Category Archives: Weekly Wrap

Fundamentals Go Out the Window

Fundamentals Go Out the Window

Macro Economic and Geopolitical Forces Continue to Dominate the Market

WEEK OF JULY 16-20 AT A GLANCE:

  • Macro and geopolitics are becoming the primary market drivers.

  • Markets are wobbly as trade wars intensify with the major equity indices basically flat for the week as of Thursday’s close. Friday morning futures in the red after Trump declares he’s ready to put tariffs on $505 billion of Chinese goods imported into the US.

  • Mixed bag on economic data:

    • A big headline number on retail sales, but core retail sales declined in June.

    • Real average hourly earnings have barely moved this year.

    • Inflationary pressures continue to rise.

    • Manufacturing strong today, but signs of weakness as we look 6+ months out.

  • If Trump succeeds in this trade battle, the big risk in the markets could be to the upside.

Markets

As of Thursday’s close, the markets were little changed over the week even as the trade wars intensified with Trump threatening to raise the stakes to over $500 billion of Chinese imports. While small-cap stocks were the big performers for most of the second quarter — with the Russell 2000 up as much as 11.6% for the quarter through June 20th, (well ahead of the S&P 500’s 4.8% move and even the 10.2% one for the Nasdaq) —we’ve  a change in the market leadership since that date as the S&P 500 has outperformed as of Thursday’s close, gaining 1.3% versus the Russell 2000 losing -0.3%.

Last year the retail sector was one of the weakest performers, as the SPDR S&P Retail ETF gained just 2.5% on the year.

Since the start of the second quarter, as international trade tensions have risen, creating a headwind to global sales, and yet retail has been the strongest performer, gaining 14.3%, outpacing even technology, which is up just +10.9% in comparison.

So far, of the 69 companies in the S&P 500 that have reported earnings for the June quarter, 30 mentioned tariffs as a concern in their earnings call and 41 mentioned foreign exchange rates. With the US Dollar Index (DXY) up 6% in the past three months, that is a material headwind to international sales. One factor driving the dollar higher has been the Fed’s rate hikes, which makes shorter-term US bonds more attractive to international investors because they pay a higher rate than non-US bonds and can provide an extra return if the dollar continues to appreciate relative to their domestic currency.

The yield curve . . . ah yes, the yield curve . . . continues to shrink with the 10-year 2-year spread down to 0.24 basis points versus 125 at the end of 2016 and the 30-year 5-year spread down to 22 from a post-financial crisis peak of 302 in November 2010 as short-term rates rise significantly and longer-term rates remain subdued. The yield on the 3-month Treasury Bill over time illustrates just how much things have changed.

 

 

Three out of the last four times we’ve seen such rapid changes have preceded recessions, typically by a couple of quarters.

 

 

Keep in mind, however, that these indicators are not great for timing and even if we follow historical norms in terms of timing, we are a few quarters away from any recessionary dips. So let’s look at the economic data. Also too, despite assurances from Larry Kudlow that he doesn’t see any recession at the forefront until AT LEAST 2024, I’ll continue to watch the data, which is a nice segue to talk about…

 

The Economy

We continue to see inflationary pressures as the Producer Price Index (PPI) from the Bureau of Labor Statistics this week showed core PPI (including trade services) reaching its highest level since 2011. The primary drivers were transportation and energy – not a surprise there, given what we are seeing in oil markets, the desperate search for truck drivers and a shortage of trucks as evidenced by robust monthly new truck order data. The one rather surprising area of deceleration on a year-over-year basis was health care.

Manufacturing still looks solid today, but we are seeing reasons for concern in the coming months. The Empire Manufacturing Composite declined in June, but less than expected. New Orders and Shipments declined, with Shipments particularly weak but more concerning is the cliff dive of Capex plans for 6 months ahead. This is in contrast to data out of the Richmond, Kansas City and Dallas Federal reserves, so we aren’t getting overly concerned, but this fits along with the rising uncertainty generated by the trade wars. We’ll be watching for more confirming data points.

While Empire Manufacturing was rather dour, the June Industrial Production data beat expectations, rising +0.6% month-over-month versus expectations for a +0.5% increase. That said, May was revised down significantly from -0.1% to -0.5%, leaving us with an overall picture that is weaker than expected. The major gains for the IP data came from an increase of +7.8% in the motor vehicle and parts category that was the aftermath of a temporary disruption in parts supplies – not a trend.

Wednesday, we had a big miss on housing data, with US housing starts falling 12.3% in June to a nine-month low, making for the biggest percentage decline since November 2016 and the biggest relative to expectations since January 2007.  Every region experienced a decline, so this isn’t about a regional weather condition. The year-over-year trend is back down to -4.2% with single-family construction falling -9.1% in June – its worst in 2018 and multifamily starts fell -20%.

Things aren’t looking like they will get better in housing in the near-term either as building permits fell -2.2% in June, having declined for three consecutive months and for four of the past five. Mortgage applications also declined last week, down 2.5%. The NAHB housing market index was unchanged in July, matching expectations and while it remains at an elevated level of 68 by historical standards, it has been slowly eroding from the cycle high of 74 in December 2017 and is today slightly weaker than back in December 2016. The present sales index component from NAHB echoed this trend, below the expansion peak of 80 from December 2017 to sit unchanged from June at 74. The forward-looking six months out sales index hit a 10-month low of 73 in July, after having declined in 4 of the past 5 months – again indicated that Q3 is unlikely to be an improvement over Q2. The Conference Board’s measure of homebuying intentions in May and June were the weakest in over two years and the University of Michigan’s home purchase plans index fell to the lowest level since December 2008.

For all the headlines about retail sales — which rose +0.5% in June after a +1.3% gain the prior month — core retail sales, which exclude the more volatile sales at gas stations, restaurants and bars, has been declining.

 

Which fits with the reality that despite the talk we are hearing about wage pressures, real average hourly earnings, which take inflation into account, have yet to take off. And yes dear reader, despite all the chin wagging over the June retails sales report the underlying data confirms our Middle-class Squeeze investment theme here at Tematica.

 

 

The Fed’s balance sheet normalization process, which started in November has reached the planned plateau of rolling off $50 billion per month. Tuesday Chair Powell spoke to the Senate Banking Committee and in his prepared testimony stated that the FOMC, “believes that for now, the best way forward is to keep gradually raising.” Gave himself quite a bit of wiggle room there with the “for now,” didn’t he?

Powell also commented that, “We’ve heard a rising chorus of concern, which now begins to speak of actual capex plans being put on ice for the time being,” in response to trade war concerns.

President Trump weighed in on the Federal Reserve’s actions this week on a CNBC interview stating that, “Because we go up and every time you go up, they want to raise rates again. I don’t really—I am not happy about it. But at the same time I’m letting them do what they feel is best….I don’t like all of this work that we’re putting into the economy and then I see rates going up.”

 

The Bottom Line for the Week

We are firmly in a macro and geopolitical dominated market. For now, businesses and the market are becoming increasingly nervous about the President’s ongoing trade battles and conflicting comments out of the summit with Putin. This is a headwind to capex investment and puts investors in a cautionary mode. If he manages to actually succeed here with improving the terms of trade for the US and if his talks with China end up giving them more control over North Korea, effectively greatly reducing the nuclear threat there, the major market risk would be to the upside.

Next week we will get more on the housing sector with June’s New Home and Existing Home Sales reports, along with the second quarterFHFA Housing Price Index, and the MBA Mortgage Applications Index. We’ll also get more on the state of the manufacturing sector with the Durable Goods report and most importantly, the first read on second-quarter GDP will be released next Friday. We’ll also see just how all this trade war talk is affecting consumers with the Michigan Sentiment Index.

 

Facing Reduced Market Visibility

Facing Reduced Market Visibility

 

  • While equity markets resumed their upward trend this week, with most of the major indices up over the past five days, trade and tariff tensions came to a boil exiting the week.
  • Bond markets are less confident as the yield curve continues to flatten.
  • The lack of available talent continues to be a headwind to the economy, yet wage growth is still less than would be expected given the unemployment rate.
  • While the data coming in still shows a strong domestic economy, we are seeing signs and concerns the trade war could exacerbate an already slowing global economy.

The Markets

It was a short trading week with below average volume thanks to the mid-week Independence Day holiday and fairly light as well for economic data. Monday all the major indices closed in the green with technology and utilities the strongest sectors. What? Yep, the Technology Select Sector SPDR ETF (XLK) rose +0.89% and the Utilities Select Sector SPDR ETF (XLU) rose +0.71% —  talk about an odd couple.

Tuesday the markets opened again in the green, but then fell throughout the day with the Russell 2000 closing in negative territory. After having been hit hard on Monday, the Energy ETF (XLE) led the sectors, gaining +0.63% after WTI crude briefly rose above $75 barrel. The Technology ETF (XLK) lost -1.2%, wiping out Monday’s gain, thanks in no small part to the ongoing drama with Facebook’s (FB) data sharing debacle.

Thursday equities were back in a bullish mood after Wednesday’s holiday, with small cap stocks continuing to outperform. The bond market was less optimistic as it reacted to the release of the Federal Reserve Open Market Committee minutes with a bearish further flattening of the yield curve. The spread between the 10-year Treasury yield and the 2-year is down to 0.30%, a level last seen in 2007. The FOMC minutes also reflected concern that trade policy could pose substation risks to growth, and this was before the President’s latest threat for new tariffs on an additional $500 billion of imports from China.

… many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponedas a result of uncertainty over trade policy. Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity.

Friday, tariffs on around $34 billion of Chinese imports kicked in and China began implementing its own retaliatory tariffs. The European Union is preparing a new list of tariffs on approximately $21.1 billion in imports from the US. This is no longer a game of chicken and no one looks like they could be willing to back down.

Also on Friday, we also got the June nonfarm payroll report, which beat expectations for 195,000 new jobs, coming in at 213,000. The unemployment rate rose to 4% from 3.8% as the labor force participation rate rose by 0.2% with more people entering the workforce. Average hourly earnings rose 2.7%, below expectations for 2.8% increase. Payrolls were also revised up an additional 37,000 for April and May. In summary, jobs are plentiful, wage increases are still below historical norms for this level of unemployment yet companies are struggling with the lack of available talent.

