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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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Weekly Market Preview, September 18, 2017

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Last Week in Review

Up until Friday, last week’s data looked like it was going to show “green shoots” of an economic reflation. But disappointing economic growth numbers on Friday off-set better inflation readings from earlier in the week, and while Hurricane Harvey likely impacted the growth data, the bottom line is the data just isn’t good enough to spur a rising tide for stocks.

From a Fed standpoint, the higher inflation data did increase the likelihood that we will get a December rate hike, although the market expectation of that remains below 50%. As such, increased expectations of a rate hike in the coming weeks could be a headwind on stocks, especially if economic data doesn’t improve.

Looking at last week’s data, the most important takeaway was that inflation appears to be bottoming. Chinese, (1.8% yoy vs. (E) 1.7% yoy), British (2.7% vs. (E) 2.5%), and US CPI (0.4% m/m vs. (E) 0.3%) all firmed up and beat expectations, and while it’s just one month’s data, it’s still a break of a pretty consistent downtrend.

That turn in inflation potentially matters, a lot, because it’s making central banks become more hawkish. The ECB is going to taper QE, the Bank of England is going to raise rates sooner rather than later (more on that in Currencies), the Fed may hike again in December and the Bank of Canada was the first major central bank to give us a surprise rate hike in nearly a decade. I’m going to be covering the implications of this a lot more this week, but the times, so it seems, they are a changin’.

That makes an acceleration in economic growth now even more important. Unfortunately, the growth data from last week was disappointing. July retail sales missed on the headline (-0.2% vs. (E) 0.1%) as did the
more important “Control” group (retail sales minus autos, gas and building materials). The “control” group fell to -0.2% vs. (E) 0.3%.

Additionally, Industrial Production also was a miss. Headline IP fell to -0.9% vs. (E) 0.1% while the manufacturing subcomponent declined to -0.3% vs. (E) 0.1%. Now, to be fair, Hurricane Harvey, which hit Southeast Texas, likely skewed the numbers negatively. But, the impact of that is unclear, and we can’t just dismiss these numbers because of the hurricane.

Bottom line, the unknown impact of Hurricane Harvey keeps this week’s data from eliciting a “stagflation” scare, given firm inflation and soft growth. But if this is the start of a trend, and it can’t be blamed on Harvey or Irma, then that’s a problem for stocks down the road. We need both inflation and growth to accelerate (and at the same time) to lift stocks to material new highs.

This Week’s Preview

The two key events for markets this week will be the Fed meeting on Wednesday, and the global flash PMIs on Friday.

Starting with the Fed, normally I’d assume this meeting will be anti-climactic, but it’s one of the meetings with the “dots” and economic projections, so there is the chance we get either a hawkish or dovish surprise. I’ll do my full FOMC Preview in tomorrow’s report, but the point here is don’t be fooled into a false sense of security if people you read say this meeting is going to be a non-event. It very well could be, but there’s a betterthan-expected chance for a surprise, too (and if I had to guess which way, I’d say it’d be a hawkish surprise… and that could hit stocks).

Turning then to the upcoming data, given the new-found incremental hawkishness of global central banks, strong growth data is more important than ever to avoid stagflation. We’ll want to see firm global manufacturing PMIs to keep stagflation concerns at bay. Looking more specifically at the US, Philly Fed comes Thursday and that will give us anecdotal insight into manufacturing activity, although the national flash PMI out the next day will effectively steal the thunder from the Philly report.

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Green Shoots of A Global Reflation, September 13, 2017

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Are We Seeing “Green Shoots” of A Global Reflation?
• Chinese August CPI rose 1.8% yoy vs. (E) 1.7% yoy.
• British Core CPI rose 2.7% vs. (E) 2.5% yoy.

Takeaway

Are there “green shoots” of inflation? I reference the Bernanke comments regarding economic growth here, because very quietly we’ve seen two better-than-expected inflation numbers in two big economies (technically three if you count the uptick in Indian CPI, although that’s not widely followed).

