Category Archives: Weekly Wrap

MAY 4 WEEKLY WRAP: The Tax Cut Narrative is Losing its Luster

MAY 4 WEEKLY WRAP: The Tax Cut Narrative is Losing its Luster

 

This week we are focused on rising interest rates and a strengthening dollar as the narrative of synchronized global growth fails; rising prices from tariffs, troubles in the oil markets and wage pressures; equity weakness despite earnings as investors become more bearish, fearing this is as good as it can get.

Markets

First, let’s recap the market’s moves for the week. Monday’s close marked the end of the first third of the year with the S&P 500 down -0.5% in the first four months of 2018, the Dow Jones Industrial Average down -1.8% and the Nasdaq 100 up +3.5% with the Russell 2000 small cap laden index up +0.80%. The strongest sector for the first four months was Consumer Discretionary, up +5.4% with the weakest Consumer Staples, down -10.8% – yet another hallmark of a late stage market. Only two other sectors closed the 4-month period in the black, Energy, up +2.9% and Technology, up +2.7%.  As we stepped into May, most every major US equity index was below its 50-day moving average, from the Dow (DIA) to S&P 500 mid-cap (IJH) to Russell 1000 (IWB) to Micro-Cap (IWC) to S&P 100 (OEF) and the Total Stock Market (VTI).

As of Friday’s close, the S&P 500 will not have made a new closing high since January 26th and its 50-day moving average is within 66 points (as of Thursday’s close) of closing below the 200-day moving average – the infamous “death cross,” having bounced off of it in an early morning plunge on Thursday. In the last bear market, we saw a death cross on December 21, 2007, which was 73 days after the market had peaked. The S&P 500 dividend yield has declined 36 basis points since February 2016 while the yield on the 2-year Treasury note has increased by 160 basis points – stocks are facing yield competition, TINA has left the building.

 

 

Rising Dollar

Wednesday the US Dollar Index (DXY) closed above its 200-day moving average for the first time in nearly a year, ending its seventh-longest streak of closes below that level dating back to 1971. The dollar is still down 6.6% over the past year, but we just may be seeing a turnaround in progress and the world is watching.

Around half of S&P 500 sales come from overseas, which makes a falling dollar a serious tailwind, but the reverse is also the case. Keep in mind too that transactions in US dollars account for almost three times more than those in euro and twenty times more than in yuan. It is the most widely used currency globally and growing in use. When it gets more expensive, it has a profound impact across the globe.

 

Earnings Fail to Impress

While more than 80% of companies have reported so far this season the average stock in the S&P 500 saw a move of +/-3.5% following the release of their company’s results, according to data from Goldman Sachs, well above the 2-year average of +/- 2.8%. While the results are rather impressive with respect to both top and bottom line results in terms of percent of companies beating expectations, shares are not feeling much love. This week’s AAII sentiment survey found bullish sentiment has fallen from 36.9% to 28.4%. Talk about a case of “What have you done for me lately?” In at least one earnings call this season we learned that analysts must work on not asking “boring” questions concerning such mundane topics as cash burn. Yep, that happened, and it sent Twitter a flutter… so much so that Elon Musk embarked on a tweet filled “guilty with an explanation” response that many have used when pulled over for a speeding ticket.

The sentiment trend has also been negative since the market peaked at close to 60% bullish earlier in the year. We are seeing lower bullish highs on the weeks that sentiment improves followed by weeks with even bigger declines. Investors are increasingly concerned that this is the best it is going to be, particularly when we see the economic data is failing to show accelerating growth as the prevailing narrative assured us we’d see post the tax cuts.

 

Economy

Let’s review just what the data is telling us about the economy. On Monday, the last day in April we received the Personal Income and Spending Report which includes the Personal Consumption Expenditure deflator, the Federal Reserve’s preferred inflation gauge, which rose by 2.0% year-over-year in March, which is the hottest reading in over a year, well above the post-recession average of 1.4% and above the Federal Reserve’s own year-end forecast of 1.9%. The core rate is 1.9%, which puts the 1.625% Fed funds rate in negative territory on a real basis. We’ve never had an economy in this position so late in the business cycle –  that’s right I said never. We’ve got rising inflation with a negative real fed funds rate when we sit at one of the longest expansions in history –I can’t imagine why anyone would be concerned (sarcasm).

Wages and Salaries on a year-over-year basis hit 4.5%, in the higher range of what we’ve seen during this expansion, while Real Personal Income was only 1.5% year-over-year, near the lower end of the spectrum since 2011. The annualized rolling 3-month rate of change in Real PCE Spending dropping to 1.06%, the lowest level since 2013 – not exactly in line with the narrative calling for a post-tax cut boost in consumer spending, but it’s right in line with our expectations here at Tematica given the consumer debt load. The 0.2% gain in wages and salary in March was utterly absorbed by higher prices – explains McDonald’s (MCD) better sales and profits performance now doesn’t it?

We also received significant manufacturing sector sentiment data. First, the Chicago PMI, which has the highest correlation to the ISM manufacturing, missed estimates for the third consecutive month, predicting a significant decline in the ISM Manufacturing PMI. Second, with the reporting on the Dallas Fed’s Manufacturing Index, we have all five regional Fed indices for the manufacturing sector and they reveal that the outlook continues to deteriorate across a wide range of categories. New orders, Shipments and Unfilled Orders have seen particularly painful declines, while Prices Received continuing to accelerate to the upside while the current index for Prices Paid declined. However, over the past year, the current Prices Paid has risen the most of any component in the index, seconded by the Prices Received component. Delivery times reached a new record high as we are seeing further capacity constraints in transportation with surging freight fees. Perhaps most concerning we saw the outlook for capital expenditures take a serious hit, which is decidedly counter to the narrative that the tax cuts would lead to an acceleration in such spending.

Tuesday the ISM Manufacturing report for April came in with the weakest headline reading since last July and the weakest relative to expectations since April 2017. To put that miss in context, the index was at its highest level since 2004 just two months ago, but this month’s report isn’t exactly supportive of an acceleration, which is what the prevailing tax cuts narrative expected. Production saw the biggest decline, falling from 61.0 to 57.2, with employment close behind with a decline to 54.2 from 57.3 to sit at its weakest level in nearly 18-months. Both Production and New Orders, down to 61.2 from 61.9, have declined four months in a row with New Orders at a 9-month low. Backlog Orders reached a 14-year high, while Prices Paid hit the highest level in 7 years – clearly backlog gets addressed with higher prices! The supply chain is under pressure, which is likely to result in higher prices paid by consumers, further eroding the historically weak rate of income growth.

The ISM Non-manufacturing Index was also weaker than the 58 expected, coming in at 56.8. New export orders accelerated, but backlog and employment slowed. The Employment component also saw a fairly large drop this month and is down significantly from its recent peak in January.

The latest data from the Census Bureau also showed the growth in capital goods orders and shipments has slowed. The narrative of post-tax cut capex acceleration is not coming to fruition, as I might add, we predicted. We argued that pre-tax cut cash levels on corporate balance sheets, thanks in part to a festival of debt issuance, was already sufficiently high to support additional capex, if that was desired.

As for the capex that has occurred, well it isn’t exactly getting the job done with productivity rising 0.7% in the first quarter while unit labor costs rose 2.7% – not a recipe for success. Overall this is looking more and more like a late stage market – real domestic final sales have slowed to a 2-year low while core consumer inflation is at a 7-year high and total labor compensation has hit a more than 10-year high. No wonder investors are skeptical.

The less than stellar results aren’t just in the US as Industrial output in the eurozone has contracted now for three consecutive months while Citigroup’s economic surprise index for the region has fallen from a euphoric peak in December to levels not seen since the depths of the EMU 2011 banking crisis. The British economy slowed to a near halt in the first quarter, part thanks to global conditions with part attributable to the Beast from the East, (lived it, don’t want to repeat it).

 

 

Strong Employment Driven by Small Biz

The headline print for the ADP Employment Reportfractionally beat expectations for 198k, coming in at 204k, but that modest beat was offset by the March revision to 228k from 241k. The headline number has been at least 200k for six consecutive months, a trend we haven’t seen in nearly four years. However, there were some warning signs with large company hiring getting weaker, and the same was found in the manufacturing and the industrial sector as well as transports and financials. The April strength came primarily from small-business services (less than 50 employees) which rose to a 4-month high and is solely responsible for the modest beat.

Ford truck sales report on Wednesday confirmed this strength in small business.Ford recently announced that it will stop producing most car models in the North American markets, instead focusing on SUVs and trucks, which are higher margin products. In April Ford sold 73,104 F-Series trucks, the best April for the F-Series since 2000 and the fourth best going back to 1996. The year-to-date sales for the F-Series is the third strongest going back to 1996, bested only by sales in 1999 and 2000. Trucks are most often purchased by small businesses and contractors, giving insight into the health of the small business sector.

 

Oil Prices

Oil prices have been rising due to a number of factors: production cuts by Opec and Russia, the implosion of the Maduro regime in Venezuela and fears that Trump will re-impose further sanctions on Iran which could reduce global supply by 700,000 barrels a day over the next 12-months. On the campaign Trump harshly criticized the 2015 nuclear deal with Iran, calling it the “worst deal ever.” On May 12thPresident Trump will be required to re-endorse the deal and it is looking increasingly unlikely that he will. Then again this is Trump, so predictability is not his strongest trait.

The current accord is the result of around 20 months of negotiations with signatories including the five permanent (and veto carrying) members of the UN Security Council, namely the US, UK, France, China, Russia, Germany and the European Union and of course Iran. Any attempts to change or replace the accords will be time-consuming and will increase geopolitical instability as there is strong support from the other permanent members of the UN Security Council, Germany and the EU to continue the agreement.

In response, Iran recently announced that it will start reporting foreign currency amounts in euros rather than in US dollars, as part of the nation’s efforts to reduce its reliance on the US dollar given the rising political tensions with Washington. The Iranian central bank governor Valiollah Seif stated that the “dollar has no place in our transactions today.” Iran today engages in hardly any trade with the US after decades of economic sanctions. Its most important trading partner is the UAE at 24% of imports and exports with China at 22%, followed by Turkey, India and the EU which accounts for about 6%.