If you are a regular reader of our work, you’ve no doubt seen either me or my partner Chris Versace mention our concern that an awful lot of perfection is expected of corporate performance this year and heading into Q3. It was the focus of this week’s Cocktail Investing podcast. We are more cautious as the impact of the tax cuts and the increase in federal spending is likely to wane as we head into the back half of 2018 and we have not yet seen the impact of the escalating trade wars. As we head into the Q2 earnings season it is worth noting that, according to research from Bespoke Investment Management, going back to 2001, there have been more than 150,000 quarterly earnings reports with the average stock gaining +0.08% on its earnings reaction day. However, the Q2 earnings season is the only quarter where stocks typically average a decline of -0.09% on their earnings reaction day with stocks that beat EPS estimates gaining less than in the other three quarters and those that miss taking a bigger hit than in other quarters.

We chalk this up to the simple fact that June quarter reporting offers the first hard look at how companies see the back half of the year. As Chris and I talked on the podcast, the last several weeks have seen a growing number of risks and uncertainties that are likely to result in companies issuing more conservative guidance vs. expectations at the beginning of 2018. The issue is, despite these mounting risks, we have yet to see a meaningful nudge down in consensus EPS expectations for the S&P 500 in the back half of 2018.

 

The Economy

The big economic news of the week was all about employment. On Thursday, the ADP Employment report for June was a fairly material miss, with a gain of just 177,000 versus expectations for 190,000, driven primarily by companies being unable to find the right talent in the available labor pool. There are now more job openings that unemployed persons at a time when legal immigration is being reduced.

 

 

In fact, the level of voluntary quits as a percent of unemployed is at a level not seen since the dotcom boom.

 

Recall that the growth of an economy is the sum of the growth in the labor pool and the growth in productivity.

 

With productivity fairly stagnant, the lack of available labor is a significant headwind to rising GDP.

 

According to the National Federation of Independent Businesses Small Business Jobs Report,

“While near record high levels of owners are hiring or trying to hire, 83 percent of respondents reported few or no qualified applicants for the positions they were trying to fill. Twenty-three percent of owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem (up one point), the highest reading since 2000, and one point below the all-time survey high.”

 

This week, while the Markit June Manufacturing PMI declined modestly, the ISM Manufacturing Index for the US bounced in June, rising to 60.2 from last month’s 58.7, beating expectations and tying for the second highest reading of the current expansion. The Institute for Supply Management (ISM) noted in this month’s release that, “the PMI® for June (60.2%) corresponds to a 5.2% increase in real gross domestic product (GDP) on an annualized basis.”  So there’s that!

I will point out though that the biggest increase in June relative to May came from Supplier Deliveries, which reached its highest level in over 14 years, and Imports with Backlog Orders seeing the biggest decline. Hmmmm – that big surge in delivery times is likely driven by the aforementioned tight labor market (drivers in short supply) and potentially some stockpiling efforts in response to all the trade war talk. In fact, if we removed the impact of the big jump in delivery times and the composite ends up nearly unchanged month-over-month.

I’m not liking that drop in backlogs as we look forward to Q3. On a positive note, the ISM Non-Manufacturing Index was stronger than expected at 59.1 versus expectations for 58.3. In contrast to the manufacturing index, new orders rose over the month, which is a positive sign for GDP.

Taking a wider economic view,  the global Markit Manufacturing PMI fell to an 11-month low in June with forward-looking new orders index declining further from the drop in May. The number of countries in expansion during June fell to 76%, an 18-month low. That synchronized global expansion looks to be a thing of the past.

The bottom line is the US economy continues to be one of the strongest in the developed world, which alongside the interest rate differentials and a central bank in tightening mode, is driving the US dollar higher which is a headwind to exports. The labor market is flashing warning signs and the unpredictable nature of the escalating trade wars means reduced visibility into the back half of 2018. We’ll be closely watching for trends in corporate guidance as we head into this next earnings season.

Next week, we’ll be taking a much need break as we recharge and prep for the onslaught of earnings to come in the later part of July and into August, so we’ll be back with the next edition of the Weekly Wrap in two weeks time.

 

 

 

 

Weekly Wrap: Navigating the Emerging New Market Dynamic

Weekly Wrap: Navigating the Emerging New Market Dynamic

 

As we close the final trading day of the week, month, quarter and half year, what may have been the most astounding event from this past week, outside of the rockin’ and rollin’ on Wall Street, was the elimination of the reigning world champion Germany from the World Cup, courtesy of South Korea – it isn’t just the markets that have been a wild ride!

 

The Markets — Tech Stocks Take a Beating

This week the trade-war-induced market turbulence continued, but with a new twist as technology stocks got pulled into the battle. Investors had previously treated tech stocks as relatively immune, (which we’ve argued was incorrect) from the trade tirades between China, Europe, the US and Canada, which had left the Dow Jones Industrials down -0.6% for 2018 at the start of the week, while the tech-heavy Nasdaq was up over 11%. That changed this week with President Trump’s move to bar Chinese ownership of U.S. companies and ban some technology exports to China.

Monday a tech-centric stock selloff left the S&P 500 to close at its lowest level in June, down -1.4%, while the Nasdaq also closed down -2.1%, its worst day in nearly 2 months, and the Dow Jones Industrial Average fell -1.3%. The safety play returned with the Utilities sector gaining +1.7% while Consumer Discretionary slumped -2.2%. The talk of tech export bans and baring Chinese ownership of US Companies pushed tech stocks such as Micron Technology (MU) down -6.9%, Autodesk (ADSK) down -5.0% and Nvidia (NVDA) down -4.7%.

The flight to safety pushed the 10-year Treasury bond yield to 2.9%, its lowest since the end of May and commodities finished in the red as well, with copper making fresh 2018 lows, despite a weaker US Dollar, and the VIX jumped by 26% for its highest close since April. Chip manufacturers were also getting hit on talk of trade war, with companies like Applied Materials, Lam Research (LRCX), ASML Holding (ASML) and KLA-Tencor (KLAC) particularly vulnerable.

 

 

Monday a victim of our Clean Living investing theme made the headlines with the beleaguered Campbell Soup (CPB) gaining +9.4% on Monday on news that Kraft Heinz (KHC) is interested in acquiring it. CPB cut its earnings forecasts at least three times in the past 12 months, saw its CEO Denise Morrison abruptly retire and a strategic review kick off. Over the past year shares of CPB have fallen -21.2% while the S&P 500 has gained +11.4% – not exactly premium pricing at the moment. As consumers are becoming more and more focused on health-conscious products, CPB is looking at a long uphill battle to reinvent itself.

Tuesday the major indices recovered a wee bit (technical term), with the S&P 500 closing up +0.2%, the Russell 2000 outperformed again, closing up +0.7% and the Nasdaq sat in the middle, up +0.4%. Volatility rose as well, with the VIX closing up +3.0%. China’s Shanghai Composite continued to fall on the tit-for-tat trade war barbs.

Wednesday started off with the Dow leading a strong rally. By late morning it was up 286 points, but once again trade war talk sucked much of the enthusiasm out of the markets as White House economic advisor Larry Kudlow gave an interview on Fox Business.

“I believe that China is operating from a greater position of weakness than folks think. We are operating from a great position of economic strength.”   – Larry Kudlow on Fox Business in the 11am ET hour

The Dow fell 453 points from the day’s peak, ultimately closing the day down 166 points, (-0.7%) to close below both its 50-day and 200-day moving averages. The S&P 500 lost -0.9% to close below its 50-day moving average and the Nasdaq lost -1.3% on rising volume. Semiconductors were the hardest hit within tech given their exposure to China, losing -1.3%. Nine of eleven sectors closed in the red, with just energy and utilities closing in positive territory. The US Dollar closed at a 52-week high and the 10-year Treasury yield fell 5 bps to 2.82%, the lowest level in a month.

Thursday each of the major indices managed to close in the green, with the Nasdaq up +0.8%, the S&P 500 up +0.6% and the Dow up +0.4%. Year-to-date as of Thursday’s close the S&P 500 is fairly flat, up +1.6% while the tech-heavy Nasdaq is up +8.7% but the Dow is down, losing 2.0%.

As of Thursday’s US market close, the MSCI World index is now below its 50-day, 100-day and 200-day moving average and down -7.5% from its January 2018 high. The spread between the 10-year and the 2-year Treasury rate is 31 basis points, versus 50 at the start of the year, 129 at the end of 2016 and 266 at the end of 2013 – talk about flattening!

US Dollar continues to strengthen which, coupled with the Fed raising interest rates on top of increased protectionism, is leading to tighter financial conditions.

 

 

The widening rate differentials, (differences in interest rates) between the US and other countries provides a strong tailwind to a strengthening dollar as international investors can look to benefit from not only higher interest rates in the US, but potentially currency appreciation as well.

  • The Chinese yuan has been falling since mid-April, falling -3.7% and dropping to its lowest level since early January.
  • The Indian rupee has hit a record low against the dollar according to Bloomberg pricing data going back to January 3, 1973. So far this year the rupee has declined by -7.4% versus the dollar.

 

The Economy — Disconnect Between Expectations and Reality Continues

The final revision of Q1 GDP was revised down to just +2.0% from +2.2%, partially due to weaker-than-expected consumer spending. Q2 expectations are all over the map from even the Federal Reserve itself, with the Atlanta Fed’s GDPNow forecasting +4.5% while the NY Fed Nowcast is at +2.9%.

This week the Case-Shiller 20-City Composite Home Price Index showed that year-over-year price appreciation is slowing. The index rose 6.6% versus expectations for 6.8%. This is likely driven by two factors: mortgage rates that have risen to their highest level in around four years and slowing wage growth.

Home prices cannot continue to rise 6% – 7% a year when wage growth is less than half of that, which we see as fostering weaker demand in keeping with our Middle-Class Squeeze investing theme,  as we discussed in last week’s Weekly Wrap. This week we also received Pending Home Sales from the National Association of Realtors, which saw sales slow for the fifth consecutive month, falling -0.5% from April and -2.8% year-over-year.  The share price of Lending Tree (TREE), which derived 45% percent of revenue from mortgage products in 2017 has fallen a whopping 47.8% from its January high after having returned +235.9%, +13.52% and +84.7% in 2017, 2016 and 2015 respectively, revealing an awful lot about what going on with mortgages. And for those not following closely, there is the fact that homebuilding stocks are down more than 20% from their highs.