August Chinese CPI beat (it came out Friday but couldn’t be priced in until markets opened on Monday) but it was the big uptick in core British CPI that saw the market extend the rally on Tuesday.

So, the logical question, given these two surprise beats is, “Will US CPI also surprise markets?”

The inclination is to believe in the trend, but to be clear, higher Chinese and British CPIs have no real bearing on US CPI—so strong numbers in those two reports don’t increase the likelihood of a strong CPI number.

But, if it comes, expect some potentially big market moves across Treasury yields, the dollar, and in stock
sector trading (banks and cyclicals will scream higher while defensives, including parts of tech, will likely badly lag). But again, that will depend on tomorrow’s number.

From a market standpoint, looking at the effects of the strong Chinese and British CPI, the clear ETF winner is…(withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

I continue to believe that an economic reflation (better growth, higher inflation) remains the key to a sustained US and global stock rally. And while two numbers don’t make a trend, they were the first positive surprises we’ve had on inflation in months, and we think that’s potentially very important (if it continues).

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Harvey’s Market Impact, August 29, 2017

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We got a couple of questions from advisors yesterday about the market impact of Hurricane Harvey, so I imagined you might be getting similar calls from your clients.

So, I wanted to clearly and briefly outline the market impact of the storm.

Macro Impact: Not Much. From a macro standpoint (Fed policy, GDP growth, inflation) Hurricane Harvey won’t have much of an effect. While clearly a significant human tragedy for Houston and Southeast Texas, storms simply don’t have a lasting effect on markets. Katrina and Sandy had impacts on the local economies, but again, the broader macro influence wasn’t big. Harvey does not change our “cautiously positive” stance on markets.

Micro Impact: The more palpable impact of Hurricane Harvey will be on specific market sectors, although I will not provide a list of “winners” given the damage wrought upon Houston and other parts of Texas.

That said, companies that likely will see increased demand due to the storm are: Refiners (HFC, DK), trucking companies (KNX), and equipment rental companies (URI). Unfortunately, there’s not a clean ETF for these sectors, and the only tradeable infrastructure ETF is a global ETF, so I don’t think it’s applicable here.

Companies that are likely to see business decline because of Harvey are: Natural gas and oil E&P companies due to a lower production and lower prices (ETF is XOP), and insurers.

Looking at insurers, the focus there is on property and casualty insurers as they will be the most affected by the storm. The big insurance ETF is KIE which traded down 1% on the news yesterday. But, while the first instinct would be to run from the insurance space, in some ways I view this as a potential opportunity to buy insurers on a dip (if this continues).

First, property and casualty insurers are just 40% of KIE. Yes, there will be more exposure through reinsurance (10.8% of assets), but that still leaves about half the assets of the ETF somewhat insulated from the storm. Additionally, 24% of the exposure of the fund is to the UK, and those should have little exposure to Harvey.

Point being, I’m not saying buy KIE today but I also want to look through the initial impulse to just shy away from the sector entirely. But, over the longer term, being long insurance companies are like betting with the house in a casino—they always win given enough time.

If Harvey creates an unreasonable downdraft in KIE, we will likely allocate capital to it for longer-term accounts. We’ll be watching this one going forward.

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Weekly Market Cheat Sheet, August 28, 2017

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Last Week in Review

There were only two notable economic reports last week, and neither were particularly controversial… and neither did anything to change the current market expectation of 1) High 2% to low 3% GDP growth in Q3, or 2) Fed reduction of the balance sheet in September.

Neither data point gave us any incremental color on whether the Fed will hike rates in December, although
we’ll get a lot more color on that issue this week. Looking at the data, the most important number last week was the August flash composite PMIs. The headline number beat at 56 vs. (E) 54.3, but that strong aggregate number hid some pretty significant discrepancies in the details.

The reason the PMIs beat was because of a surge in service companies. Flash service sector PMI rose to 56.9 vs. 54.8. But, the more important manufacturing PMI dropped to 52.5 vs. 53.2 (the manufacturing PMI is just a better reading of activity, so it’s more heavily weighted in the minds of economists).

