Six Charts That Explain This Market from the Sevens Report

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Below you’ll find six charts, spanning asset classes and economic data.

The charts are divided up into two groups.

Group 1 is comprised of four charts that explain why stocks have rallied so nicely in 2017, and why, in the near term, the trend in markets is still higher.

Group 2 is comprised of two charts that look into the future, and show that despite a bullish set up right now, there are real, serious reasons to be worried about how long this rally can last. Point being, these indicators are telling you not to be complacent!

Group 1: Why Stocks Have Rallied

Chart 1:  Economic Data 

Chart 2:  Earnings Growth  

Earnings and Economic Data – The Unsung Heroes of 2017

We have said since the early summer that an acceleration in economic data and earnings growth have been the unsung heroes of the 2017 rally.

And, as long as both of these factors continue to trend higher, that will underpin a continued rise in U.S. stocks, regardless of noise from Washington, North Korea, Russia, etc.

Chart 3:  S&P 500 

The Trend Is Your Friend

The trend in stocks has been relentlessly higher since early in 2016, and the S&P 500 has held that trend line through multiple tests.

Bottom line, the technical outlook on this market remains powerfully positive.

Chart 4:  Commodities (Oil & Copper)

There are few better indicators of global economic growth than industrial commodities, and two or the most important (oil and copper) have been telling us for months that global growth is accelerating.

And, as long as oil and copper are grinding to new highs, that will be a tailwind not just on U.S. stocks, but on global stocks as well.

Group 2:  Risks to This Rally

While the four charts above explain why stocks have rallied and why the outlook remains, broadly, positive, there are still risks to this rally and this market.

Don’t be fooled into being complacent with risk management, because while trends in U.S. and economic growth, earnings and the stock market are all still higher, there are warning signs looming on the horizon.

Chart 5:  Inflation (Warning Sign #1)

Non-Confirmation: Why Isn’t Inflation Rising?

Inflation remains inexplicably low, considering that we’re near full employment and global economic growth is accelerating.

And, accelerating inflation remains the missing piece of a true “Reflation Rally” that can carry stocks 10%, 15% or even 20% higher over the coming quarters and years.

But, it’s not just about missed opportunity.

The lack of inflation is a big “non-confirmation” signal on this whole 2017 rally, and if we do not see inflation start to rise, and soon, that will be a major warning sign for stocks, because…

Chart 6: The Yield Curve – Will It Invert?

Yield Curve: Sending a Warning Signal? 

If the outlook for stocks is so positive, then why did the yield curve (represented here by the 10’s – 2’s Treasury yield spread) equal 2017 lows on Wednesday?

Simply put, if we’re seeing accelerating economic growth, rising earnings, potential tax cuts and all these other positive market events, the yield curve should be steepening, not flattening.

So, if this 10’s – 2’s spread continues to decline, and turns negative (inverts) then that will be a sign that investors need to begin to exit the stock market, because a serious recession is looming, and the Fed won’t have much ammunition to fight it.

If I was stuck on a desert island (with an internet connection and access to my trading accounts of course) and could only have one indicator to watch to tell me when to reduce exposure in the markets, this 10’s – 2’s spread would be it – and it’s not sending positive signals for 2018!

“Should I buy more stocks because tax cuts are coming?”

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“Should I buy more stocks because tax cuts are coming?”

I was asked that question three separate times this weekend at the local pumpkin patch, while my kids were running around grabbing pumpkins.

And, honestly, it’s a legitimate question, because on Friday stocks shot to new highs on rising investor optimism for tax cuts (at least, that’s what the financial media said).

But, here’s the problem: The answer to the question is… “No.” 

In fact, tax cuts pose more of a risk to stocks than they present an opportunity.

That’s because the outlook for tax cuts didn’t improve last week. In fact, it probably got worse.

But, as usual, that’s hard to discern through all the market and financial media “noise.”

Here’s what I mean:

Stocks rallied on Friday after the Senate passed a budget resolution that, potentially, paves the way for tax cuts.

But, as I said to paid subscribers in today’s Sevens Report:

“The market rallied on the passage of the budget resolution in the Senate last week, but that’s the equivalent of cheering because your team’s bus made it to the stadium for the game.”