Last week we also discussed the disconnect between the Philadelphia Fed manufacturing index which fell to a nineteen-month low and the Empire State factory index which hit an eight-month high. This week the Richmond Fed regional manufacturing index came in stronger than expected at 20 versus expectations for 15. Still below its high of 30 during this business cycle, but a strong result. More importantly, the New Orders Index came in quite strong, rising from +16 to +22. The report found that prices paid has risen to the highest level in six years, which also appeared in the Philly Fed non-manufacturing report, with those costs being passed on to their customers – more signs of inflation that should keep the Fed on its path to higher interest rates. The main drivers of rising costs have been construction materials and fuel/shipping. While manufacturing overall is looking strong, the rising dollar and the ongoing trade wars are sources of concern as the last time the dollar had a strong rally in 2015, US manufacturing sector experienced a recession.

In contrast, the data Durable Goods Orders was a disappointment, with New Orders and Shipment (ex-aircraft) slowing further. The expectation going into that report was that with a tighter labor market, higher capacity utilization rates and tax reform, we would see a significant increase in capital expenditures – so far nothing too exciting happening here. This could be trade-related, or perhaps they aren’t quite as confident about the coming years as the headlines and tweets emanating from Washington would have one believe.

In contemplating trade, let’s remember the United States remains more insulated from a trade shock than other countries as exports represent just 12% of US GDP. That’s the lowest share among the 35 members of the Organization for Economic Cooperation and Development (OECD), a group of industrialized countries. In contrast, trade represents 31% of Canadian GDP, 37% for Mexico and 44% in the European Union.

But here’s the thing — about $440 billion of US corporate profits are generated abroad, which translates into about 20% of earnings. These tariffs could easily have an impact on jobs in the US in areas ranging from the largest American producer of nails to domestic whiskey distillers, lobster dealers and even to cranberry and peanut farmers.

 

Pulling the US back to the tariffs rates we experience in the 1970s would likely mean the Federal Reserve may have to rethink its economic forecasts.

“Changes in trade policy could cause us to have to question the outlook.”

The Fed chairman, Jerome H. Powell at a European Central Bank conference in Portugal, June 20th, 2018

And here’s a great example of what I’m talking about — the US imports almost half of its consumption in the auto industry and currently has no spare capacity. Estimates published by the Peterson Group found that if these 25% tariffs are imposed, automotive industry production would be cut by 5% which would mean a 4% reduction in employment in the sector. This would mean overall lower vehicle sales and significantly higher prices – essentially the dynamics that we are seeing in new home sales.

While consumer confidence and expectations for the future, as measured by the Conference Board Consumer Confidence Index, remain near multi-year highs, both have been rather stagnant over the past year and may be rolling over. We’ve also seen a disconnect between expectations and consumption. Digging into the details on the latest report from the Conference Board, the expectations component fell to the lowest level of 2018 and experienced the sharpest pullback since December. Expectations for where business conditions would be between in six months dropped to the lowest level since September 2017.

Friday morning the Bureau of Economic Analysis reported on Personal Income and Outlays for May, which saw the Personal Consumption Expenditures (PCE) index rise +2.3% in the 12 months through May – the biggest gain in over six years. The core PCE Index, the Fed’s preferred inflation metric, rose +2.0% on an annual basis after gaining +1.8% in April. Consumer spending, on the other hand, was unchanged in May, when adjusted for inflation, after having increased 0.3% in April. Personal income growth matched expectations, rising 0.4% after gaining +0.2% in the prior month and the savings rate rose to +3.2% from +3.0% in April, potentially a sign that households are a bit less confident about their finances.

And then there is this — the Citibank Economic Surprise Index (CESI) has finally dropped into negative territory, having experienced a run of 188 trading days of positive readings – the longest such streak by 37 days in the 15-year history of the index. There have only been five other streaks of 100+ days in the history of the index. This index tracks the rate that US economic indicators come in better or worse than estimates over a rolling 3-month period. When indicators are better than expected, the CESI is in positive territory and when indicators disappoint, it is negative. The fact that it has rolled over makes intuitive sense given the goldilocks expectations at the start of 2018 that haven’t quite been met by reality, which we’ve frequently discussed here. Bespoke Investment Management found that following the end of a 100+ day streak of positive CESI readings, the S&P 500 has averaged -0.3% and -0.8% returns for the next one and three months respectively. Six months later, returns were back in positive territory, up +2.9%on average.

The impact of our Disruptive Technology and Digital Lifestyle investing themes was evident in the first half of 2018, despite the trade war talk, as global M&A deals reached a record-setting $2.5 trillion, driven by a wave of megadeals led by US media and telecoms who are facing a powerful tide of digital disruptors. Volumes for the first six months of 2018 are 65% above the same period last year and the most, on a nominal basis, since Thomson Reuters started tracking the data in 1980. A record 35 deals were inked over $10 billion and another record 79 deals were closed above $5 billion. Disney (DIS) and Comcast (CMCSA) are in an intense bidding war for 21st Century Fox (FOX) and European broadcaster Sky as the two contend with increasing competition from Amazon (AMZN), which is part of Tematica’s Aging of the Population, Cleaning Living, Digital Lifestyle, Digital Infrastructure and Disruptive Technology investing themes, not to mention Alphabet (GOOGL) and Netflix (NFLX), which are both members of Tematica’s Digital Lifestyle theme.

 

Bottom Line — Realities of a New Market Dynamics

This is the final trading week of the month, the quarter and the half year, so the negative action we have seen likely indicates that portfolio managers are in a less bullish mood. With half of the companies in the S&P 500 in official correction mode, they have good reason to be concerned. We’ve now gone 106 trading days without the S&P 500 making a new high and volatility is on average nearly 50% higher in 2018 than in 2017 – this is a new market dynamic.

With an arguably overheating labor market, tightening monetary policy, a flattening yield curve and signs that economic activity is rolling over, we are (using historical norms) probably 18 to 24 months away from a recession. The recent tax cuts and higher government spending are likely to boost economic growth in the near term, but as fiscal stimulus fades and financial conditions continue to tighten, growth will face more headwinds.

This time really is different, as since WWII, the US government typically increased spending during downturns to soften the blows and pulled back during periods of low unemployment and improved growth. This time we are getting stimulus at a time when unemployment is at multi-decade lows – that’s new. We’ve also never had this level of debt in the world, nor have the world’s major central bankers ever engaged in such a coordinated effort to suppress interest rates and will be, by the end of this year, reversing the flow of liquidity.

Investors face the risk of stronger-than-expected economic growth as well as an overheating economy that is only made more complex by trade tensions that threaten to reduce global trade to where it was 4 to 5 decades ago on top of unprecedented monetary policy on a global level. Because we are in unchartered territory, investors need to be more flexible and disciplined, especially compared to the 13-month period following the 2016 presidential election.

 

Weekly Wrap: The bond market isn’t buying the booming economy narrative

Weekly Wrap: The bond market isn’t buying the booming economy narrative

 

 

This week was again all about the trade war heating up between China and the US as well as internal political tensions as the Senate voted to reinstate the ban on ZTE sales, a clear challenge to President Trump. That led to a spike in CBOE S&P 500 Volatility Index (VIX) futures early in the week with the index up over 20% in the past five trading days as of Thursday’s close.

 

The Markets

With the exception of the Russell 2000, the major equity market indices have all declined over the past week. On Tuesday the Dow Jones Industrial Average moved into the red for the year and by Thursday’s close was down 1% from the start of the year. Conversely, the small cap Russell 2000 and the Nasdaq Composite were both up over 11% for 2018 as of Thursday’s close, with the S&P 500 lagging well behind at up 2.9%. The Russell 2000 index reached a new high Wednesday. The story here has been tech and a shift towards domestically focused, small cap as the global trade war heats up and the dollar strengthens. The chart below shows just how powerful the tech sector has become with 7 of the 10 biggest stocks in the world tech-based.

 

If we dig into the details, the underlying market dynamics are very telling. The median stock (ex-tech) is down 5% from the late January peak and down 40 basis points year-to-date. Nearly 70% of the S&P 500 is trading below their late January peaks and around half of the S&P 500 is 10% below their 52-week highs. The S&P 500 has not made a new high in almost 5 months and the forward P/E has compressed from 20x to just over 17x. This suggests to us here at Tematica that confidence in robust earnings expectations is waning as trade war and tariffs escalate.

While the headlines tell us that the economy is booming and expectations for Q2 GDP growth are well over 4%, the bond market isn’t buying it with the 10-year U.S. Treasury yield, (a proxy for longer-term GDP growth expectations) remaining stubbornly below 3% while GDP estimates are being revised up. Talk about a disconnect. Q2 GDP is still looking like it will be pretty solid, but according to FactSet, corporate earnings growth has already peaked.

 

 

While the Fed is expecting that it will hike rates four times this year, we are seeing the yield curve continue to flatten as short-term rates rise, but the longer-term rates remain low. The 1-month Treasury bill yield hit a multi-year high this week, bringing the spread between it and the S&P 500 dividend yield down near zero for the first time in 10 years. The spread between the 30-year Treasury yield and the 5-year Treasury yield is down to a level not seen since 2007.

 

 

Stepping outside the domestic market, emerging markets are down about 17% this year, as measured by the MSCI Emerging Markets iShares ETF (EEM) versus a 4% loss for foreign developed markets, as measured by the SPDR® Portfolio Developed World ex-US ETF (SPDW). The EEM is down to its lowest level in nine months and is trading below its 200-day moving average with its 50-day below its 200-day – not looking so good as the dollar continues to strengthen and that dollar carry-trade is being forcefully unwound.

The escalating trade war has been a major headwind to commodities linked to trade between the U.S. and China. For example, soybeans, high-protein wheat, cotton and industrial metals in the U.S. saw significant price declines this week.  The Bloomberg Agricultural Index has hit its lowest level in years. Shares of Industrial companies have likewise taken a beating as trade tension rise. So far the trade war has led to tariffs on steel and aluminum as of June 1st. On July 6thadditional tariffs of 25% are to be imposed on 818 products from China amounting to $34 billion in goods with another $16 billion planned after a public hearing period, for a total of $50 billion. If China retaliates, President Trump has pledged to impose tariffs on an additional $200 billion of imports from China into the US by September/October. Threats have also been tossed out concerning 20% tariffs on European cars and auto parts.

All this helps explain the gap up in the VIX I mentioned at the outset of this week’s Weekly Wrap. As we all know, uncertainty is not a friend of investors or the stock market.

