Commodities

Not a Bearish Game Changer

Stocks dropped sharply last week, thanks partly to positioning (the S&P 500 sprinted from 2,044 to 2,132 in less than two weeks and some digestion was needed), but there were also legitimate fundamental reasons: disappointing earnings, and the implosion (again) of the commodity space. And, given the surprising weakness in the SPX last week, it’s reasonable to ask whether last week was a bearish game changer.

For now, the answer is “No,” it was not a bearish game changer.

Starting with earnings, there were some high-profile disappointments: AAPL, MMM, MSFT, UTX, IBM, COF among others. And, it is fair to say that this earnings season has been more “mixed” than good. But, most importantly, the 2015 and 2016 full-year EPS expectations are not being revised lower, which means the S&P 500 is still trading at around 16X 2016 earnings, and that is not a rich valuation given interest rates (and not a bearish game changer).

Turning to commodities, the implosion is being extrapolated out to be a large “caution” flag on global growth. But, like the similar declines last December/January, and as we covered in The 7:00’s Report last week, this commodity decline has a lot more to do with supply than demand (at least so far).

bearish game changer

Demand is falling, but mostly in emerging markets, specifically China and Brazil, not globally. Earnings haven’t helped this idea either; as a lot of the higher-profile misses (UTX and other industrials) have highlighted China weakness. But, consumer oriented companies also highlighted the opportunity in China this quarter (AAPL in particular). Point being, it’s too simplistic to say this decline in commodities is a red flag for the global economy. It’s also too simplistic and too premature to call this a bearish game changer.

Finally, Friday a “leaked” Fed staff paper strongly implied a rate hike at some point this year (which should be known by the market but still elicited the Pavlovian negative reaction). It’s the reason that stocks dropped but bonds didn’t rally Friday. More important than signaling a hike this year, the paper also confirmed a “one and done” approach to policy this year, and we believe that first rate hike will likely end up being a positive for stocks, as long as it’s signaled as being the only one this year (again, not a bearish game changer).

Bottom line, despite the surprisingly weak price action we do not think a mixed earnings season, the commodity drop, or a Fed rate hike in September is a bearish game changer, and they are not making us more cautious on this market.

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Are Commodities Warning About Deflation?

In Markets 101 we’re taught that when industrial commodities (base metals, oil, coal, etc.) plummet, it is usually a harbinger of deflation. Commodities in aggregate have absolutely plummeted, all the way back to panic lows of early 2009. Additionally, the recent bond rally quasi-confirms the whiff of deflation. So, the question we are obviously asking is: Are commodities signaling deflation?

For now, we believe the answer is “No.”

There are multiple reasons we think that:

1) A lot of the commodity declines are supply based.

2) Demand destruction is occurring primarily in emerging markets, so Brazil and Asia (mainly China but also Japan and South Korea), and while that may export commodity price deflation globally, and statistically weigh on CPI and other inflation measures like last summer, that’s a lot different than consumer-driven deflation.

deflation

3) ETFs are exacerbating the declines in commodities.

4) The bond market isn’t fully confirming this deflation scare.

Starting with the first point, much of the massive declines in industrial commodities are the result of rising supply, not collapsing demand. Copper, iron ore, steel, oil, natural gas, wheat, corn, soybeans and other commodities (coffee) are seeing huge supply booms, and that, more than anything else, is depressing prices—and that’s actually a virtue for consumer-oriented economies like the US.

With regards to demand, the destruction is coming primarily from emerging markets and Asia, with most of the focus on China. I’m not trying to minimize that effect on commodity stock investors, but a reduction in Chinese demand, which itself is an offshoot of their slowing growth, isn’t by default a global economic calamity.

In the late 90s China (and Asia/emerging markets more broadly) exported raw material deflation, which capped the cost of most products in the US during that time period, despite a strong economy. Again, it was a positive for consumer-based economies. So, the demand issue is mostly a China (and more broadly Asian/emerging markets) issue, and while that is a potential risk to continue to monitor, at this point it’s not a huge, negative influence on US stocks.

Third, ETFs are exacerbating the declines in commodities. ETFs for gold, silver and copper hold physical, and need to dump it to produce cash to make redemptions. And while these ETFs provided a nice tailwind of demand on the way up, the same thing is happening on the way down.

Finally, looking at the bond markets, they simply aren’t fully confirming this deflation threat, yet. Yes, bonds have rallied since early July, but they remain well below levels of a few months ago. And while the yield curve has flattened over the past three-to-four weeks, it has steepened considerably over the course of the year.