That analogy prompted some great response from advisor subscribers:

“Hi Tom!  I really enjoy your analogies in breaking down industry jargon…and this has to be one of my favorites, in terms of you describing the budget resolution being passed.”  – A.L. Financial Advisor in Cleveland, OH.

Point being, last week’s vote, which was the catalyst for the Friday rally, didn’t improve the chances of tax cuts passing at all – it merely removed the prospect of spectacular failure!

But, the important truth is that right now, we should be more worried about tax cuts failing and causing a correction late this year, because tax cuts are already priced into the markets (I show you why below).

More broadly, is your subscription research breaking down the daily jargon and giving you explanations and analogies that help you impress clients?

Case in point, in Monday’s issue we told subscribers that Friday’s rally was misguided, so it didn’t surprise us, or our subscribers, that markets gave back those gains on Monday.

I created the Sevens Report because I know that most financial advisors and professionals are not glued to blinking screens from 9:00 – 4:00 each day.

They are discussing the financial goals of their clients and mapping a course to reach those goals.  Most of their time is spent building and fostering relationships, not analyzing Fed commentary, studying the yield curve, or digging through an oil inventory report.

Every trading day, at 7 a.m., we email our subscribers their morning Report, which contains the information they need to show their clients they are on top of the markets with a plan to outperform, regardless of the environment. And, our research continues to help our subscribers grow their businesses!

“Let me know if there is anything else that you need from us. Thanks again for everything. I really enjoy the Report – it is helping me grow my business and stay on top of things.” –  D.M. Registered Independent Advisor.

Anticipation of tax cuts has once again become a major contributor to the recent rally in stocks, and at these levels I can confidently say that tax cuts are now priced into the market, so there is risk of a disappointment later in 2017 or early 2018. 

Given that, I want to make sure everyone is aware of 1) Where we are in the tax cut process, 2) What major hurdles remain and 3) How much stocks could pullback if tax cuts fail.

I’ve included an excerpt of that research below as a courtesy.

Sevens Report Excerpt: Tax Cut Update

Where Are We on Taxes? Answer: Not Very Close. I want to be clear here: The market rallied on the passage of the budget resolution in the Senate last week, but that’s the equivalent of cheering because your team bus made it to the stadium for the game.

The budget resolution (which will pass the House later this week) is a necessary step to even begin to discuss tax reform. It has little-to-no bearing on whether tax cuts will actually get passed. In fact, it’s pretty disheartening that it was so close in the Senate at 51-49. This was not reason for optimism.

What major hurdles remain? Answer: SALTs. The major hurdle with tax cuts now is how does Congress pay for them? If Congress is going to cut taxes, they must offset the reduced revenue by increasing taxes elsewhere (simply reducing government spending is out of the question).

Early in 2017, the idea on how to pay for tax cuts was “BATs,” or Border Adjustment Taxes. Basically, that would put a “value-add tax” on imported goods like they have in Europe, and that would offset the corporate tax cuts (I’m over simplifying for effect, but you get the idea).

Businesses pushed back on that idea big time because most American companies buy the raw materials or manufacture their products overseas, so that would be a big tax increase for them. So, BATS died.

Now, we’ve moved in to SALTs. SALTs stands for “State and Local Taxes,” or more specifically, removing the ability for taxpayers to deduct state and local taxes against their federal income taxes.

But, as you can imagine, people in high-tax states like New York, Connecticut, Massachusetts, California, etc., don’t like this idea at all, so it has met with some serious opposition. Bottom line, Republicans need to find a compromise on SALTs otherwise the tax cuts will likely significantly add to the deficit, and they won’t have the votes to pass the Senate.

That is the No. 1 issue in the tax cut fight, and it’s a very big (and difficult) one. 

Until the SALTs issue is resolved, the outlook for tax cuts is neutral at best (despite market anticipation). And, if SALTs die the same death as BATs, then the outlook for any tax cuts is outright dire—and that’s a risk to markets.