 

The Economy

It was a relatively light week for economic data but what we received was a mixed bag with fresh signs that consumer buying power is not keeping pace with the mounting inflationary pressures. Sad to say but that confirms our Middle-Class Squeeze investing theme. Now for the specifics…

The Philadelphia Fed Manufacturing Index fell to a 19-month low in June, down to 19.9 versus 34.4 in May and expectations for 28. The biggest source of the drop came from new-orders index, which dropped by almost 23 points to 17.9. Expectations for activity in the next six months dropped for the third consecutive month. In contrast, the Empire State Factory Index from last week had hit an eight-month high of 25 in June, up from 20.1 in May and beating expectations for 18.8. The really good news in this report came from New Orders which rose significantly during the month. Mixed messages here so we’ll be looking to next week’s reports from the Richmond and Dallas Feds for more insight.

Housing Starts hit the highest level in years in May, but that may be misleading as the reading was elevated from weather-induced delays in April. Residential building permits have been slowing, with new permits coming in below expectations. On the other hand, multi-family housing construction remains strong. Existing home sales have stalled out and inventory of existing homes for sale is at multi-year lows for this time of year.

Yes, we are seeing some wage pressures, but they aren’t accelerating nor are they translating into better take-home pay thanks to inflationary pressures.

 

 

 

Putting It All Together

Portions of the US equity markets continue to be in correction mode in the near-term but remain within their longer-term upward trends. The strong dollar and trade wars have pushed small cap stocks to outperform. Overall corporate guidance remains strong, outside of those most immediately affected by the trade wars, i.e. industrials. The domestic economy remains strong and employment is robust. While there are signs of rising inflation, they remain fairly muted by historical standards. Investor sentiment is not overly bullish and while the economy is likely slowing, we see no imminent signs of a recession.

Global growth is decidedly slowing, and we have record high levels of debt around the world. The cost of capital for corporations is now higher than the return on capital at a time when we have record level corporate debt in a rising rate environment with mid-term elections right around the corner amidst a presidency facing increasing resistance, even from within the Republican party – that was a mouthful even for me! Keep in mind too that corporate cash net of corporate debt securities and loans has fallen to a new all-time low of -$6.4 trillion, (more than 1/3rdof GDP). That rising rate environment is particularly concerning when we look at the total of Federal, State and Local Government; Corporate; Mortgage; and Personal Interest Payments that has hit a record $1.8 trillion at a seasonally adjusted annual rate. These payments are just $100 billion less than Total US Corporate Profits and greater than the total of all individual tax receipts in the US – rate hikes matter people!

 

Looking Ahead

Next week we’ll get the Chicago Fed National Activity Index for May, after having seen little change in economic growth in April. We’ll also get more on housing with New Home Sales for May, the S&P/Case-Shiller Home Price Indices for April Pending Home Sales for May.

We’ll also get the Richmond Fed Manufacturing Index and the Dallas Fed Manufacturing Business Index, which we’ll be looking at for more insight into the impact of the trade wars and for clarification, as mentioned earlier, from this week’s conflicting manufacturing reports. Later in the week, we’ll get May’s Wholesale Inventories and Durable Goods Orders. Friday we’ll see Personal Consumption Expenditures for May, along with Personal Income and Personal Spending to give us insight into the consumer.

Next week also closes out the month of June and 2Q 2018. Over the coming days, we’ll begin to hear from companies reporting their latest quarterly results and those comments will set the stage for the ensuing onslaught of reports to come. On the docket next week are homebuilders Lennar (LEN) and KB Home (KBH), food companies General Mills (GIS:NYSE) and ConAgra (CAG:NYSE), Sonic (SONC:Nasdaq) and Rite Aid (RAD:NYSE). Two of the higher profile reports will be Nike (NKE:NYSE) and Constellation Brands (STZ:NYSE).

Across all of these reports, team Tematica will be listening for factors driving revenue but also costs. In the March quarter earnings, many investors were caught off guard by rising costs that included freight and transportation as well as various commodities. With more signs of inflation cropping up over the last few months, we’ll be looking to hear from companies on their abilities to absorb those costs as well as expectations for price increases to offset them. Along those lines, this weekend’s OPEC meeting will be one to watch closely as upsized oil production levels from the OPEC countries is likely to lead to lower oil and gas prices. We’ll also be tuning into trade and tariff comments to be had as well next week, assessing how the market may need to re-adjust its expectations for the back half of 2018.

Have a great weekend!

 

 

 

WEEKLY WRAP: Goldilocks expectations are meeting up against some tough realities

WEEKLY WRAP: Goldilocks expectations are meeting up against some tough realities

 

This week it was all about the politics and the market wasn’t too keen on what transpired, despite some positive surprises on the economy. Wednesday’s FOMC meeting announcement and Fed Chairman Powell’s press conference led to the major indices reversing earlier gains to close at the day’s lows. Friday’s announcement from Trump on China tariffs had the markets in the red from the start. The Goldilocks expectations heading into 2018 are meeting up against some tough realities that so far have kept the markets rangebound as we wonder, “Is the best behind us?”

 

The Markets

Monday all the major indices closed in the green and the Dow Transports rose to the highest level since January versus the Dow Utilities, which fell to the lowest level in four months thanks to rising bond yields and investor moving portfolios away from defensive bond proxies. In fact, the ratio of Dow Transports to Dow Utilities has just broken out to a new record high. The strength in transports is typically a bullish sign for equity indices. Tuesday the Dow Jones Industrial Average closed down one point, but the S&P 500 managed to notch its eighth close in positive territory out of the past nine as the Nasdaq and Russell 2000 also closed in the green.

On Wednesday we learned that the Federal Reserve expects to hike four times in 2018, as opposed to the three hikes discussed in prior meetings, and Chairman Powell’s press conference gave the market heartburn with the Dow Jones falling in the final hour to close at a 119 point loss. Only two sectors were able to hang onto gains in light of the FOMC decision, Consumer Discretionary Select SPDR (XLY) +0.15% and Healthcare Select SPDR (XLV) +0.02%. Real Estate dropped over 2.3% and telecoms were hit hard by the fallout from the merger approval for AT&T (T) and Time Warner (TWX), a move that highlights one of the drivers behind our Digital Lifestyle investment theme.

Thursday the markets resumed their upward trend, helped in part by strong Retail Sales report. The Consumer Discretionary ETF (XLY) has, as of Thursday’s close, posted gains for every trading day in June and closed above its open every single day. It looks like much of the strength here is coming from the retail sector, with the Retail SDPR ETF (XRT) utterly dominating since the start of the month, outperforming the broader S&P 500 by nearly 4%.

Thursday the European Central Bank (ECB) announced that it would further taper asset purchases from €30 billion/month to €15 billion/month with purchases ceasing in 2019, but it will continue to reinvest redemptions. The euro fell against the USD by the most in one day since Brexit given that no rate change is planned until the end of the summer in 2019, much further out than the markets had priced. Global bond markets rallied in the wake of the decision.

Friday the major equity indices opened in the red after we learned that President Trump intends to impose 25% tariffs on $50 billion in imports from China, who quickly vowed to respond with, “equal scale and equal strength.” Bond markets rallied across the board despite the recent boost to Q2 GDP expectations on fears that this latest trade tantrum may lead to all-out trade wars. Last week the AAII Bullish sentiment index rose to a four-month high of 44.8% from 38.9% the prior week, the escalation in trade war talk could reverse that.

Taking a step back and looking at the bigger picture of the stock market over time we can see that the ratio of cyclical to non-cyclical sector stocks in the S&P 500 has reached a 40-year high, yet another indication that we are in the later stages of this expansion. If we look at the spread between the ratio of just Consumer Discretionary and Consumer Staples stocks, it is at a record high going back to 1990, with the prior record having been set at the end of the 1990s with the dot-com boom. The record low was in 2009, one of the best times to have gone seriously long the major equity indices.

We are also seeing the relative strength of S&P 500 Growth over S&P 500 Value at near record highs, the only other time in history that growth has so significantly outperformed value was during the dotcom boom. In fact, according to research by Bespoke Investment Group, going back to 1995 there were only 43 trading days scattered between February and July 2000 where the S&P 500 Value Index was underperforming the S&P 500 Growth Index by a wider margin – that’s less than 1% of all occurrences.

 

 

Economy

Tuesday the National Federation of Independent Businesses (NFIB) released its May report which found small business optimism rising to the second highest level in the 50-year history of the survey. The NFIB President, Juanita Duggan noted in the report that, “Main Street optimism is on a stratospheric trajectory thanks to recent tax cuts and regulatory changes.” However, Labor Quality once again topped the list of issues facing small businesses with the 23% of business owners reporting it their most important problem, the second highest level on record and a level not seen since late 2000. While taxes and red tape continue to be cited as a problem and come in at number two on the list of biggest problems, over time Labor Quality has become increasingly more worrisome.

 

 

This week’s report on the Consumer Price Index (CPI) delivered right on expectations for both Core and Headline, rising 0.2% month-over-month. The Producer Price Index data showed increased momentum in year-over-year price increases facing businesses. Both headline and core indices came in above estimates, while core ex-trade services was slightly below. Total and goods-only year-over-year increases are both up to the highest levels since 2011.

Retail sales for May surprised to the upside this week, rising +0.8 from April, doubling expectations. Ex-autos, gasoline and building materials, sales rose +0.5% versus the +0.4% expected. 10 of the 13 subcategories saw an increase and department stores had their best month in 18 months, up +1.5%. Year-over-year brick and mortar is experiencing its best run-rate in 13 years, which had led to the S&P 500 Retailers to be up +9% so far this year.

The biggest concerns for the week came from the Federal Reserve’s Open Market Committee decision to raise rates four times in 2018 and the ending of the one-month trade truce with China as President Trump announced 25% tariffs on some $50 billion in Chinese imports. Another list of $100 billion of trade actions is apparently also being pulled together.

I’d like to review a few of Chairman Powell’s comments during his press conference. I discussed my take on his assertions earlier this week on Cheddar and TD Ameritrade.