The effect of rising energy costs on a slowing global economy ought not be ignored. For example, during the oil price decline in 2015 and 2016, consumers in the US, Europe, China and India effectively benefited from a $1.6 trillion windfall. In contrast, this year they face a $800 billion headwind. From a consumer perspective, we are seeing gas prices close in on $3 per gallon, something last seen four years ago. We see this as another factor in addition to rising credit costs that will crimp discretionary consumer spending at the margin.

And that brings me to my final comment for the week is all about rates and debt levels. During the last cycle, the outstanding nonfinancial debt load peaked at $27 trillion. Today it has reached $47 trillion with roughly one-fifth of that rolling over annually. I’m less concerned about the shape of the curve during any given month than I am with what rising rates are going to mean for debt-servicing capacity, defaults and delinquencies. For example, mortgage rates have risen more than 50 basis points this year, with the 30-year fixed rate reaching 4.8%, the highest it’s been in four years.

Over the past five years, the median sales price for existing home sales has risen 23.3% while US average weekly earnings has increased just 12.4%, making that home less and less obtainable.  Adding to the pain, new homes are becoming less affordable as inflation on construction materials accelerates and builders pass on the higher costs to buyers, including new tariffs to be had on building materials such as lumber and aluminum.

 

 

To wrap it all up, rising rates and a strengthening dollar are exacerbating and being exacerbated by the failure of the synchronized global growth acceleration narrative. I have no idea how I pulled out that sentence on a Friday afternoon. Rising tension around trade wars and now tensions with Iran are just adding to the upward price pressures as is the employment situation. Investors are taking it all in and wondering, what is the catalyst for my happily ever after in 2018.

 

 

WEEKLY WRAP: Is the Best of This Business Cycle Behind Us?

WEEKLY WRAP: Is the Best of This Business Cycle Behind Us?

 

The week started off optimistically on Monday as the markets enjoyed a late-day rally, paring earlier losses as the S&P 500 managed to close slightly in the black. The energy sector was the winner of the day, while technology was the weakest, dragged down by the semiconductors, Apple and Apple suppliers. Perhaps Tim Cook ought to send Wonder Woman Gal Gadota basket of muffins at the very least for her attempt to help the company this week, inadvertent as it may have been. The Energy Select Sector SPDR (XLE) has broken out of the $66-$69 trading range that had persisted since early February, closing at just shy of $75 by Thursday’s close.

 

 

Monday the US Dollar closed at its highest level since mid-January and hasn’t looked back, breaking out of the trading range that had persisted for most of the year, rising well above its 50-day moving average with the 200-day within striking distance by Thursday’s close. While the greenback had been rather directionless over the past few months despite rising treasury yields, it looks to be finally catching up. The PowerShares DB Dollar Index ETF (UUP) has risen above its 200-day moving average for the first time in a year. A breakout for the dollar to the upside would be a significant headwind to the S&P 500 in the coming months as a stronger dollar would hurt exports. Conversely, it would be a boon for the smaller cap, Russell 2000.

 

 

Tuesday looked like a solid day in the pre-market action but ended up being a rough one as the 10-year Treasury yield reached over 3% for the first time in four years during intra-day trading, closing the day just below. The U.S. is not the only nation seeing rising rates, with the U.K., Germany and Japan as seeing rates moving higher. Caterpillar (CAT) started the day off strong after reporting both revenue and EPS results that beat expectations and raised guidance. Shares were up as much as 5% in the morning, which would have you thinking, “Pop open the Bollinger,” but then the CFO mentioned that they are thinking this might be peak earnings for the cycle. I’m thinking the post-earnings call debrief might have gotten a little testy in the C suite given shares traded in a range of over 11%, closing right around the lows of down 5.8%. The market has become so jittery that other industrials also took it on the chin after the CFO’s remarks, Deere and Co (DE) falling nearly 5.5% and Cummins (CMI) dropping over 4.5%.

The Technology sector was hit hard on Tuesday by Alphabet (GOOGL) shares which fell almost 5% despite a strong earnings report. Most of the major U.S. equity indices were heading towards a test of their 200-day moving average.

Despite the 10-year Treasury closing at a yield over 3% on Wednesday for the first time since 2014, the Dow Jones Industrial Average and the S&P 500 managed to eke out slight gains as the S&P 500 bounced off its 200-day moving average for the third time since February. The Nasdaq and Russell 2000 couldn’t quite get the motivation to move out of the red for the day.

By Thursday’s close most sectors remained in the red for the prior five trading days, with Industrials down the most (-3.4%) and only 4 sectors in the green (slightly). Energy was the strongest performer, up +1.3%, with the next strongest Utilities, up +0.9%. The Dow Jones Industrial Average, the S&P 500 and the Nasdaq all closed higher on Thursday, with the Nasdaq ending its five-day losing streak thanks to better-than-expected results from Facebook (FB) that drove the share price up 9.6%. The Dow closed above its 200-day moving average thanks to Visa (V), up 5.0% on strong earnings results that pushed the stock price to new all-time highs.

Friday saw Amazon (AMZN) deliver solid results with Q1 sales rising 43% year-over-year as well as solid EPS of $3.27 versus expectations for $1.25, which pushed shares up over 7% in early trading to new all-time highs. Equity markets began the day modestly in positive territory despite the better than expected GDP numbers.

 

The Economy

Monday’s economic data was a mixed bag. Existing home sales beat estimates, coming in at a 5.6 million seasonally adjusted annual rate versus expectations for 5.55m and prior reading of 5.54m. Absolute inventory levels and inventory levels as a percent of sales remain near the lowest levels on record. The Chicago Fed’s National Activity Index came in weaker than expected at 0.10 versus 0.28 expected. While February’s numbers were revised higher, the quarterly average for the index is slowing. On the plus side, Markit’s Flash Manufacturing PMI for the U.S. reached the highest level since September of 2014 in April.

Tuesday Richmond Fed Manufacturing Composite Index for March dropped to -3 from February’s +15 versus expectations for 16. The report showed broad declines for the month, with current shipments, new orders, a backlog of business, capacity utilization and local business conditions all flipping from expansion to contraction. Expected readings 6-months out was even worse, with nearly every category declining – overall a brutal report. On the plus side for the day, Case-Shiller home prices rose again, up 6.3% versus a year-ago with the 20-city composite rising 6.7% year-over-year. Overall the national price index is 8.2% above the 2007 peak and 11 of the 20 cities are above their prior cycle highs with 10 of 20 at new all-time highs. Perhaps rising home prices helped push the Conference Board Consumer Confidence reading up to 128.7 versus expectations for 126. The net percentage of consumers expecting income growth hit the highest level since 2001.

Wednesday brought initial jobless claims well below expectations, falling to their lowest level in 49 years. March’s durable goods came in above expectations, with the headline number at a gain of 2.6% versus expectations for 1.7%.

Thursday the US Census released preliminary durable goods manufacturing data, which supported the weaker data reported by the Richmond Fed on Tuesday. While new orders were strong, with total durable goods order up 2.6% month-over-month, ahead of forecasts for 1.6%, nondefense capital goods shipments were down 0.7% month-over-month, the worst since May 2016 for a metric that is widely considered the best indicator for business capital spending. The 3-month/3-month annualized rate dropped to 4.1%, the weakest since December of 2016 and a big drop from the roughly 15% rate in October 2017. To really rub it in, capital spending plans from regional Fed manufacturing surveys are also falling: the three we have so far, Empire, Philadelphia and Richmond, have seen a sharp decline in the next 6 months for the capital expenditure category.

Thursday also brought data on quarterly home ownership rate, which has risen to 64.2% from its lowest level on record back in Q2 2016. The current rate is more in line with the normal levels seen in the 1980s to mid-1990s, before various policies pushed for higher and higher rates of home ownership, which ended so very well in the Great Recession.

 

 

Friday’s first estimate for GDP growth for the first quarter came in slightly better than expected at 2.3%, versus consensus estimates for 2.0%, but down from the 2.9% rate in the final months of 2017 and the slowest pace since Q1 of 2017. Let’s remember that 1Q 2018 figure, while a beat relative to the 1.8%-2.0% GDP forecasts for the quarter, was far lower than the initial forecasts for nearly 5.5%that were put forth back in February. Digging into the details, consumer spending was the weakest in more than four years, up only 1.1% following an increase of 4% in the prior quarter, which was skewed by forced spending thanks to the twin hurricanes in the South and fires in the West. Consumers spent less on food and drink and acquired fewer cars and less new clothes during the winter months. On the other end of the spectrum, the core Personal Consumption Expenditures price index, which excludes food and fuel prices due to their high volatility, saw its biggest increase in over 10 year, up 2.5%. The Labor Department’s Employment Cost Index was also release Friday, revealing accelerating wage growth with the year-over-year increase in private sector wages and salaries rising 2.9%

 

Earnings Season

Earnings so far this season have been quite strong, with an EPS beat rate at around 76.7% so far. Stock prices are initially moving up on the positive results but are often coming under serious pressure throughout the remainder of the reporting trading day. Perhaps the fact that earnings are by definition backward looking has something to do with this, and perhaps Caterpillar’s CFO is on to something. I say this because 3M (MMM) reduced its 2018 outlook and Lockheed Martin’s (LMT) raised outlook included almost all key metrics for the company save the closely watch operating cash flow line. PepsiCo (PEP:NYSE) shared that every one of its businesses was hit by cost inflation in 1Q 2018 due to higher raw-material input prices. Hershey (HSY:NYSE) echoed those comments as its gross margins came in below expectations due to a combination of higher input and freight/logistics costs.

While the later comments are likely to stir the drums of inflation hawks, I’d like to point out that looking at history, strong earnings results do not assure a strong economy going forward. In fact, many times in the past, S&P 500 companies have often delivered strong EPS results just before a recession:

 

Quarter           Results          What came next

2007 Q1          +14.0%           Recession December 2007 – June 2009

2000 Q3          +15%              Recession March 2001 – November 2001

1980 Q1          +12%              Recession January 2000 – July 1980

1973 Q2          +27%              Recession November 1973 – March 1975

 

The bottom line for this week is while earnings have been pretty fantastic, they are backward looking and many are starting to wonder if the best is behind us for this cycle, including the CFO of Caterpillar. Investors are not responding positively to earnings strength, as the average stock (as of the end of last week) has traded down over 0.8% from the open of the earnings reporting trading day, despite an earnings beat rate that has so far been the best since the turn of the century – talk about a “What have you done for me lately?” market mood. The employment situation is unlikely to get a whole lot better with unemployment at a near 50-year lows and structural changes in the American economy are limiting wage gain, which we will discuss in more detail in the coming weeks.