How much stocks could pullback if tax cuts fail? Answer: At least 5%. Here’s how I get to that number. For the last two-plus years (up until the September melt up this year) the S&P 500 has traded between 17X and 17.5X next year’s earnings. But, due to the recent melt up, the S&P 500 currently trades at nearly 18.3X the 2018, $140/share S&P 500 EPS.

If we believe the market still wants to trade at about 17.5X earnings, that means the market is pricing in $147/share for the S&P 500 for 2018, or about $7 more than the consensus.

I feel confident saying that all of that $7.00 is anticipation of tax cuts, because frankly there isn’t much else that can explain it (and it makes sense because consensus is for an additional $4-$10 dollars in S&P 500 EPS if substantial tax cuts are passed).

Point being, if the outlook for tax cuts dims between now and year end (and this is entirely possible despite current optimism) then we could easily see the S&P 500 drop to that $140 2018 S&P 500 EPS times 17.5 (the long-standing market multiple), and that equals 2450, or 110 points (about 5%) lower from current levels—and that’s assuming no additional negative surprises.

Bottom line, at this point, I feel safe saying that corporate tax cuts are at least partially priced into the market, and that’s important given the neutral outlook for tax cuts.

Dow Theory Update, October 17, 2017

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Charles Dow’s famous (but simple) theory for stock market investing is based on a series of higher highs and higher lows registered by both the Dow Jones Industrial Average and Dow Jones Transportation Average, indicating bull market conditions. On the contrary, as soon as a set of lower lows and lower highs have been registered by both of the aforementioned indexes, the theory indicates bear-market conditions are likely.

Over time, investors have applied the tenets of Dow Theory to a wide range of time frames from intraday
charts to monthly bar charts. The success rate, number of trades, and maximum drawdowns vary from time frame to time frame, but for now, it doesn’t matter whether you are looking at a 15-minute chart or a
monthly chart; Dow Theory is bullish.

Starting with the industrials, the index just made new highs yesterday, and most recently made “higher lows” back in late September (on a faster time frame). That leaves a cushion of almost 1000 points in the Dow before the “faster” Dow Theory practitioners begin sounding the bearish alarm.

The Dow Transports, on the other hand, have been trading a little heavier over the last few sessions, but most recently made new highs last Friday. And while the Transports could very well break down further (as momentum has been decidedly bearish near term (over the last two sessions), but the recent new high leaves a still-bullish signal in the lesser-followed index.

Bottom line, a potential breakdown in the Transports in the weeks or months ahead would be notable, but because of the recent moves to new highs in both Transports and the Industrials, and the clear upside momentum still in the Industrials, the oldest technical theory on the financial markets continues to suggest the path of least resistance is higher—and that stock investors should continue to hold long positions.

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Weekly Market Preview, October 16, 2017

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Last Week in Review

The major takeaway from last week was that inflation remained stubbornly low in September and that took some of the momentum out of the recent reflation rebound. A decent retail sales number helped salvage the week’s economic data in aggregate, so the fallout for stocks was contained.

From a longer-term view, the fact that inflation remains stubbornly low does undermine the economic reflation that is needed to carry stocks materially higher, given valuations and the economic outlook.

Bottom line, last week wasn’t a particularly good one for the macro bulls, but given retail sales, it didn’t warrant a reversal of the September rally, either.

Looking at the important economic data from last week, there are really only two numbers of consequence: CPI and Retail Sales. The former was a disappointment, as the headline rose 0.5% vs. (E) 0.6% thanks to a hurricane-related surge in energy prices. Core CPI rose just 0.1% vs. (E) 0.2%, and the year-over-year Core CPI declined to 1.7% from 1.8%.

That’s well below the Fed’s 2% stated goal (and given how CPI is constructed, the real CPI goal for the Fed is probably more than 2.5%). So, the Fed still is not creating the type of statistical inflation it wants to.

While the inflation data was disappointing, the growth data on Friday was good. September retail sales were light on the headline at 1.6% vs. (E) 1.8%, but that was because of a dip in auto sales. The more important “control” group, which is retail sales less autos, gas and building supplies (it gives us the best
look at truly discretionary consumer spending), rose 0.4% vs. (E) 0.2%. Importantly, the August core Retail Sales reading was revised to 0.2% from flat.

