FOMC Meeting Takeaways, August 17, 2017

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The FOMC minutes resulted in a “dovish” reaction in currencies and bonds, but in reality they didn’t reveal anything new.

Takeaway
The two big takeaways from Wednesday’s FOMC were 1) The Fed is united in reducing the balance sheet in September (which will be the start of the removal of additional accommodation) and 2) The Fed is divided on whether to hike rates in December because of low inflation. Neither of those takeaways should be surprising to anyone who has been paying attention.

The former (that the Fed is committed to reducing its balance sheet) was reaffirmed by the minutes yesterday, and while the market seems to be ignoring this event, I do want to remind everyone that the Fed will be reducing its Treasury holdings for the first time in a decade. That will, over time, have a “tightening” effect on the economy (although admittedly not at first).

The latter was where the market generated it’s “dovish” interpretation of the Fed minutes, but in reality the fact that “some” Fed members want to not hike rates again this year shouldn’t be a surprise. Bullard, Kashkari, Mester and others have voiced caution about further rate hikes in the past few weeks due to low inflation.

Conversely, Dudley, Williams and others have stressed very low unemployment and still-loosening financial conditions as reasons to continue with gradual rate increases. Otherwise, they risk getting behind a sudden upshot in inflation that forces them to raise rates very quickly.

Point being, we know there is this divide, and it will be resolved in the coming months based on inflation data. If inflation data bottoms and heads higher, they’ll hike rates in December. If it doesn’t, they probably won’t. That’s no different than it was Wednesday at noon.

From a market standpoint, the reaction was “dovish” as the dollar and bond yields dropped, and stocks rallied modestly. But, yesterday’s FOMC minutes should not be enough to elicit a material rally in stocks, nor should it be enough to push the dollar or bond yields to recent 2017 lows.

About the only notable takeaway from the minutes is that it’s likely anecdotally bullish for the “Stagnation” portfolio…(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

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Brick and Mortar Retail Update, August 16, 2017

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From a single-stock standpoint, retail was again a quasi-disaster thanks to earnings (the strong retail sales number is more positive for credit card companies like V, LC and AXP than it is the retailers). Now, you would think at some point this year expectations for retailer results would get so low and the outlook so pessimistic that we’d start to get post-earnings rallies in retail on “not-as-bad-as-feared” results. Unfortunately, that’s just not happening.

Of the 10 biggest decliners in the S&P 500 Tuesday, six were retailers: Advance Auto Parts (AAP) (down more than 20%!), Coach (COH), Urban Outfitters (URBN), Bed Bath & Beyond (BBBY), Ulta (ULTA) and Foot Locker (FL). Even Home Depot (HD), which posted strong numbers and raised guidance, couldn’t overcome the negativity. After an initial rally, HD fell 2.65%.

The contrarian in me is all over retail, as I’ve seldom seen a sector where there’s more pervasive negativity. However, I also remind myself that whale oil was once a contrarian opportunity… and we saw how that turned out.

I’m being a bit silly, as brick-and-mortar retailers aren’t whale oil, but the point is that these names simply aren’t cheap enough, and the outlooks aren’t negative enough—which is a scary thought from an industry standpoint. The contrarian in me will continue to watch the space, but for now, I see nothing to do.

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Weekly Market Cheat Sheet, August 14, 2017

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Last Week in Review

There was more underwhelming economic data last week, especially on the inflation front, as the prospects for an economic reflation in 2017 continued to dim.

From a Fed standpoint, the disappointing CPI and PPI reports further reduce the chances of a rate hike in December, although importantly the Fed is still expected to begin to reduce its balance sheet in September.

Starting with the headline numbers, CPI and PPI, they were both disappointing. The Producer Price Index declined to -0.1% vs. (E) 0.1% while the core figure was flat vs. (E) 0.2%. Meanwhile, the CPI report was slightly less underwhelming at 0.1% vs. 0.2% on the headline, and the same for the core.

