Copper futures maintained gains in resilient trade yesterday despite the sharp reversal in stocks and general risk-off money flows. Continued strength in “Dr. Copper” could be signaling a retest of all-time-highs in stocks.
This is an excerpt from today’s Sevens Report—everything you need to know about the markets in your inbox by 7am, in 7 minutes or less.
One of the reasons I watch all asset classes so closely is because I’ve learned that other sectors often will confirm (or not confirm) a move in the stock market. Right now we are getting a pretty notable non-confirmation from the bond market.
Specifically, when stocks rally I like to see: 1) Bond yields rising, which reflects investors expecting greater economic growth and inflation (two stock positive events). 2) A steepening yield curve, which also reflects rising inflation expectations and increased demand for money via loans (something that has been sorely missing from this recovery). 3) I like to see “riskier” parts of the bond market, specifically junk bonds, rising (or at least holding flat) as investors show confidence in corporate America by lending money to riskier companies in search of greater yield (it’s an anecdotal risk-on signal).
Throughout Q4 2016, that’s exactly what we got. First, the yield on the 10-year Treasury rose from 1.54% in late September, to 2.40% at year end. Second, the yield curve steepened as the 10’s-2’s spread rose from 0.81% on Sept. 29 to 1.25% on Dec. 30. Finally, junk bonds were broadly flat during that period (although with notable volatility).
Since the start of 2017, the opposite has occurred. The 10 year started at 2.44% but now is sitting at 2.35%. The 10’s-2’s spread has decreased from 1.23% on Jan. 1 to 1.11% on Monday (the low for the year). Finally, junk bonds rallied through March with stocks, but have since given back some of those gains. If JNK (the junk bond ETF) breaks $36.19 that will be the first “lower low” of 2017, and a negative technical signal.
Point being, the bond market is reflecting an outlook that is comprised of slower growth, less inflation, and more general concern—which is almost the exact opposite of what we’re seeing in stocks right now.
To be clear, this non-confirmation isn’t a guaranteed death sentence for a stock rally. Bond markets gave non-confirmation signals consistently in 2015 when Europe was on the verge of deflation because of the flood of European money into Treasuries, which sent bonds higher and yields lower despite a stock rally. But, that’s not happening now.
So, the “gaps” in this environment are growing in size and number. The gap between political expectations and likely reality regarding tax cuts is as wide as it’s even been. The gap between hard and soft economic data continues to widen as sentiment indicators continue to surge. Now, the gap between bond market direction and stock market direction is widening.
Bottom line, the trend in stocks remains higher, but there are cracks appearing in the proverbial ledge stocks are standing on, and we better get some positive catalysts soon, otherwise we are in danger of a real pullback.
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The S&P 500 is currently in a consolidation pattern with key support lying at 2328 while downtrend resistance has moved down to 2367 today.
The S&P 500 has been consolidating the late February/early March sprint to new highs for 5 weeks now. And while the long term trend remains higher, there are a few technical levels worth watching in the near term (see chart for visual on initial levels).
Below is an excerpt from today’s Sevens Report. Cut through the noise and understand what’s truly driving markets, as this new political and economic reality evolves—start your free two-week trial today.
Economic data was the major influence on markets yesterday, and while most of the focus was on the ISM Manufacturing PMI and the Markit manufacturing PMI, (both of which were in line with expectations), the real market mover was the disappointing auto sales report.
Auto sales fell to 17.0M saar vs. (E) 17.2M saar, and that number joins a growing chorus of caution signs on the auto industry, including fears about used car pricing and used car debt.
Bottom line, auto sales aren’t as popular as the ISM Manufacturing PMI, but the auto industry in the US is massive and very cyclical, and if we are starting to see the beginnings of a pullback in the auto industry that’s not a good sign for the broader economy. That’s why the disappointing auto sales number hit stocks so hard yesterday, even in the face of in-line manufacturing PMIs.
Bigger picture, the “gap” between soft and hard economic data continued to widen yesterday, as the soft PMI survey data was strong while the hard March auto sales data was disappointing. That gap between sentiment/survey data and actual hard economic numbers must be closed sooner rather than later, and it’s a growing risk to stocks.
ISM Manufacturing Index
• The Index fell to 57.2 vs. (E) 57.1
Takeaway
The trend in the manufacturing sector of the economy remains healthy according to the latest release from the ISM. The March ISM Manufacturing Index did edge back for the first time since August, slipping from 57.7 to 57.2 month over month, but the headline was still narrowly ahead of estimates (57.1).
The details of the report were solid as New Orders remained notably strong at 64.5. That was a slight pullback from February’s reading of 65.1; however, it was the second-largest reading in more than three years (after February). New export orders also were at a three-year-plus high of 59.0 while Employment jumped 4.7 points to 58.0, the highest level in almost six years. Rounding out the report’s internals, Prices Paid rose to 70.5, the highest reading since May 2011, underscoring a potential uptick in inflation in the US.
