Markets Reach New Highs, But Why?

Markets Reach New Highs, But Why?

At Tematica, we separate our politics from our analysis to be able to provide objective assessments, which means that we need to call out an error we see in the prevailing narrative. Thursday the Dow hit its 7th straight record close, despite the news that Special Counsel Mueller has impaneled a grand jury in the Russia election tampering probe. While many are attributing the market’s gains to president Trump’s administration, this divergence calls that into question. As does the reality that President Trump’s approval rating has hit new lows with disapproval ratings reaching new highs while the market has continued to rise.

Apple (AAPL) and Boeing (BA) collectively have been responsible for 70 percent of the Dow’s gains the past 6 weeks while the FAANG stocks – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL) – which account for just 11 percent of the S&P 500 market capitalization have generated 26 percent of year-to-date return. Juicing up those returns has been leverage, with margin debt up 20 percent on a year-over-year basis in each of the past 5 months and is today over 60 percent HIGHER than at the 2007 peak.

The reality is that in the past 6 weeks, the median stock price and median sector price haven’t actually moved. What has happened has been a falling U.S. dollar, which is on track for the weakest annual performance in 14 years. That’s really something in light of the prevailing narrative that assures us the U.S. economy is going like gangbusters. Ignore that recent ISM report which saw Services experience the biggest drop since November 2008 – same goes for the Composite Index. Amazing to have a falling dollar and the U.S. Treasury 10-year yield right around where it was during the depth of the Great Recession while the Fed is tightening and yet we are to believe the economy is firing away, hmmm.

The top three stocks in the Dow for foreign revenue, Apple (APPL), Boeing (BA) and McDonalds (MCD) account for 50 percent of the Dow’s year-to-date gains, hmmmm.

So what’s going on here?

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

In euro terms, the S&P 500 is actually down 1.9 percent year-to-date. In Mexican peso terms it is down around 4 percent and even in the polish zloty it is down roughly 5 percent.

In fact, when President Trump was elected, the U.S. stock market capitalization represented 36 percent of total global market capitalization. That ratio rose to nearly 38.5 percent but has since fallen to 35 percent where it was all the way back in June 2015. On a relative basis, the U.S. stock market has significantly outperformed. What we are seeing here is more a function of a falling currency that a rising stock market reflecting a robust economy.

What could go wrong? The Intercontinental Exchange now has a net short position for the U.S. dollar for the first time since May 2014 and after that time the greenback gained 5 percent within 3 months. If the market has been rising on a falling dollar….

Then there is that debt ceiling debate that, when taking into account recent dynamics in D.C. between various members of Congress and the White House, could make Game of Thrones appear rather tame. This coming at a time when the tax reform debate is set to kick off. Oh and there are those November elections to really bring out the softer side of politics. With the Chargers no longer playing in San Diego this Fall, (What the hell?) I think I’ll have more than enough games to watch coming out of Washington.

Markets Narrowing as Trump Trade Fades

Markets Narrowing as Trump Trade Fades

We are seeing the beginnings of de-risking as for the first time since the election as the S&P 500 has broken below its 50-day trendline, but is still just 3 percent shy of its all-time high, so let’s not get overly carried away here. Volatility, in the form of the CBOE’s volatility index (VIX), rose every day last week and has jumped 24 percent to be at its highest level since November. Meanwhile, those talking heads on mainstream financial media keep focusing on the same thing the herd does – which rarely results in successful investing.

Ten big stocks are exerting an unusually large influence on the S&P 500 in 2017, the latest sign that the herd instinct is alive and well on Wall Street. Those 10 large stocks have powered nearly 53% of the S&P 500’s 4.7% advance this year, according to Fundstrat Global Advisors’ data through the middle of last week. During an average year, the 10 stocks with the greatest impact typically account for only 45% of the market’s price moves, according to analysis of data from AQR Capital Management.


Looking at what has happened with core CPI and PPI rolling over as well as current GDP estimates for Q1, we think it is quite likely that non-financial corporate profits may have contracted in Q1 on a quarter-over-quarter basis while rising on a year-over-year basis thanks to the weakness in Q1 2016. Those CPI and PPI numbers tell us that corporate pricing power just isn’t there, a reality that does not support the narrative of “animal spirits” igniting post-election. Nor is the reality of declining productivity in the face of rising unit labor costs, which serve to squeeze margins.