  • Powell claimed that households are in great shape.
  • Powell asserted that that economy is strengthening thanks to increased business investments, expanding economies outside the US and strong labor market.
    • Business investments don’t look that strong to me.
      • By my read the data here is mixed. Core Capex orders have risen at a 1.2% annual rate year-to-date, which is well below the 20%+ pace we had last September.
      • Regional Fed survey data of capex intentions are above historical standards but down to an 8-month low and have been declining for 3 consecutive months.
      • Instead, companies have been engaging in buybacks and paying dividends, on pace to total almost $1T in the 12 months ending March! Good news for investors, but not the economy.
    • Outside the US growth is slowing. May’s global manufacturing PMIs revealed that just 36% of countries saw their PMIs rise sequentially during the month and only 26% had a reading above their 6-month moving average. This is the worst reading in the past 3 years.
  • He said he is not concerned with credit risk but does believe asset prices are elevated. I strongly agree. The financial asset share of total household assets remains near a historical record high of over 70%. The only other times we’ve seen such levels were in the late 60s and late 90s, right before equity markets became quite challenging.

As for the initiation of trade hostilities with China on Friday, this is going to get messy. First off, President Trump has a good basis for wanting to take action. About 70% of the software in use in China today, valued at nearly $8.7 billion, is pirated and China is the source of 87% of the counterfeit goods seized upon entry into the United States. That being said, these tariffs are technically illegal under the very international laws we helped to establish under the World Trade Organization. Where an international dispute falls within the scope of coverage of the WTO treaty, and this does, taking unilateral action without first going to the WTO for a legal ruling on whether there is a violation is itself a violation of the treaty. The United States is not permitted by the international rules to which it has long since agreed to be both judge and jury for its own complaint. Like I said, this is going to get messy.

 

The bottom line for the week

While the US economy is looking stronger, I am concerned that the factors behind where we are seeing strength are not long-term in nature. Add to that a global environment in which we are seeing a reduction in the pace of central bank supplied liquidity, rising rates within the US, slowing growth outside of the US, an incredibly tight US labor market, and the potential kick off of global trade wars.  That leaves me with the question, “Is the best behind us?”

 

 

Weekly Wrap for June 8 2018

Weekly Wrap for June 8 2018

The Market

Most of the major US indices gained over the past week as did almost all sectors as of mid-day trading on Friday, with the exception of the Utilities sector, which lost around 3%. The economic data for the week came in mostly positive, but further reinforced the view that we are late in the business cycle. Things are heating up once again on the geopolitical front, which by the end of the week had investors back on the defensive.

Consumer stocks led the market on Monday, with the Consumer Discretionary ETF (XLY) and the Consumer Staples ETF (XLP) gaining 1.12% and 0.83% respectively. The Nasdaq closed above 7,600 for the first time in its history, having previously peaked at the opening on March 13th at 7627.52 – notch one up for the bulls.

Internet stocks have been particularly strong with the Dow Jones US Internet Index rising more than 100 points since testing its 20-day exponential moving average just one week ago. The index moved into overbought territory Monday with its RSI (Relative Strength Indicator) going above 70. Monday also saw strength in Retailers as the Down Jones US Apparel Retailers Index gained 2.74% and is also overbought with its RSI above 75 as of Monday’s close.

Tuesday the Nasdaq set another record high record close as tech stocks continued on their tear, likely fueled by the, I would argue questionable, belief that they are relatively insulated from trade wars compared to say industrials which are clearly facing strengthening headwinds as tariff talk tempers flare.

Wednesday the Nasdaq once again closed with a new all-time high and the Dow Jones Industrial Average gained 1.4% to move above 25,000, closing at its highest level since mid-March. Materials and Financials were the strongest performing sectors with the 10-year Treasury yield rising to 2.98%.

Thursday, the Dow Jones Industrial Average gained 0.6% thanks primarily to McDonald’s (MCD), which gained 4.4% on news that of more layoffs intended to reduce its corporate structure and make the company more nimble and competitive. Only on Wall Street are layoffs considered good news. The Nasdaq, after four consecutive days of gains and three of record closes, fell 0.7% thanks to widespread loses in tech after U.S. Senator Mark Warner, vice chairman of the Intelligence Committee, said he’s looking for answers from Alphabet (GOOGL) and Twitter (TWTR) on whether the companies have any data sharing agreements with Chinese vendors. That of course came after Facebook (FB) disclosed it had done just that. The pain continued for Facebook as it also disclosed that as many as 14 million of its users may have had their private posts shared publicly thanks to a software glitch. Wait, you mean things posted on the internet don’t necessarily remain private? Shocking.

By Friday the risk-on momentum faded as renewed problems in Italy, Brazil and South Africa as well as rising international trade war verbal battles dampened investor confidence. We’ve seen this waning confidence also manifest itself in the reduction of the enormous net speculative long position of 42,192 S&P 500 option contracts as of April 24thto just 27,606 – the lowest level since mid-March.

The strengthening dollar trend, which has been a solid tailwind for small cap stocks, has taken a breather of late. The Amex Dollar Index (DXY) declined from its May 29thpeak of 94.83 to close Thursday at 93.45. As a point of reference, the index started the year at 92.30 and bottomed at 88.62 on February 15th.  We’ll be watching this to see if it is a short-term consolidating pull-back or if the strengthening greenback trend is reversing.

 

The Economy

As we learned this week, global Manufacturing PMI has hit a 10-month low, primarily from a loss of momentum across Developed Markets. The Orders-to-Inventories ratio indicates that this is likely to continue as it has dropped to its lowest level in 11 months. The globally synchronized growth story is taking a further beating. While the US manufacturing PMI is near its highest level in over 40 months, the Eurozone is at a 15-month low. That being said, most countries are still seeing expansion – above the all-important 50 line in these reports – just not as many as the roughly 90% of them that we saw around the start of the year. It is important to not only look at levels, but also the changing vector and velocity and how it syncs with the prevailing narrative.

As more countries are slowing, we are also seeing rising cost pressures. Globally output prices have hit a 7-year high as have supplier delivery times. This is a headwind to margins, which we have discussed here frequently, that is likely to be made worse with the growing trade wars. Another area of rising costs is in the US labor market, which is seriously tight. For those with a college degree, the unemployment rate is down to just 2.0%. Joblessness in the leisure and hospitality sector has hit a record low of less than 5% while the financial sector unemployment rate has dropped from 8% earlier in the recovery to a near all-time low of 1.7%.

For those who get a bit irritated at my rather dour sounding assessment of the job market – I know you are out there — a tight labor market is fantastic for job seekers, but not so great for the overall equity market as below average unemployment historically has meant rising labor costs which hurt margins. We have equities priced richly in an environment in which multiple cost categories are on the way up. The S&P 500 is on track to close this week at roughly 17.3x expected 2018 earnings vs. the 2002-2017 average of 16.8 – we should expect to see more people come out of the woodwork and sharing their view the domestic stock market is or is quickly approaching fair value.

This week the JOLTS report (Job Openings and Labor Turnover Survey), a personal favorite, was released by the Bureau of Labor Statistics and it reinforced the view of a problematically tight labor market. The level of job openings reached a new record high of 6.7 million in April versus the number of unemployed, which stands at just 6.1 million. So not only do we have a tight labor market, which is getting tighter, but we have a material disconnect between the jobs employers need to fill and the skillset of those still on the sidelines of this economy. The labor tightness is evident in the cycle-high quit rate of 2.3%. Keep in mind that as the voluntary quit rate rises, wage growth follows with about a 90% correlation at a 6-month lag. If that doesn’t convince you that businesses will be paying more in the future, there are over 1.1 million more job openings than there were hires, something wholly unprecedented in recorded history.

The labor tightness is evident in the cycle-high quit rate of 2.3%. Keep in mind that as the voluntary quit rate rises, wage growth follows with about a 90% correlation at a 6-month lag. If that doesn’t convince you that businesses will be paying more in the future, there are over 1.1 million more job openings than there were hires, something wholly unprecedented in recorded history.

 

We have a near record high 23% of those polled by the National Federation of Independent Businesses reporting that labor quality is their top concern. It is no wonder they feel this way given that according to the Bureau of Labor Statistics, total compensation for all civilian workers in all industries and occupations saw the biggest 12-month percent change in the first quarter of 2018 since the third quarter of 2008.

May ISM Non-manufacturing Index rose to 58.6 in May from 56.8 in April, beating expectations for 57.6. Digging into the details we saw some positives as well as some reasons for concern. On the positive side, Business Activity rose to a 3-month high alongside strengthening in New Orders and Employment. We are concerned however to see that over 50% of the gain in the overall index came from a surge in Supplier Delivery Delays, this sub-index now at the highest level since November 2005, and Order Backlogs rose to an all-time high. When delivery times get stretched and backlogs rise, we typically see higher prices. We can add another one to the inflation side of the ledger and in this report as the Prices Index is now at its highest level since September 2012.

Putting it all together, those who regularly read my musing know how frequently I repeat what ought to be, (in my somewhat humble and occasionally annoyed opinion when reading the news) a daily mantra for all who work in or with government –

The growth of an economy is the sum of the growth in the labor pool and the growth in productivity.

  • We have productivity levels that are quite low by historical norms.
  • We have an aging population with the largest demographic heading into if not already in retirement.
  • We have demand for labor that exceeds the supply by a record margin.
  • We have rising labor costs thanks to a tight labor market amidst an environment in which we see rising costs across a wide range of areas from transportation to material input costs with tariffs set to exacerbate that problem in an equity market that is richly priced.

I love to see solid employment and rising demand as a member of society but am less excited as a long-term investor when that unemployment hits record lows.

 

Turning to the Week Ahead

The upcoming big events will likely be the G7 Summit in Canada June 8-9, the meeting between North Korea and the President, and the Federal Reserve’s FOMC meeting, which begins on Tuesday. We’ll get the National Association of Independent Business Optimism Index report on Tuesday as well, (we’ll be looking for more data on the labor market) along with the Consumer Price Index. Wednesday brings the FOMC Meeting Announcement and Chair Powell’s press conference. We’ll be looking to see the committee’s stance, if they offer any, on the risks presented by all this tariff talk and their assessment of rising costs. Thursday brings the Retail Sales report which we will assess in light of a near record low household savings rate, rising credit card balances and rising subprime auto default rates. Thursday also brings Business Inventories and Import/Export Prices, which we will evaluate with respect to, among other factors, the strengthening dollar. Friday we’ll receive Industrial Production, Consumer Sentiment and the market will experience the Quadruple Witching of options expirations which includes stock market index futures, stock market index options, stock options and single stock futures – likely making for a more volatile day and higher trading volumes than we’d otherwise experience.