Looking ahead to next week, we will be closing the books on April and will have data coming in for March on Personal Income and Spending, Construction Spending and Factory Orders as well as data for April on the ISM Index, Auto and Truck Sales, ISM Services and the Employment Report. Next week we will also get March quarter earnings reports from the likes of McDonald’s (MCD) and Yum! Brands, Apple (AAPL), MasterCard (MA), Skyworks (SWKS), and Ferrari (RACE). What makes the week’s data stream a little more interesting is the Fed’s next FOMC rate decision lands during all of it. That’s right, Wednesday May 2, is the day and given the inflation-related comments above, I have a pretty strong feeling what the market will be focused on Wednesday at 2:15 PM ET.

 

 

 

 

The Change and The Strange Continues in the Markets

The Change and The Strange Continues in the Markets

 

 

Ch-ch-ch-ch-changes
(Turn and face the strange)
Ch-ch-changes
Don’t want to be a richer man
Ch-ch-ch-ch-changes
(Turn and face the strange)
Ch-ch-changes
Just gonna have to be a different man
Time may change me
But I can’t trace time

– Changes (David Bowie)

As the late, great David Bowie sang to us, the change and strange continued this past week, including in the equity markets. Things started out with a bang on Monday as the S&P 500 had its largest final two hours reversal in nearly 7 years, falling almost 2% throughout the day before managing to close slightly in the green after news that the offices of Michael Cohen, President Trump’s lawyer, were raided by the FBI in New York.

Inflation concerns returned to the forefront with Tuesday’s Producer Price Index report showing continued acceleration in prices across a wide range of categories. We’ve all seen the headlines concerning rising oil prices, so it was no surprise to see rising energy prices. Food has also been rising, while ex food and energy has risen the most on a year-over-year basis since 2011. Service inflation was the strongest on a year-over-year basis since late 2009. Transportation and Warehousing acceleration rose nearly 5%. The only fairly stable component has been trade services, which is retailing and wholesaling.

All the barbs being tossed around concerning trade wars have led Brent oil futures to trade at the highest levels since 2014, gaining 6.28% in the first two days of the week alone, its best two days since late November 2016. Tech also benefited on Tuesday from Facebook’s (FB) CEO Mark Zuckerberg testifying in front of the Senate as investors liked how he handled himself – from Harvard dropout to billionaire getting grilled in front of the U.S. Senate, strange and changes as Bowie said.

 

The Fed Remains in “Transitory” Mode

The Federal Reserve released its FOMC minutes for the March meeting on Wednesday. They revealed that the committee unanimously agreed that the outlook had picked up in months, inflation is rising and more tightening is warranted. Nearly all agreed that rates should be increased at the current meeting, but that policy would remain accommodative despite the hike and that the future tightening path should be gradual. The committee noted that while the first quarter data has been coming in weaker than expected (not so strange to us), this was determined to be transitory.

Call me crazy but we’ve been hearing that disappointing growth has been caused by “transitory” forces for years – strange how that “transitory” has serious staying power. And it seems the one thing not to change is the Fed being a cheerleader for the economy.

We’ve been hearing a lot about the potential for rising wage pressures, but the FOMC has a slightly different take. Their analysis is that while the labor market does appear to be tight, rather than raising wages to attract new hires as many expect, businesses are changing job requirements to better fit the pool of available talent, offering training or more flexible work arrangements. Rather wage pressures, instead, the workforce is being increased by bringing those currently on the sidelines into the active labor pool. That certainly supports our Tooling & Re-tooling investment theme, and implies that the Federal Reserve may not see the labor market quite as tight.

This time around the FOMC minutes referred to the impact of potential trade wars as being a source of, “downside risk to the U.S. economy,” but “did not see steel and aluminum tariffs, by themselves, as likely to have a significant effect on the national economic outlook.”  The statement also addressed the impact of tax cuts, “participants generally regarded the magnitude and timing of the economic effects of the fiscal policy changes as uncertain, partly because there have been few historical examples of expansionary fiscal policy being implemented when the economy was operating at a high level of resource utilization.”

We translate this as it is highly unusual to implement stimulative tax cuts when the economy is already running about as fast as it can, so there isn’t much in the way of prior examples from which to glean insight. We are also in unprecedented and strange times with the Fed shrinking its balance sheet by around $600 billion while the Treasury is set to increase its issuance by $1 trillion to fund the deficits as the Fed is raising rates.

 

Hump Day Brought On Continued Change 

Wednesday also saw core CPI rise to a 2.2% annual rate, the 3-month slowed to 2.8% annualized and the 6-month is at 2.6%. The New York Fed’s Underlying Inflation Gauge reported the highest level since July 2006 – that is definitely a change.

Stocks closed Wednesday near the day’s lows, but much better than the pre-market action predicted. House Speaker Ryan announced he will not seek re-election this Fall, a meaningful change for his party, which didn’t garner much of a reaction from the market but it is a tough blow for Republicans in the November mid-term elections.

Thursday the markets closed at their best levels since March 21st on the news that President Trump is assessing re-joining the Trans Pacific Partnership (TPP) negotiations and seemingly ignored the more hostile tone from Secretary of Defense Mattis concerning actions against Syria. By the end of the week, trade tension had eased markedly as we are now hearing that there may be no new tariffs between China and the U.S., a welcome change for the markets.

That’s a lot of change.

We have a new team at the Fed that is decidedly less dovish and appears disinterested in the stock market’s reactions to its decisions – that is big change after the tenures of Greenspan, Bernanke and Yellen, who all appeared to prefer strong market performance in their CVs. The narrative of coordinated global growth is changing as the U.S. and Canada are unlikely to reach even 2% real GDP, the Eurozone is cooling in part thanks to the significant appreciation in the euro and Asia is no longer accelerating. The eurozone just experienced three consecutive months of declining industrial production and saw exports slide 2.3% and imports down 3.1% in February. China’s exports dropped 2.7% year-over-year in March.

Despite this, Q1 year-over-year earnings growth is expected to reach +18%, which is a record 6% higher than it was at the start of the quarter. That is a high bar, which we suspect means fewer companies are likely to beat as they did during the previous low-bar earning. After last year’s record low volatility, the market is on track this year to have 100 or so trading days with at least a 1% range in the S&P 500. The years in which this has last occurred? 1974, 2001, 2002, 2008 and 2009 – I’d say that’s not exactly indicative of a bull market.

The major markets are reflecting the changing environment with the 50-day moving average for the S&P 500 having rolled over quite convincingly and the CNN Money Fear and Greed Index now registering Extreme Fear. The percent of bulls from the Investor’s Intelligence poll has dropped to 42.2%, the lowest level since just before the 2016 election.

More change and likely even more strange is to come in the weeks and months ahead.

 

 

Turning to the Week Ahead: April 16 to 20, 2018

Next week we’ll hear about how the Consumer is doing with the Retail Sales Report, which is expected to see an increase of 0.4% after having declined -0.1% and the Bloomberg Consumer Confidence Index coming out on Friday. We’ll get a reporting on housing with the NAHB Housing Market Index, Housing Starts and Building Permits. We’ll also get a feel for how the corporate sector is doing with Business Inventories, Industrial Production, Capacity Utilization.

Earnings season really kicks into gear as we hear from companies such as Bank of America (BAC), Charles Schwab (SCHW), E*Trade (ETFC) and Goldman Sachs (GS) in the financial world. We’ll get insight into the consumer from tech powerhouse Netflix (NFLX), consumer goods giant Johnson & Johnson (JNJ), and consumer credit firm American Express (AXP). We’ll get insight into just how much is getting moved around – a good proxy for economic growth – from transports CSX (CSX) and Schlumberger.

 

 

Weekly Wrap: The Sounds of Uncertainty

Weekly Wrap: The Sounds of Uncertainty

 

 

To paraphrase singer-songwriter duo Simon and Garfunkle,

 

Hello volatility, my old friend

I’ve come to talk with you again

Because presidential tweets softly creeping

Left its seeds while I was sleeping

And the stock market was filled

With uncertainty

 

That, in a nutshell, sums up the wide gyrations in the stock market this week as both President Trump and China engaged in a “mine is bigger than yours” round of tariff announcements. While the stock market attempted to shrug these off, the reality is additional rounds adds to what is likely to be tension filled talks as both sides look to claim victory while saving face.  Now let’s get into the nitty-gritty of the past week …

Monday the markets and the northeast of the U.S.A. took it on the nose, with the region getting a whopper of a snow storm and NYC getting almost 6 inches. The S&P 500 fell 2.2% and closed below its 200-day moving average for the first time in 442 trading days, ending what had been the sixth-longest streak of consecutive closes above the 200-day on record. Monday’s close also marked the worst start to an April since 1929, not exactly a rosy year for stocks, and left the market down 3.5% for the year with ten of eleven sectors in the red for the year and just 17% of S&P 500 stocks above their 50-day moving average.

Tuesday saw Amazon (AMZN) shares spike almost 4% on reports that, contrary to the implications from Presidential tweets, the White House does not intend to pursue policies that would harm the company’s business model. After Monday’s thrashing, Tuesday saw all the major indices closing in the green. As we shared with our Tematica Research Premium Members, we were rather surprised that President Trump didn’t rail on how inept the U.S. Postal Service (USPS) was in dealing with Amazon. Then again, even we have to admit the Connected Society investment theme headwinds the USPS is dealing with are formidable.

Wednesday and Thursday the markets were in a more upbeat mood from Monday’s downturn, closing in positive territory. By Friday morning the markets were back in the red on renewed trade war concerns. China vowed that in response to the $100 billion in tariffs,  “we will immediately fight back with a major response,” and that it will respond, “to the end and at any cost.” Frankly, anyone who thought that China would roll over and give up when presented with President Trump’s threat hasn’t read much about the history of China. It is a very proud nation who has throughout much of history been a major player on the global stage. The current leadership is looking to regain China’s place as a, if not the primary powerhouse in global affairs.