As for that accelerating economy narrative, it is wholly inconsistent with the data coming out of bank earnings reports with commercial loan balances at J.P. Morgan Chase (JPM) and Wells Fargo (WFC) unchanged over Q1 while new auto loans fell 17 percent at JPM and 29 percent at Wells on a year-over-year basis. Citigroup’s (C) profit from consumer banking in North America dropped 25 percent thanks to credit losses on some credit cards while JPM and WFM consumer banking profits dropped 20 percent and 9 percent, respectively.

Treasury bonds benefited from Trump’s talk last week on preferring low-interest rates, despite his criticism of Fed Chair Yellen during his campaign, with the 10-year Treasury falling to levels last seen in November. We suspect there is more room for rates to fall here as all those sentiment surveys sync up with the much weaker hard data.

Rates aren’t just falling here though as the 10-year Japanese sovereign bond yield is now below zero again for the first time since November, with the German 10-year falling below 0.2 percent. With all the talk about the U.S. needing a weaker dollar, gold is moving up, well on its way to cracking $1,300.

The risk-off move is likely driven in large part by the geopolitical tensions ranging from the recent MOAB drop in Afghanistan to North Korea getting cranky again to the upcoming elections in France where a Marie Le Pen victory has become more of a possibility. If however, Macron wins in the second round, we wouldn’t be surprised to see a bit of a rally in those battered French bank stocks.

As the first 100 days of the Trump administration nears its end, we’ve gone from campaign of isolationism to a more aggressive military; the failed healthcare reform plan is returning to center stage while tax reform, deregulation, and infrastructure spending are pushed further back. Those who follow our analysis ought to be unsurprised that the Trump Trade is fading fast.


Source: Investors Follow the Herd as 10 Big Stocks Power Market’s Gains – WSJ

Once Again the Fed Overestimates the Strength of the US Economy

Once Again the Fed Overestimates the Strength of the US Economy

Looking at the moves in the stock market, one would likely think all is right with the world and the US economy is back on track after bobbing and weaving around 2 percent GDP for much of the last several years. That is until we got the most recent reading on the health of the economy.

Friday’s estimate for fourth quarter 2016 GDP came in below expectations at 1.9 percent quarter-over-quarter, seasonally adjusted, versus the consensus expectations for 2.2 percent and the Atlanta Fed’s GDPNow estimate for 2.8 percent. The Fed’s consistently excessive expectations never cease to impress. To put 2016 in context, going all the way back to 1950, only four other years were as weak and they were all recessionary (1954, 1958, 2008, 2009).

This reading was a material decline from the 3.5 percent posted in Q3, but then that was primarily driven by an increase in inventories and exports. The net export contribution in Q3 was the largest since late 2013 was due in large part, and we are seriously not making this up, to soybean exports to South America where the weather decimated their soybean crop, adding a full 0.9 percent to the Q3 GDP growth. Exports in Q4 dropped -4.3 percent with goods declining -6.9 percent, revealing the headwind presented by a strong and strengthening dollar as net exports overall subtracted 1.7 percent from the fourth quarter’s growth. We’ve heard comments from a growing number of companies about the impact of the dollar and foreign currency translation in the current earnings season, but to put it in context, Q4 was the largest trade-related drag on overall growth since Q2 2010.

The U.S. economy decelerated in the final three months of 2016, returning to a lackluster growth rate that President Donald Trump has set out to double in the face of challenging long-term trends.

We are seeing some recovery in fixed investment, with fixed investment in mining, shafts and well structures contributing to GDP for the first time since Q4 2014, thanks to rising oil prices. While this contribution was relatively small, the removal of the headwind of low oil prices in this sector had allowed it to start contributing to GDP. We remain cautious here as the number of rigs coming online is rising week after week (see today’s Monday Morning Kickoff for more), and we remain skeptical that the OPEC deal on production cuts will survive given all the, shall we call them, colorful relationships involved.

