Action Alerts PLUS: 2nd Half Cranks Up

 | Jul 09, 2017 | 10:00 AM EDT
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This commentary was excerpted from the Weekly Roundup sent to subscribers of Action Alerts PLUS, a charitable trust co-managed by Jim Cramer and the AAP staff. Click here to learn about this actively traded stock portfolio.

Markets trended relatively flat in the abbreviated trading week (we hope everyone had an enjoyable Independence Day). We are officially in the second half of the year and preparing for the slew of earnings reports that begin next week when we hear from portfolio companies PepsiCo (PEP) , Wells Fargo (WFC) and Citigroup (C) . This week, the Federal Reserve and European Central Bank (ECB) released their June meeting minutes, both of which provided upbeat views on the overall economy. The Fed appears to be getting ready to unwind some of its massive balance sheet over the next few months, while some officials from the ECB were so encouraged by the eurozone economy that they suggested the ECB should drop its pledges on its quantitative easing program. Read our Alert on the releases here.

For this week, Treasury yields continued to push higher following the recent Fed rate hike and last week's positive stress-test results. Gold trended lower as the dollar strengthened just slightly against the euro. Oil moved lower, stuck in the mid-$40s as investors remain skeptical that the worldwide supply glut will subside any time soon.

Second-quarter earnings are just getting under way and appear to be off to a good start. No portfolio companies reported earnings this week.

Turning to the economic front, on Monday the Institute of Supply Management (ISM) reported that the June manufacturing index rose 2.9% to 57.8, surpassing expectations of 55.6. Recall that anything above 50 represents expansion, while levels below 50 indicate a contraction. The rise comes on the heels of May's 54.9 reading and marks the fastest rate of growth for American manufacturers in roughly three years. June marked the 97th consecutive month of expansion in the overall economy and the 10th in the manufacturing sector. Following the release, the Atlanta Fed raised its second-quarter GDP estimates from 2.7% to 3% annualized.

Digging deeper, of the 18 manufacturing industries tracked by ISM, 15 showed growth in June. The apparel, leather and allied products; textile mills; and primary metals industries were the only three to indicate a contraction. The new-orders index rose 4% (indicating a faster rate of growth) month over month to 63.5, and production surged 5.3% to 62.4, picking up speed after a slowdown last month. Employment also jumped 3.7% to 57.2 while prices fell 5.5% to 55 (indicating that prices are increasing at a slower pace). The slowdown in price appreciation comes following an 8% decline in the index in May.

U.S. markets were closed on Tuesday in observance of Independence Day. On Wednesday, the Commerce Department reported that new orders for manufactured goods declined for the second straight month in May, falling 0.8% following a (revised) 0.3% decrease in April and missing expectations of a 0.5% decline. Shipments increased 0.1%, marking the fifth monthly gain in the last six months after a virtually flat reading in April. Unfilled orders dropped for the first time in three months, falling 0.2%, while inventories fell 0.1% after rising for six consecutive months.

Importantly, the Commerce Department also revised estimates for non-defense capital goods excluding aircraft (i.e., core capital goods) upward from -0.2% to +0.2% in May. Capital goods are not sold to consumers, rather they are tangible goods used in the manufacturing of consumer goods. For this reason, the core capital goods reading is a key metric that many consider to be a proxy for business investments. It is important to consider new orders excluding transportation equipment (planes and automobiles) because the high value of these goods can easily skew month-to-month readings, increasing volatility and making it more difficult to analyze the underlying trend.

Breaking down the reading, new orders for manufactured durable goods declined 0.8% and were pulled down by a 3% decline in orders for transportation equipment, which was down for the second straight month; new orders for nondurable manufactured goods also fell 0.8%. Shipments for manufactured durable goods rose 1%, led by a 2.3% rise in transportation equipment shipments, which rose for the first time in five months. Shipments of manufactured nondurable goods fell 0.8%, the second decline in three months. Leading the decrease was a 3.2% decline in shipments of petroleum and coal products. Unfilled orders for manufactured durable goods fell 0.2%, pressured by a 0.4% decrease in transportation equipment. Finally, inventories of manufactured durable goods rose for the 10th time in the past 11 months, increasing 0.2%, driven by a 0.8% increase in primary metals (which also led the rise in inventories in March and April) while inventories of manufactured nondurable goods fell for the third consecutive month, falling 0.5% following a 0.4% decrease in April.

