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Jobs Report Preview, October 5, 2017

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Hurricanes Irma and Harvey have sapped some of the importance from tomorrow’s jobs report because it’s likely going to be temporarily distorted lower than it should otherwise be. Case in point, the expectation is for 100k job adds when it should normally be about double that. So, it’s likely we’ll get a soft number and it’ll be dismissed by the markets.

But, it’s not clear what impact the storms will have on the wage component (theoretically it shouldn’t be much). Regardless, the practical effect is that is we see a soft number tomorrow (jobs and wages) it will be handed a relative pass given the storms.

That said, the jobs report still remains very important from a “reflation rally” standpoint. This week, the Manufacturing and Non-Manufacturing PMIs and auto sales have all helped to push stocks slightly higher, despite the market’s clear preference to see some profit taking in the reflation sectors. If tomorrow’s jobs report is “Just Right” and the wage number is firm, that will add fuel to the “reflation rally.”

From a practical standpoint, I’ll be adding about 75k jobs to whatever the number is on Friday to account for one-time, Hurricane Harvey/Irma-related declines.

“Too Hot” Scenario (A December Rate Hike Becomes 100% Certain, Risk Increases for More than Three Hikes in 2018)

>200k Job Adds, < 4.1% Unemployment, > 2.8% YOY wage increase. A number this hot will reinforce that an economic reflation is in deed underway, and it’ll likely make the Fed marginally more hawkish. Likely Market Reaction: This would not result in a “Virtuous Reflation.”…withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Just Right” Scenario (Leaves a December Rate Hike Likely But Not Certain)

• 50k–200k Job Adds, > 4.2% Unemployment Rate, 2.5%-2.8% YOY wage increase. This gap is really wide because of the hurricanes, but the best scenario for stocks would be a print at the upper end of this range. Likely Market Reaction: A continued “Virtuous” reflation…withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Too Cold” Scenario (Economic Growth Potentially Stalling)
< 50k Job Adds, < 2.5% YOY Wage Gains. Again, this number is artificially low because of the hurricanes, but if we see a big disappointment in the jobs number and a further softening of wage inflation that will send bond yields lower, but it would also likely weigh on stocks as it will raise concerns about economic growth. Likely Market Reaction: Bonds and gold should…withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

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Should We Buy Value to Get Growth?, October 3, 2017

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At the start of 2017, I incorrectly expected growth sectors of the market to outperform, as I anticipated inflation and economic data to steadily improve as the Fed continued to hike rates.

The latter expectation (Fed rate hikes) has been met, but the former two, until now, have not, as the dip in inflation and growth caused a drop in bond yields and resulted in the outperformance of defensive sectors (not growth/cyclical sectors) so far in 2017.

But things appear to be changing, and while past performance is no guarantee of future results, if we are on the cusp of a “reflationary” rally, then history suggests buying “value” funds will be the way to outperform into year-end.

On the surface, though, this doesn’t make sense. If we are going to see a reflation, won’t “growth” styles naturally outperform given the acceleration in inflation/economic activity?

The answer is “yes,” but here’s the rub: Growth-oriented sectors like banks and energy have massively underperformed this year and are now heavily owned by most value-styled ETFs. Meanwhile, growth-styled ETFs are heavily overweight tech, and stand to underperform in a reflation, just like they did in 2016.

The key here lies in the fund’s sector allocations.

My favorite “growth sector” ETF is actually the iShares S&P 500 Value ETF (IVE), which is allocated as follows: 28% financials, 12% healthcare, 11% energy. So, 40% of the ETF is weighed to sectors (financials and energy) that will surge in a reflationary rally. Conversely, utilities are just 6%, tech is 7% and consumer staples are weighted at 11%.

Up until September, this weighting has caused IVE to lag the S&P 500, but IVE rallied 2.7% in September, more than doubling the S&P 500. Looking further back, in the pro-growth, post-election rally between Nov. 8 and year-end 2016, IVE surged 17% compared to just 9% for the S&P 500.

Point being, lackluster inflation and economic readings in 2017 have created a scenario where outperforming sectors are predominantly “defensive” sectors. But, this big rally has caused these sectors (utilities, staples, super-cap tech) to be significantly underweighted in some value ETFs and mutual funds—and that creates this weird  set up where getting exposure to growth sectors that can outperform in an economic reflation means buying “value” ETFs and mutual funds due to their recent underperformance.

So, as we start the fourth quarter, if you’re reviewing client exposure, don’t forget that “value” funds, if we see a confirmed economic reflation, will provide the exposure to growth sectors we need to outperform.