 

 

We are barely three months into the year and yet we have already had, as of Thursday’s close, 21 trading days in which the Dow traded in a 400 point or greater range versus just 1 day in 2017. The average number of sessions in a year with swings that great is all of 2 and the only time in history where we’ve seen such heightened volatility was between October 2008 and January 2009. The current run of 47 closes below all-time highs, (as of Thursday close) is the third-longest since the spring of 2013.  The average for the VIX in 2018 is 17.6, 60% higher than in 2017 and just under what the saw in 2012 – a tough year for equities. For reference, the VIX average was right around this level back in 2007. This is most definitely a market in transition with a global political backdrop that is more volatile than we’ve experienced in years

 

 

Data, data – it’s all about the data

This week both the March ISM manufacturing and non-manufacturing results came in below expectations with the indices sitting at three-month lows as were orders at three-month lows. The manufacturing report was not only below expectations, but also below February’s number. The Prices Paid component saw a huge jump that was well above expectations and at a level we haven’t seen since 2011.

The Census report on manufacturer’s sales for February showed new orders and shipments for nondurable goods have slowed from their peak rates, but overall growth remains at a solid pace with durable goods shipments at a new year-over-year growth rate high. While inventories are rising, inventory-to-sales ratios have been trending lower.

Non-manufacturing business activity declined while employment rose -not a good sign for productivity which likely means margin compression thanks to decade low unemployment that is forcing companies to hire those with fewer skills than required. The National Federation of Independent Businesses confirms our assessment with 22% of small businesses citing labor quality as their number-one constraint, a 17-year high. The Ism non-manufacturing also reported that production bottlenecks are the worst since November 2005, backlogs up as were prices paid.

ADP private sector employment rose 241k in March, blowing away expectations for 210k and revised February’s gains up by 11k as well. This is roughly 2x the pace necessary to maintain the jobless rate and continues the streak of above 200K jobs per month that started in December. Jobless claims however spiked this week, up to 242k versus expectations for 219k, which put the figure in the upper range of its long-term downtrend channel – not cause for concern just yet, but we will be watching for any consistent moves over 250k. On a more positive note, the number of Americans claiming unemployment benefits dropped to the lowest level since the early 1970s in terms of raw numbers and as a percent of the labor force or even the population.

On the other hand, the Bureau of Labor Statistics on Friday reported that nonfarm payrolls rose by just 103k in March versus expectations for 193k. The average workweek remained unchanged during the month, but for the around 82% of the population in the production and nonsupervisory employee category, the workweek declined by 0.1 hours. Average hourly earnings for this cohort rose 2.4% year-over-year and 2.7% for all employees, once again raising concerns over inflation. Paired with the prices component of the March ISM Manufacturing Index, we suspect inflation hawks will once again soon be on the rise.

Bottom line is this year is all about change. We have very new fiscal policy, new leadership at the Federal Reserve, a new tone when it comes to trade and foreign policy and a market dynamic that is nothing like last year’s. Despite all the excitement around the impact of tax cuts on the economy, in the first two months of 2018 real U.S. consumer spending contracted at a 1.3% annual rate. That’s the weakest we’ve seen since October 2009. In fact, real retail sales have fallen at a 4.4% annual rate from November through to February. Despite all the talk of a tight housing market, builders aren’t exactly chomping at the bit with housing starts down 18% (annualized) over the past three months.

Keep in mind as well that as the Fed is in a rate hike cycle, the level of corporate bonds that need to be rolled over in the next several years is unprecedented. The replacement issuance will be at materially higher rates, unless the economy completely crashes before then, which means higher interest expense and thus compressed margins. We aren’t seeing that reflected anywhere in earnings estimates. Remember that as you read about how PE multiples have been compressing!

 

Turning to the Week Ahead: April 9-13, 2018

Coming off a week that was chock full of economic data with some 20 earnings reports mixed in, next week have several key pieces of economic data and a modest pickup in earnings reports. The 45 or so earnings announcements that we will have over this week and next will set the stage for expectations for the more than 200 earnings reports that hit during the week of April 16, with hundreds more announcements to be had in the following weeks. It’s going to get fast and furious, and that means dissecting what’s to come next week to get ready the coming onslaught.

On the economic data side of the equation, we have the March NFIB Small Business Index on deck, a barometer of small business and job creation, as well as the March readings for both the PPI and CPI. Given the pick up in inflation contained in the March ISM Manufacturing Index as the March Employment Report, we expect these two data points will be of keen interest and could re-ignite the talk of a potential fourth Fed rate hike this year. Adding to the prospects for that talk, next week also brings the FOMC minutes for Fed Chairman Powell’s first meeting. In addition, offering a better understanding as to how the committee weighed three vs. four rate hikes, we expect analysts will be comparing Powell’s press conference performance with what was said behind the Fed’s doors. Exiting next week, we get the February JOLTS report and that should add another layer of context to job creation following the mismatched March ADP Jobs Report and the March Employment Report.

On the earnings front, this week we have 27 companies reporting, which includes a host of financial service firms and banks ranging from Citigroup (C) to JPMorgan Chase (JPM) and Well Fargo (WFC). Inside these results, we’ll be looking at loan growth activity and credit card charge-off rates for clues on the true speed of the economy and the consumer. As a reminder, we have started to see a rise in credit charge-off rates at smaller banks, and we are looking to see how widespread this has become.

Adding to the assessment of the economy, commentary to be had from maintenance, repair and operations firm MSC Industrial (MSM) and Fastenal (FAST) should clue us in on manufacturing and industrial firm sentiment. In normal times, MSM’s comments and outlook would be important to monitor, but on the heels of escalating tariffs, MSC’s commentary should add another layer of insight for what’s to be said over the coming weeks.

 

We Are Dealing with a Market in Transition

We Are Dealing with a Market in Transition

 

Thus far in 2018, we’ve dealt with far more uncertainty injected into the market than we have seen in some time, and this week was a doozy from a new tone out of the Federal Reserve to rising talk of trade wars, never mind the shuffling of personnel around the White House.

The week started off on a seriously rough note with the Technology sector taking some serious punches as Facebook (FB) suffered its worst day in over six years, losing more than 7% as investors worried about ramifications from the possible abuse of Facebook’s user data by Cambridge Analytica. Monday also saw the U.S. Treasury selling $51 billion in 3-month bills and another $45 billing in 6-month bills. Over the past month, the Treasury has sold a record $747 billion in bills on a gross basis, the highest relative to the stock of outstanding public debt since the end of 2009. Treasury Bill issuance is at a record high relative to the size of the economy. That is a lot of investable capital being sucked up to pay for record level deficit spending outside of a recession or a war. Given the trade war saber rattling emanating from DC and China, we’re not surprised investors are flocking to this safe haven.

On Tuesday Facebook dropped hard again, as much as 12% from the prior Friday’s close, but managed to rally to close down just 2.5% on the day as Oracle (ORCL) found itself in the spotlight of investor angst, losing almost 10% on slower cloud sales guidance. The S&P 500 and the Tech sector managed to eek out a close in the green, but the Russell 2000 closed slightly in the red.

Wednesday was the first press conference for the newly appointed Federal Reserve Chair Jerome Powell and he showed that there is definitely a new monetary sheriff in town. Powell indicated that he is much less focused on the Fed’s models and projections and more on the actual data. For years, Fed officials have recited the mantra of being data-dependent, but the actions of the Fed were clearly more model-driven. For example, when unemployment reached 6.5%, WHEN the Fed did not tighten policy as it had claimed it would. While we like the focus on data versus models, in part because it’s how we roll here at Tematica, the market wasn’t too pleased as it looks like (and we expected) that Fed punchbowl is going to be drained faster than many had hoped. The major indices were down as much as 1.5% in the morning trade as investors adjusted their expectations to the more hawkish tone out of the Fed. By the way, had just one person voted differently, the Fed would have plotted a total of four hikes in 2018, so there is a very real probability of having more than three this year.

Thursday the markets opened in the red as investors nerves were further frayed on rising concerns of a trade war. The 10-year Treasury yield experienced its biggest one day drop in six months, falling more than 10 basis points to just under 2.8%. We are seeing a meaningful flattening in the yield curve as the difference between 10-year and 3-month has fallen to just 100 basis points. From a historical perspective, we are currently in the longest streak in history without an inverted yield curve.

 

 

The Fed’s rate hike this week is the 6th rate hike in the current business cycle and we have not yet seen the full lagged effects of the first five rate increases. At least 2 more are planned, (we suspect a third is likely this year) which means a 200 basis point increase in total. We have also not seen the full effect of the roughly 100 basis point equivalent in tightening from the unwinding of the Fed’s balance sheet. Put the two together and you have effectively about 300 bps of cumulative tightening. Looking at this level of tightening relative to past rate hike cycles:

 

Well now, that doesn’t sound like much fun, so let’s look at what we’ve experienced during prior rate hike cycles. Post World War II there have been thirteen rate hike cycle, ten of which ended in recessions. The three that did not end in a recession, (mid-1960s, mid-1980s and mid-1990s) all saw an average slowing of GDP of around 2%. Yep, that is right around the level of GDP growth we have today.

Is it time to sell everything, head for the hills, fill up the generator and stockpile the dehydrated food?

Not so fast. Using history as a guide, on average, one year prior to the first rate hike, real GDP sits around 3.1% and economic growth accelerates to an average of 4.2% by the time the Fed begins its tightening cycle. By the time of the last rate hike GDP growth slows to an average of 3.7%. Notice the lag.

What we can learn from history is that with these rate hikes we are heading into the part of the cycle where liquidity will become an issue which means lower quality credit get hit hard and the loftier asset prices come under pressure. We can see evidence of this looking at the 2-year Treasury, which is highly liquid and hypersensitive to shifts in Federal Reserve policy. The yield on the 2-year has risen over 100 basis points since September and has overtaken the dividend yield on the S&P 500 by 45 basis points. We haven’t seen that in nearly 10 years.