Looking elsewhere economically last week, there were other reports (NFIB, Chinese Trade Balance, European IP), but none provided any big surprises and none will influence the next direction for stocks or bonds. Bottom line, taken in aggregate (and thanks to retail sales) the economic data last week was close enough to “Goldilocks” to prevent a reversal of the September rally.

From a Fed standpoint, the data this week coupled with some dovish Fed comments turned a December rate hike from a “sure thing” to a “probably,” unless we get more soft inflation or growth readings. That helped push stocks slightly higher on Friday initially, but a Fed that can’t hike rates to 1.5% from 1.25% for fear of low inflation or economic growth isn’t the prescription to materially higher stock prices.

This Week’s Preview

There are a lot of anecdotal economic reports this week that, when taken in aggregate, should give us decent insight into the current state of the US economy, and whether we’re seeing growth accelerate.

The most important numbers this week are the Empire Manufacturing and Philly Fed Indices, which offer the first look at October economic activity. Since the creation of the national flash PMIs, Empire and Philly have lost some of their significance, but this week they are the only October data points, so they’ll be watched to see if economic momentum in September carried over into October.

Away from Empire and Philly, the next more important releases come from China. On Thursday, we get Chinese Fixed Asset Investment, Retail Sales, Industrial Production and GDP. None of these should offer any surprises, but if they are weaker than expected that could cause a mild headwind on stocks.

Finally, this week we get September Industrial Production. Remember, “hard” economic data has, until very recently, badly lagged “soft” survey-based data. In September, retail sales helped close that gap some, but industrial production has remained well below levels you would think given the PMIs. If industrial production can accelerate in September (and remember the key is the manufacturing sub-component), then that will be a good signal that actual economic activity is finally accelerating to meet survey data (a positive for stocks).

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CPI Preview, October 13, 2017

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Looking to today’s CPI report, the preference here is for a slightly “Too Hot” number in headline and core CPI while a worst case scenario for stocks is a soft number, but keep in mind there will be impacts from the Hurricanes so the details in the report will be important.

Bottom line, I’ve said consistently for months that the only way I can see stocks moving materially higher is if they are driven by a reflationary rally. We got a glimpse of that in September, but for the reflation rally to continue, we need more Goldilocks data starting with today’s CPI.

Disconcertingly, if we don’t get that Goldilocks data, then the onus is going to be totally on earnings season to support stocks, and ensure this September rally doesn’t reverse. In that scenario, it’s an awful lot of pressure to put on continued growth in corporate earnings this late in an economic cycle.

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Reflation Pause- Part 2, October 11, 2017

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Reflation Update Part 2—Why This Reflation Is Different

In Wednesday’s Report, we covered why the reflation trade that started again in early September has taken a pause, and the reasons are twofold.

First, the market is unclear about who the next Fed chair will be. If it’s Kevin Warsh, that will be a “hawkish” surprise and rates could rise too quickly to keep this reflation “virtuous.”

Second, it’s unclear if upcoming central bank meetings, which means primarily the ECB but secondarily the Bank of England, will be Goldilocks. If either bank is more hawkish than the market expects it could send global rates sharply higher, causing a
pullback in the broad market.

Conversely, if either bank expresses doubts about growth or inflation, it could undercut the whole reflation idea that’s propelled stocks higher.

Point being, there are some key events that need to be resolved before the reflation trade can move higher. And, frankly, that makes this 2017 version of the reflation trade unique compared to previous economic reflations, most recently from ‘03-’06.

For simplicity, the easiest analogy to describe a normal reflation trade is a beach ball. When a recession occurs, the beach ball (the economy) deflates. But, low interest rates and government stimulus act as an air pump, and eventually the beach ball (economy) reflates.

Accelerating economic growth and rising inflation (due to easy money) are the “air” that inflates our economic beach ball. From a market standpoint, economic reflations are usually wonderful things. Markets go up in concert, and the way to outperform is to add beta and be exposed to cyclical, growth-oriented sectors. During a normal reflation (the last one was in ’03-’06) everything goes up regardless of what else is going on in the world.

However, this reflation is different.