Bottom line, the commodity collapse certainty is something to watch closely, as in the past it has been a harbinger of trouble. Remember the same thing happened last year and it didn’t result in real deflation, and given the strengthening US jobs market and generally good level of credit availability and strong housing market, I do not see the commodity decline representing a deflation “scare” this time around.

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Oil Tumbles on Iran Nuclear Deal

The big news Tuesday morning was the Iran nuclear deal that would see an easing of sanctions against Tehran and a gradual increase in its oil exports.

Oil futures were down sharply Tuesday morning, a trend that’s continued from Monday afternoon after oil finished down by 1.18% in anticipation of this morning’s deal.

The focus of the oil markets is understandably on the Iran nuclear deal, and this development along with the news that Saudi Arabia just reported record oil output, are both very strong bearish influences on an already oversupplied global oil market.

The WTI crude contract remains in a consolidation pattern after the sharp 15%+, peak-to-trough drop we saw over the last two weeks, but after the announcement of the Iranian nuclear deal overnight, international fundamentals took a bearish turn which could turn out to be the next catalyst for a breakdown to new multi-month lows as traders get to their desks and see the news.

Iran nuclear deal

However, beginning with today’s API numbers reported after the close, focus will likely begin to turn away from the Iran nuclear deal and back to the production and supply situation here in the US.

The oil market is very fluid right now (no pun intended) and to a big extent an Iran nuclear deal has already been priced in to markets. But we need to keep a close watch today to see how traders react to the global reaction on the Iran nuclear deal to see just how much potential downward pressure it will have on oil prices.

To find out more about the Iran nuclear deal and the price of oil, or to get our exclusive recommendations in our 7 Best Ideas page as well as the elite market analysis from The 7:00’s Report, delivered to your inbox each trading day by 7 a.m. EST, then click here to start your subscription today!

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Chinese Stock Market vs. the Chinese Economy

This week, the collapsing Chinese stock market has taken over Greece as the No. 1 macro concern for markets.

Although the Chinese stock market has rebounded over the past 48 hours, why the Chinese stock market went into freefall in the first place, and more importantly, if that decline actually really represents a potential global market headwind, is what we really need to get to the bottom of.

Find out all of the details in my new article, which is also my first contribution to appear on InvestorPlace.com.

Chinese stock market

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Greece, Euro and the Dollar

The turmoil in Greece has been caused a lot of tumult in currency markets, and not surprisingly this has had a big influence on the euro and the dollar.

On Tuesday, the dollar continued its recent breakout with the U.S. Dollar Index rising back above 97.00 for the first time since late May. The seemingly never-ending saga in Greece continues to weigh on the euro.

The euro dropped below 1.10, down 0.56% on the day Tuesday, proving the euro and the dollar remain intimately linked. Notably, both the euro and the dollar were much stronger and weaker, respectively, at the start of trading Tuesday and the dollar came in throughout the day while the euro rallied.

The main reason for that was the constant drip of “hints” of some sort of a short-term deal to be struck this Sunday for Greece. That not only was responsible for the late-day rally in stocks, but also the lift in the euro, Treasuries—and then the pullback in the euro.

There is so much noise and positioning around Greece it’s hard to read anything into the daily trading, but the bottom line is that the euro and the dollar are either:

1) Not screaming “Grexit” yet, or

2) Confident the ECB will act with enough force to counter any ill effects of a “Grexit”—and that remains somewhat reassuring.

euro and the dollar

The pound was the big decliner yesterday as it dropped 1% vs. the dollar following very disappointing manufacturing data, as Great Britain manufacturing output declined -0.6% vs. (E) -0.1%.

Also weaker vs. the dollar yesterday was the Aussie, as that currency declined to new, multi-year lows following the RBA holding interest rates steady but making “dovish” comments. Another weight on the Aussie and the Loonie was the fact that commodities continue to implode this week (silver being the latest yesterday, down nearly 4%).

Bottom line: With China wavering, commodities falling and global growth at risk generally, the outlook for the commodity currencies near term remains challenging, even ignoring the expectation of dollar strength. This means that the path of least resistance for both remains lower.

Of course, Greece will continue to hold markets hostage through at least the next 48 hours, sadly, but once the dust settles from however this situation is resolved we continue to expect more action in the euro and the dollar, with more dollar strength and more euro weakness.

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Commodities Weighed Down by Oil

Amidst all of the Greek drama there was a bearish start to the week in commodities. The big culprit weighing down commodities comes from the energy space, as oil and natural gas continue their recent collapse.

Copper also extended recent losses, while the precious metals failed to materially rally despite global volatility levels spiking thanks to both Greece and China. The broad-based commodity tracking index ETF, DBC, dropped 3.35% in Monday trade.