Real investment in industrial equipment is at an all-time high, totaling more than $200 billion in 2009 chained dollars and looks to be still rising. On the other hand, investment in manufacturing structures is slowing a bit, which isn’t shocking given that capacity utilization rates are at levels normally seen around a recession.

We have also now seen Consumer Spending decline over the past three consecutive quarters despite all the euphoric talk.

This brings full-year 2016 GDP growth to just 1.6 percent, putting the U.S. growth now in 2nd place within the G7 group with the U.K. delivering growth of 2 percent for the year. We are no longer the cleanest shirt in the laundry. This is the worst growth rate for the U.S. since 2011 and down from the 2.6 percent in 2015. America has now experienced a record eleven consecutive years without generating annual 3 percent GDP growth going all the way back to 1929. Is it any wonder there is a lot of frustration in the country?


Despite what we keep hearing from the Fed, this is not an economy that is accelerating. While over 80 percent of the survey data has come in above expectations, giving investors a sense of security, the actual hard data, rather than the more sentiment-oriented survey data, has seen over 50 percent come in below expectations.

With the recovery in oil prices and inventories back on the rise, two major headwinds have been removed, but the biggest and potentially most lethal remains – a rising dollar. The Fed still appears to be confident that it will raise rates three times this year which increases the dollars’ relative strength. Any trade barriers that result in fewer imports into the US, such as a 20 percent tax on fruits and vegetables from Mexico, would also serve to strengthen the dollar; the less we buy from the rest of the world, the fewer dollars are outside the country. That scarcity bids up the price of the dollar, particularly given the effectively massive short position in the dollar due to the over $10 trillion in dollar-denominated emerging market debt.

Mr. Trump has argued the U.S. can achieve stronger growth by overhauling the tax code, boosting infrastructure spending, rolling back federal regulations and cutting new trade deals that narrow the foreign-trade deficit.

The two big hopes that Wall Street has been relying on to boost the economy have been President Trump’s infrastructure plan and his tax cuts. This past week we saw signs that our concerns over when these would actually be enacted are warranted. Last week senior congressional aides revealed that the spring of 2018 is a more likely target for passage of tax reform legislation. According to Reuters, as the days passed at the annual policy retreat for Republicans last week in Philadelphia, leaders were also discussing that it could take until the end of 2017 or even later to pass fiscal spending legislation. Trump has taken office with the lowest approval rating in modern history and the level of controversy surrounding him isn’t declining, which will likely make passage of legislation he wants more challenging.

Putting it all together, despite the headlines over more sentiment-oriented reports, the economy does not look to be accelerating and the expectations around the timing of Trump’s infrastructure spend and tax reform plans are likely overly enthusiastic. Even the Wall Street Journal’s survey of over sixty economists projects GDP growth of 2.2 percent in the first quarter of 2017 and 2.4 percent in the second. We will continue to monitor the data to see how likely that consensus view becomes in the coming weeks. We believe the market is also incorrectly discounting the potential negative impact of a strengthening dollar and the degree to which this strengthening may occur.

Source: U.S. Economy Returns to Lackluster Growth – WSJ

Falling Prices

Looking out into the future, markets and economies will driven in large part by falling prices in a few major areas:

  • Falling Oil Prices
  • Crashing Prices and Excess Capacity in Commodities
  • Diverging Monetary Policies and the Strong Dollar

Falling Oil Prices

Last week oil fell to $36/barrel, going below $40 for the first time in six years. Earlier in December OPEC had its final meeting for the year, and at this point I think it is fair to say OPEC has become completely irrelevant.  A cartel that has no ability to control the production of its members is no cartel. OPEC can’t control its members because Saudi Arabia already learned its lesson in the 1980s, when it cut production in response to falling oil prices and ended up mostly just losing market share. Other nations paid attention. On top of that, these countries’ budgets are in dollars, as oil is priced in dollars, and they need to keep up their spending in order to maintain control over their citizen – the perpetual challenge for countries in which the primary source of national income is owned by the State.