 

Weekly Wrap: Only a Little Left in This Expansion

Weekly Wrap: Only a Little Left in This Expansion

 

With the Memorial Day holiday, there were just four trading days this week and what a ride they were. Tuesday began with an Italian political crisis as the coalition between Italy’s far-left Five Star Movement and far-right League fell apart. The yield on the Italian 2-year bond rose all the way from (-0.1%) on May 12th to over +2.8% during the kerfuffle, but by Friday had dropped back to just over 1.04%.

To be fair, given that Italy has had 68 governments since the end of World War II with an average duration of less than 15 months, the phrase Italian political crisis is arguably redundant. Tuesday the nation was without a Prime Minister and set to return to the polls, but by Friday morning the odd couple coalition had mended fences with one another and along with the President of the Republic, had restored the on again off again Prime Minister Conte and even agreed upon an Economic Minister – the role that had begun the entire drama.

With Italy having the third largest economy in the eurozone and eighth largest in the world alongside the second largest debt to GDP ratio, (bested only by Japan) its drama, filled with anti-euro sentiment, has the potential for far-reaching impact. Those involved may have temporarily kissed and made-up, but the economy and its political system is still a mess with no clear path to successful reform. This drama is on the backburner for now but is far from over.

By Tuesday’s close, stocks around the world had sold off sharply and the AMEX Dollar Index had risen over 7% from its mid-February lows as investors pulled away from risk assets. The euro fell to its lowest level in 10 months and the yield on the 10-year Treasury, having risen as high as 3.12% on May 17th fell to as low as 2.76% during Tuesday’s trading and closed Thursday at 2.88%, surprising the hell out of many of those bond bears who had loudly proclaimed that once the yield broke 3%, it would never look back.

The concerns in Europe and the impact of the rising dollar on emerging markets has led to the return of US equity outperformance versus the rest of the world, as can be seen on the chart below, (hat tip to Martin Pring) which shows the relative performance of the SPDR S&P 500 ETF (SPY) to the Vangard FTSE All-World ex-US ETF (VEU).

 

 

This week the Dow Jones Industrial Average bounced off its 50-day moving average after having dropped to a three-week low on Tuesday.  Financial stocks in the US were hit harder than most all other sectors on Tuesday, primarily due to contagion fears from eurozone banks. The Financial SPDR ETF (XLF) tested support along its 200-day moving average but managed to remain above its 50-day.

Wednesday the markets saw strong recoveries with a modest pullback again on Thursday while Friday opened up strong again thanks to a stronger than expected jobs report and recovering European stocks. That being said, the number of stocks in the S&P 500 making new highs has not gone above 50 (10%) since mid-March, reflecting a lack of leadership. On the other end of the spectrum, with the strengthening dollar, the S&P Small-Cap 600 has had more than 60 (10%) new highs several times this month. Technology stocks also fared better in this week’s rousting with the Nasdaq 100 ETF (QQQ) remaining in its overall uptrend.

Things outside the US aren’t looking so great, which is likely to keep US equities outperforming as we are seeing capacity utilization rates in Asia rolling over along with slowing export growth. Emerging market equities are down around 10% as the dollar continues to strengthen, which is increasing the burden on a region with an $11 trillion debt overhang, nearly twice the $5 trillion load in 2011.

On the US economic front, GDP for the first quarter was revised down slightly to 2.2% from 2.3% with consumption at just 1.0% versus 1.1% but non-residential investment strengthened to 9.2% from 6.1%. To the north, Canada’s first quarter GDP came in at just +1.3% versus expectations for 1.8% and the prior quarter’s 1.7%. Thursday’s US personal income report was mostly in-line with expectation, up 0.3% in April, but March saw a downward revision to 0.2% from 0.3%.

The big news for the week came with Friday’s job report which saw the headline payroll number hit 223k, well above the expected 190k. There was also an upward revision of 15k to the prior two months. Even retailers added 31k to their ranks, despite the headwinds facing our Cash-Strapped Consumer with a savings rate of just 2.8%, near the lowest on record.

The headline U3 unemployment rate declined to 3.76% from 3.93%. The last time the unemployment rate was this low was in December 1969, with a recession just starting. While we love to see people getting jobs, a rate this low means there is little left in this expansion. We are today fractionally below the Fed’s forecasted 3.8% unemployment rate for the end of 2018 and well below its estimate for a sustainable unemployment rate at 4.5%. On top of that, the core Personal Consumption Expenditure index is up 2.3% year-to-date, which is well above the Fed’s 2% target.

The Fed is going to have to raise rates at the next meeting and the likelihood of more rate hikes than the market is expecting continues to increase. Average hourly earnings rose more than expected at 0.3% month-over-month to push the annualized rate to 2.7% from 2.6%. From a historical norms perspective, this is still pretty weak, but for this expansion, that is really heating up. For the over 80% of the economy in the nonsupervisory production category, the annualized rate has increased to 2.8% from 2.6% with the annualized three-month rate up to 3.6%. Ladies and gentlemen, we have wage growth! Businesses will be facing margin pressure from both rising labor costs and high borrowing costs as the Fed continues is hikes.

The bottom line for the week is that we have near record low unemployment and savings rate, so just where is the accelerating spending going to come from as businesses face shrinking margins with such a tight labor market? The increase in wages isn’t going to be sufficient with rising prices, particularly as more tariffs are likely to add to higher prices. Something to think about.

Next week we’ll be looking out for the JOLTS report to get more insight into the labor market, the ISM Non-Manufacturing Index and with such a low savings rate, we’ll be paying particular attention to the report on Consumer Credit on the 7th. Have a great week!

 

 

Weekly Wrap: Don’t Count Those Geopolitical Wins Too Early

Weekly Wrap: Don’t Count Those Geopolitical Wins Too Early

 

This week the markets lost the vigor from last week as investors learned to not only to count on those geopolitical wins too early in the game but to expect the negotiation flip-flopping to continue, bringing uncertainty along for the ride.

 

Markets

Monday the markets were in a jovial mood after the weekend’s indications that the trade war between the US and China had been given a stay of execution, though as of Monday’s close, it remained to be seen if Treasury Secretary Mnuchin’s declaration of a cease-fire would get the support of the rest of the administration. That trade relief mood led the S&P 500 to gain over 0.7% and the Russell 2000 gained 1.3% on the day.

Tuesday things took a decided turn for the worst as once again, in this era of instant news and policy by tweet, the stories of China and the US resolving the trade dispute around Chinese company ZTE Corp, (who had previously been fined $1.2 billion under the Obama administration and was banned from sourcing chips and other parts from the US for 7 years) were more rumor than fact.  On top of that, the Senate Banking Committee passed an amendment by 23 to 2 to limit the president’s ability to remove sanctions on Chinese telecom companies – we talked about this and much more on this week’s Cocktail Investing Podcast. I’m thinking some senators might have voted themselves off a certain someone’s Christmas card list. As for that meeting with North Korea, by the latter part of the week, it was off the table too, but by this morning Trump shared the two are once again talking and the June 12 summit could be a go.

Not to be outdone in this era of political instability, Italian politics have proved to once again be a fantastic source of reality TV style drama. Giuseppe Conte, a little-known attorney and law professor, who was nominated by Luigi Di Maio of the Five-Star Movement and the League’s Matteo Salvini to be Italy’s next prime minister saw his chances take a serious blow as it appears his 12-page curriculum vitae may be a tad overstated. In it, he claims to have studied at some of the world’s most prestigious universities, including New York University, which have since stated they have no record of his attendance. Another report from an Italian journalist based in Germany found that Conte’s claim to have studied law at the International Kultur Institute in Vienna in 1993 seems unlikely given it is a language school. In the end, it turns out Italian President Sergio Mattarella was just fine with the creative license and approved the populist candidate’s nominee.

Aside from the entertainment value, why should investors care about this circus?

Italy is a critical member of the European Union. Its economy is 10-times the size of Greece’s – it matters. Its public debt is the largest in the eurozone at €2.3 trillion and the fourth largest in the world. Non-residents held nearly €700 billion of Italian government bonds at the end of last year and the Italian central bank owes the Bundesbank €443 billion. The bottom line is this — Italy’s debt makes it at once too big to fail and in reality, too big to save.

Italy’s economic growth since the eurozone was launched has been weaker than that of Greece and the Italians are more than a little angry that the rest of the major European powers have no interest in being involved in Italy’s immigration crisis. Pick up a map and you’ll get a feel for just how bad it is in the nation. Italy’s unemployment rate stands at 11%, compared to Germany’s at 3.4%and France’s at 9.2%. The youth unemployment rate is a shocking 31.7%, which is a serious headwind to the country’s future. This is a nation in desperate need of massive reform in which voters are becoming increasingly angry over the continual broken promises from everyone they elect.

Many Italians blame the European union for their suffering and they now have two parties with wildly differing ideology in some sort of bizarre union with a prime minister who has absolutely no experience or qualifications that would indicate he just may be up to this monumental challenge. This is a crisis on low heat on the back burner, but one that could flash to a boiling point, thus warranting our continual monitoring. We’ll be pulling the curtain back on this more with next week’s Episode 63 of the Cocktail Investing Podcast, but in our view, the iShares MSCI Italy Capped ETF shares, which are now down nearly 11% from its January highs, aptly reflect these concerns.

By Thursday’s close, the major indices were mostly flat for the week. The S&P had gained 0.6%, the Russell 2000 0.1%, the Nasdaq 1.0% and the Russell 1000 0.5% from the prior Friday’s close. The best performing sector over the prior 5 days has been Utilities, with the Utilities elect Sector SPDR ETF gaining 2.6%. The weakest sector has been energy, falling 2.0%.

 

Economy

Last week we mentioned rising freight costs could become a material headwind for margins and that we would be keeping an eye on this sector. Monday the monthly report by Cass Freight revealed that the overall slowing we’ve seen internationally is occurring domestically as well. The report found that shipments, seasonally adjusted three-month over prior three-month annualized, have slowed from a more than 20% growth rate to around 10%. Pricing has also fallen. Linehaul prices were rising around 12% early in the year but are now down to up roughly 6% on an annualized basis. So far shipping data remains strong on an absolute basis, but directionally we see material signs of slowing.

