The Elephant in the Room

By David Nelson, CFA

With earnings in the rear-view mirror what will be the next catalyst to drive returns? Last week’s performance was the best since March and for you stock chart jockeys a breakout above the descending trend line drawn from the highs of January. All in, the earnings season was about as good as it gets this late in the cycle.

SPX Breakout May 11

Many will point to the Tax Cut as an artificial boost but that would be a mistake. It wasn’t just the bottom line that got a kick in the ass. Top line growth was exceptional. There’s any number of rabbits you can pull out of the hat when it comes to earnings but revenue growth; either you have it or you don’t.

Most of the economic data last week continued to show the economy on track but one data point caught my eye. Rail traffic for the week was well over 1/2 million carloads and intermodal units. That’s +7.5% year on year growth touching most of the country.

In a recent note Morgan Stanley’s Chief Cross-Asset Strategist, Andrew Sheets said it best pointing out; “the economic cycle is maturing, but not ending.”

To date we have an economy that is outpacing the market. I think my comment from last week’s post says it best. The monster run from November last year to the January highs likely pulled forward some of the return of 2018. The anticipation of a strong Q1 was well telegraphed in estimate revisions as well as CEO commentary. With much of the quarter priced in by the end of 2017, flat became the new up.

The Elephant in the Room
Fed Elephant in the Room

Markets once again are looking to geopolitical events, but the Elephant in the Room is still a Federal Reserve hell bent on normalizing rates and to date having little regard for a yield curve that is flashing “RED.”

Let’s touch on the geo-political first. On the heels of North Korea agreeing to release three American prisoners to Secretary of State Mike Pompeo, the President pulled out of the 2015 JCPOA (Iran Nuclear Deal). One would have expected a negative reaction especially in the face of WTI Crude hitting the highest levels in 3 1/2 years. While high oil prices are certainly good news for the U.S. oil complex rising prices at the pump often weigh on retail sales. Tuesday’s retail sales number will show if the recent economic strength is enough to fight off higher gas prices as well as the Amazon (AMZN) effect which continues to cannibalize sales.

Yield Spread 2-10 5-30

Back in Washington the Fed is weighing their next round of hikes where economists currently predict 100% probability they will raise rates at the June meeting. I hope someone in the ivory tower is looking at a yield curve that continues to flash red. The spread between 2 and 10-year treasuries as well as the 5 & 30 year are at the lowest levels in a decade.  A flat or inverted curve doesn’t guarantee a recession but considering most recessions in one way or another owe their existence to a central bank, it begs the question what does the market see that they don’t?