 

 

Where can we look to see where we are in the process? We are watching rising subprime auto loan defaults, rising delinquencies for credit cards held at smaller banks, and the spread between investment grade and high yield corporate bonds. We are currently sitting at all-time debt-to-GDP ratio highs and the share of investment-grade bonds that are BBB-rated is up to nearly 50%. This means there is a growing risk associated with a wave of credit downgrades once the economy slows, which would force selling of bonds that are no longer investment grade. We are watching interest rates rising during a year when $1.5 trillion of investment grade credit is coming due and an additional $430 billion of high yield credit, much of the proceeds of which were used to fund share buybacks, leaving balance sheets more highly leveraged.

We are seeing economic expectations being reset. At the beginning of February, the Atlanta Fed GDPNow was 5.4% but has now fallen to 1.9%. Looking out to the rest of 2018, the potential impact of the now rising potential for real trade wars is a headwind to many sectors that will at the very least increase input costs, reducing corporate profit margins. This coming at a time when we are hearing nonstop about the tight labor market, which is also expected to put upward pressure on labor costs, which will also reduce corporate profit margins.

The bottom line is that in 2017 the market was very focused on hearing only what it wanted to hear and to be fair, the economic data coming in was mostly positive as were the actions coming out of Washington D.C. But as we are seeing, 2018 is no 2017. We are witnessing a market in transition. That synchronized global expansion is rolling over.  The VIX, the volatility index, this year is on average 50% higher than it was last year. The last time this happened was 2008. Looking at the past, in periods where the VIX is low and declining, the bull market is intact. When it rises and sets new and higher ranges, it means we are in transition and so we are. As I said above the easy money liquidity punchbowl is being drained. All that liquidity that had been pushing asset prices higher is being sucked out of the system and in its wake, we have record high levels of debt across a broad range of the U.S. economy and the globe. This is the time for quality balance sheets, better earnings visibility and an active eye on the evolving data.

 

Something Just Isn’t Adding Up in the Recent Data

Something Just Isn’t Adding Up in the Recent Data

 

The week started off strong out of the gate on Monday in the wake of Friday’s post-payroll rally, but the momentum quickly faded, leaving the S&P 500 down four consecutive days as of Thursday’s close. If it closes in the red again Friday, it will be the longest losing streak in over 16 months going back October 31st, 2016. We dug into the details of the recent data and in this week’s edition, we point out some things that just aren’t jiving.

Wednesday the Industrials sector fell below its 50-day moving average with Boeing (BA) leading the decline as the weakest performer in the Dow, also falling below its 50-day moving average. In the Materials sector Century Aluminum (CENX) fell below its 50-day moving average to lead metals lower. DowDupont (DWDP) also failed to rise above its 50-day moving average. Thursday the Dow Transports sector followed Industrials, falling below its 50-day moving average and finding resistance at its late February peak.

The strongest performing S&P 500 sector over the past five days has been Utilities, followed by Real Estate – not exactly typical bull market leaders. After having experienced one of the strongest starts to a year, the S&P 500 is up less than 3% from December’s close and ended Thursday below its 50-day moving average. Technology has been the only sector to reach a new record high, but its technical indicators are starting to weaken, so this one looks to be over-extended. By Thursday’s open the percent of stocks in the S&P 500 trading above their 50-day moving average was down to 43% with over 22% of stocks in oversold territory and 21% in overbought.

 

Bonds

US 10-year Treasury yield broke above its 100-month moving average in November of last year for the first time since July 2007 and hasn’t looked back. That being said, while the yield for the 10-year recently peaked on February 21st at just shy of 3% and has fallen roughly 12 basis points since then, the S&P 500 hasn’t been able to make much progress.

Meanwhile, no one seems to be talking about how we are seeing flattening in the yield curve.

 

 

The Consumer

February Retail Sales were weaker than expected, declining for the third consecutive month, the longest such streak in three years. Then again, the month-over-month change in average hourly earnings for all employees has been either flat or negative in 6 of the past 7 months and in the fourth quarter of 2017, consumers racked up credit card debt at the fastest pace in 30 years – bad for consumer spending, but rather confirming for our Cash-strapped Consumer investing theme. Most concerning is that credit card delinquencies at smaller banks have reach levels not seen since the depths of the Great Recession.

 

 

Corporate America

Homebuilder sentiment, after reaching the highest level since 1999 this past December, has now declined for 3 consecutive months, but even so, it still remains at nearly the highest levels since the financial crisis. Meanwhile, the NAHB Housing Market Index has fallen 17% from the January 22nd high and its most recent report found a significant downturn in traffic, perhaps due to rising mortgage rates as the 30-year fixed rate has reached the highest level in over 4 years. Perhaps the weakness has something to do with the aforementioned lack of wage growth as the ratio of the average new home price to per capita income has again reached the prior peak of 7.5x – people just can’t afford it.

We’ve been warning of the dangers of exuberant expectations for a while here at Tematica. The General Business Conditions Average for manufacturing from the Philadelphia & New York Fed this week illustrated just why we have. The two saw a small uptick in March after having been weakening in recent months. However, the outlook portion, which had been looking better in the past is now showing some weakness. For example, CapEx expectations 6-months out fell in March from the highest levels on record in February.  Expectations around Shipments also dropped, having been at the second-highest levels of the current expansion. After having reached extreme levels in November, New Order expectations also declined. When sentiment expectations reach new highs, tough to continue to rise significantly from there.

While Friday’s job report got the markets all excited, perhaps the reason that enthusiasm has cooled is folks are realizing that the 50k gain in retail jobs isn’t syncing up with the -4.4% SAAR decline in retail sales over the past three months. Then there is what we are hearing from the horses’ mouth. Walmart (WMT) and Target (TGT) both issued weak guidance, as did Kroger (KR) who also suffered from shrinking margins. A tight and tightening job market is unlikely to help with that. Costco (COST) missed on EPS, as did Dollar Tree Stores (DLTR), who also missed on EPS and gave weaker guidance. Big Lots (BIG) saw a decline in same-store sales. At the other end of the spectrum, the 70k gain in construction is in conflict with rising mortgage rates, traffic and declining pending home sales, while the 31k gain in manufacturing has to face a dollar that is no longer declining, high costs on tariff-related goods and potentially some sort of trade war.

 

Inflation

As I mentioned above, while real retail sales fell -4.4% SAAR over the past three months, Core Consumer Prices rose 3.1% SAAR and Wednesday’s Producer Price Index (PPI) report from the Bureau of Labor Statistics also showed rising inflation pressures. Core PPI (yoy) has reached its highest levels since 2011 with the annualized 3-month trend having gone from 1.5% last summer, to 2.7% at the end of 2017 to 3.4% based on the latest data.

Import prices for February rose 0.4%, taking the year-over-year trend up to 3.5% from 3.4%. Recall that last summer this was around 1%. Ex-fuel the pace rose to 2.1% from 1.8% previously and 0.8% over the summer.

The bottom line this week is that we are no longer in the easy peasy 2017 world of hyper-low volatility and relentlessly rising indices with a VIX that has found a new normal more than 50% above last year’s average. The wind up is the major market indices haven’t been able to commit to a sustained direction. The hope and promises of 2017 have been priced in, leaving us with a, “So now what?” which is reflected in the Atlanta Fed’s GDPNow forecast falling from 5.4% on February 1st to a measly 1.8% on March 16th – talk about a serious fade.

What has us really concerned is that at a time when big job gains are making all the headlines we see credit card delinquencies at the level last seen in the depths of the Financial Crisis and retail sales contracting at a 4.4% annual rate over the past three months. This is the best we can get with a booming job market? Something here just isn’t right.

This is the best we can get with a booming job market? Something here just isn’t right.

 

WEEKLY WRAP: The Tortoise Economy vs The Hare Market

WEEKLY WRAP: The Tortoise Economy vs The Hare Market

 

 

Happy Bull Market Birthday!

Today is the ninth birthday of this equity bull market, a rather impressive run that has generated roughly 5x in returns within an economy that has grown at a yawn-inducing pace. As the third longest bull market in history, this is an impressive day in an otherwise unimpressive week in the markets. Even as the market rallies on less toothy tariffs and a better than expected February Employment Report, there are reasons contained inside today’s jobs and wage report signaling the all clear on inflation has yet to arrive.

On Monday the major equity market indices started off on a downtrend but then shifted to a more risk-on tone during the day as the markets shrugged off last week’s tariff tantrum with the Trump Administration’s softer talk. The major U.S. equity indices rose over 1% on the day as the VIX, gold, and silver fell. The bullish tone on Monday saw 29 of the 30 Dow components ending the day in positive territory, with Nike (NKE) the only stock to lose ground on an otherwise very bullish day. Ironically, Nike, a contender for our Rise of the Middle-Class investment theme, has been one of the best performing Dow stocks since last October.

Monday once again saw the Utilities Sector (XLU) ETF lead all other sectors, which is not typical when the market is bullish, nor is it typical to see the 10-year Treasury yield close higher on a bullish day for equities. We’ve noted this odd occurrence a few times before in the Weekly Wrap, and the frequency of this contradiction has our attention as does the yield curve, which is once again flattening.

Tuesday the international markets were more bullish as participants became more skeptical of tariff talk. U.S. equities closed in the green, but the gains were more modest than Monday’s, while the dollar lost nearly 0.5%.

Wednesday the markets were mixed with the small cap Russell 2000 lead the pack, gaining 0.8% on the day, the Nasdaq up 0.3% while the S&P 500 declined nearly 1% early in the day, but rallied back to close down just 1 point. The Dow lost 83 points. The VIX remains elevated while the US Dollar looks to be unable to muster momentum for a bullish breakout.

Thursday the S&P 500 closed just shy of its 50-day moving average, having been below this metric since late February, as buying towards the close pushed stocks higher on rising volume. The President’s speech at 3:30 PM ET revealed that Canada and Mexico would be exempted from the tariffs on aluminum and steel while the NAFTA talks continue, and he hinted that he may be willing to be more flexible than he had previously indicated. The upward move towards the end of the day in the major equity indices and the 6% drop in the VIX indicate that the market’s fears from last week have been mollified.  It is looking like Tematica’s Chief Investment Officer, Chris Versace, nailed it this week when he said this whole thing is likely a negotiating tactic right out of Trump’s Art of the Deal book in our weekly Cocktail Investing podcast.

