Atlanta Fed Downgrades Q2 GDP Growth Estimate To 3.0%

Regional Banks Soar

It was interesting to see the financials rally on Friday given the problems with getting Dodd-Frank repealed. After falling 12.37% from its high on March 1st to its low on June 6th, the KRE regional bank index is up 7.13%. As I said, the Dodd-Frank repeal isn’t going as smoothly as the Republicans would like. The House passed a bill this week which repeals most of the Dodd-Frank regulations. The bill is called the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs (CHOICE) Act. However, it is dead on arrival in the Senate, meaning nothing will get done in the near term. This legislation bottleneck reminds me of when the Republicans used to pass Obamacare repeal bills constantly even though there was no chance Obama would sign them into law. This is disconcerting because the banks rallied after the election partially because of deregulation.

The fact that the House would pass a bill which has no chance of becoming law signals to me that we’re far away from getting the deregulation that we were promised. The GOP may have to gain a few more Senate seats in the 2018 mid-term elections to see progress on that front. One reason why the banks may have rallied this week is because the entire selloff was probably caused by disappointment over deregulation. At this point, nothing getting done is probably priced in. It’s the case of sell the rumors, buy the news.

Historic Valuations

The chart below shows a point worth harping on. I think high valuations imply a greater crash than what the Nasdaq did on Friday will occur at some point in the next few quarters. The valuations are at record highs in terms of the S&P 500’s market cap in relation to its revenues and U.S. equity in relation to nominal GDP. The two reasons for this are low interest rates and high profitability from the top firms. Long term interest rates don’t look to be rising anytime soon because the ECB is buying $60 billion in bonds per month, GDP growth is stagnant, and inflation is low. It will be interesting to see what happens to stocks when corporate profit margins start to hit their ceiling. This may suppress stocks from rising much more in the 2nd half of the year.

The chart below shows another way to look at valuations. Not only are the market cap to GDP and price to sales ratios near record highs, the enterprise value to EBITDA multiple is coming close to the tech bubble high. On Friday, the VIX reached its lowest point since 1993 and the Shiller PE nearly reached 30 which would have been the first time it hit that level since April 2002. Extreme bullishness is palpable.

Another way of looking at the level of speculation in the markets is in the chart below. It shows the 3-month implied volatility of the S&P 500 along with the BB corporate bond spreads. Both indexes are near their 2014 lows and their 2007 lows. It’s dangerous how some market commentators are beginning to compare bond spreads to before the financial crisis. They have no choice because the level of speculation is at the highest point since then. However, it’s not fair to say the market from 2005 to 2007 was normal because that’s when the speculation got out of hand and the seeds for the crisis were sowed.

To further this point, the chart below shows the Bloomberg Financial Conditions Index. As you can see, the conditions are as loose as they were in the 2005 to 2006 period and in 2014. Just because the easy conditions in 2014 didn’t lead to a crisis doesn’t mean it won’t this time. The conditions are much easier than they were in the tech bubble. It’s difficult to see in this chart because the crash in 2008 distorts the scale. Like some bearish commentators have said, it’s like the tech bubble and the housing bubble had a baby (which is this current bubble).

Latest Economic Reports

The reason why I have said for the past few weeks that you can’t trust the forecasts for Q2 GDP is because most of the data hadn’t been reported yet. Now we are beginning to close in on the time where you can trust the various forecasts. The latest reports have pushed down Q2 growth estimates. April’s wholesale sales ended up being down 0.5% month over month which is the weakest report since May 2013. Auto inventories dropped 1.4%. I think GDP growth will struggle as autos will be a consistent headwind all year. As you can see from the chart below, wholesale sales appear to have peaked. The economy was able to avoid a recession in 2015 which is the last time wholesale sales declined year over year. I think the next downturn in this indicator will finally signal a recession.

Speaking of the latest Q2 forecasts for GDP, let’s review the Federal Reserve banks’ forecasts. The St. Louis Fed lowered its forecast to 2.64% from 2.78%. The NY Fed maintained its forecast of 2.3%. As you can see from the chart below, the Atlanta Fed’s forecast has cratered in the past several days from 4.0% to 3.0%. This latest reading fell from 3.4% to 3.0% because of the weak wholesale report, the weak manufacturing report, and the weak motor vehicle sales estimates.

The estimates for Q2 started out overly optimistic because of the weak Q1 report. Once the Q1 report was revised higher to 1.2%, it lowered the chance of a sharp bounce back. Now that the April economic reports have all come in, it’s clear that the estimate for 4% GDP growth was outlandish. I’m still expecting Q2 growth to be higher than Q1’s growth, but it will be tough to get to above 2% growth for the first half. The economy is still mired in a slow growth stage. The 10-year- 2-year spread is now at 86 basis points which tells me more weakness is to come, but no recession is on the immediate horizon.

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