Eight years after the end of the financial crisis, our economic beach ball is only half full. That’s because we’ve pumped in the “air” of accelerating economic growth (GDP going from negative to 2.5%ish) but we haven’t pumped any “air” of inflation in, yet.

Despite that, stocks are at all-time highs. Valuations are as stretched as any of us have seen them in decades. And, now we’re very late in the typical economic cycle.

Given that, barring some big surprise on tax cuts or infrastructure spending, it’s unlikely that we’re going to see a material acceleration of economic growth. In reality, 3.5% – 4% GDP growth is quasi impossible given demographics in this country—specifically the large demographic of baby boomers entering retirement, and them being replaced by a smaller workforce.

Getting back to our beach ball analogy, if inflation finally accelerates there will be a shorter time of euphoria—as the other half of our beach ball inflates. We got a hint of that in September.

But given valuations, stock prices and economic growth all are at or nearing reasonable ceilings, the risk is that after a short bit, the “air” from rising inflation over inflates our economic beach ball, and a bubble (or multiple bubbles) develop and we burst the ball. Practically, what I’m talking about is the Fed hiking rates and inverting the yield curve, which would be our signal that the beginning of the end of this eight-year expansion is now upon us.

From an advisor or investor standpoint, this creates a difficult set up. For now, we must continue to be invested and, potentially, allocate to the reflation sectors. Yet we also must do so knowing that unlike most revelations, we’re not going to enjoy an easy rally that lasts years.

So, the now years-long game of market musical chairs continues, albeit with a potentially reflation accelerating the pace of the music. For shorter or more tactical investors, holding “Reflation Basket” allocations makes sense as we approach and navigate these upcoming events.

For longer-term investors, we continue to await confirmation from the 10-year yield that this reflation truly is upon us. A few closes above the 2.40% level will be the signal, in our opinion, to rotate out of defensive names and into part or all of our Reflation Basket—Banks (KRE/KBE/EUFN), industrials (XLI), small caps (IWM) and inverse bond funds (TBT/TBF).

Bottom line, at this point in the economic cycle, for stocks to move materially higher we need inflation to accelerate and cause that reflation trade, but weneed to realize that brings us one step closer to the ultimate “bursting” of the recovery. This market remains more dangerous over the medium/longer term than the low VIX would imply.

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Reflation Pause, October 20, 2017

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Why Is the Reflation Rebound Pausing? Because It Should. Here’s Why…

After surging basically from Sept. 11 through Friday’s jobs report, the reflation rebound has taken a pause for the last few days, and I wanted to provide a comprehensive update of:

1) Where we are in the reflation process and specifically the key catalysts that are looming in the near future and that are causing this pause, and

2) Explain why this reflation trade is different from others, and requires A) A more tactical allocation to get the outperformance we all want, and B) Greater patience on the part of longer-term investors before abandoning what’s worked so well in 2017 and allocating to more reflation-oriented sectors.

Due to space constraints, I’m going to break this up into two parts covered today and tomorrow.

Reflation Update Part 1: Where Are We, and What Will Decide Whether It’s Going to Continue?

We’ve been saying since the July Fed meeting that inflation was now the most important economic statistic, and that markets needed inflation to start to rise to help fuel a “reflation rebound.”

Well, during the week between Sept. 11 and Sept. 15, Chinese, British and US CPIs beat expectations, and combined with an uptick in global economic activity, caused tactical investors to rotate into tactical sectors (banks, energy, industrials, small caps, inverse bond funds).

And, we were early on identifying that switch, and our “Reflation Basket” has outperformed the markets since we re-iterated it for short- and medium-term investors in the Sept. 21 Report.

However, also in that Report we cautioned longer-term and less-agile investors to wait for clear confirmation that the reflation rebound had started, and we identified two keys. The first was the KBW Bank Index closing above 100. This occurred both Monday and Tuesday. The second was the 10-year yield breaking above 2.40%.This has yet to happened.

So, while much of the mainstream financial press is now pumping the reflation trade (a month after it started) we’re acknowledging that it’s paused. Practically, that means we’re holding (not adding to) our “Reflation Basket” of KRE/KBE/IWM/EUFN/XLI/TBT/TBF, and think shorter-term/tactical investors should too.