On the positive side, the Kansas City Fed Manufacturing Index surprised to the upside, joining the other factory surveys that have recently delivered positive surprises. The composite index rose to the highest reading in the history of the survey. Putting all five manufacturing surveys together, we should see a solid upturn in the ISM Manufacturing PMI this month. Digging into the details though, the KC Fed report indicated that there are rising concerns of higher costs and a meager pool of available labor which means margin compression in the future. That echoes similar comments from other reports we’ve received over the last several weeks.

New home sales were weak in April, rising just 1.5% month-over-month at a 662k annual rate, versus 672k annual rate in March, which was also revised down from a prior 694k pace. Digging into the detail, things look grim. Sales of completed homes fell 15% to 210k units, which is the slowest since August 2017. Sales of homes that are currently under construction fell 5.3% to a four-month low of 231k. For all the talk of home prices, the median new home price declined 6.9% month-over-month, the steepest decline since May 2016 and the fourth decline in the prior five months. The year-over-year price increase has slowed from 10.5% in February to 4.3% in March to 0.4% as of April and the share of homes priced below $300k rose to a thirteen-month high of 47% from 41% in March.

Existing home sales fell 2.5% during the month of April and are now 1.4% below the level from this time last year. This is likely impacted by the fact that 30-year mortgage rates have risen to their highest level since September 2013 and have been on the rise for seven consecutive months amidst home prices that are up 5.3% year-over-year, grossly outpacing income growth. Which leads us to Residential mortgage lending, which was rising at 4.6% annual rate toward the end of the first quarter but over the last four weeks has declined at a 5.4% annual rate.

Once again, the data does not sync with the narrative of an accelerating economy. Over the past four week, US commercial bank lending growth to businesses and households slowed to a 1.8% annual rate from over 7% at the end of March. Commercial and Industrial lending growth has slowed to 2.6% annual rate from the 17.4% pace at the end of March while consumer auto loans have actually contracted 2.3% over the past four weeks and consumer credit card balances are rising at a 3% annual rate.

Reports from the retail sector didn’t exactly point to a consumer whose wallet is full. Walmart (WMT) reported this week that its online sales in the US rose 33.0% during its most recent quarter, compared to just 23% in the prior quarter but below the over 50% growth it enjoyed in online during each of last year’s quarters. Total revenue and adjusted EPS both beat analyst estimates. On the other end of the spectrum, store traffic in the US rose a meager 0.8%, the weakest rate in over a year. J.C. Penny (JCP) reported disappointing same-store sales and cut its full-year guidance – same for Target (TGT), Lowe’s (LOW) and Home Depot (HD). Perhaps this is in part due to the reality that even though consumer sentiment is high, according to the Federal Reserve Report on the Economic Well-Being of U.S. Households in 2017, 40% of adults would not be able to cover an unexpected $400 expense, this at a time when the unemployment rate is 3.9%. Despite having no appreciable savings, 74% of adults reported that they were either doing okay or living comfortably in 2017. That noise you hear all of us here at team Tematica scratching our heads as we digest the implications of that.

The bottom line for the week is that while manufacturing has been strong, the lack of available talent in the labor pool and rising transportation costs are a headwind to margins. Despite an exceptionally low unemployment rate, most adults have little in the way of savings, which means when we do hit those economic bumps in the road, most don’t have a safety net upon which they can rely. Consumers may report feeling pretty good, but their piggy banks aren’t sharing their enthusiasm.

Next week we have a shortened trading week thanks to Memorial Day holiday on Monday. During the week we’ll be looking for the S&P Corelogic Case-Shiller Home Price Index, Consumer Confidence, The Dallas Fed Manufacturing Survey, Retail and Wholesale Inventories, Personal Income and Outlays, the PMI Manufacturing Index and the ISM Manufacturing Index. We’ll also be keeping an eye out on all those geopolitical dramas.

Have a great week!

 

 

 

Weekly Wrap: With This Market, the Devil is in the Details

Weekly Wrap: With This Market, the Devil is in the Details

 

 

The Market: Within Eyeshot of Its Lower High

This week the yield of the 10-year Treasury reached over 3.12%, a level not seen since 2011 and the 2-year rose over 2.5%, to levels last seen in 2008. The spread between the 2-year (2.573%) and the 30-year Treasury yield (3.246%) remains near multi-year lows. With the market pricing in a more than 50% likelihood of three additional 25 basis point rate hikes by the end of the year, up from 33% just a month ago, the potential for an inverted yield curve in 2018 is a material possibility. Looking at the charts for the 10-year, the next potential upside targets are around 3.75% and 4.0%, the peaks formed from 2011 to 2010.

The rising yields are a headwind to rate sensitive sectors such as real estate and utilities, causing the iShares US Real Estate ETF (IYR) to fall -3.5% over the prior five trading days as of Thursday close and the Dow Jones All Equity All REIT Index (REI) lost 3.0%. The Utilities Select Sector SPDR ETF (XLU) was the second worst performer, down -2.6%. While the rate sensitive shares were punished, growth stocks were back in fashion as the iShares Nasdaq Biotechnology ETF (IBB) gained 3.7% for the week, followed by the Energy Select Sector SPDR (XLE), up 2.8%.

Rising rates have seen the dollar continue to strengthen with the Amex Dollar Index (DXY) up 5.7%, (as of mid-day Friday) since its mid-February lows. This has helped small cap stocks, whose revenue is primarily domestic, outperform the large cap S&P 500, that generates roughly 60% of revenue internationally, by 5.56% since the DXY bottomed out. In fact, the S&P 500 SmallCap iShares ETF (IJR) has been the only major index ETF to record a 52-week high in May and has the strongest breadth indicators. Over the prior 5 trading days as of Thursday’s close, the Russell 2000 has continued to outperform, gaining 0.6% while the S&P 500 lost 0.1%, and the Nasdaq lost 0.3%.

Despite the lack of material progress over the last week, the S&P 500 has been able to move into the top of its downtrend channel and is within striking distance of its first “lower high” at 2,787 it reached after the correction began on January 26th, (a lower high refers to an interim peak within a downward slide). Breadth levels are improving with five cyclical sectors outperforming the overall S&P 500. That being said, according to the 10-day Advance/Decline line, the S&P 500 is slightly in overbought territory, which means more sideways moves are likely in store for a bit before any meaningful gains.

 

The Economy: Distilling the Mixed Signals Its Giving Us

While the stock market looks like it still has legs, the economy continues to give mixed signals, some improving and some degrading. Our view is that the longer-term indicators are flashing warnings signs, but we don’t see, barring any kind of geopolitical lunacy, material threats within the next quarter or two.

 

The Consumer

Retail sales for April rose 0.3%, matching consensus estimates, after a 0.8% increase in March that was stronger than initially reported. February’s numbers were also revised up from flat to an increase of 0.1%.  Nine out of thirteen major retail categories showed increases, with Gasoline Stations gaining the most year-over-year, up 11.7%, up for nine consecutive months, marking the longest streak of gains since May 2011. Non-store retailers – such as our posterchild for thematic investing, Amazon (AMZN) – coming in second place with 9.6% year-over-year gains. Since the end of the recession in June 2009, no other sector has seen more consistent growth in month-over-month sales than the non-store sector, gaining in 74% of all months. Not a surprise, given the accelerating shift by consumers to digital shopping. At the current pace, non-store’s share will likely overtake general merchandise category within a year. The three categories that have seen year-over-year loses are Department Stores, down -1.6%; Sporting Goods, hobby, books & music stores down -1.1%; and Health and Personal Care down -0.5%, all of which are victims of the shift to digital shopping. Just look at Amazon’s expanding Prime offering…

The chart below, which depicts the 3-month moving average for retail sales, shows that sales have definitely been improving over the past few years, but remain below the longer-term, pre-2008 average. In fact, retails sales have spent most of this second-to-longest economic growth period below that longer-term average, a testament to just how weak the recovery has been – difficult to get strong spending growth when households have too much debt relative to income and wage growth is tepid at best.

 

 

For consumer spending to increase, household incomes need to increase and/or household borrowing needs to increase. Despite the increasingly tight labor market, wage growth has actually been slowing recently. The following charts show that both overall average wage growth for usually full-time and the average wage growth for the prime working age population has been slowing.

 

 

 

Other indicators for wage growth have been more positive, so this is something we will continue to keep a close eye on. The May 2018 Lending Tree Consumer Debt Outlook revealed that while incomes have been rising, household debt has been rising faster. Total outstanding consumer debt is now at a record high as 26.2% of disposable personal income.

 

 

Thursday, we got the New York Fed’s quarter recap of consumer debt levels which found that student loans continue to grow as a share of total consumer debt, now up to 10.7% of the total, a record high, while mortgage debt has bottomed out, having hit a record low of 67.4% in Q4 2016 and is now up to 67.7%. Mortgage delinquencies remain quite low, a good sign for household health, as the current to 90+ day delinquent transition rates continue to sit near the lowest levels on record. Conversely, delinquencies for auto loans continue to rise with the share of loans 90+ days delinquent up to 4.3%, the highest since Q1 2012 and not too much below the post-recession peak of 5.3% in Q4 2010.

On top of slowing wage growth and record high household debt levels, rising oil prices are taking more of household wallet share in the form of higher gas prices. Tematica’s Chief Investment Officer noted $2.96 per gallon was had as he traveled down the I-95 corridor. Put all three together and it is unlikely that we will see sustained acceleration in retail sales (ex-gasoline) growth rates.

Housing starts for April were weaker than expected, falling -3.7% versus 0.7% forecast, with the bulk of the decline attributed to the volatile multi-family component. The prior month was revised up to +3.6% from +1.9%, which makes the miss less painful. Digging into the details, single unit starts have gained very little since last October, rising just 1.4% (annualized) over that time which is right near stall speed. Permits were also weak, down -1.8%, which was better than the expected -2.1% decline.

 

Business

Businesses are facing rising costs from a variety of areas outside of impact of rising oil prices as surging trucking rates are squeezing margins. Coca-Cola (KO) recently reported a 20% year-over-year increase in freight expense. Procter & Gamble (PG), Hasbro, Inc. (HAS), Danone SA (DANOY), and Nestle SA (NSRGY) also reported higher transportation costs and Unilever PLC (UN) expects high single digit to high-teens increases in U.S. freight costs in the coming quarters. Universal Logistics Holding (ULH) reported a 12.7% increase in rates per mile on a year-over-year basis and demand continues to outpace supply.  We see this driving further year over year growth in new heavy-duty truck orders, and thereby confirming the investment decision to add Paccar (PCAR) shares to the Tematica Investing Select List several months ago.