While these aren’t horrible numbers, they aren’t good either, and the bottom line is that statistical inflation
remains stubbornly low, and it is appearing to continue to lose momentum. Again, for context, that’s a problem because in this environment, with (supposedly) strong economic growth and low unemployment, inflation should not be going down. Period. And the longer it goes on, the more it sparks worries that eventual deflation or disinflation will rise, and that’s not good for an economy with still-slow growth and extended asset markets.

Bottom line, even before the uptick in North Korea jitters this was a market in need of a positive catalyst to spur further gains. Unfortunately, the economic data (ex-jobs and sentiment surveys) has been consistently underwhelming, so the chances of a rising tide driven by an economic reflation continue to dim. And while a “dovish” number may be good for a mild pop in the S&P 500, soft data and a lower dollar/bond yields aren’t going to drive the market to material new highs.

This Week’s Preview

This week is busy, with mostly anecdotal data that will give us a better overall picture of the economy and inflation—and the main risk to stocks now is that the data comes in light, and along with low inflation that spurs fears of an economic loss of momentum. If that happens, stocks will take out last week’s lows.

The most important report this week will be tomorrow’s Retail Sales report. Consumer spending has been lackluster for most of 2017, but around now we see a typical seasonal uptick. That will be welcomed by markets if that appears again this year. If the number is soft, it’s going to spur worries about the pace of economic growth (remember, hard economic data hasn’t been great all year, it’s been the PMI surveys that have been strong).

Beyond retail sales, we also get a first look at August economic data via the Empire and Philly manufacturing indices. Both numbers haven’t been highly correlated to the national PMIs lately, but it’s still our most-recent economic data and it could move markets, especially if we see any weakening in the data. Empire comes tomorrow and Philly comes Thursday.

Turning to central banks, we get the Fed minutes from the July meeting on Wednesday, and the ECB minutes from the July meeting on Thursday. The Fed minutes are important because we will be looking for clues as to how eager or committed the Fed is to September balance sheet reduction. With the ECB, the key will be seeing how committed or eager the ECB is to announce tapering of QE in September. As is usually the case, there shouldn’t be any big surprises in these minutes, but they could slightly shift expectations for those two events (balance sheet reduction/announcement of tapering), and as such also move Treasury yields and Bund yields.

Finally, July Industrial Production and Housing Starts also come this week (Thursday and Wednesday,
respectively). Again, these are an opportunity for the hard data to rise and meet strong soft data surveys, and in doing so reassure investors that the economy’s accelerating.

Bottom line, none of the numbers this week are “major,” but in aggregate they will give us a lot more insight into the pace of economic growth and the outlook for the Fed and ECB. And, this market needs some economic reassurance to help bolster sentiment after last week. Better data and steady Fed/ECB are a needed boost markets this week.

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Why Yesterday’s Decline Wasn’t Just About North Korea, August 11, 2017

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Why yesterday's decline wasn't just about North Korea

Thursday was another risk-off day in the currency and bond markets thanks to North Korea, but there were some underwhelming economic reports that shouldn’t be missed, either. The Dollar Index fell 0.09% and never strayed too far from unchanged, in part due to the looming CPI report out this morning.

Starting with the obvious, North Korean angst again kept a lid on most currencies and pushed the yen higher, in classic risk-off trade (although importantly, the moves were mild and currencies and bonds did not confirm the angst in stocks).

However, beyond North Korea there was important economic data that did also impact currencies, and again I maintain that unless we get a big deterioration in the North Korea situation the data remains more important for the remainder than the geopolitical landscape.

First, US PPI was soft, declining for the first time in months and again reinforcing the idea of slowing inflation. Now, PPI isn’t as important to the Fed or markets as CPI, but the bottom line is that if we are in (or approaching) an economic reflation, we shouldn’t see these types of underwhelming inflation reports.

That soft PPI weighed slightly on the dollar and bond yields, although again it was largely overshadowed from a market standpoint by North Korea and today’s CPI.