So, despite the headline beat, this number was actually a disappointment, although I want to be clear that it was not an outright negative (PMIs need to drop below 50 before they imply economic activity is slowing). Bottom line, this is not the type of August reading that would make us think we’re seeing an economic acceleration.

Turning to Durable Goods, they were in line. Yes, the headline reading missed expectations as orders for Durable Goods fell -6.8% vs. (E) -5.8%. But, longer-time readers of this Report know you should ignore the headline as it’s massively skewed by airplane orders. The more important number is New Orders for Non-Defense Capital Goods ex Aircraft (NDCGXA) and it rose 0.4% vs. (E) 0.5%, although June data was revised 0.1% higher, so it was an in-line reading.

Again, we watch NDCGXA because it’s the best proxy for business spending and investment. And, similar to the flash PMI, while the number isn’t an outright negative, it’s not the kind of number that makes us think a broad economic acceleration is coming.

Bottom line, both numbers last week implied continued steady, but unspectacular, economic growth, and that’s simply not enough to cause a rising.

This Week’s Preview

This will be one of the busiest weeks of the year from an economic data standpoint, and it will come during one of the lowest liquidity weeks of the year… so the potential for data-based volatility this week is high.

The key reports this week (in order of importance) are: Jobs Report (Friday), Personal Income and Outlays (Thursday) and Global Manufacturing PMIs (Thursday night/Friday morning).

The reason those reports are ranked like that is because of inflation. Remember, barring a shockingly week Jobs Report on Friday, nothing is going to stop the Fed from reducing the balance sheet in September.

But, whether they hike rates in December remains uncertain, and the key variable that will decide that is inflation. So, that means that the wage number in Friday’s Jobs Report, and the Core PCE Price Index (the Fed’s preferred measure of inflation, which is contained in the Personal Income and Outlays report) will be the two key numbers this week.

If they run hotter than expected, you will see markets begin to price in the chance of a December rate hike, which would likely be a near-term headwind on stocks as a rate hike is not priced in to bond yields, the dollar or equities.

Turning to measures of economic growth, the August manufacturing PMIs are always important, but again there really shouldn’t be any major surprises here. A firm number in the US that refuted the soft flash PMI from last week would be welcomed as we need better growth to push stocks higher, but really the focus will be on inflation this week.

Looking at the dovish possibilities, we could easily see the data this week push the 10-year Treasury yield to new lows if the inflation data is underwhelming, and we would view that as a negative for stocks broadly.

Bottom line, I know this is a heavy vacation week, but it’s important one for Fed and ECB expectations, and that has the potential to move markets, especially given the precarious technical situation the S&P 500 is sitting in.

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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.

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FOMC Preview and Projections plus the Wildcard to Watch, July 25, 2017

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Tomorrow’s FOMC meeting is important to markets for multiple reasons, because it will give us additional color on when the Fed will begin to reduce its balance sheet, and whether a December rate hike is still on the table.

Those revelations will be the latest catalyst for the ongoing battle between “reflation” (which means cyclical sectors like banks, industrials and small caps outperform) or “stagnation” (super-cap tech and defensive sector out-performance).

Given the latter sectors have been the key to outperforming the markets in 2017, understanding what the Fed means for these sectors is critically important. Remember, it was the Fed’s “hawkish” June statement that saw Treasury yields rise and banks and small caps outperform from June through mid-July. And, it was Yellen’s “dovish” Humphrey-Hawkins testimony that reversed the rise in yields and resulted in the two-week outperformance of super-cap tech (FDN) and defensive sectors such as utilities. So again, while not dominating the headlines, the Fed is still an important influence over the markets, just on more of a micro-economic level.

What’s Expected: No Change to Interest Rates or Balance Sheet Policy. The Fed is not expected to make any change to rates (so no hike) or begin the reduction of the balance sheet. However, and this is important, the Fed is expected to clearly signal that balance sheet reduction will begin in September by altering the fifth paragraph to state that balance sheet normalization will begin “soon” or “at the next meeting.” Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Hawkish If: The Fed Reduces the Balance Sheet. This would be a legitimate hawkish shock, as everyone expects the Fed to start balance sheet reduction in September. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Dovish If: No Hint At Balance Sheet Reduction. If the Fed leaves the language in paragraph five unchanged (and says balance sheet reduction will happen “this year”) markets will react dovishly, as balance sheet reduction likely won’t start until after September, and that means no more rate hikes in 2017. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Wild Card to Watch: Inflation Language.

