Stocks Rally As Macron And LePen Make Second Round Of French Presidential Election
Inflation Decelerates
Before I get into the latest market moving headlines this week, I want to emphasize the recent movement in inflation. While I have mentioned the decelerating inflation in passing, I didn’t give it enough coverage considering the large movement the CPI had in March. As you can see from the chart below, the core CPI was negative on a month over month basis for the first time since January 2010. Even in recessions the core CPI turning negative is a rare event. The bond market had been forecasting the decline in inflation since March. This isn’t a one-off situation because inflation is decelerating, but I wouldn’t expect to see more negative reports. Once again, I will say the Fed raising rates in this environment doesn’t make sense.
The CPI including energy and food fell 0.3%. This was caused by the decline in gas prices. Part of why inflation had moved up starting late last year was the base effect of oil price increases and the optimism surrounding potential GOP fiscal policy boosts. I have been forecasting this decline as the third reflation trade of this cycle has ended with both catalysts rescinding. One of the factors which pushed down core inflation was declining costs in wireless smartphone services. As you can see from the chart below, the core CPI on a year over year basis fell to 2%. Technically that’s exactly where the Fed wants inflation, but the deceleration is a problem because it had taken so long for it to get above 2%. It rose above 2% in February for the first time since 2012.
French Presidential Election
This trend of decelerating inflation growth had hurt financials recently as the major banks didn’t rally on good results and Goldman Sachs fell on disappointing ones. However, this trend was ignored Monday because of the French presidential election which saw Macron and Le Pen make it to the second round of voting on May 7th. The financials led the charge with Bank of America up about 4%. The XLF financials ETF was up over 2%. As I forecasted, Macron’s chances of winning increased after making it to the second round because he wins in polls against Le Pen.
As you can see in the chart below, Macron’s odds of winning went above 70% after the first-round results were reported. The headlines in the financial press were that the market rallied because Le Pen and Macron made it to the second round which was expected. However, this is slightly inaccurate as the market rallied because Macron made it and he’s beating Le Pen in all the polls. I am aware that polls can be inaccurate, but the polls were accurate in the first round and they show an even larger margin of victory for Macron in the second round. Since the first round ended, there have been four polls. The average of the polls has Macron with a 24-point lead over Le Pen. There’s only 12 days until the second round which makes it unlikely that there will be a 24-point swing in the polls by then.
Earnings Season
As I mentioned, the banks mostly reported good results. You can make the case that they fell because of the pockets of weakness in consumer lending or you can say the macro factors, namely declining inflation expectations pushed them lower. Now let’s review the aggregate earnings changes which were updated on April 20th. For some reason which I’m not sure of, the FactSet metrics didn’t update. Therefore, I’ll be using the information from S&P Dow Jones. Keep in mind, S&P Dow Jones shows as reported results and operating earnings while FactSet uses only operating earnings in its earnings summaries.
The operating earnings estimates for the full year 2017 fell from $129.78 on March 31st to $129.66. This decline was driven by future quarters because the partially reported Q1 saw estimates increase from $35.10 to $35.17. This is common because actual earnings usually beat expectations. The trend in Q1 estimates will be higher. There may be some lumpiness in the trend because of the timing of reports. If you look at as reported results, the aggregate S&P 500 earnings peaked at $105.96 in Q3 2014. They bottomed at $86.44 in Q1 2016. The 12-month rolling aggregate earnings results are expected to be $99.24 at the end of Q1 2017. As you can see, the earnings recession is over, but the results have still not met their prior peak. The S&P 500 has rallied 21.7% since the end of Q3 2014, yet earnings now are lower than then. Earnings are expected to exceed the Q3 2014 peak in Q3 2017. Estimates can easily fall by then which furthers the point that stocks are overvalued.
As of April 20th, 18.81% of S&P 500 firms reported earnings. So far, 74.74% of earnings reports beat expectations. If this mark can be maintained, this quarter would have the most beats since at least Q2 2013. It’s safe to say the quarter has had a great start. The main reason the quarter has been good is because of financials which usually report first. 26 of the 95 reports have been financials and 20 of the 71 earnings beats were financials. Both are sector highs. To be clear, my bearishness on financials is for the second half of the year as the auto and student loan bubbles start to impact results. The one stat which jumps out is how great consumer discretionary earnings have been. 12 out of 14 consumer discretionary firms beat expectations. This is impressive given the level of retail store closings which you can see in the chart below. Since 2000, the number of store closings is the second highest on a year to date basis.
The final point about this quarter which is important is the decline in the level of buybacks. This decline is not surprising given the decline in earnings. The chart below shows the percentage of S&P 500 firms which are retiring greater than 4% of their diluted float and the percentage which are retiring less than or equal 4% of their float. As you can see, the percentage of firms retiring greater than 4% of their float has fallen from 10.48% in Q4 2016 to 6.90% in Q1 2017.
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