I say that because I believe the first stage of this reflation trade is now complete, and in the next three weeks we will see two key events that will decide whether this reflation extends into November, pauses longer or potentially back tracks.

Near-Term Reflation Catalyst #1: ECB Meeting. Thursday, Oct. 26. Why it’s Important: As we’ve covered, markets have enjoyed a “virtuous” reflation recently because 1) Economic data has been good, but 2) Not so good that it’s causing global central banks to hike rates faster than expected.

Markets have a general expectation of what ECB tapering of QE will look like (somewhere around 20B per month) but we’ll get the details at this October ECB meeting.

If the ECB is more hawkish than expected, that could potentially send yields too high, too fast, and kill the
“virtuous” reflation. If that happened, banks and inverse bond ETFs would rally, but everything else would fall.

Conversely, if the ECB is too dovish, then markets might lose confidence in the reflation itself, and that would become a headwind.

Bottom line, the ECB needs to release a taper schedule that implies confidence in the economy and inflation, but that also isn’t so aggressive it kills the “virtuous” reflation rally.

Near-Term Reflation Catalyst #2: Fed Chair Decision.
The fact that President Trump will name a potentially new Fed chair in the next two weeks has been somewhat lost amidst the never-ending (and seemingly everescalating) Washington drama.

Right now, it’s widely believed there are three front runners: Kevin Warsh, Jerome Powell and Janet Yellen.

If Yellen is reappointed (and that’s seeming increasingly unlikely) then clearly that won’t cause any ripples in the reflation trade, and we can go back to watching inflation and yields. However, if one of the other two are appointed, things get interesting.

Warsh is considered the biggest “hawk” of the group,and if he becomes Fed chair we may see yields rise sharply, potentially endangering the “virtuous” reflation.

Powell is viewed as in the middle of the other two—not as dovish as Yellen, but not as hawkish as Warsh. But, it’s reasonable to assume that a Powell appointment would put at least some mild upward pressure on Treasury yields. It likely wouldn’t be enough to spur a killing of the “virtuous” reflation, but it would be cause for a pause in the move.

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Macro Drama Playbook, October 10, 2017

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Macroeconomic Drama Rundown (It’s Not That Bad, Yet)

Over the past week, the macro environment has suddenly become populated with multiple headline grabbing (and seemingly dire) macroeconomic dramas, and I imagine you might be getting calls about these dramas from clients.

So I want to: 1) Cover each drama, 2) Explain why it’s not materially important to the market yet (despite the headlines) and 3) Identify what has to happen for these events to cause a pullback. I’ve covered each event in order of their respective potential importance to the markets.

Drama 1: North Korea
What’s Happened? More communication, some official, some not. Secretary of State Tillerson is apparently in direct talks with the North Koreans on some sort of deescalation. However, that comes as President Trump tweets vague threats implying the only option is military. It’s unclear if this is some geopolitical game of “Good Cop/Bad Cop,” or just an administration that’s not on the same page (the answer likely depends on which papers you prefer reading), but the point is that on the surface, rhetoric remains unnerving (at least the public rhetoric).

What’s Next? North Korea is expected to test another long-range missile sometime between Oct. 10 and Oct. 22.

Bearish Game Changer If: This has remained consistent: Talk is just talk and it won’t cause anything other than a brief pullback. But, this geopolitical drama becomes a reason to de-risk if North Korea shoots the missile at anything US, including planes, ships and Guam. At that point, the potential for a US military strike on North Korea goes up considerably, and we would advise getting more defensive in nature (i.e. buying Treasuries or going to cash).

Drama 2: Iran Nuclear Deal

What’s Happened? President Trump is expected to decertify the Iran deal on Oct. 12 (Thursday). This is important, because once President Trump announces that he believes Iran is not in compliance with the deal, a 60-day clock starts ticking. Over those 60 days, Congress must decide whether to reimpose sanctions on Iran (it’s not President Trump’s decision).

What’s Next? Thursday’s official announcement on the Iran deal (it’s not a sure thing that Trump will decertify the deal, so there’s some drama here).