Oil remained the primary focus of the commodity segment yesterday, as rising concerns about the ongoing situation in Greece and Chinese equity markets added additional pressure to an oil market that has already started to break down thanks to bearish fundamentals.

WTI crude oil futures declined 7.66% yesterday; however, that figure was slightly skewed due to the fact that electronic futures traded on Friday. The Nymex was closed Friday, and therefore there was no official settlement. Nonetheless, futures declined 7.66% between Thursday’s close and yesterday’s close, marking the worst session for oil since February.

oil

As for the reason for the sharp declines in oil, there were the demand concerns stemming from both Greece and China as investors look at both situations as potentially weighing on global oil demand.

From a supply standpoint, Iran has said they would look to double their oil exports as soon as possible if/when sanctions are lifted. Additionally, investors continue to digest the last two weeks worth of bearish developments in the US oil and energy space, including the continued rise in domestic production, the unexpected rise in oil inventories last week and the first increase in rig counts being reported so far this year.

Bottom line, the oil market has been in freefall for the past four sessions, already reaching and crashing through our initial downside target of between $53 and $54/ barrel. And, the way futures closed essentially on the low ticks Monday suggests there is still some downside momentum in this market.

However, nothing goes straight up or straight down, so we are now looking for a healthy counter-trend rally in oil to play out at some point this week, likely taking oil futures back up to the mid $50s/barrel.

Still, we see that potential rally in the oil as a good entry point to sell the energy space again, as the path of least resistance in oil remains lower based on both the technicals and fundamentals.

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June Jobs Report Preview

All the risk in the June jobs report, from an equity and bond market standpoint, is that it increases the chances of two rate hikes in 2015 by running “Too Hot.” That outcome (two hikes this year) is not priced into assets (stocks, bonds, dollar, commodities) and is the single biggest threat to the rally near term.

Additionally, the stakes are high here because given the Greek drama this week; stocks are below technical support levels. If we get a “hawkish” sell-off on the June jobs report there’s the chance it could cascade a bit given the technical situation right now.

But, in order for this June jobs report to increase the chance of two hikes in 2015, it’s going to have to be very good, so the “Too Hot” bar is a bit higher than usual.

If we see a “Too Hot” jobs report expect a “hawkish” reaction: stocks & bonds down (potentially sharply), dollar up.

The “Too Hot” Scenario (What it Takes to Materially Increase the Chances of Two Rate Hikes)

> 300k Job Adds. The headline number re-asserts itself as the key number in this report this month, and if we see a 300k or higher jobs report, chances of two hikes go up materially.

< 5.3% Unemployment Rate, ≤ 10.7% U-6 Unemployment Rate. In the March statement the Fed lowered “NAIRU” to 5.0% and below, so it’s going to take a material drop in the unemployment rate (bringing it close to 5%) to increase the chances of two Fed rate hikes.

> 2.4% yoy wage increase. There is ample evidence to show that wage inflation is accelerating, but with general inflation still low it’ll take an even bigger jump to put two hikes on the table this year.

June jobs report

The “Just Right” Scenario (September Rate Hike)

150k—280k Job Adds, 5.4%-5.6% Unemployment Rate, ≤ 2.4% YOY wage increase. The range for this June jobs report number to be “just right” or “Goldilocks” is pretty wide, and this is by far the highest probability. If the number is at the higher end of the Goldilocks range then that will probably be a good tailwind on stocks, as it will cement the “one and done” expectation of the market—and stocks can rally in that situation.

The “Too Cold” Scenario (December or early 2016)

< 150k Job Adds, ≤ 2.2% yoy wage increase. This number will be technically “dovish” but it’s not a positive for stocks or the economy, so fade any material rally on a number this weak. The Fed wants to get at least one hike in, and if the job market starts to soften and we see two sub-150k job prints in the last three months, that’s not going to be good for risk assets.

Again, all the risk into this June jobs report is of it being “Too Hot” and causing the Fed to consider hiking twice, which is probably a greater probability than the market currently is considering (at least according to comments by Williams and Dudley). But, unless this June jobs report number prints “Too Hot” then it will likely be a mild-to-moderate short-term positive on stocks.

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Shrimp on the Wage Inflation Barbie

It’s time to throw another shrimp on the wage inflation barbie.

Three trading days after the May jobs report revealed a 2.3% yoy increase in wages (over the Fed 2.2% target), and one day after record JOLTS (job openings) and the citing of difficulty finding adequate talent in the small business survey, the Employer Costs for Employee Compensation (ECEC) data came in surprisingly firm—Q1 ’15 ECEC rose 4.9% yoy, the same pace as Q4 ’14—again anecdotally implying we are seeing wage inflation start to accelerate.