Looking internationally, the euro was flat all day vs. the dollar amidst little news, while the pound dipped 0.26%. The reason for the pound weakness wasn’t just risk off in the markets. It also was due to an underwhelming Industrial Production report. While the headline number beat estimates (0.5% vs. (E) 0.2%), the manufacturing sub-component was flat vs. (E) 0.2%. That was why the pound dipped back below 1.30 vs. the dollar.

The big gainer vs. the dollar yesterday was, again, the yen, which rallied 0.55% on a standard risk-off move. Economic data in Japan yesterday was, at best, mixed, but the yen isn’t trading off data right now… it’s trading off sentiment. And, the North Korea news is causing a flight to safety, and that means higher yen, higher Treasuries and, for now, higher gold.

Turning to bonds, Treasuries rallied as the 10 year rose 0.11% and the 10-year yield fell below support at 2.22%, although that drop happened into the close.

Bottom line, this flare up in North Korea has put the 10-year yield at a critical technical crossroads. If CPI is light this morning, the 10-year yield will likely drop below 2.20%. At that point, a test of the 2017 lows certainly isn’t out of the question. And, we’d find that disconcerting for multiple reasons, chief of which because it would imply too low inflation and largely destroy the chances for a reflationary rally in stocks in 2017.

We maintain that an economic reflation (higher growth, higher inflation, higher rates) is the only path to a sustainable medium- and long-term rally. While it may cause more of a decline short term, the medium- and longer-term investor in us is hoping for a strong CPI report later today. Unfortunately, I have a sneaking suspicion I will be disappointed. I hope I’m wrong.

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North Korea Update, August 10, 2017

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Stocks are down again this morning on this topic, and the reason is because North Korea said it will shoot a missile within “30 or 40” miles of Guam in mid-August. That would be another escalation because it would extend the range of the North Korean missiles—and at that point the US might actually shoot one down. Undoubtedly some of you are getting calls from nervous clients about North Korea, and while I don’t view this as a major market issue, I do want to briefly cover the situation so you can handle any client calls.

Ignoring the rhetoric and bluster on both sides for a moment, two important things happened with regards to North Korea this week.

First, in what was a major positive, the UN passed very harsh sanctions on North Korea with a unanimous vote. That unanimous vote part is key, because both China and Russia supported the sanctions, implying the international community is finally on the same page regarding North Korea’s nuclear program.

Second, in what was a negative that resulted in the recent escalation of tensions, North Korea has apparently learned how to miniaturize a nuclear warhead and place it on an intercontinental ballistic missile. If true, that means they could theoretically strike Japan with a nuclear missile.

Those two events, one positive, one negative, are why this situation has escalated so quickly.

Going forward, despite the escalation in rhetoric, the net events of the past weeks need to be viewed as a positive. If China and Russia stay on board, then the chances of resolution (peaceful resolution) go up significantly. So while things seem bad now, in reality, the chances of a lasting solution have gone up since this time last week.

However, if you have clients who are worried about this and want to hedge up a bit, basically the “North Korea Defensive Playbook” would be as follows: 1) Buy Treasuries (belly and longer dated, so IEF or TLT), 2) Buy defense stocks (TRN, LLL, LMT, NOC ) and 3) Buy the yen via FXY and sell Japanese stocks (i.e. DXJ or EWJ). Now, to be clear, I don’t think you should do this now, but this is the playbook if any clients are asking what to do in case of a conflict.

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Why the Phillips Curve Matters to You, August 8, 2017

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Pushing unemployment lower should, eventually, cause inflation—unless this entire theory (upon which most of monetary policy is based) is incorrect.

Pushing unemployment lower should, eventually, cause inflation—unless this entire theory (upon which most of monetary policy is based) is incorrect.

The Phillips curve is a term you’re likely seeing and hearing more recently than at any time previously in your career (regardless of how long it is). The reason the Phillips curve is being discussed so much is simple: There’s a growing school of thought that thinks the Phillips curve is broken, and if that’s the case, then the Fed and other central banks may be largely powerless to spur inflation (which is a potential negative for the broad markets).

