ISM Manufacturing Misses Estimates

Peak Economic & Earnings Growth?

The debate among investors is whether growth has peaked. I think economic growth peaked in 2017. The blue chip average is at 3.1% growth for Q2, so that’s not settled yet. The main problem with the 2018 economy is expectations were so high headed into it. If 2018 growth is slightly less than 2017, it would be a big disappointment from the initial expectations. The ECRI model projects economic growth will pick up in the next few months before falling again. That may be the final decent towards a recession. It will be interesting if stocks start to rally on positive reports in the next few months or if the worry about rate hikes prevents a rally.

Earnings growth probably hasn’t peaked yet. The chart below shows Q1 earnings grew 22.4%. It gives the appearance that growth in Q2 and Q3 will be lower than the current period, but that’s wrong. The earnings growth was expected to be 17.1% headed into this quarter. If the beat rate is similar, you can say any expectation above 17.1% growth shows acceleration. Growth is expected to be 19.6% in Q2, 21.9% in Q3, and 18.4% in Q4. All those quarters could have higher growth if the expectations don’t fall before the reporting period and the results beat estimates at a decent rate. The peak growth rate should be in Q2 or Q3; the real drop off will occur in Q1 2019. This is a topic I’ve discussed for a few months. I didn’t expect the market to ignore the current great earnings reports for the decelerating results in 2019 until later in this year.

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Peak Growth Only Bad At The End Of The Cycle

The interesting part about this period is earnings growth peaks aren’t usually a problem. As you can see from the chart below, the average return in the next 12 months following an earnings peak is 8.9%. The problem with this earnings period is it is probably more like the 1999 and 2006 peak than the others listed because we are late in the cycle. Investors aren’t worried about earnings growth in 2019 being in the high single digits or low double digits. They’re worried about a recession eliminating all growth. That’s far from a certainty, but it has enough likelihood to limit share price gains.

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Strength Of The Consumer

The 1.1% growth in consumer spending in Q1 held down GDP. I’m looking for a rebound in Q2 as wage growth strengthens. As you can see from the chart below, the good news is that the real consumer spending growth was 0.4% in March which was a 0.6% increase from February’s decline. The real disposable income growth also improved slightly to 0.2% which was up from 0.1%. The good news is the April jobs report on Friday should show increased wages for nonsupervisory workers. The bad news is real growth is limited by the increase in inflation. The 10 year breakeven inflation rate was 2.17% as of April 27th which is the highest point since August 2014.

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The chart below shows the consumer stress index which aims to show us the health of the consumer. As you can see, stock prices, jobs, income growth, and expenses are all used in the index to calculate the stress level of the consumer. The recent decline in stocks after retail investors went all-in, in January along with the pick up in inflation are hurting the consumer. A strong jobs market is required to keep the consumer’s head above water. Personally, I’m bearish on oil, but I can’t deny the rally this year is putting a dent in the consumer’s wallet.

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Weakness In Manufacturing

Based on what I’ve been seeing in the manufacturing sector, I expected a miss in the April ISM manufacturing report. That’s what we got as the report came in at 57.3 which was below the estimate for 58.6. It was also below the low end of the range which was 57.5. This represents 2 straight months of declines and the weakest headline reading since June 2017. It’s below the 12 month average of 58.4. To be clear, this report still shows growth, just at a slower rate. This report is consistent with 4.3% GDP growth, so it’s still decent. The table below is a summary of the report. The new orders index was only down 0.7%. The production index was down sharply to 57.2 from 61. The price index is now at 79.3 which signals there are sharp inflation pressures. These results are mostly consistent with the regional Fed manufacturing reports.

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Let’s review some of the quotes taken in this report for greater context on this transition from great to good. A fabricated products firm stated “The recent steel tariffs have made it difficult to source material, and we have had to eliminate two products due to availability and cost of raw material.” This is one of the first comments I’ve seen on the tariffs hurting production. It makes sense that higher costs will slow business. It’s just a matter of how much it will hurt manufacturing. Manufacturing is already slowing, so this adds to the woes the sector is facing. The general tone of these quotes is tariffs are causing price increases, growth is strong, and the trucking shortage is hurting delivery times. If oil prices increase further, the combination of this cost and the shortage of trucks will increase shipping costs dramatically. That can really hinder economic growth.

Conclusion

Economic growth slowed in Q1. I’m looking for a rebound in consumer spending in Q2, but I still think growth peaked last year. It certainly looks like manufacturing growth peaked earlier this year. The good news for stocks is that even if next year’s earnings growth is less than half this year’s growth, it doesn’t mean the market will fall. We’ll likely need an even more hawkish Fed in the second half of 2018 and 2019 to push the economy into a recession. The meeting Wednesday will give us an idea if that will occur.