Bottom line, the ISM release showed some slight moderation month over month, but the general trend remains strong which is a positive (although again, this surging survey data needs to start being confirmed by hard economic numbers).
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The 10-Yr. Note Yield has given back all of the post-Fed-hike gains from early March and is again threatening to break back down below the 2.30% level as “soft data” remains strong but “hard data” continues to disappoint.
“Last Week and This Week in Economics”—an excerpt from today’s Sevens Report: everything you need to know about the markets in your inbox by 7am, in 7 minutes or less.
Last Week
Economic data was sparse again last week, but what data did come beat expectations (although it didn’t do a lot to bridge the gap between survey-based indicators and hard economic data). Still, the numbers did continue to be enough to offset growing Washington noise.
Consumer confidence was the highlight of the week, and it blew away expectations. The number rose to the highest level since summer 2001, coming in at 125.6 vs. (E) 113.8. While a strong number, that is another sentiment survey, and these soaring sentiment surveys need to start reflecting in the hard data starting in Q2 (remember, Q1 GDP is still expected to be around 1%).
The other notable number last week was Pending Home Sales, which also beat estimates, rising 5.5% vs. (E) 2.5%. The biggest takeaway from the March housing data is that it appears higher mortgage rates are not hurting the residential housing market, and that’s an important but underappreciated tailwind on the economy, generally speaking. Going forward, a stable housing market remains critical if there’s any hope to seeing a material economic acceleration.
Bottom line, the last two weeks have been light on economic data, but what numbers we’ve got have generally been good, and as a broad statement the economic data has continued to offset lack of progress in Washington… but that trend will be put to the test this week.
This Week
After two quiet weeks of economic releases, we more than make up for it this week, as the three most-important economic releases of the month all come over the next five days. From a broader context standpoint, with Washington stuck in neutral and hopes of big tax reform fading, economic data needs to stay firm to support stocks. If the data disappoints this week, don’t be surprised if we test last week’s lows.
The most important release this week is Friday’s jobs report. We will do our typical “Jobs Report Preview” later this week, but again it’s important this number is Goldilocks, in that it’s strong enough to support the market, but not so strong that it makes a May rate hike more likely.
The next most-important release this week is the global manufacturing PMIs (out today). The European and Asian numbers have already been released, and focus now turns to the March ISM Manufacturing PMI at 10 a.m. today. This number is taking on a bit more significance due to the disappointment of the flash manufacturing PMI of two weeks ago. It hit a surprise six-month low, so markets will want to see the ISM Manufacturing PMI refute that reading.
The manufacturing PMI is followed by the global manufacturing PMIs out Tuesday night/Wednesday morning. Those reports will again potentially confirm the uptick in global growth, and especially in Europe, where numbers have been strong lately. Domestically, it’s the same story. Economic data needs to support this market in the face of disappointment from Washington. Failure to do that puts this rally at risk.
The only other notable event this week will be the ECB minutes. If the minutes read hawkish, that could put a temporary headwind on HEDJ and long Europe positions. But a dip will likely be a buying opportunity in HEDJ.
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While the post-election breakout in the dollar was a long term bullish development, a lot of that move is being retraced and the current trend favors the bears for the medium term.
The Case for Emerging Markets, an excerpt from today’s Sevens Report. Everything you need to know about the market in your inbox by 7am, in 7 minutes or less.
As expectations for a pro-growth policy based reflation trade (i.e. the Trump trade) fade here in the US, one potential beneficiary is emerging markets. The sector has underperformed since the election due to a combination of
1) Dollar strength,
2) Rising US bond yields, and
3) Fear of trade wars.
But, if we see an extended pause in the dollar and bond yield rally, and continued poor execution on pro-growth policies, then emerging markets offer value in an otherwise expensive market.
Now, I’m not saying I’m a long-term bull on emerging markets, nor does this analysis mean I’m not a long-term bull on the dollar or bond yields… I think both go higher long term.
However, the fact is this market has already priced in a an acceleration of growth in the US. If that doesn’t materialize, we could see a sideways chop in the dollar and bond yields, and emerging markets will likely outperform near term (i.e. the next few months).
The investment thesis behind EM is comprised of three pillars: Valuation, inverse correlation to the US-based reflation trade, and positive exposure to global growth.
Pillar 1: Attractive Relative Valuation. Emerging markets are much cheaper than most developed markets, as several research pieces we’ve read have emerging markets trading 12X forward P/E, compared to 17X and 15X for the US and Europe, respectively. So, there is value there, especially after the under-performance following the election.
Pillar 2: Hedge Against a Reflation Trade Unwind. If we see the reflation trade continue to unwind (which started in earnest last Tuesday) then emerging markets will benefit. Case in point, since the election, our preferred emerging market ETF (withheld for subscribers) has returned 5.9%. But, almost all of those gains have come over the past few weeks thanks to the Fed’s dovish hike, and the healthcare failure.
