just days away from an official bear market. That makes talk of a rebound in September kind of comical. Or irresponsible. Any buyer jumping in now to take advantage of a 17% price decline might end up losing all of their equity by the end of the year.

The threats are growing. Higher retail sales in May, a strengthening dollar and robust GDP expansion north of 3% confirm the Bank of Canada was correct in raising its rate this month, and certain to do it again in a few more weeks. Ontario’s anti-bubble measures are only now starting to have a real bite, chasing away foreign capital, whacking amateur landlords with new rent controls and spawning myriad CRA audits.

In BC the lefties are now in control, destined to make the 4% price drop and 80% decline in new home starts even worse. Ottawa has just announced measures to raise $500 million more in taxes from the hides of small businesses and incorporated professionals. And the bank regulator still plans on subjecting all buyers to a new mortgage stress test, even if they have a big down payment.

So how, exactly, are things supposed to get better in six weeks? Household debt will still be off the charts, two-thirds of it in mortgages. The cost of servicing $211 billion in home equity lines of credit will go up again. Governments desperate to stop people from buying digs they cannot afford are not about to reverse course and reflate the bubble. And right around the world, we’re in an environment of tightening monetary policy. In other words, you will never again see a bank offer a five-year 2% mortgage.

Simply put, why would anyone buy a property? The 17% slash in prices has occurred in a short ten weeks. An equal loss could lie ahead between now and the end of September – leading into the next round of rate hikes. Yes, there are more choices, vendors are motivated, conditional sales are back and you can spend $160,000 less than your best friend did in March – who now looks like a moron.

The market will continue to descend until it finds a bottom. Not there yet.