In addition to the higher wage inflation implications, the ECEC staying at Q4 ’14 levels offers more proof that Q1 economic weakness is being overstated and was transitory and not a material shift in the economy. This is something that many analysts had thought to be the case, but now the jobs and wage inflation data is really starting to confirm initial intuitions.

From an investment standpoint, near term the evidence for wage inflation incrementally adds to the potential for a more “hawkish” Fed than currently expected, which is dollar positive/bond negative.

wage inflation

In terms of sectors, this also bolsters our “consumer” theme that retailers via Market Vectors Retail (RTH) are poised for a potential breakout if consumer spending rebounds (as it should given the positive fundamentals).

Beyond the near term, wage inflation begets real inflation.

So, this is positive inflation-hedged assets (stocks) and to a point gold, which was up decently yesterday (although despite the gold bugs’ beliefs, statistically gold is not the greatest inflation hedge—although it is obviously positively correlated).

Bottom line, wage inflation has started, and that should lead to an ultimate uptick in real inflation unless growth unexpectedly stalls.

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The Improving Labor Market

Last week, we received one of the best jobs reports we’ve seen in a very long time. On Tuesday, we saw more data suggesting an improving labor market. The April JOLTS, or job openings, number came in at a record high of 5.376 million, which is obviously positive for an improving labor market.

Meanwhile, the NFIB Small Business Optimism Survey rose to 98.3 vs. (E) 97.2. From a wage standpoint, the survey results were especially important. That’s because the survey of small businesses found that third on the list of “problems” small business faces (behind taxes and government regulation) was “No Qualified Applicants” for open positions.

improving labor market

More specifically, 45% of respondents to the survey said they planned on hiring or were trying to hire more workers in May (up 2% from April), but 47% of respondents said there were few or no qualified applicants for the open positions.

So, the practical takeaway from the improving labor market data is: A lot of job openings plus difficulty finding qualified workers to fill those openings is a great recipe for an acceleration in wage inflation—which if it continues, will put further “hawkish” pressure on the Fed.

It won’t change anything in the immediate term from a Fed outlook standpoint, but the anecdotal evidence of an improving labor market implies wages are accelerating higher. Wage inflation be-gets nominal inflation, and for a market that is still very dovish, that is notable.

From an investment standpoint, the improving labor market adds more credence to my “hawkish” scare pullback in stocks (despite Wednesday’s rally). It also is bearish bonds, a trend we have seen ramp up significantly over the past six weeks.

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May Jobs Report Preview

The key to the May jobs report, due out Friday morning, is whether it solidifies September as the date of Fed rate hike “lift off”, or whether it leaves open the consensus of a later than September rate hike (October/December/early ’16). Going into the May jobs report, December remains the slight consensus expectation, although a strong number Friday could shift that to September.

So, look at it this way:

“Too Hot” = Potential of a July hike

“Just Right” = September hike

“Too Cold” = October/December/2016 hike

The “Too Hot” Scenario (What It Takes to Put July on the Table)

> 250k Job Adds. It’ll take a pretty strong number to put a July hike on the table (there’s almost no chance of June), but a 250k or higher May jobs report would do it. 

< 5.4% Unemployment Rate, ≤ 10.9% U-6 Unemployment Rate. In the March statement the Fed lowered “NAIRU” to 5.0% and below, but if we continue to see both unemployment rates grind steadily lower, again in the context of a “fully dovish” expectation by the market, this will elicit a hawkish reaction because it’ll make a September hike more likely.

> 2.3% yoy wage increase. YOY wage gains again moderated a bit in the April report, but inflation metrics are clearly bottoming. If we see year over year wages move above the 2.2% target, expect calls for a small hike in July.

The “Just Right” Scenario (September Rate Hike)

150k—250k Job Adds/ 5.4% Unemployment Rate, ≤ 2.2% YOY wage increase. There’s the chance we could see a “hawkish” reaction by markets to this type of May jobs report, but this is closest to expectations.

The “Too Cold” Scenario (December or early 2016)

< 150k Job Adds/≤ 2.2% yoy wage increase. This May jobs report number will be technically “dovish” but it’s not a positive for stocks or the economy, so fade any material rally on a number this weak. The Fed wants to get at least one hike in, and if the job market starts to soften and we see two sub-150k job prints in the last three months, that’s not going to be good for risk assets. 

I continue to believe that clarity on the state of the economy and on the timing of the first Fed rate hike is the key to materially higher stock prices, so I am hoping for a strong number tomorrow—but I’m also ready for any surprises in the May jobs report.

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