As of Thursday’s close, the S&P 500 and the Russell 2000 were both up 2.4% year-to-date with the Nasdaq up a more impressive 7.6%. Even so, the S&P 500 remains 4.7% below its January high, the Russell 2000 2.2% below its and the Nasdaq down just 1.0% from its high.

Despite the relative calm on Thursday, volatility has returned with the number of days the S&P 500 has traded in a 1% or greater range in 2018 already nearly double what we experienced in 2017. The chart below puts the anomaly of 2017 in perspective. The number of 1% days in 2017 was roughly 1/10th the annual average between 1990 and 2016!

 

 

Economy

This week the economic news was generally pretty good after having had more misses than beats since the start of the year when it comes to the hard data reports.

The ISM’s Non-Manufacturing composite declined from January’s 59.9 to 59.5 in February but still beat expectations for 59.0. To put this figure in perspective, this is the third strongest reading since August 2005. On a year-over-year basis, 7 subsectors rose while just 3 declined. New Orders were up on both a month-over-month and year-over-year basis, as were backlog orders. The employment measure, however, saw its biggest month-over-month decline since February 2014. Given the strength we saw in Thursday’s ADP report, (more on that later) this is likely just a reversion to the mean from the big jump we saw in the Employment index in January. The Prices Paid component if the ISM report also declined, falling from 61.9 in January to 61.0 – no big inflationary pressures evident in at least this month’s report.

One area in which we are not seeing increasing pricing pressure has been with gasoline prices. Year-to-date prices have risen just 1.6%, which is well below the average year-to-date change of 7.2%, going back to 2005. The average price of $2.53 per gallon (as of 3/6) is also below of average price at this point in the year of $2.74.

The employment data this week was overall very strong. Wednesday’s ADP Private Nonfarm Payroll report showed much stronger payroll growth than expected, rising to 235,000 versus 200,000 expected. There were gains in both the Goods-Producing and Service-Providing sub-sectors, up 37,000 and 198,000 respectively. In fact, the only industry sector that experienced declines was Information, losing 1,000.

The stronger-than-expected 2.5% increase in Unit Labor Costs quarter-over-quarter, versus 2.1% expected confirms the strength of the ADP report and the continuing commentary from business on the challenge of finding the right talent to fill open positions. Initial unemployment claims came in at a 231,000 versus the 220,000 expected, rising from last week’s 48-year low, while job cuts announced by U.S. based employers fell 20% in February.

The big news came on Friday with the nonfarm payroll report which had the economy adding 313,000 jobs versus expectations for 200,000. The market sighed with relief to see the year-over-year average hourly earnings for all employees slowed to 2.6% after last month’s 2.8% pace. For the Nonsupervisory and Production employees, the rate rose slightly to 2.5% from 2.4% last month.

 

 

To sum it up succinctly, the February Employment report was a Goldilocks report, at least that’s what much of the mainstream is reporting. We dug into the data a bit more though and found something that should get the attention of those concerned with rising inflationary pressures. Average weekly earnings on a year-over-year basis for both the All Employees category and the Production and Nonsupervisory categories increased over the month. The All-Employee category isn’t too concerning as it rose to 2.9% from 2.8% in January but is still down from the 3.0% pace in December 2017 and 3.1% in November 2017. The concern data point is the 82% of the workforce in the Production and Nonsupervisory category that saw average weekly earnings rise 3.1%, up from 2.4% in January.

 

 

Is this the start of more powerful wage pressures?

One month does not make a trend, but the Production and Nonsupervisory group has seen average weekly earnings on a year-over-year basis increase by 3% or more in 2 of the past 3 months. The last time we saw a 3 handle was in July 2011.

This week’s Weekly Wrap started with the Bull Market Birthday performance in contrast to the weak economic recovery. The past 8 bull markets have seen a median annual return of 17.3% for the S&P 500 amidst median nominal GDP growth of 7.3% and real GDP growth of 3.8%. While the performance of the S&P 500 is right on track in this bull run at 17.3%, nominal GDP growth has been a meager 3.6% (less than 50% of the median) and real GDP a miserable 2.1% (55% the median). Imagine if the stock market performance had been more in line with the economy. Perhaps equity investors ought to send some sort of collective gift basket to the world’s central bankers.

The bottom line for the week is the stock market looks to have stabilized for now on the hopes that Trump’s actual tariffs will be a tad less tortuous than the tone of his previous weekend tweets. While the market’s knee-jerk reaction to this month’s jobs report was positive, we see rising wage pressures and suspect those fellows over at the Fed are noticing the same. While we see a lot of headwinds to inflation from a long-term secular perspective, the near-to-medium term forces are rising. Investors would do well to assess their portfolio’s sensitivity to rising rates.

 

 

Weekly Wrap: Markets Get Blindsided

Weekly Wrap: Markets Get Blindsided

 

Coming into this week, market participants thought the big risk was going to be Federal Reserve Chairman Jerome Powell’s first Monetary Policy Report — or Humphrey Hawkins testimony as it used to be called — in front of Congress. Turns out, that wasn’t all that was to come from Capitol Hill.

 

Equity Markets — A Roller Coaster of a Week

Monday the markets opened with an enthusiastic risk-on mood. The Nasdaq Composite, Russell 1000 and S&P 500 all closed up more than 1.0%. The Russell 2000, (small cap stocks) continued to lag, gaining just 0.7%.

Then the punchbowl was pulled on Tuesday when new Fed Chair Jerome Powell gave his first testimony in front of Congress. The markets were not pleased. All the major equity indices lost more than 1% on the day.

As the markets digest Powell’s testimony Wednesday morning — something Chris Versace, Tematica’s Chief Investment Officer, and I focused on in this week’s Cocktail Investing Podcast — equities tried to muster some enthusiasm, but couldn’t pull it off. By the close of Wednesday’s trading, the Nasdaq lost -0.8%, Russell 1000 and S&P 500 lost -1.1% and the Russell 2000 fell -1.6%, as small-cap stocks continue to underperform – never a bullish indicator.

Not to be outdone by Powell, the big risk for markets this week arrived on Thursday when President Trump announced that the U.S. will implement import tariffs of 25% on steel and 10% on aluminum.

Did we mention that the seventh round of NAFTA negotiations have been going on this week in Mexico? Timing…

How did U.S. equities respond?

In response to the President’s comments, the Dow Jones Industrial Average, having gained more than 150 points earlier in the day, dropped 577 points closing down 1.7% from the prior day. The S&P 500 dropped briefly below its 100-day moving average, losing 1.3% on the day, the VIX rose over 13% and the S&P 1500 Steel Industry Group gained 3%.  In general, Industrial companies fell on the news of tariffs, but those that would benefit, such as United States Steel Corp (X) and Nucor Corp (NUE) gained 5.7% and 3.5% respectively.

We saw something similar with Whirlpool (WHR) shares a few weeks back when the administration slapped tariffs on foreign washing machines. Those whose input costs would increase under these tariffs saw shares take a hit, with Ford Motor Co (F) and General Motors (GM) losing 3% and 4% respectively. Friday morning all the major U.S. indices opened well into the red.

 

Powell’s Pain

Whenever I feel like life is unfairly kicking the puddin’ out of me, I’m going to remind myself that on Powell’s first day as Fed Chair the Dow Jones Industrial Average was hit with its biggest one-day point drop ever and the VIX had its largest one-day percentage gain in history. After his testimony on Tuesday, the markets again took a dive, which continued into Wednesday. Thursday morning Secretary

Thursday morning Secretary Powell spoke before the Senate Finance Committee and after his prepared remarks, he noted that “We don’t see any strong evidence yet of a decisive move up in wages. We see wages, by a couple of measures, trending up a little bit, but most of them continuing to grow at about two and a half percent. Nothing in that suggests to me that wage inflation is at a point of acceleration.”

In contrast to Powell’s testimony earlier in the week, these comments were a hell of a lot less hawkish. In response, the Dow, S&P 500 and Nasdaq all shot up to session highs.

Then Trump spoke.

I feel like sending Jerome some muffins or a fruit basket.

Of course, not to be outdone by Trump, Putin had to throw his hat into the ring this week by announcing in his annual state of the nation address that the Russian military has developed nuclear-capable weapons that can render defense systems useless.

To recap, we now have on the table a potential trade war brewing, (according to Australia,  the European Union, Mexico, China and Brazil), and now talk of a restart to the Cold War?

At least the weather has been mild. Yes, that was sarcasm.

 

Leverage and the Game of Chicken the Market is Playing

With all those sparks flying, one has to wonder about the market kindling in the form of margin debt, which has again reached record highs. Now some have pointed out that as a portion of market cap, margin debt doesn’t look all that impressive. I think that is some seriously flawed math as it utterly negates the importance of breadth and the effect of leverage.

If some portion of investors borrow more every day to buy shares, then obviously, share prices will continue to rise. This becomes a game of chicken that lasts right up until enough folks stop playing the leverage game and are no longer there to keep pushing prices up. Then all hell can break loose as the run-up was based on a dwindling volume of investors simply increasing leverage.

Instead, we like to use margin debt as a percent of GDP, which ties it to the real economy. Margin debt relative to GDP has exceeded the levels reached in 2007 and even the sky-high valuations of 2000, giving us the most highly leverage market relative to GDP in history. (Hat tip to Jessie Felder of the Felder Report for this chart.)

 

Total Market Capitalization as a percent of GDP reached a new all-time high of 152.4% before the February correction outpacing even the 146% from the dotcom bubble. This is even more concerning when you consider that the number of publicly listed companies has fallen from the peak of 8,090 in 1996 to 4,331 as of 2016 (latest date for which data is available from the World Federation of Exchanges).

 

 

As the data above shows, the number of publicly traded companies has declined by almost 50% while market cap as a percent of GDP has gone from less than 90% at the end of 1996 to over 150%!

That couldn’t possibly have anything to do with the suppressed interest rate policies that allow the very big to borrow at ultra-low or even negative interest rates – oy vey!