Food for thought.

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Weekly Market Preview, October 2, 2017

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Last Week in Review

Economic data was mixed last week from a reflation standpoint, as growth data was a positive surprise while inflation data mildly disappointed. But, importantly, the inflation numbers weren’t enough to cause a reversal of the reflation trade or cause an unwind of the gains.

Inflation data remains the most important data point in the market, and Friday’s Core PCE Price Index was a mild disappointment. The August reading rose 0.1% vs. (E) 0.2%, while year-over-year Core PCE Price Index rose 1.2% vs. (E) 1.3%. That’s still well below the Fed’s 2.0% target, and it does somewhat undermine the strong CPI report—but it’s not the kind of number that would make the Fed think inflation is getting materially worse, and as such it didn’t cause a big move in markets.

Staying with inflation, the data was similarly underwhelming with the flash core EU HICP. It rose just 1.1% vs. (E) 1.2%, again sapping some of the positive momentum from the firm CPI data from earlier in December (Chinese, British, US). But like the soft Core PCE Price Index, it wasn’t a major market mover and it doesn’t undermine the fact that there are “green shoots” of inflation lurking out there, so it didn’t cause a pullback.

Looking at growth data, it was more positive. Durable Goods was the other important report from last week, and it handily beat estimates. New Orders for Non-Defense Capital Good ex-Aircraft rose 0.9% vs. (E) 0.3%, and the July number was revised higher to 1.1% from 0.4%. That number is important, because it implies that we’re seeing an acceleration of business spending and investment—and if that continues it will help create that economic “rising tide” that we need to help push stocks materially higher.

This Week’s Preview

For the remainder of the year, every week is an important one for markets as there will need to be constant reinforcement of virtuous reflation, but this week is more important than most given we get the global ISM PMIs and the US jobs report.

Starting with the latter, it’s jobs week, so we get ADP Wednesday, Claims Thursday, and the government report on Friday. We’ll do our normal Goldilocks preview later this week, but once again the wage number will be the key component of this release, and once again the risks are for a number being “Too Hot” and potentially recalibrating Fed rate hike expectations.

Beyond the jobs report, we get the global manufacturing PMIs (out later this morning for the US) and global composite PMIs (out Wednesday). Given the growing number of global central banks that are already removing accommodation (Fed, Bank of Canada) or are about to remove accommodation (ECB, Bank of England) economic growth data needs to stay firm to avoid a “stagflation” scare. So, Goldilocks numbers from both the manufacturing and composite PMIs this week will be welcomed by stocks.

Finally, turning to central banks, the minutes from the September ECB meeting will be released on Thursday, and investors will be searching for clues as to the severity and pace of the Fed’s taper. The
ECB usually plays things pretty close to the vest, so it’s unlikely we’ll see too much revealed in the minutes (they are going to do that at the October meeting), but the bottom line is any hints of extra hawkishness from the minutes could be a mild headwind on stocks this week. Bottom line, economic data in September helped spur a virtuous reflation rally, and that will need to continue this week if we’re going to see new highs in stocks.

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Virtuous vs. Non-Virtuous Reflation Trades, October 29, 2017

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Can the economic data support a continued bullish “reflation” trade in the markets? So far, the events of this week (strong Durable Goods, “progress” on pro-growth tax reform) have supported that idea, and that’s why the S&P 500 is sitting at fresh all-time highs.

But, the next seven days will present both risks and opportunities for the reflation trade to accelerate, or falter.

In yesterday’s issue, I referenced a “virtuous” reflation trade—one that is positive for the broad stock market and especially positive for our reflation basket.

In this scenario, 1) Inflation firms and gradually accelerates, 2) Growth accelerates modestly, 3) Central banks gradually raise rates but not at a pace that unnerves the stock market or sends yields too high, to quickly.

That’s what we’ve seen from the data starting almost three weeks ago with the Chinese inflation numbers
(followed by firm British CPI and US CPI). That’s why stocks have rallied, and it’s why our reflation basket has outperformed.

Conversely, there is a “non-virtuous” reflation we need to be aware of. In this scenario, growth and inflation accelerate too quickly, and markets begin to price in a more hawkish Fed, ECB and BOE.

In this scenario, while banks and other ETFs listed in our reflation basket would either outperform on an
absolute basis and/or on a relative basis, the rest of the market might not fare as well (particularly tech).

This is what we saw in June, where the declines in tech weighed so much on the market that it began to “suck in” other, more cyclical sectors. This is the negative side of reflation we need to watch for in the weeks ahead.