If reflation trade enthusiasm wanes in the US, emerging markets will continue to benefit thanks to the weaker dollar and lower yields. To put it simply, emerging market returns are highly inversely correlated to the dollar. If we see the dollar continue to grind sideways or continue to fall, emerging markets should outperform.
Pillar 3: Positive Exposure to Global Growth. Finally, emerging markets should benefit from a rising global economic tide. US rate hikes aside, the rest of the world’s central banks remain very “easy,” and generally speaking global growth is on an upswing… and that should continue to benefit emerging markets. There are, however, risks to the trade. First, if we get border adjustments in a corporate tax cut package, that’s negative EM because it effectively puts a tax on all emerging market exports (i.e. raw materials), which will reduce demand. Second, if the Fed becomes more hawkish near term, then the dollar and bond yields will rise, and EM will lag. Third, if China sees another growth scare that will hurt EM. Finally, if the Trump administration begins to levy import taxes or engages in aggressive trade policies, that will obviously be EM negative. Of these risks, we view the most probable as the Fed getting more hawkish. But, near term that just isn’t very likely. So, the risks to this strategy are real, but we don’t view them as imminent.
Finally, I’m not saying emerging markets are a long-term strategy, but I do think EM is something that can outperform over the coming months, especially if we see a lack of progress on tax cuts. As such, EM offers reasonable upside in a market where not much is cheap, and we think the potential reward is worth the risk.
How to Play It
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The S&P 500 has held our key support level at 2328 so far this week, but that has made that zone all the more important as a violation would be interpreted by many Technical Quant-Funds and CTA Shops as bearish.
With healthcare shelved, focus now will turn to the truly important topic for markets: Corporate tax cuts. This is an excerpt from today’s Sevens Report. You can sign up for your free trial at 7sReport.com—everything you need to know about the markets in your inbox by 7am, in 7 minutes or less.
I’ve covered this a lot so far this year, but I wanted to dedicate a special section today for a tax cut primer that you can refer back to as this process unfolds over the coming months.
Going forward, there are two key points to understand. First, in order for tax cuts to be a bullish gamechanger (i.e. push the S&P 500 materially above 2400) they must drop the nominal rate to 20% or below. That will provide the expected $10-$12 EPS boost for the S&P 500 in 2018 that will help stocks break out, because at $146 S&P 500 EPS (the current $134 2018 expectation, plus an additional $12 from tax cuts) the S&P 500 would be cheap at 16X 2018 earnings.
Second, tax cuts will be a bearish gamechanger if the market begins to believe: 1) They won’t happen at all, or 2) They will be so small that it won’t make a difference. Point being, tax cuts can be delayed in 2018 and it won’t be a bearish game changer as long as the market still expects that rate to be cut to 20% or lower.
So, to stay ahead of the tape we need to figure out what must happen to get material corporate tax reform passed. To that point, there is one issue that is the key to whether material tax reform gets passed: Border adjustments.
Here’s why border adjustments are key: Dropping the corporate tax rate from 35% to 20% would mean a big loss of revenue for the government, so that needs to be offset otherwise the deficit will explode. A plan that does not have an offset will not be passed despite the Republican-controlled government.
To that point, the Tax Policy Center estimates that implementing border adjustments would generate $1.2 trillion in additional tax revenue over 10 years, which is two-thirds of the $1.8 trillion in lost revenue that would occur if the corporate tax rate drops to 20% from 35%. It’s the key to getting tax cuts at least somewhat revenue neutral.
I’m not going to get into the nitty-gritty details of what border adjustments are, because I’ll put everyone to sleep. But generally, border adjustments have to do with changing the way US corporations are taxed on overseas sales and purchases. To use a simple-but-imperfect analogy, border adjustments are similar to import taxes (they aren’t the same, but for purposes of illustration the comparison makes my point).
The problem for markets is that there appears to be even bigger disagreement on border adjustments within the Republican party than there was on healthcare, so right now there is no credible path to material corporate tax reform. This is especially true after the healthcare fight created additional resentment within the party.
Bottom line, without a border adjustment compromise, there’s very little chance the corporate tax rate can be dropped to 20%, and provide the earnings boost to push stocks higher.
Going forward, a key name to watch is Kevin Brady. Brady is the House Ways & Means Chairman (where tax legislation begins). A compromise on this issue won’t happen without him, so going forward we’re closely watching any comments or articles from Brady.
Sector Winners & Losers of Tax Cuts/Border Adjustments
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Bottom line, for fiscal stimulus to push stocks further, we have to have meaningful corporate tax cuts (20% or lower). For tax cuts to be that powerful, there has to be compromise on border adjustments, and right now, there are no signs of compromise (although again the market will likely give Republicans the benefit of the doubt till Memorial Day).