While market cap relative to GDP is not a useful timing metric, it does give a good idea of what overall market returns are likely when it reaches extreme levels. In the 15+ years between the March 2000 market cap to GDP peak to the next peak in June 2015, the S&P 500 gained all of around 40% and the Nasdaq Composite just over 4% – ouch. While that 40% move may sound like a big number, keep in mind it’s over 15 years, which means very modest returns on an annualized basis.

 

Bonds are Not Sitting on the Bench Anymore

While much of the focus this week in the news has been on equities, Tuesday a $60 billion auction of four-week Treasury bills were priced to yield 1.495%, the highest rate since September 2008. Another $22 billion auction of 52-week priced at 2.02%, which is the highest rate since the reintroduction of the 52-week in June 2008. Recall how we’ve shared our concern that increases in consumer spending have been driven primarily by rising household debt levels? That’s getting more expensive.

Sentiment around bonds has been so negative that the Commodity Futures Trading Commission’s weekly Commitment of Trader’s Report for February 20 revealed that Treasury futures short contracts on the 10-year reached over 4x the average and a record high going back to 1992. Thursday the 10-year Treasury yield dropped 6 basis points to 2.8%, the biggest one-day decline since September 5th. We may be seeing a giant short squeeze here.

 

The Good and the Bad in the Economic Data

Aside from all the fireworks this week, the economic data continues to deliver mixed results.

The Good:

  • Dallas Fed manufacturing beat expectations for 30.0 at 37.2 in February. As a side note, the Inflation Index came in much stronger, rising from 33.5 in January to 39.8 in February. Haven’t seen it this high since May 2011.
  • February’s ISM Manufacturing report beat expectations by rising to 60.8 from last month’s 59.1 versus expectations for a decline to 58.7. In fact, February’s reading was the strongest since May 2004. While the headline is a beat, in reality, this report is a bit of a mixed bag because as we dig into the details, two of the only three categories (out of eleven) that declined month-over-month were Production and New Orders. Those tend to be leading indicators, so we prefer to see them improving and we also don’t like seeing that the Priced Paid component rise to its highest level since May 2011. The market is already skittish when it comes to any hints of inflation and this isn’t going to help.
  • On the other hand, Core PCE Inflation came in as expected at 1.5%.
  • Eurozone Producer Prices rose less in January, up +1.5% versus expectations for +1.6%. The measure has mostly been declining since September when it reached 2.9%, then 2.5% in October, 2.8% in November, then down to 2.2% in December. This measure is not showing signs of rising inflationary pressures.

 

The Bad

  • The Citibank Economic Surprise Index (CESI), which measures expectations versus the actual data coming in, fell into negative territory for the first time in 18 months as expectations continue to be overly optimistic.
  • The Chicago Fed National Activity Index (CFNAI) surprised to the downside in January at +0.12, the worst level in five months, versus expectations for +0.25. On top of that December was revised down as well, from +0.27 to +0.14. On top of that, the diffusion index for CFNAI is indicating decaying breadth.
  • Japan’s factory output fell by the most in around 7 years in January with Industrial Production falling 6.6% versus expectations for a 4% contraction.
  • New home sales were weaker than expected… again… declining -7.8% month-over-month versus expectations for an increase of +3.5%. The annualized pace has dropped to a 5-month low and is 1% below January 2017. The weakness was more concentrated in the south, so we’ll be watching next month to see to what degree this was weather-related. While some tried to blame it on the weather, we’ve now seen new homes sales miss expectations in four of the last six months – sounds like something more than just the weather.
  • Aside from the new tariff headwind hitting the auto sector, Thursday’s release showed that auto sales in February fell below 17 mm SAAR. The first two months of 2018 have seen auto sales at the weakest pace since 2015 – another signal that we are likely in the later stages of the business cycle. Given that durable goods consumption is an important factor in GDP, the over 15% annualized decline in auto sales from 2017 will present a headwind for Q1 growth.

 

The auto sales data confirmed our Cash-Strapped Consumer and Middle-Class Squeeze investing themes. While the luxury brands had a great month, the major brands that appeal to the majority of the country had a tough month. Porsche, Audi and BMW saw year-over-year sales increase by 21%, 12.4% and 7.5% respectively while General Motors, Ford, Honda and Hyundai were hit with 6.9%, 6.9%, 5% and 13.1% year-over-year sales declines respectively.

  • From Thursday’s Personal Income and Outlays report for January, Real Personal Spending slowed -0.1% in January, but what was more frustrating was that the annual figures that show real Disposable Personal Income rose just 1.2% in 2017, less than the 1.4% in 2016 while Personal Consumption Expenditures rose 2.7%, the same as in 2016. Disposable income rose less than in 2016 while outlays continue to grow faster. Remember those rising interest rates?

The bottom line is the economic data continues to paint a mixed picture while geopolitical risks are rising in the context of a market that has been priced for Goldilocks. Toto, I have a feeling we aren’t in 2017 anymore.

 

All the Talk of an Accelerating Economy and Rising Inflation Just Does Not Add Up

All the Talk of an Accelerating Economy and Rising Inflation Just Does Not Add Up

 

The biggest news for the markets this week came from the Federal Reserve. On Wednesday it released the January Federal Open Market Committee meeting notes and they were interpreted as dovish by some and hawkish by others as analysts raced to divine insight from the text.

The recent data isn’t supporting the narrative of accelerating global growth and inflation while equities continue to experience higher volatility.  What does it mean for stocks, bonds and yields? Glad you asked! Here’s my take on why all the talk on an accelerating economy and rising inflation just doesn’t add up when you look at the data.

 

Equity Markets — A Relatively Narrow Recovery

The shortened trading week opened Tuesday with every sector except technology closing in the red. The S&P 500 fell back below its 50-day moving average after Walmart (WMT) reported disappointing results, falling over 10% on the day, having its worst trading day in over 30 years.

Walmart’s online sales grew 23% in the fourth quarter, but had grown 29% in the same quarter a year prior and were up 50% in the third quarter. We saw further evidence of the deflationary power of our Connected Society investing theme as the company reported the lowest operating margin in its history.

Ongoing investment to combat Amazon (AMZN) and rising freight costs — a subject our premium research subscribers have heard a lot of about lately — were the primary culprits behind Walmart’s declining numbers. To really rub salt in that wound, Amazon shares hit a new record high the same day. This pushed the outperformance of the FAANG stocks versus the S&P 500 even higher.

Wednesday was much of the same, with most every sector again closing in the red, driven mostly by interpretations of the Federal Reserve’s release of the January Federal Open Market Committee meeting notes. In fact, twenty-five minutes after the release of those notes, the Dow was up 303 points . . . and then proceeded to fall 470 points to close the day down 167 points. To put that swing in context, so far in 2018, the Dow has experienced that kind of a range seven times but not once in 2017.

Thursday was a mixed bag. Most sectors were flat to slightly up as the S&P 500 closed up just +0.1%, while both the Russell 2000 and the Nasdaq Composite lost -0.1%. The energy sector was the strongest performer, gaining 1.3% while financials took a hit, falling 0.7%.

The recovery from the lows this year has been relatively narrow. As of Thursday’s close, the S&P 500 is still below its 50-day moving average, up 1.1% year-to-date with the median S&P 500 sector down -1.0%. Amazon, Microsoft and Netflix alone are responsible for nearly half of the year’s gain in the S&P 500. The Russell 2000 is down -0.4% year-to-date and also below its 50-day moving average. The Dow is up 78 points year-to-date, but without Boeing (BA), would be down 317 points as two-thirds of Dow stocks are in the red for the year.

 

Fixed Income and Inflation — the Coming Debt Headwind

The 1-year Treasury yield hit 2.0%, the highest since 2008 while the 5-year Treasury yield has risen to the highest rate since 2010, these are material moves!

 

 

What hasn’t been terribly material so far is the Fed’s tapering program. It isn’t exactly a fire sale with the assets of the Federal Reserve down all off 0.99% since September 27 when Quantitative Tightening began, which translates into an annualized pace of 2.4%.

As for inflationary pressures, U.S. Import prices increased 3.6% year-over-year versus expectations for 3.0%, mostly reflecting the continued weakness in the greenback. The Amex Dollar Index (DXY) has been below both its 50-day and 200-day moving averages for all of 2018. The increase in import prices excluding fuel was the largest since 2012 and also beat expectations. Import prices for autos, auto parts and capital goods have accelerated but consumer good ex-autos once again moved into negative territory.

Outside the U.S. we see little evidence that inflation is accelerating. Korea’s PPI fell further to 1.2% – no evidence of rising inflation there. In China the Producer Price Index fell to a 1-year low – yet another sign that we don’t have rising global inflation. On Friday the European Central Bank’s measure of Eurozone inflation for January came in at 1.3% overall and has been fairly steadily declining since reaching a peak of 1.9% last April. This morning we saw that Japan’s Consumer Price Index rose for the 13th consecutive month in January, rising 0.9% from year-ago levels. Excluding fresh food and energy, the increase was just 0.4% – again, not exactly a hair-on-fire pace.

 

 

The reality is that the U.S. economy is today the most leveraged it has been in modern history with a total debt load of around $47 trillion. On average, roughly 20% of this debt rolls over annually. Using a quick back-of-the-envelope estimate, the new blended average rate for the debt that is rolling over this year will likely be 0.5% higher. That translates to approximately $250 billion in higher debt service costs this year. Talk about a headwind to both growth and inflationary pressures. The more the economy picks up steam and pushes interest rates up, the greater the headwind with such a large debt load… something consumers are no doubt familiar with and are poised to experience yet again in the coming quarters.

 

The Twists and Turns of Cryptocurrencies

The wild west drama of the cryptocurrency world continued this week as the South Korean official who led the government’s regulatory clampdown on cryptocurrencies was found dead Sunday, presumably having suffered a fatal heart attack, but the police have opened an investigation into the cause of his death.

Tuesday, according to Yonhap News, the nation’s financial regulator said the government will support “normal transactions” of cryptocurrencies, three weeks after banning digital currency trades through anonymous bank accounts. Yonhap also reported that the South Korean government will “encourage” banks to work with the cryptocurrency exchanges. Go figure. Bitcoin has nearly doubled off its recent lows.