Bottom line, the market now again nearing a tipping point, and the data today and next week will go a long way to telling us 1) Whether we’re seeing a legitimate reflation, and 2) Whether it’s virtuous (bullish).

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Reflation On? Why the Durable Goods Number Was Important, September 28, 2017

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Durable Goods
• August Durable Goods rose 1.7% vs. (E) 1.5%.

Takeaway
Wednesday’s Durable Goods report was a surprisingly strong number, and if it’s the start of a trend in the data, then we could finally be seeing an economic reflation.

The reason the Durable Goods number was so strong wasn’t because of the headline (it was a mild beat, but revisions largely offset it), but instead because of the key New Orders for Non-Defense Capital Goods ex-Aircraft (NDCGXA). NDCGXA surged 0.9% vs. (E) 0.3%, and the July number was revised sharply higher to 1.1% from 0.4%, signaling that business spending and investment accelerated during the summer.

That’s a legitimately positive surprise, as business spending and investment have been lackluster so far in 2017.

But if we see that activity pick up (and importantly close the gap between actual data and survey data), then that will help push broad economic growth higher. And if inflation keeps accelerating, then we’ve got a legitimate reflation.

Stocks reacted accordingly to this surprisingly good data, as the market rallied (growth is good) and was led higher by our “reflation basket” of banks (KRE), industrials, smalls caps, and inverse bond ETFs. That carried through to other assets, as bond yields surged on the news to new multi-week highs while the dollar also broke above 93.00.

Bottom line, this was a legitimately positive surprise for markets, and stocks and the dollar/bonds reacted accordingly. However, one number does not make a trend, so we’ll need to see continued acceleration in other data (industrial production) before we can confidently say the gap between very strong, “soft” survey data and actual, hard economic numbers is closing in a bullish way. Still, yesterday’s number was definitely a good start.

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Tax Cut Preview, September 27, 2017

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Today we should see the next  step in the tax cut drama, as Republicans unveil a more detailed tax cut plan. But while some of the headlines around this are sure to seem “pro-growth” and positive, it’s important to realize that almost nothing announced today will actually make it into any legislation (and it doesn’t remove the chances nothing gets done at all).

Still, tax cuts are the most credible and legitimate “bullish” or “bearish” wildcard remaining for the markers in 2017.

From a bullish standpoint, real tax cuts could easily push the S&P 500 up another 4% (to 2610) because that will increase expected 2018 EPS to (conservatively) $145/share.

From a bearish standpoint, while tax cuts aren’t fully priced into stocks, there is the expectation something does get done, especially regarding foreign profit repatriation. If tax cuts, like healthcare, fail, then we’re now sitting with a market at 18X next year’s earnings—and no identifiable future growth catalyst (and a Fed raising rates). That will cause investors to reduce exposure.

Regarding today’s announcement, here’s what’s (generally) expected:
1. Corporate rate cut to 20% from the current 35%.
2. 10% tax on foreign profits (this is the foreign profit repatriation piece).
3. Individual top rates cut to 35% from 39.5%.
4. “Pass through” rate cut to 25% from 39.5%.

Again, little (if any) of this will make into final legislation.

But, it’s the starting point for negotiations to a potential deal.

Bigger picture, the expectations for tax cuts (what makes them bullish of bearish) won’t change regardless of today’s details.

To review, from a corporate rate standpoint…

What’s Expected: Corporate rate cut to around 28%.

Likely market reaction: Mildly positive.

Bullish If: Corporate rate cut below 25%. Likely market reaction: Reflation basket outperforms.

Bearish If: Corporate rate doesn’t change. Likely market reaction: Modest Decline, but not a bearish game changer.

Foreign Profit Repatriation Holiday: Expected to pass.

Likely market reaction: (Withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

Wildcard to Watch: I was actually surprised and encouraged to see that a “pass through” rate cut is in this proposal. This is very important to small businesses (like mine). Approximately 95% of American businesses are “pass through” (LLCs, S Corps, etc.) where the business owner is taxed at the individual rate. So, in many ways that makes corporate tax cuts just important for large corporations and shareholders.

A cut to the pass through rate lowers taxes for small business, and that could be a potentially significant (and unexpected) positive for the economy, if any of this actually gets passed into law (and that remains very much in doubt).

Bottom line, don’t let positive (or negative) headlines fool you today. The tax cut fight has only just begun, but how it works out will have potentially significant consequences for the economy. We will remain on top of it for you throughout the process.