Before we get into this issue, though, first lets get a bit of background on the Phillips curve. Basically, the Phillips curve is just a graph of this simple idea: Low unemployment creates higher inflation.

From a commonsense standpoint, it is logical. Less available workers and robust business activity (so low supply and high demand for workers) will cause salaries (the “price” of a worker) to rise, and that in turn will flow through to the entire economy and spur price inflation.

So, put simply, the Phillips curve says low unemployment will spur inflation. And, this idea has been the cornerstone of Fed policy for decades and largely explains the Fed’s strategy post financial crisis.

Plunging unemployment: At some point, this must create inflation, or at least that’s what Yellen believes.

Plunging unemployment: At some point, this must create inflation, or at least that’s what Yellen believes.

But, there’s a small problem: It doesn’t appear to be working in today’s economy, as historically low unemployment is failing to spur inflation.

Now, this may seem like a theoretical, academic conversation, but it has real, near-term market consequences.

For instance, the entire mid-July rally in stocks came because the Fed began to note low inflation more than low unemployment.

That caused the decline in Treasury yields and exacerbated the drop in the dollar—and that helped spur a rally in stocks.

However, that may have changed with Friday’s jobs report. The unemployment rate hit 4.3%, matching a fresh low for this expansion (i.e. since the financial crisis). And, unemployment that low will get the Fed’s attention (at least Yellen’s attention) because while there is a debate about the Phillips curve still being accurate, the bottom line is that the Fed still follows it. At some point, if unemployment continues to drop, the Fed will have to continue with rate increases regardless of what’s happening with inflation.

And, that could have an important impact on returns and performance.

Here’s why: If unemployment grinds towards 4% or below, the Fed will have to get hawkish or either 1) Abandon decades of monetary policy that has largely worked, or 2) Risk a significant rise in inflation down the road (according to the Phillips curve) that would require a sharp, painful increase in interest rates—a move that almost certainly would put the US economy into recession.

The practical investment takeaways are this: (withheld for subscribers of the 7sReport—sign up for your free two-week trial to unlock). 

Weekly Market Cheat Sheet, August 7, 2017

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Weekly market cheat sheet

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Last Week in Review

Friday’s jobs report caused a mild reversal of the week’s long downtrend in yields and the dollar, but that was more a function of “covering shorts” on the news rather than it was a function of the jobs report being materially hawkish (it met our “Just Right” scenario).

In total, while unemployment dipped further and wages were steady, in aggregate the economic data from last week largely reinforces the “stagnation” outlook for markets (slow-but-steady growth, low inflation).

Starting with the jobs report, as mentioned, it hit the upper end of our “Just Right” scenario. The headline job adds was stronger than expected (209k vs. 178k) while the June revisions were positive (up 9k to 231k).

Meanwhile, unemployment and wages met expectations: 4.3% unemployment and 0.3% wage gains, with a 2.5% yoy increase. In all, it’s a pretty Goldilocks jobs report, as job adds remain strong and the downtrend in wage inflation appears, at least in July, to have stopped.

That’s why we saw the rally in the 10-year Treasury yield and dollar. It wasn’t that the report was hawkish, but it did stop the trend in lower inflation stats. And, with a market as stretched to the downside as the Dollar Index and 10-year yield both are, it caused a snap-back rally.

Importantly, other than potentially making a December rate hike slightly more expected, Friday’s jobs report did nothing to alter the outlook for the Fed (still balance sheet reduction in September).

Looking at the economic data the rest of last week, it was more of the same: Not particularly impressive, but not implying a slowdown, either.

The ISM Manufacturing PMI slightly beat estimates at 56.3 vs. (E) 56.2, and that remained well above the important 50 mark. So, while there was a decline from June, it remains indicative of a manufacturing sector that is seeing growth accelerate.