This week’s Empire Manufacturing report on activity in the New York Fed’s district headline index came in better than expected and found that prices paid hit their highest level since March 2011 – more margin pressure and the latest in a string of rising inflation data.  The Philly Fed Manufacturing report also came in at 34.4, better than versus the expected 21.0 and last month’s 23.2. This was the 18thconsecutive month that the headline index has come in above 20, which was never happened before as the prior record stood at 17 months. In addition, breadth was relatively strong with six categories rising and just three declining. The biggest gain came from New Orders with the biggest decline in Price Paid, in contrast to the Empire report.

Industrial production came in slightly above expectations, rising 0.7% in April versus the 0.6% forecast. March’s gain was also revised up by 0.2% as well. The business equipment category saw a +1.2% increase, the biggest so far this year. Business supplies also rose 0.4% as did construction supplies, up 0.3% and materials, up 0.5%.

 

The Bottom Line

The impact of tax reform may be kicking in as we see signs of increased investing. The lack of talent to fill the extraordinary number of job openings is a material headwind to growth. The lack of wage gains despite the ultra-low unemployment rate tells us that the underlying dynamics of the labor market are different from past expansions. That is a topic we will be covering in the weeks ahead.

We remain concerned with the level of debt across all three components of the economy – government, corporate and households. Rates are rising and debt levels across the board are high which increases the risk of dramatic price movement, yet so many of those Baby Boomers heading into retirement have had to take on high levels of risk in their portfolios to boost returns. While true even in normal times, this is a market in which one must increasingly pay close attention to its underpinnings.

 

The Week Ahead: May 21-25

Coming up next week we will get the April New Home Sales and Existing Home Sales reports. This two reports will give us additional insight after the slower-than-expected sales reported by Home Depot (HD) this week. We will also get more data around the state of the consumer with quarterly results from Kohl’s (KSS), TJX (TJX), Ross Stores (ROST:), Big Lots (BIG), Target (TGT), Ralph Lauren (RL), Gap (GPS), Tiffany & Co. (TIF), and Williams Sonoma (WSM).

Next week we’ll also get the Richmond Fed and Kansas City Manufacturing Index reports to add more color to this week’s Empire and Philly and Industrial Production. Friday brings the Durable Goods report, which focuses mainly on higher-priced goods with an expected lifespan of three years or more, thus giving us insight into the confidence level of corporations and consumers with respect to the economy.

 

 

 

 

 

WEEKLY WRAP: Buying the Next Dip Might Not Be the Best Strategy

WEEKLY WRAP: Buying the Next Dip Might Not Be the Best Strategy

 

With the major portion of earnings season behind us, this week we are going to take a look at the vector and velocity of economic forces that will affect earnings in the coming quarters, but we first need to know where we are, before we can understand where we are likely to be heading. Much as they were for 1Q 2018, expectations for year over year earnings growth in the coming quarters is running rather high, but we are hearing more and more about rising costs and other inflationary pressures that could lead investor to revisit their profitability assumptions in the coming weeks and months.

In a typical business cycle, after a recession, the economy is saddled with excess capacity. Prices face serious downward pressure as supply is in excess of shrinking demand with households and corporations shifting away from consumption and expansion – most of the economy downshifts into survival mode. Capital expenditures are cut way back and monetary policy remains loose.

Midway through the cycle, the Fed shifts towards less accommodative monetary policy as the output gap closes with spare capacity shrinking and prices are no longer falling. Late in the cycle, there is typically no excess capacity with cost and price pressures rising. The Federal Reserve hikes rates, which either flattens or inverts the yield curve, creating debt service strains. Typically, the greatest pain is felt in those areas that benefitted most from the prior excesses in credit.

As we discussed on this week’s Cocktail Investing Podcast, at 107 months, we are now in the second longest economic expansion period in history, bested only by the dotcom boom-bust which lasted 120 months. For perspective, the average post-WWII expansion has lasted less than 60 months. This has also been the weakest growth period in U.S. history, averaging 2.1% GDP growth versus the prior eight expansion periods which averaged nearly twice that rate at 4.04%.

While this the second longest expansion in history, as the saying goes, no expansion ever died of old age. They die thanks to rate hikes and hello there, we are in a rate hike cycle with the most hawkish FOMC in years.

The real federal funds rate, (effective federal funds rate less core Personal Consumption Expenditure) has rarely ever been this low and we have never had the rate this low at this point in the economic cycle. This means that if the economy were to slide into a recession in the coming months, the Federal Reserve wouldn’t have nearly as much room for stimulus as is typical using its primary monetary policy tool, the funds rate. Remember that when considering why the Federal Reserve may be less-than-robust economic data, something we at Tematica have been talking about for some time.

The US federal government is also in a unique position, with annual budget deficits expected to be the largest ever outside of a recession or war. At the end of FY 2018, the gross US federal government debt is estimated to be $21.5 trillion, according to the Fiscal Year 2019 Federal Budget, putting debt as a percent of GDP close to 110% — a level also unprecedented outside of a war. About 50% of the US deficit last year was funded by foreign investors, but US foreign policy has been shifting toward a more “go it alone” strategy under the new administration. This raises concerns the US does not have lasting fidelity to international agreements it signs. This is a change to the playing field that could affect non-US interest in US government debt securities.

It isn’t just the government that is dealing with record levels of debt as we have a record high level of non-financial corporate debt as a percent of GDP of over 310%. The prior peak during the financial crisis reached a relatively paltry 271%.

We also have a record high 48% of investment grade corporate bonds rate BBB. That figure was at 30% just over ten years ago and at 25% in the 1990s. The net leverage ratio for those BBB borrowers is at a record 2.9x, well above the 1.7x level in 2000. In the coming years, we are going to see a significant amount of corporate credit coming due during a period of rising rates. By 2020, $1.92 trillion will have come due, with $2.92 trillion by 2021 and $4.0 trillion by 2022.

The Fed is raising rates as record levels of corporate credit will need to be rolled over during a period of rising budget deficits which means extra Treasury issuance in the context of increasing geopolitical tensions – talk about a quadruple whammy.

This week we also received the second quarter Federal Reserve’s Senior Loan Officer Survey which found Commercial and Industrial (C&I) lending standards at the easiest level since the first quarter of 2014 while at the same time, the net demand index has been falling from +2.9 (rising) to -7.0 (declining) for large firms and from +6.0 (rising) to -1.5 (declining) for smaller companies. Residential mortgage standards have been easing as well, the index falling from -3.0 (declining) to -3.6 (declining further) yet demand has declining from -15.0 to -17.6.

One area in which standards have been tightening has been in credit cards, which is no surprise given the increase in delinquencies and overall balances in recent quarters. Demand for the plastic has been falling from 0 to -9.6. Overall appetite for taking on new debt is declining in the private sector.

Despite easing lending standards, business loan demand has been weakening. Consumers aren’t looking to jack up their spending either via credit cards while rising rates and rising building costs are major headwinds to demand for mortgages.

We also have a record level of household net worth on an absolute basis, as a percent of personal disposable income and as a percent of GDP, this despite wage growth for the 82+% of the economy in the production and non-supervisory category that has been below average.

 

 

While wage growth remains low by historical standards, it is rising as the above chart shows and this month’s JOLTS report (Job Openings and Labor Turnover Survey) showed another record high in Job Openings at 6.55 million. The total available labor pool is around 10 million, yet we have that level of job openings while Hirings have been declining, down 86k in March after falling 63k in February – a sure indicator that companies are having a rough time finding the right person for the job. The decline in the level of Firings supports this, down 56k in March after falling 164k in February. More wage pressures are likely on the way.

The President’s decision to pull out of the Iranian nuclear accord means that the fifth largest oil producer in the world will see its sales sharply curtailed, putting upward pricing pressure on crude, which means upward pressures across the economy as energy is an input to pretty much everything. This comes at a time when businesses have already been facing higher input costs for everything from fuel to freight hauling and from raw materials such as steel and lumber to professional services.

Input prices have outstripped consumer prices since late 2016 and that trend looks to be accelerating. According to Wednesday’s data from the Labor Department, some pipeline costs are rising 2x to 3x the rate of consumer inflation. While the consumer price index is rising around 2.4%, intermediate prices for processed goods rose 4.7% in April (yoy) with transportation rising 6%, gasoline up 14.6% and steel mill products up 7.4%. Within transportation, costs for some refrigerated trucks hit 40-year highs last year, according to data from the US Agriculture Department. Tyson Foods (TSN), for example, estimated recently that rising freight costs will likely add an additional $250 million to its expenses. We suspect that investors are underestimating future margin pressures.

Companies are not only facing rising borrowing costs as the Fed hikes rates, but rising input costs ranging from wages to raw materials and services.

 

How Much Longer Can the Bulls Run?

Looking at the market, we are now 9.2 years into the current bull market with the total return to date for the S&P 500 about 350%. The average bull market, going back to 1926, has lasted 9.0 years with an average cumulative return of 474%. The charts below, which present the length and total returns for each bull and bear market going back to 1926, which the years of bear markets inverted, shows that this current bull market is not exceptional either in terms of length nor total returns.

 

 

 

What is remarkable is what investors are willing to pay for earnings in light of an economy that has been anything but robust by historical standards in the context of rising cost pressures with minimal pricing power. The 10-year cyclically adjusted PE ratio is at levels outpaced only during the dot-com mania.

 

Shiller PE Ratio

Shiller PE Ratio

Total US market capitalization as a percent of has also reached a new high as a percent of GDP, even outpacing the heady days of the dotcom boom.

 

 

Putting it all together we have a historically pricey market at a time when costs are rising — from wages to borrowing to inputs and service — all while the supply of debt is increasing and a major buyer, the Fed, is no longer adding to its balance sheet, but rather reducing it. On top of that this has been a market in which “Buy the dip” has been strongly rewarded while value investing has been pummeled. Attempts at risk management have also been mostly brutally punished and we have about 3 million working in financial services who have never experienced a bear market.

The bottom line is market dynamics have fundamentally changed in a way that will likely catch many market participants off guard after having learned lessons in this bull market that may be past their time. We are in the later stages of the economic cycle and the bull market, which means this is a great time to put together your shopping list of those companies benefiting from major thematic tailwinds along with target entry prices so that you are ready to act when opportunities present themselves.