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North Korea Update, September 26, 2017

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Starting at last week’s UN General Assembly, the war of words between US and North Korean leaders has been steadily escalating, but things got even more serious yesterday for two reasons.

First, the North Korean foreign minister said Trump had “declared war” on North Korea with his tweets.

Second, the same foreign minister said North Korea reserves the right to shoot down US bombers, even if they are not in North Korean airspace.

This is no doubt in retaliation to the US flying bombers very close to North Korea in a recent show of force.

Of the two statements, the later is much more important than the former for this simple reason: The
war of words can escalate, but the event that makes North Korea a bearish game changer for stocks would be the firing (but not necessarily striking) of a missile or rocket at anything US, including planes or Guam.

The North Korean threat to fire a missile at US war planes operating outside of North Korean airspace ups
the ante and creates another opportunity for a potential incident.

From a market standpoint, despite the uptick in tension, and despite yesterday’s mid-day dip, I don’t think the North Korean threat is going to cause a pullback, at least not in its current situation. Taxes (will we get cuts?), rates (will they rise?), inflation (will it gain momentum?), the dollar (will it appreciate?) all are much more important in the near term for stocks than North Korea.

But, that said, clearly this is something that can still move markets and dominate the headlines, so we’ll continue to watch it for you and look for signs of it legitimately becoming a bearish game changer for stocks.

For now, and until North Korea shoots at something US, the situation remains more bluster than bearish (although it still makes me uncomfortable).

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When Will Rate Hikes Kill The Rally?

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When Will the Fed Kill the Bull Market? (Or, What is the Neutral Fed Funds Rate?)

A lot of clichés on Wall Street aren’t worth the paper they’re printed on, but one saying I have found to be  quite accurate is: Bull Markets Don’t Die From Old Age. It’s the Fed that Kills Them.

At least over the last 20 years, that has largely proven true. The general script goes like this:

First, the Fed starts raising rates because financial conditions have become too easy (this should sound familiar). In this cycle, rate hikes began in December 2015 but importantly, they are starting to accelerate.

Second, those rate hikes cause the yield curve to invert. That happens as bond investors sell short-term Treasuries and send short-term yields higher (because the Fed is raising short-term rates), and buy longer-dated Treasuries, pushing those yields lower, because investors know the rate hikes will eventually cut off economic activity. In this cycle, the yield curve hasn’t inverted yet, but the 10s—2s Treasury yield spread has fallen from over 2% in late-2014 to fresh, multi-year lows at 0.77% (as of Sept. 5).

Third, the inversion of the yield curve is a loud-and-clear “last call” on the bull market. The rally doesn’t end when the curve inverts, but it’s a clear sign that the end is much closer to the beginning. In this cycle: We are not at that inversion step yet, although we are getting uncomfortably close.

Fourth, after the curve inverts, the Fed keeps hiking rates until economic momentum is halted. During the last two economic downturns (2001/2002 and 2008/2009) the Fed was able to hike rates to 6.5% and 5.25%, respectively, before effectively killing the bull market.

But just as the Fed continues to cut rates after the economy has bottomed, it also hikes rates after economic growth has stalled (because of the lag time between rate hikes and the effect on the economy).

So, it’s reasonable to assume the actual Fed Funds rate level which caused the slowdown/bear market is at least 25 to 50 basis points below those high yields, so 6% or 6.25% in ’01/’02 and 4.75% or 5% in ’08/’09.

In this cycle, the most important question we can ask is: At what level of rates does the Fed kill the expansion and the rally? That number, which the Fed calls the “neutral” Fed Funds rate is thought to be somewhere between 2.5% and 3% this time around (at least according to Fed projections).

However, we’ve never come out of a cycle where we’ve had:
1. Four separate rounds of QE

2. The maintaining of a multi-trillion dollar balance sheet

3. Eight-plus years of basically 0% interest rates

4. Eight-plus years of sub-3% GDP growth

So, common sense would tell us that this “neutral” Fed funds rate is going to be much, much lower than it’s been in the past.

How much lower remains the critical question (2.5%? 2.0%? 1.5?)

This is really important, because if the answer is 1.5%, we’re going to hit that early next year (it likely isn’t 1.5%, but it may not be much higher).

And, what impact will balance sheet reduction have on this neutral rate?

Again, common sense would tell us that balance sheet reduction makes the neutral rate lower than in the past, because balance sheet reduction is a form of policy tightening that will go on while rates are rising (so it’s a double tightening whammy).

There are two important takeaways from this analysis.