The one disappointing economic data point last week was the ISM Non-Manufacturing (or service sector) PMI. It declined to 53.9 vs. (E) 56.9, and was the weakest reading since August 2016. However, the private sector Markit Services PMI rose to 54.7 from 54.2, so there is a conflicting message there (ISM is one firm that produces PMIs, and Markit is a competitor. Usually, their PMIs are generally in agreement, but not this month… and it has to do with the survey questions each use and the makeup of the final indices. It’s an oddity that there was a discrepancy, but it’s not an economic red flag (at least not at this point).

Bigger picture, economic growth through June and July appears consistent with the slow-but-steady growth we’ve become accustomed to over the past several years. It’s certainly not a negative for stocks, but it’s not going to create a rising tide that propels us to new highs.

This Week’s Preview

As is usually the case for the week following the jobs report and the PMIs, this week will be quieter from an economic data standpoint, although there is a very important report coming this Friday… CPI.

As we’ve said consistently, inflation is much more important right now (because it’s declining) than economic growth (which remains steady), so inflation numbers will have the potential to move markets more than growth numbers, as we saw on Friday with the jobs report.

To that end, Friday’s CPI has the potential to send bond yields and the dollar higher, if it confirms Friday’s wage number that implies inflation steadied in July. Conversely, if the CPI report is soft we’ll see Friday’s rally in bond yields and the dollar undone, quickly.

Outside of CPI Friday (and PPI on Thursday) the next most-important data point this week will be the Productivity and Costs report Wednesday. In Friday’s Report, I listed a number of events that could push stocks higher if earnings growth has peaked near term. Increased productivity was one of those events, so a strong productivity number will be positive for markets.

Beyond those two numbers, the domestic calendar is quiet this week, and none of the reports coming (NFIB Small Business Optimism Index, jobless claims) should move markets too much.

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Is the Earnings Rally Losing Steam?

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Earnings have been an unsung hero of the 2017 rally, but there are some anecdotal signs that strong earnings may already be fully priced into stocks, leaving a lack of potential positive catalysts given the macro environment.

Now, to be clear, earnings season has been (on the surface) good. From a broad standpoint, the results have pushed expected 2018 S&P 500 EPS slightly higher (to $139) and that’s enough to justify current valuations, taken in the context of a calm macro horizon and still-low bond yields.

However, the market’s reaction to strong earnings is sending some caution signals throughout the investor
community. Specifically, according to a BAML report I read earlier this week, the vast majority of companies who reported a beat on the top line (revenues) and bottom line (earnings) saw virtually no post-earnings rally this quarter. Getting specific, by the published date of the report (earlier this week) 174 S&P 500 companies had beat on the top and bottom line, yet the average gain for those stocks 24 hours after the announcement was… 0%. They were flat. To boot, five days after the results, on average these 174 companies had underperformed the market!

That’s in stark contrast to the 1.6%, 24-hour gain that companies who beat on the revenues and earnings have enjoyed, on average, since 2000.

In fact, the last time we saw this type of post earnings/sales beat non-reaction was Q2 of 2000. It could be random, but that’s not exactly the best reference point.

So, if we’re facing a market that’s fully priced in strong earnings, the important question then becomes, what will spur even more earnings growth?

Potential answers are: 1) A rising tide of economic activity, although that’s not currently happening. Another is 2) A surge in productivity that increases the bottom line. But, productivity growth has been elusive for nearly a decade, and it’s unclear what would suddenly spark a revival. Finally, another candidate is 3) Rising inflation that would allow for price and margin increases. Yet as we know, that’s not exactly threatening right now, either.

Bottom line, earnings have been the unsung hero of this market throughout 2017, but this is a, “What Have You Don’t For Me Lately” market, especially at nearly 18X next year’s earnings. If earnings growth begins to slow and we don’t get any uptick in economic growth or pro-growth policies from Washington, then it’s hard to see what will push this market higher beyond just general momentum (and general momentum may be fading, at least according to the price action in tech). To be clear, the trend in stocks is still higher, but the environment isn’t as benign as sentiment, the VIX or the financial media would have you believe.

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Goldilocks Jobs Report Preview, August 3, 2017

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Goldilocks Jobs Report Preview: What Will Make the Report too Hot, too Cold, or Just Right?