So why are oil prices falling? Simply because while demand is growing, it is growing at a slower rate than supply. The high oil prices from years ago combined with the Fed’s ZIRP (Zero Interest Rate Policy) and technological breakthroughs in oil extraction technology, led to an influx of investing in oil production capabilities which was funded in part by a lot of high yield debt. As the price of oil continued to fall, many of the companies have found themselves in violation of debt covenants. This is leading to rising defaults, (although the default rate today in aggregate is not at historically high levels) which then leads to tightening of credit conditions as lenders are forced to rebalance their lending portfolios. This make conditions even more challenging on these distressed firms, as credit is increasingly less available, which will eventually lead to bankruptcies for many of the more highly-levered firms. We saw a similar pattern back in the financial crisis as the real estate investing boom blew up in spectacular fashion when borrowers were unable to refinance on major portions of their real estate portfolios, even on properties that may have had more than 50% equity, resulting in a complete wipeout of their clients’ invested capital in those properties.

The good news for investors is that this is also reminiscent of the heady days of the Dotcom boom when all the rage was broadband infrastructure, with high-fliers such as Global Crossing, which eventually flamed out in headline grabbing bankruptcies that wiped out most debt and equity holders alike. However, that led to the ability for those that survived the carnage to be able to pick up that infrastructure for pennies on the dollar, leading to materially lower broadband pricing, which facilitated the next wave in the Internet evolution. I think oil is likely to experience something similar, with those companies that have healthy balance sheets being able to pick up production capacity at pennies on the dollar, greatly improving their overall margins and providing the economy with lower-cost energy into the future, which will be a much appreciated tailwind.  For now, I think it best to avoid this sector, but at some point in the near-to-mid future it will provide spectacular opportunities.  This lower-price oil will also be a fantastic boon to those emerging economies that are big energy importers, helping their economies grow at a faster pace than was previously possible, providing investors with yet another great opportunity. U.S. lawmakers are also expected to lift the ban on oil exports as part of the current spending bill legislation, which will provide additional support for domestic producers.

For now, the defaults and struggle in oil will be a strain on the overall economy. For those who point out that oil and gas drilling accounts for only around 4.6% – 6.5% of GDP, residential housing makes up around 5% of GDP and we all recall just how much damage excessive investment and use of debt in that sector did.

Crashing Prices and Excess Capacity in Commodities

Commodity prices have been falling for years, with the CRB commodity index down 21% from just its May 2015 highs. An entire book could easily be written on this topic, so I’ll narrow it down to just a few illustrative points in the interest of preserving your sanity! The last major commodity super-cycle began when China was allowed entrance into the World Trade Organization. Thanks to the enormous shift in its population from rural agrarian to industrial manufacturing, it was able to supply the world with cheap labor, which meant cheaper products for exports. The money it took it was funneled into gobbling up commodities to use in its eye-popping infrastructure build out; for example, China accounts for about half of the world’s aluminum consumption.

During and after the financial crisis, the world greatly benefited from China putting its pedal to the metal on its infrastructure build out, effectively creating a floor under commodity prices and protecting commodity producers from what would have been a much more painful fall without China’s purchasing. To put in it context, in 2009, with the markets crashing, oil stood around $100/barrel and steel plate was at $600, today oil has fallen below $40 and steel is at $260.

Today China’s steel production capacity is around 400 million tons a year, which is nearly four times the U.S.’s capacity at 120 tons. With China’s slowing economy, and more importantly rapidly slowing infrastructure build, it has more and more excess capacity.  China’s steel consumption is declining for the first time in two decades, with the nation’s steel sector experiencing layoffs in the tens of thousands.  Year-to-date the one hundred largest steel companies lave lost around $11 billion with 37 steel plants closing so far.

Most of China’s excess capacity cannot be shipped to the U.S. as it is of lower quality and is barred by tariffs, but it can go to Europe where prices are crashing and has caused quite the crisis in the U.K.  European players have been forced to continually lower prices and unlike China, they can export to the U.S.; despite the tariffs, U.S. steal producers cannot be totally insulated.