First, while clearly the tone of this analysis is cautious, it’s important to realize that the yield curve has not inverted yet, so we haven’t heard that definitive “last call” on the rally. And, just like at an actual last call, there’s still some time and momentum left afterwards, so an inverted curve is a signal to get ready to reduce exposure, not a signal to do so that minute.

Second, on a longer-term basis, if the Fed really is serious about hiking rates, then this bull market is coming to an end, and the risk is for it happening sooner rather than later. Because the level at which rate hikes cause a slowdown and kill the bull market is likely to be much, much lower than anything we’ve seen before (unless there is a big uptick in economic activity).

That is why I said yesterday that if the Fed is serious about consistently hiking rates going forward, that the “hourglass” may have finally been flipped on the bull run. So, while hitting that “Neutral” Fed funds rate Is hopefully at least a few quarters away (unless things are way worse than we think) it’s my job to watch for these types of tectonic shifts in the market so that we’re all prepared to act when the time is right. We will be watching this closely.

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Is It Time to Buy Our Reflation Basket, September 21, 2017

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Trading Color and Bottom Line: Is It Time To Allocate to Our “Reflation Basket”?

There’s a simple question that we need to address following the Fed’s hawkishly interpreted announcement: “Is it now time to rotate out of defensives (super-cap internet, healthcare, utilities, staples) and into cyclicals/reflationary sectors?”

I bring this up for two reasons.

First, getting this rotation right was the key to outperforming in 2016, and I don’t think it will be different this year. Second, there are growing signs that it may be time to make this tactical rotation.

Looking at the sector trading yesterday, it was a classic “reflation rotation.” Tech, utilities and consumer staples (sectors that have outperformed YTD) all lagged the market while cyclical sectors (which have badly underperformed) rose. Meanwhile, banks surged 1.1%, energy rose 0.35% and industrials gained 0.73%, while consumer discretionary rallied 0.34%. Additionally, small caps (which have been laggards YTD but are playing catch up in a hurry), rose 0.35% and the Russell 2000 was again the best-performing major index.

So, to answer the question of whether we need to begin to rotate into these cyclical sectors, I believe the answer depends on your time frame.

For medium- and longer-term investors, I continue to believe the answer is “no,” or at least “not yet.”
However, for short term oriented, tactical traders/investors, legging into some reflation/cyclical sectors at
these levels could make sense.

For medium and longer term investors/advisors, I’m looking for two key indicators to tell me when to rotate
into cyclicals.

First, I want to see the bank index ($BKX) hit a new high for the year. That means trading above $99.77, and closing above $99.33 (so call it 100 to make it easy).

Second, I want to see 10-year yields close above 2.40% (currently 2.28%).

If those two signals are elected, then for medium- and longer-term advisors/investors, I would advocate booking (large) profits in healthcare (XLV/IHF/IBB), super-cap internet (FDN), consumer staples (XLP) and utilities (XLU).

And, I would advocate allocating those dollars to our “Reflation Basket” we introduced earlier this summer: KRE/KBE (bank exposure), XLI (global industrials), IWM (small caps), TBT/TBF (short bonds). Additionally, I view yesterday’s price action as position for European financials and EUFN specifically.

Again, for those investors who are nimble and can stand some pain, establishing positions now does make some sense. But, for the remainder (again medium– and longer-term investors) I’d wait until those two indicators (BKX and 10-year yield) have been elected.

Regardless, we are witnessing a potential sea change in the outlook for central bank policy, and that’s going to require more vigilance on the part of advisors and investors.

If the global rate-hike cycle is now underway, then the proverbial hour glass just got flipped and the sand is now running out on the eight-year bull market (more on that in tomorrow’s issue).

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Import and Export Price Analysis, September 20, 2017

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Import and Export Prices
• Import Prices rose 0.6% vs. (E) 0.4% in August
• Export Prices rose 0.6% vs. (E) 0.2% in August

Takeaway
A normally overlooked price report, Import and Export Prices came out yesterday and the release is worth mentioning. The headlines showed a decent upside beat in both import and export prices, which underscored the uptick in inflation we saw last week in several overseas CPI reports including China, Britain and India.

The reason this is worth pointing out is the bond market. Over the last several weeks, firming inflation overseas has become a recurring theme that has started to influence global fixed income markets, including Treasuries, pushing yields higher despite the fact that US inflation still remains very low.

Bottom line, yesterday’s Import and Export Prices report is showing the effects of both a weaker dollar, but also the fact that global inflation is beginning to edge higher.

From a macroeconomic standpoint that is encouraging for the reflation trade argument.

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