On Thursday, the Department of Labor reported the initial jobless claims for the week ending July 1 were 248,000, an increase of 4,000 claims from the prior week's unrevised numbers and 5,000 claims higher than expectations for a decline to 243,000 initial claims. Importantly, the four-week moving average for claims (used as a gauge to offset volatility in the weekly numbers) increased by 750 from last week's unrevised average to 243,000. The low rate of layoffs reflects a strengthening labor market and suggests that despite some disappointing inflation numbers, the economy has potentially begun to reaccelerate in the second quarter. Claims have remained below 300,000 -- the threshold typically used to categorize a healthy jobs market -- for an astounding 95 straight weeks (compared with 122 weeks under the older seasonal-adjustment process, according to the updated data), the longest streak since 1970.

Finally, on Friday, the Labor Department reported that the economy added 222,000 jobs in June, exceeding expectations of roughly 179,000. Employment numbers were revised up for both April and May. April's reading was revised up from 174,000 to 207,000, while May's reading was revised up from 138,000 to 152,000. Job gains now average 194,000 a month for the last three months.

The better-than-expected headline number appears to support the Fed's decision last month to increase short-term interest rates for the second time this year. The question becomes, can the economy sustain a pace that will warrant an additional hike in September as the Fed looks to reduce its massive balance sheet?

The unemployment rate held steady at 4.4%, above expectations of 4.3%. Unemployment is down 0.4% from the start of the year -- a big accomplishment for the Fed, which tracks unemployment when making decisions regarding whether to raise interest rates. In line with the steady unemployment rate, labor force participation was relatively unchanged in June at 62.8%. The low participation rate suggests that many able-bodied Americans are remaining on the sidelines despite what appears to be growing optimism within the economy.

Digging deeper, healthcare led the way, adding 37,000 new positions, followed closely by business services, which added 35,000 jobs in June. Average hourly wages are up roughly 2.5% on a yearly basis, however, remaining relatively unchanged from May (rising a meager $0.04) while the average workweek ticked up 0.1 hours to 35.5 hours.

For those skeptical of the headline measure of unemployment (for reasons like the decline in the labor force participation rate), a different, broad measure of unemployment and underemployment known as the U-6 -- which accounts for those working part time due to the inability to find full-time work -- was 8.6% in June, up from 8.4% in May and in line with April's 8.6% reading. The U-6 had averaged around 8.3% in the years before the recession.

Overall, the report was relatively positive. The bigger focus will now be on the longer term, questioning whether we are beyond peak employment and if the labor market can continue to carry the economy. In the immediate term, the report is unlikely to have much impact on the market, other than on financials (which are negatively impacted by declining yields), as strong earnings reports continue to fuel optimism regarding improving fundamentals for companies moving forward.

On the commodity front, oil remains pressured as the worldwide supply glut rages on. On Thursday, the Energy Information Administration (EIA) reported that U.S. crude inventories fell 6.3 million barrels last week. Despite the better-than-expected reading, the news was overshadowed by an increase in U.S. production, which is now up roughly 11% from the same time last year.

On a brighter note, The Wall Street Journal reported on Friday that OPEC is considering production limits for Nigeria and Libya, both of which have relentlessly increased production and undermined OPEC's efforts to reduce worldwide production. Recall that the two countries are currently exempt from the production-cut extension that was announced at the most recent OPEC summit in Vienna.

While U.S. producers have certainly played a significant role in offsetting the OPEC production cuts, the U.S. is not a member of OPEC. Libya and Nigeria, on the other hand, are both member countries and are thus more subject to the cartel's control. Some OPEC members have gone as far as to ask that the two countries send their respective oil chiefs to the cartel's July 24 meeting in St. Petersburg, Russia. Libya and Nigeria typically do not attend this meeting, as the two countries have not been subject to the same OPEC cuts as other members. This is unusual (and, in our view, positive) as the monthly meetings are usually focused on assessing the level of compliance from those countries subject to the cut. We will continue to monitor for any news out of OPEC and for any reports regarding worldwide supply levels.

Moving on to the broader market, first-quarter earnings were relatively positive vs. expectations, with 73.2% of companies reporting a positive EPS surprise. Total first-quarter earnings growth increased roughly 14% year over year vs. expectations for an overall 14.11% increase throughout the season; of the 435 non-financials that reported, earnings growth is up 13.4%. Revenues are up 7.2% vs. expectations throughout the season for a 7.13% increase; 73.2% of companies beat EPS expectations, 19.8% missed the mark and 7% were in line with consensus. On a year-over-year comparison basis, 73% beat the prior year's EPS results, 25% came up short and 2% were virtually in line. Information tech, health care and industrials have had the strongest performance this year vs. estimates, whereas consumer staples and telecom have posted the worst results in the S&P 500.

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