Many of these steel and oil mid-cap companies have “crossover” bond ratings, which means they are in-between investment grade and junk status, (BBB and BBB-).  All it takes is one little nudge and they will be in junk territory, which means then that the funds that hold them will have to rebalance their portfolios which in turn affects the credit market as a whole. Here too, those producers that maintain healthy balance sheets and do what they can to raise cash, will be able to goggle up bankrupt production capacity at below-cost, lowering their margins and allowing for lower cost steel into the future, which will help not only domestic users, but will be particularly beneficial for those emerging market, commodity importing nations. While I’ve only talked about oil and steel in depth here, similar dynamics have and are occurring in other commodity markets across the globe.

Diverging Monetary Policies and the Strong Dollar

The strong dollar continues to be one of the most common problems cited by companies in their quarterly reports. So what does it mean, why is it happening and is it likely to continue to strengthen?

The dollar began strengthening when the Federal Reserve first pulled back on its quantitative easing programs. This directional shift marked the first step. Then it ceased quantitative easing altogether, whilst other nations continued or even accelerated their programs. Now the Fed has raised interest rates, which further strengthens the dollar against other currencies. As other nations around the world engage in stimulative monetary policies, the dollar will further strengthen against them.

Commodities are globally priced primarily in dollars. I just walked you through falling oil and steel prices and as those prices have fallen, dollars have essentially been disappearing into thin air. By that I mean, imagine you have drilled an oil well or built a steel plant. When you did so, you forecasted a certain productive capacity that would result in a dollar value of sales based on an assumption of price. Falling prices have cut your expected sales enormously, meaning dollars you expected to have in your pocket will never show up. This means that your investors and/or creditors are not in the same position they expected to be – you don’t have the dollars you were expected to have, so no wonder there is an increased demand for dollars.

This brings us to the $9.5 trillion dollar carry trade which I’ve talked about before in the October 2014 issue, where I explained how the carry trade works, and again in August of this year. The higher the dollar goes, the greater the demand for dollars to pay back that dollar denominated debt. If we look at history, there are two main dollar bull markets. The first one was in the 1980s that only ended after the world’s central bankers got together in the Plaza Accord to weaken the dollar after it had risen about 100%. In the late 1990s, we experienced a second bull run which ended in the Asian Crisis after the dollar had appreciated about 50%. During both, the dollar experienced pullbacks, but never of more than 10%, which gives us a potential metric to mark this bull run. Today, we have the largest global carry trade ever seen, which makes the bigger picture look closer to the 1980s. Looking at the data, there is a material probability that the dollar strengthening process could start to accelerate again, which will put more downward pressure on commodity prices. I think being long the dollar and even owning longer-term bonds while either being short or just staying away from the commodity complex would be the wiser move here. (Hat tip to Raoul Pal of Real Vision Television for some of the research on the dollar bull runs.)

As for longer dated bonds, if the Fed continues to raise rates and the economy is in fact slowing and the rate hikes weaken the economy further, then growth expectations will slow which will cause longer-dated bond yields to drop and bond prices to rise. If the Fed continues to raise short-term rates, an inverted yield curve, (in which short-term rates are higher than long-term rates) is possible, which would be very damaging for banks as they borrow short-term and lend long term. If the dollar continues its rally, demand for bonds will rise as well, which will push up bond prices and push down bond yields. Bond prices could however get hit if the Fed hikes, but hikes much more than is expected, which given the reasonably dovish commentary Wednesday, currently seems unlikely.

Bottom Line: We are in unchartered territory in many areas; higher levels of sovereign debt than during the financial crisis, a bigger U.S. dollar carry trade than the world has ever seen, more excess reserves at the federal reserve than ever before, tectonic shifts in global economic power and rising political tensions throughout much of the world coupled with challenging demographic trends, (aging populations) in the U.S., Europe, China and Japan while many emerging economies are blessed with a much lower median age in their populations. Never before in the modern era of high-yield bonds has the Fed hiked rates when the high-yield bond spread was greater than 6.25%; today it is 7%. Over the next decade the “it” places to invest are likely to be economies that were previously not on many investors’ radars. We are likely to face some challenging times, but those inevitably lead to wonderful opportunities. 2016 will probably give us some