What a difference a month makes. For June’s jobs report, we were equally worried about a “Too Hot” report sending bond yields materially higher, and a “Too Cold” report implying a loss of momentum in the jobs market. Now, almost all the risks to this July report are skewed towards “Too Cold” given the drop in inflation we’ve seen since early July.

More specifically, even if the jobs report is a blow-outnumber, unless it’s accompanied by a big surge in wages it’s not going to elicit a “hawkish” reaction from the Fed or a spike in Treasury yields. Point being, the risk of the report being “Too Hot” is a lot lower than usual, given the drop in inflation.

Looking at the potential impact of this jobs report on the rally, it’s important realize that the dip in inflation since July has been a bullish catalyst, because economic data has stayed firm. So, low inflation makes the Fed more dovish, but economic growth stays constant, and that’s good for stocks.

However, that equation changes if US economic data starts to follow inflation lower (i.e. a big miss on the jobs number). As a result, the “Too Cold” scenario is the biggest risk for stocks heading into tomorrow’s report.

“Too Hot” Scenario (A December Rate Hike Becomes More Certain)

  • >250k Job Adds, < 4.1% Unemployment, > 2.8% YOY wage increase. A number this hot will refute the lower inflation of July and reintroduce the potential for a “not dovish” Fed. Likely Market Reaction: We should see a powerful re-engagement of the “reflation trade” from June..(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Just Right” Scenario (Confirms Expectations of September Balance Sheet Reduction & Likely December Hike)

  • 125k–250k Job Adds, > 4.1% Unemployment Rate, 2.5%-2.8% YOY wage increase. This is the best-case scenario for stocks, as it would reinforce the current expectation of balance sheet reduction in September, and (probably) one more 25-bps rate hike in December. Likely Market Reaction: A knee-jerk, mild stock rally, but how powerful the rally is will depend on…(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Too Cold” Scenario (Economic Growth Potentially Stalling)

  • < 100k Job Adds, < 2.5% YOY Wage Gains. If we see a big disappointment in the jobs number and a further softening of wage inflation, that will send bond yields lower, and that would likely weigh on stocks as it will raise concerns about economic growth. Likely Market Reaction: Bonds and gold should surge and…(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).`

Bottom Line

From a short-term equity standpoint, the best outcome is for “Just Right” job adds (so between 100k-250k) and “Too Cold” wages (so less than 2.5% yoy). That will likely make the Fed incrementally more “dovish,” and take a December rate hike off the table, although it shouldn’t stay the Balance Sheet Reduction in September.

Beyond the short term, it’s important to remember that an economic reflation is the key to sustainably higher stock prices. For anyone with a medium- or long-term time horizon (so almost all of us), I’d gladly take better growth and higher inflation over falling inflation and stagnant growth, even if it meant some short term stock weakness.

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Are Banks About to Break Out?

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Banks were again the highlight, as BKX rose 0.83%, and that pulled the Financials SPDR (XLF) up 0.72%. The bank stock strength came despite the decline in yields, which we think is notable. In fact, over the past several trading days, bank stock performance has decoupled from the daily gyrations of Treasury yields, and we think that potentially signals two important events.

Regardless, this price action in banks is potentially important, because this market must be led higher by either tech or banks/financials. If the former is faltering (and I’m not saying it is), then the latter must assume a leadership role in order for this really to continue.First, it implies bank investors are starting to focus on the value in the sector and on the capital return plans from banks, which could boost total return. Second, it potentially implies that investors aren’t fearing a renewed plunge in Treasury yields (if right, that could be a positive for the markets).

Bottom Line

This remains a market broadly in search of a catalyst, but absent any news, the path of least resistance remains higher, buoyed by an incrementally dovish Fed, solid earnings growth, and ok (if unimpressive) economic data.

Nonetheless, complacency, represented via a low VIX, remains on the rise, and markets are still stretched by any valuation metric. Barring an uptick in economic growth or inflation, it remains unclear what will power stocks materially higher from here. For now, the trend remains higher.

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