Tuesday the crisis-ridden nation of Venezuela launched an oil-backed cryptocurrency, the “petro,” in hopes that it will help circumvent financials sanctions imposed by the U.S. and help improve the nation’s failing economy. This was the first cryptocurrency officially launched by a government. President Nicolás Maduro hosted a televised launch in the presidential palace which had been dressed up with texts moving on screens and party-like music stating, “The game took off successfully.” The government plans to sell 82.4 million petros to the public. This will be an interesting one to watch.

 

Economy — Maintaining Context & Perspective is Key

Housing joined the ranks of U.S. economic indicators disappointing to the downside in January with the decline in existing home sales. Turnover fell 3.2%, the second consecutive decline, and is now at the lowest annual rate since last September. Sales were 4.8% below year-ago levels while the median sales price fell 2.4%, also the second consecutive decline and this marks the 6th decline in the past 7 months. U.S. mortgage applications for purchase are near a 52-week low.

Again, that’s the latest data, but as we like to say here at Tematica, context and perspective are key. Looking back over the past month, around 60% of the U.S. economic data releases have come in below expectations and this has prompted the Citigroup Economic Surprise Index (CESI) to test a 4-month low. Sorry to break it to you folks, but the prevailing narrative of an accelerating economy just isn’t supported by the hard data. No wonder that even the ever-optimistic Atlanta Fed has slashed its GDPNow forecast for the current quarter down to 3.2% from 5.4% on Feb. 1. We suspect further downward revisions are likely.

 

Looking up north, it wasn’t just the U.S. consumer who stepped back from buying with disappointing retail sales as Canadian retail sales missed badly, falling 0.8% versus expectations for a 0.1% decline. Over in the land of bronze, silver and gold dreams, South Korean exports declined 3.9% year-over-year.

Wednesday’s flash PMI’s were all pretty much a miss to the downside. Eurozone Manufacturing PMI for February declined more than was expected to 58.5 from 59.6 in January versus expectations for 59.2. Same goes for Services which dropped to 56.7 from 58 versus expectations for 57.7. France and Germany also saw both their manufacturing and services PMIs decline more than expected in February. The U.K. saw its unemployment rate rise unexpectedly to 4.4% from 4.3%

 

The Bottom Line

Economic acceleration and rising inflation aren’t showing up to the degree that was expected, and this was a market priced for perfection. The Federal Reserve is giving indications that it will not be providing the same kind of downside protection that asset prices have enjoyed since the crisis, pushing markets to reprice risk and question the priced-to-perfection stocks.

 

 

We are back to “bad-news-is-good-news” and “good-news-is-great-news”

We are back to “bad-news-is-good-news” and “good-news-is-great-news”

This week the markets shrugged off last week’s fears and went back to the slow and steady melt up, despite economic news that looked likely to once again rock the boat. By Thursday’s close, the S&P 500 had gained 5.8% from the prior Friday’s open, putting it and the rest of the major market indices back in the green for 2018. While next week will be a lite one on the economic data side, it will contain a few data pieces that we’ll be watching to gauge the vector and velocity of the global economy and inflation. Those results will tell us if we’re in for more weeks like this one or the prior one when it comes to the stock market.

Now let’s recap this week’s happenings and share my observations on it all…

Monday the S&P 500 soared 1.4% in the first half hour of trading only to then drop 1.3% from that high, then back up again to close up 1.4%. Tuesday and Wednesday were both basically days of further upward movement for the market. Thursday there was a slight wobble at the open — falling -0.3% in the second hour of trading — but then moved back up again to close up 1.2%. Having briefly dipped below its 200-day moving average last week, the S&P 500 closed Thursday all the way back up above its 50-day moving average and down just 4.9% from the January 26 all-time high, retracing roughly half of the decline from the January 26th peak.

Investors appear to still be rather skeptical when we look at fund flows. For the 8 days through Tuesday, equity ETFs saw the largest outflows of the past 5 years when converted to a monthly rate. Then again… Monday inflows were the largest year-to-date so perhaps after the Xanax and Zantac kicked in over the weekend, folks were feeling better. Perhaps some of the concerns are coming from the record high 24% of investors surveyed in the BofA Merrill Lunch Global Fund Manager Survey who think corporate balance sheets are overleveraged – problematic with rates rising as bonds need to be rolled over at a higher rate, leading to higher interest costs that weigh on earnings. That brings us to fixed income ETFs, which are still not feeling the love, having seen positive inflow days only 8 times this year as of Tuesday and have hit new cumulative outflow lows.

Looking at sector performance, since the opening on Friday 9th, the technology sector has gained an incredible 8.5% and financials rose 6.9% and we’ve seen a sharp rebound in the Connected Society and Disruptive Technologies positions on the Tematica Investing Select List. The weakest performing sector has been energy, which gained a comparatively weak 2.4%, and isn’t surprising given the continued fall-off in oil prices as more US capacity comes on stream.

Here’s the thing, technology is still 2.8% below its all-time high, while financials are 4.5% below their highs, whilst energy is 12.5% below its all-time high – again the weakest sector in terms of recovery. The performance in financials has been related to the changes in the yield curve – something I’ve talked about on our Cocktail Investing Podcast. The decline in the spread between the 10-year and the 2-year Treasury bond since December 2016 sharply reversed course back in early January and has continued to widen. The spread between the 30-year and 5-year Treasury bond yield had been declining since November 2013 has given signs of possibly starting to widen as of the beginning of the month, but nothing definitive yet. Financials perform better with wider spreads given that they borrow short and lend long, so the wider the spread, the greater the potential profit margin.

On the economic front this week we saw a meaningful increase in consumer credit, wage growth that was weaker than the headlines indicated, CPI and PPI numbers that gave further support to a Federal Reserve that is looking increasingly more hawkish and retail sales that came in below expectations with the biggest drop in nearly a year. That’s the quick summary now for the details and my observations:

In the fourth quarter consumer debt, (excluding mortgages and other home loans), increased 5.5% year-over-year to a record high $3.8 trillion. Non-housing debts also hit a record high of 29% of the overall debt load. Roughly 5.8% of disposable income is going to keep households current on their nonmortgage debt, which is the highest percentage since the end of 2008. For context, the lowest percentage reached was 4.9% in 2012. This is a potentially worrisome sign as this type of debt is more sensitive to rising interest rates. It is worth noting that the average repayment period for new car loans has hit an all-time high of 69 months as of Q3 2017, according to data from Experian. Personal loans to consumers during 1H 2017 were 7.8% higher than 2016.

The dangers here become apparent when we look at the Real Earnings report from the Bureau of Labor Statistics, which was also released this week, and showed that for the roughly 82% of workers in the Production and Nonsupervisory category real average hourly earnings have fallen in 5 of the past 6 months. Year-over-year their average weekly earnings have grown a meager 0.2% – further support for our Cash-Strapped Consumer investing theme. You can read more about that here. Rising credit card balances combined with income that for many people has been basically unchanged in a year is a coming headwind for consumer spending and the economy even before we factor in three to maybe four Fed rate hikes this year. As for all that talk of the economy heating up, the aggregate weekly hours for this group fell dramatically in January as the chart below shows.

 

Aggregate Weekly Hours of Production and Nonsupervisory Employees

 

We are cognizant that this decline could be misleading due to the exceptionally cold weather for parts of the country in January and one month certainly doesn’t make a trend, but this is an area we will be watching in the coming months.

This week also saw inflation data that is cause for concern with the headline Consumer Price Index rising more than expected, which you can read more about here.  Core CPI is now rising at the fastest 3-month pace since 2011 and the fastest six-month pace since 2008, but year-over-year core CPI is still below 2% and is little changed compared to the last few months. Taking a step back we can also see that during the summer of 2017, the 3 and 6-month rates were at the lowest levels since the last recession, so base effects are making the increase look outsized. There has been some talk about the 1.7% increase in apparel prices, which was the largest since 1990. Again, we suspect that the fact that Floridians had to go buy parkas played a role here and in the bigger picture, and the reality is that apparel prices have fallen in 3 of the past 4 months and declined or were flat in 5 of the last 7 months. As we said above, one month does not make a trend people!

The 3-month annualized median CPI is up nearly 3.2% while the 6-month annualized is up 3% and year-over-year median CPI is up 2.4%, indicating that inflation overall is on the rise. We believe that this means the Federal Reserve’s plan to hike 3 times in 2018 is (at least as of now) essentially a done deal with the probability of a fourth hike rising. The Producer Price Index came out after CPI and also pointed towards inflationary pressures.

Thursday’s report on retail sales reasonably should have given the market at least some pause, but we are back to bad-news-is-good-news and good-news-is-great-news. The Commerce Department reported that retail sales in January fell -0.3%, the biggest decline since February 2017 versus expectations for a 0.2% increase and to really rub it in, December was revised down to unchanged from a gain of 0.4%. The market ignored the disappointing numbers and kept moving on up. From our perspective, nonstore retail sales – code words for digital commerce – rose 10% year on year, still taking consumer wallet share and boding very well for the thematic investing poster child better known as Amazon (AMZN).

The bottom line for the week is equities appear to have shrugged off the concerns from earlier in the month, 3-4 Fed hikes are increasingly likely and wage growth for much of the country remains stubbornly elusive despite the tightening labor market. We believe we have a decent grasp on what is behind the wage conundrum, but that is a topic for another day. As for what to expect from the markets in the coming weeks, we suspect that we are not out of the woods and that another retest of the recent lows is likely before moving on to make new highs.

Longer term we are in store for a fascinating battle between the impact of Fed tightening and fiscal stimulus (tax reforms and increased spending) on the economy and portfolio returns. Driving with one foot on the accelerator and one on the brakes comes to mind. The coming months and year are likely to be more challenging for investors than 2017, which is all the more reason to have solid investment strategies based on long-term themes.

With U.S. equity markets closed on Monday in observance of President’s Day, the weekly Monday Morning Kickoff penned by Tematica’s Chief Investment Officer, Chris Versace, will not be published. While that may disappoint more than a few folks, Chris and I will have no shortage of commentary next week due in part to the monthly Flash PMI data to be published by IHS Markit. While we will dig into those reports to gauge the velocity of the economy, we expect the comments on input prices will be of keen focus following the January inflation reports we received this week.

Enjoy the long weekend and be sure to look for our comments at TematicaResearch.com next week.!