Bearish Headwind If: Congress decides to reimpose sanctions on Iran, causing a total collapse of the
international agreement. This outcome would not, by itself, constitute a reason to materially de-risk (i.e. sell stocks). I say that because stocks rallied for years while there was no agreement in place. However, taken in the context of the North Korea nuclear program, Iran/Russia ties, etc., this entire situation would get potentially much more complicated and dangerous, as markets will take notice and it would be a headwind (but not enough to cause a material pullback).

Drama 3: Catalan Independence

What’s Happened? On Oct. 1, Catalonia (a region of Spain where Barcelona is located) held a referendum on independence from Spain. That referendum passed with 90% of the vote choosing independence. However, less than 50% of the population voted, so that’s more impressive than it seems (meaning the majority of Catalans didn’t vote for independence). The proper analogy to understand this situation is to think of this like a US state having a vote to try and se- cede from the nation. States can’t just vote to leave the US, and neither can Catalonia vote to leave Spain. The vote was illegal and meaningless, outside of the fact that it has stirred up a Spanish political hornet’s nest.

What’s Next? The President of Catalonia will speak on the matter tomorrow night, and will either declare independence (legally it will mean nothing) or will vow to negotiate with the Spanish government on enacting some changes to make the Catalan people happy.

Bearish Headwind If: This one has been a bit exacerbated by the press. First of all, Catalonia has wanted to secede from Spain pretty much since it was conquered by Spain in the 1700s. Catalan culture is different from Spain (they speak Catalan, which is different than Spanish) and the people always have considered themselves different from the rest of Spain. So, it’s not shocking they held the vote.

Second, this is as much a money issue as a cultural one (surprise!). Catalonia is wealthy compared to the rest of Spain. And, the Catalan people perceive (somewhat correctly) that they subsidize the rest of Spain, and they are tired of it (years of recession will do that).

At this point, there are three ways it can go:

The “Good” scenario is that the Catalan government and Spanish government negotiate this out (this is the likely outcome). The “Bad” scenario is the Catalan government declares independence and the Spanish government fires the entire Catalan government and assumes control of municipal services and holds a new election. The “Ugly” scenario is the Spanish government declares martial law and occupies Catalonia (this is very unlikely).

But, even if the “Ugly” scenario come to pass, this is still mostly a local problem. For it to become a bearish game-changer for European ETFs and US stocks, we’d need to see Catalonia achieve independence, and spur an independence movement across Europe. ZeroHedge is warning of this, but in reality, it’s very, very unlikely.

This drama is not something keeping me up at night.

Drama 4: Turkish Diplomatic Drama

What’s Happened? The US has stopped issuing all non-immigrant visas in Turkey, and the Turkish government retaliated and is doing the same. This conflict is just the latest drama surrounding Muslim cleric Fethullah Gulen.

Over the weekend, the Turkish government arrested a Turkish US embassy worker the government believes is linked to Gulen. The Turkish government blames Gulen for the failed 2016 coup, and this is a problem, because Gulen currently lives in Pennsylvania and the US won’t hand him over.

What’s Next? Diplomats are working through it, and it’s unlikely to metastasize into a bigger problem.

Bearish Headwind If: The US and Turkey suspend all diplomatic ties (which is very, very unlikely).

Bottom Line
Absent the North Korea flare up that began in August, 2017 has been largely devoid of any international dramas, which is a departure from most of the current decade. Yet clearly there has been an uptick in geopolitical uncertainty over the past few weeks.

However, while the financial media is quick to cover the worst-case scenarios from these events, the facts tell us that none of them, at this point, represent a reason to alter positioning or to de-risk. More importantly, tax cuts remain the key political and geopolitical event to focus on during Q4. That can obvi-ously change, but so far none of these dramas are nearly as important to stocks as whether we get tax cuts. And, if that changes, we will tell you first thing.

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Weekly Market Preview, October 9, 2017

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Last Week in Review

For the most part economic data was solid last week, and suggested the recent reflation rally can continue further. But almost all the data released last week was at least in some way affected by Hurricanes Harvey and Irma. In most cases, the data was skewed for the better, and until Friday that was supporting hawkish money flows.

