Liz Ann Sonders: Working off the Froth

Turning on the lights

After a party is over, and the host turns on the lights, the picture often looks quite different than it did just a few minutes before. The realities of the U.S. political process are being recognized and the "hard" economic data is not yet living up to the "soft" (confidence/survey-based) data. This has allowed some of the sentiment froth to ease, which we believe is a healthy development. The Ned Davis Research Crowd Sentiment Poll has pulled back from excessive optimism territory, while we finally broke a 109 day streak of no 1% decline days. A pattern of two-steps-forward, half-a-step-back is healthier than if the market had maintained its melt-up status in our view.

The recent pullback was mild, but under the surface, a larger correction occurred among individual securities; potentially setting the stage for the next move higher.  According to Strategas Research Group, 24% of the S&P 500 has already experienced a correction of 10-20% from their 52-week highs, while another 14% are down more than 20%.

We have recently opined that some of the optimism about the administration's pro-growth policies may have accelerated too sharply. The failure of the Affordable Care Act (ACA) reform attempt shown light on the process that is lawmaking in the United States, and it often isn’t pretty. But investors appear heartened by the renewed focus on tax and regulatory reform.

"Soft" vs "Hard"

Investors are facing the realization that "soft" data—such as confidence readings and business surveys—doesn't necessarily translate immediately into "hard" data—like retail sales, capital expenditures, and industrial production. It's this hard data that translates into economic growth and increasing profitability. Looking at some of the parabolic moves in recent confidence surveys, it would be difficult for hard data to keep up.

Historically, wide spreads between soft and hard data tend to narrow in both directions—soft data tends to retreat, but hard data tends to play some catchup. We expect that pattern in this cycle, too. (read more on Hard vs. Soft and the implications from Liz Ann Sonders here.

There do exist some impediments to higher growth. Within housing, existing home sales fell 3.7% in February, with the National Association of Realtors noting that "buying interest is strong" but "we don't have enough inventory to satisfy that buying interest." That dip contrasts with the 6.1% rise in new home sales, and a strong reading in confidence from the National Association of Homebuilders.

Additionally, the flat industrial production reading from the Federal Reserve was a bit disappointing, but it was largely influenced by a 5.7% drop in utilities output due to warmer-than-average weather in much of the United States.   Finally, the Index of Leading Economic Indicators (LEI) moved higher, as have miles driven by U.S. drivers, and railcar loadings—all signs of economic growth. In fact, for the first time in this recovery/expansion, the LEI finally took out its prior pre-recession high—a sign that recession risk remains quite low.

Turn the lights back off!

That may be what some investors are saying after the health care debacle, exposing the inner workings of sausage-making (oops, we mean lawmaking). At this point, we don't think the failure of healthcare reform meaningfully lessens the odds of tax reform. After licking its wounds, we think the administration and Congress will jump into the tax reform debate. Although we are optimistic about tax reform getting done, the process is likely to be complicated—especially if corporate and personal tax reform continues to be packed together (corporate reform and/or tax cuts are arguably the lower-hanging fruit). But Schwab’s team in Washington also cautions that the timeframe is likely later in 2017; which may mean tax reform is more of a 2018 economic and earnings story.

Brexit Begins

Arguably the most lasting political event occurring recently wasn't in the United States, as United Kingdom (UK) Prime Minster Theresa May triggered Article 50, beginning Britain's two-year withdrawal from the European Union (EU).

Article 50 has never been triggered before, so nobody really knows for sure how an exit from the EU will unfold or how long it may take for the UK to form new relationships. But it poses a risk for investors even in the near-term since the potential for major changes can have a negative economic impact. For example, when the UK entered the precursor to the EU in January 1973, the economy quickly slipped into a recession just four months later.

The Bank of England (BoE), which is the UK's central bank, is going to stress test banks in the UK for what might happen if the Brexit goes badly. These tests include a sharp rise in inflation, interest rates, and unemployment during a period of a shrinking economy, reduced global trade and high levels of consumer debt. These are some of the worst-case outcomes that could come from a plunging currency and rising trade barriers. The BoE won't know results of the theoretical tests until the fourth quarter.

In the real world, we're already seeing UK households cut back their borrowing and spending as they prepare for the worst. We can see this in the big drop in inflation-adjusted retail sales this year, as you can see in the chart below. This could act as a major drag on the UK's first quarter gross domestic product (GDP).

Also, inflation is jumping higher, with imports costing more after the 15% drop in the value of the British pound—and wages aren't keeping up, as you can see in the chart below. For example, measured in U.S. dollars, UK wages are the lowest in 10 years. Investors should keep an eye on the value of the British pound as a gauge of Brexit-related risk.

The economic data bear watching, but markets also may react to the negotiations. Now that Article 50 has been triggered, we will be hearing about Article 218, which governs the terms of negotiation. The back and forth will likely influence how consumers and businesses assess the potential outcomes and adjust their behavior. It could lead to volatility in the markets.

Fortunately, the worst-case scenario of a Brexit-induced recession and financial crisis is far from a sure thing. According to the UK yield curve (which measures the spread in yield between short-term and long-term UK government debt and has been a good forecaster of recessions in the past), the odds of a UK recession in the next 12 months are currently 30-40%, based on 50 years of history. So there's an elevated chance of recession, but it's not the base case. Investors should pay attention to changes to the yield curve; if short-term interest rates in the UK rise relative to long-term rates it would be a sign of deepening concern, and rising probability of a coming recession that could negatively affect global stock prices.

The latest polls show that only 29% of UK consumers think the economy will fare better after Brexit; that could mean a lot of pessimism is already reflected in consumer behavior and markets. Investors should stay diversified and invested according to their asset allocations—the most reliable indicators are telling us it isn't time for a more defensive stance. But we’ll be keeping a close eye on them as Brexit negotiations develop.

So what?

The recent pullback in stocks and failure of the ACA repeal appears to have helped take some of the froth out of the market and correct some overly optimistic sentiment conditions. We believe this will prove to be healthy for the continuation of the bull market, with an improving economy and a still business-friendly administration supporting further gains. But potential political-induced volatility isn't limited to the United States, as the official Brexit process started.  A UK recession doesn't appear to be in the cards at this point, but risks have risen; while U.S. recession risk remains quite low.