The next phase of the rally

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

With US eq­ui­ties mak­ing new highs and an­other earn­ings sea­son now un­der way, it is a good time to re­mem­ber that to be sus­tain­able, a bull mar­ket should rest on three pil­lars: liq­uid­ity, val­u­a­tions, and growth. At any given point in time, how­ever, just one of the pil­lars is likely to be do­ing most of the load-bear­ing. Con­sider the cur­rent bull mar­ket. At the out­set, cen­tral bank liq­uid­ity played the key role.

Then, last year was largely about val­u­a­tions. While sales and earn­ings growth were lack­lus­tre, an im­pres­sive mul­ti­ple ex­pan­sion brought val­u­a­tions up from ob­vi­ously cheap to roughly fair value. With val­u­a­tions neu­tral and Fed pol­icy not get­ting any eas­ier, the growth pil­lar is now go­ing to have to take the weight if we are to re­main com­fort­able buy­ing into this rally. Hap­pily, the data is en­cour­ag­ing. Con­sider the fol­low­ing bullish com­bi­na­tion:

House­holds have delever­aged.

In early 2012, we set a low tar­get for US house­hold lever­age. Largely for de­mo­graphic rea­sons, we thought the debt/as­set ra­tio needed to fall all the way back to lev­els that pre­vailed in the 1990s. The good news is that road has been trav­eled, with the lever­age ra­tio now back at early 1990s lev­els. More im­por­tantly, house­holds are com­fort­able with their bal­ance sheets and have started to add debt again in the last few quar­ters. As long as as­set prices hold up, healthy house­hold bal­ance sheets are pos­i­tive for do­mes­tic de­mand.

is The labour mar­ket is get­ting tighter and wage growth back.

For the mid­dle to up­per in­come brack­ets, the im­prove­ment in house­hold bal­ance sheets is huge. For lower in­come brack­ets, the state of the labour mar­ket and wage growth are more im­por­tant. Here, too, we see pos­i­tive signs. Pri­vate pay­rolls were sur­pris­ingly strong in June, up 262,000 (ver­sus the ex­pected 210,000 rise).

Our pre­ferred cycli­cal labour mar­ket in­di­ca­tor, the em­ploy­ment-to-pop­u­la­tion ra­tio for the core work­ing ages of 25-54, also rose to 76.7% in June, from 76.4% in May (and up from 75% at the bot­tom in 2010-11). Head­line un­em­ploy­ment fell from 6.3% to 6.1%. If we strip out 65% of the long-term un­em­ployed, our ad­justed un­em­ploy­ment rate is just 4.9%. No won­der pri­vate wages are ris­ing 2.3% YoY. That is not stel­lar, but it is up sig­nif­i­cantly from the trough of 1.3% at the end of 2012. Sure, stronger wage growth could erode mar­gins, but ex­pe­ri­ence from the last cy­cle sug­gests the ef­fect will be mod­est. US com­pa­nies have be­come masters at man­ag­ing labour costs, and if cost in­creases can­not be avoided, they will be passed on to con­sumers with re­cent busi­ness sur­veys and CPI read­ings sug­gest­ing pric­ing power is on the rise. At this stage, the dom­i­nant ef­fect of ris­ing wages should be in­creased top-line growth. With a more mod­est im­pact on mar­gins, most of that should feed through to the bot­tom line.

House­hold homebuilding.






The re­ces­sion forced a lot of kids into their par­ents’ base­ments, but that is now be­hind us. House­hold for­ma­tion growth is back at pre-re­ces­sion lev­els; but homebuilding has still to catch up. That is good news for growth.

Busi­ness capex should then

Look­ing fur­ther ahead, if we are right that sales growth is set to re­bound on the back of stronger house­hold fi­nances, then this should be fol­lowed by a re­bound in capex.

How much of this will shine through in 2Q earn­ings we are not sure. But at the very least it should im­prove the earn­ings out­look for the rest of the year.


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