Starting with the ISM data, the Manufacturing release on Monday surged to 60.8 vs. (E) 58.0 which was, I believe, the strongest print in decades. However, there was a distinct outlier in this report that meaningfully skewed the headline. Supplier Deliveries (one of the five subcomponents of the headline) spiked to 64.4 vs. 57.1. Rising supplier deliveries means longer deliveries of ordered parts, which is a sign of increased demand and economic activity. But this data point was directly affected by the hurricanes and not a real uptick in demand.

Then, the ISM Non-Manufacturing Index jumped to 59.8 vs. (E) 55.5. Like the Manufacturing data, delayed deliveries had spiked 7.5 points to 58.0, which was a major supporting factor for the headline (but again, the data was skewed by the hurricanes).

As far as the two ISM reports are concerned, they both need to be taken with a grain of salt as the hurricanes played a major role in boosting the headlines. Additionally, “survey style” data continues to come in much better than “hard data” like Industrial production. Until we start to see some more upbeat “real data,” the reflation trade will only be able to accelerate so much.

Continuing with the theme of skewed data, Friday’s September jobs report was the big release of the week and the data was “off the charts” on several subcomponents while the headline job adds actually declined. Unemployment fell to 4.2% vs. (E) 4.4%, which was the lowest since 2001 while the participation rate rose to 63.1% vs. (E) 62.8%, well above the highest estimates.

While the ISM reports earlier in the week were seen as hawkish and supportive of the reflation trade, the jobs report on Friday was not as well received, as investors were skeptical of such robust data. The immediate reaction was inflationary, with the 10-year yield punching through 2.40% (the tipping point) for the first time since early May. Then with the help of some adverse headlines regarding North Korea, the morning moves unwound and bonds rebounded while gold rallied and stocks sold off. The market has started to take the September data with a grain of salt, as it is clearly skewed in favor of the hawks. This is likely to result in the reflation trade stalling, as investors await more data to see what the real trend in the economy is doing.

This Week’s Preview

As banks observe the Columbus Day holiday today, economic data doesn’t kick off until tomorrow. The NFIB Small Business Optimism Index for September will be more important than normal as investors will be looking to see how small businesses fared through the hurricanes. The previous read was 105.3, so any significant divergence from that level could likely cause some movement, especially if it misses, which could see a further unwind of the recent reflationary money flows.

On Wednesday, the Fed minutes from the September meeting will be in focus as investors look for further clues about future Fed policy. But as is normally the case, it is more likely than not that the release will essentially be a non-event.

Later this week focus will be on inflation data for September, as PPI and CPI are out Thursday and Friday, respectively. Also on Friday, Retail Sales data will be watched closely to see if the effects of the hurricanes were felt in the retail space. Again, any softness in the data could spur an extended pullback from recent reflation moves. Finally, Consumer Sentiment will be worth watching to see if optimism about the economy is actually taking hold, or if consumers remain mostly cautious on the forward outlook.

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ECB Minutes Analysis, October 6, 2017

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There were no real surprises in the minutes of the September ECB meeting, but nonetheless the minutes caused a modestly decline in the euro, which fell 0.4% following their release.

The reason for the decline was the discussion of euro strength, and the risk it poses to the EU economy. Remember, one of the reasons the euro accelerated so much in August was because ECB President Draghi refused to take multiple opportunities to comment on euro strength, and the market took those omissions as tacit endorsements of the stronger euro.

But, yesterday’s minutes told us the ECB has indeed noticed the 12% rise in the euro vs. the dollar, and if the euro stays strong it may impact its upcoming tapering decision, due on Oct. 26.

To be clear, the stronger euro won’t delay that tapering decision, but it could make the reduction in QE more gradual. And that matters, because with the euro at 1.17 vs. the dollar, a very gradual tapering is not priced in, and that represents downside risk in the euro—perhaps into the low 1.10- 1.15 range depending on taper details.

That also matters for US stocks, because if the euro falls, the dollar will rise, and a stronger dollar will, at some point, become a headwind on stocks if we don’t see continued acceleration in inflation or economic data.

Bottom line, the ECB meeting is a real risk to our “Virtuous Reflation,” because if they are dovish and cause a dollar rally, that may indeed hit stocks. That’s not necessarily a problem until later in the month, but I do want everyone to be aware of it.

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