In this article, I will look at the latest earnings metrics from FactSet, some of the latest figures in the auto loan market, and the lack of volatility in the market compared to the policy uncertainty. First, I want to discuss updated pricing of interest rates shown on the CME Group website. Since the day of the February FOMC presser the chances of rate hikes have fallen as the general market consensus appears to disagree with Goldman Sachs’ prognostication that there’s a 35% chance of a rate hike in March. Instead the market agrees with my estimate that March is not a ‘live’ meeting. Now there is only an 8.9% chance of a rate hike in March. The earliest possible rate hike is in June because May will need to be a ‘live’ meeting. A ‘live’ meeting is a warning of an impending hike.
I foresee the chances of a rate hike in June rising as Wall Street comes to that consensus. Currently there’s a 64.8% chance of a rate hike in June. The economic data will determine if this happens. In the past two years, a combination of a dovish Fed and a weak recovery has led to a lack of rate hikes. Even though business optimism, the ISM Manufacturing PMI, and employment reports are all looking great, the economy has yet to break of this scenario. I’ve always had the opinion that raising rates at a rate of one quarter point per year would cause the Fed to bump into a recession before it reaches its long-term goal of 3%. The Fed has been a lose, lose scenario. Either it starts raising rates at a fast clip which could spur a recession or it continues raising rates slowly which would mean they can’t be cut when a recession occurs. I am operating with the mindset that the Fed is still on the same trajectory until it proves otherwise by raising rates at least twice in a year.
Any metric which has the VIX in it will likely be at an extreme level because the VIX has been near historically low levels. The market is 4 days away from tying this cycle’s record for the number of trading days without a 5% correction. That’s an amazing feat because this is the second longest bull market ever. The market started this run at expensive valuations and firms have already seen a peak in margins, so I don’t see this one becoming the longest bull market ever. Considering the fiscal policy uncertainty, it’s not surprising to see the difference between economic policy uncertainty and the VIX reaching a record high. With the statements out of the White House, I am becoming less uncertain about fiscal policy and more uncertain about how the Fed’s reaction to it will affect the markets. The timeline for pro-business measures such as tax cuts, regulatory reform, and a free market approach to health care are expected to become law sometime between the second half of 2017 and the first half of 2018. The question I have is if the Fed will start to accelerate rate hikes around that time or wait until after they start showing signs of improving economy. The answer to that question should come in the next few months. If the stock market has to start pricing in more rate hikes, it could increase volatility.
The year is only one month old and Q4 2017 earnings won’t be reported for another 12 months, but the preliminary data on Q1 earnings looks good. It will prove my projections to be exactly wrong if the trend continues. Bottoms up earnings estimates for Q1 have fallen 1.5% which is relatively great when compared to historical results. In the first month of a quarter, on average in the past 5 and 10 years, estimates have fallen 2.5%. I think those averages may be distorted by the 2008 recession and the recent earnings recession. I wish FactSet put out 20 year averages to see a better picture. Having earnings decline is still not good because the market is already expensive on a forward PE basis. However, my thesis that earnings will increase in the mid-single digits on a year over year basis seems too bearish based on this small sample. I have said earnings misses would be spurred by energy, but energy estimates rising 3.5% is the reason why this quarter looks better than average. It’s not surprising because oil prices haven’t fallen yet.
I think oil prices correcting to the high $30s combined with the rolling over of the auto sector can result in weak earnings growth in the second half of the year. While the oil price correction hasn’t happened yet, the auto sales market has shown negative signals. As you can see auto sales in January will fall from December when there was record high incentives. Like a lot of the indicators in the economy, there has been a plateau in the past 18 months. Record high discounts followed by declines in sales looks like the beginning of a top to me. I expect the next few months of data to see year over year declines in sales.
Besides discounting and sales, the other aspect of the auto market worth focusing on is the loan market which is now showing signs of stress. As you can see in the chart below, 60 plus day delinquencies increased 50 basis points year over year. Annualized net losses increased 111 basis points year over year. The defaults in the auto loan market hurt worse than usual because used car prices are falling which is caused by the increase in leases expiring.
Conclusion
The market is pricing in a dovish Fed. Equity volatility is not reflecting the uncertain fiscal and monetary policy. If Trump’s economic policy is considered uncertain, surely his Fed appointments must also be uncertain. FactSet shows earnings for Q1 2017 are looking bright. My prediction for weak 2017 earnings looks more doubtful than before, but it can easily turn around if oil prices fall and the auto market falls apart. The weakening subprime auto loan market is a signal this may occur in the first half of this year.
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