So far, the Fed has been pretty dismissive regarding the undershoot of inflation, but that may change in tomorrow’s statement. If the Fed reduces its outlook on inflation (implying low inflation isn’t just temporary) or, more significantly, implies the risks are no longer “roughly balanced” (which is Fed speak for we can hike at any meeting), then a December rate hike will be off the table, and that will result in a likely significantly dovish move. If made, that change will come at the end of the second paragraph.

Bottom Line

To the casual observer, this Fed meeting might look like a non-event, but there are a lot of potential changes that could have significant implications on sector performance over the next few months. So, again, getting this Fed meeting “right” will be important from an asset allocation standpoint.

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Gold and Real Interest Rate Update, What It Means for the Economy, July 19, 2017

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Gold rallied 0.67% Tuesday, as political angst spurred a fear bid while strength in the Treasury market continued to help the “real-rate” argument for gold. British inflation data missed expectations, and that was the third release since Friday that showed below-expected price pressures.

That trend helped fuel dovish money flows, which ultimately bolstered the case for gold, because a lower pace of inflation changes the narrative of the world’s central banks. It’s also cause for recalculation of the real interest rate equation (which is simply interest rates minus inflation rates equals real rates).

If real interest rates are actually poised to move lower (as nominal rates fall and inflation remains flat/does not accelerate) that will be bullish for gold and the rest of the precious metals, as they are safe-haven assets that do not offer yield.

For now, we remain neutral on gold due to the technical support violation in early July. Looking ahead, it’s all about the fundamentals, which come back to real rates.

If real rates continue to fall, even because of soft inflation causing a slightly dovish shift in central bank expectations, that will be bullish for gold long term.

From a broader standpoint, if real rates fall further, that will mean that the economy is struggling, or at the very least not meeting expectations. That will be a concern for stock investors, and ultimately holding gold allocations would be a sound hedge against volatility.

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What Does “Reflation” Actually Mean?, July 7, 2017

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What Does “Reflation” Actually Mean?

One of the reasons I started the Sevens Report more than five years ago was because I hated the overuse of jargon by analysts and commentators. Frankly, markets and economics are not particularly complicated topics. There are a lot of variables involved, so getting the future right is difficult. However, understanding market dynamics and economic conditions is actually mostly common sense, because markets and economies are just the sum of collective actions by people. And, since people generally act in their own best interests, it’s not too difficult to understand markets and economics once you get past the jargon.

To that point, I’ve found myself using the terms “reflation” and “cyclical” entirely too much lately. That’s jargon, and I want to make sure that everyone knows exactly what I mean when I say “reflation trade” or “cyclical outperformance.”

So, what is Reflation?

Reflation is simply the idea that economic growth is going to accelerate in the future. To understand why we use the term reflation, think of the economy as a soccer ball. The ball is full of air when we have consistent 3% GDP growth. But, fallout from the financial crisis has put GDP growth around 2% for nearly a decade. So, the soccer ball (i.e. the economy) is deflated.

However, if we see economic acceleration back to consistent 3% growth, the ball (i.e. the economy) has been “reflated.” So, any economic news that implies better growth is termed “reflation.”

And, since reflation is just the expectation of an accelerating economy, people (i.e. investors and the market) react to that expectation. That reaction, typically, is comprised of:

1) Selling bonds (so higher rates) because in an accelerating economy central banks hike rates and inflation rises, both of which are negative for bonds.

2) They allocate investment capital to sectors of the economy that are more reactive to better economic growth.

These sectors are called cyclicals, because their profitability rises and falls with economic growth (like a cycle). Banks (better economy=more demand for money), industrials (better economy=capital investment in projects), small caps (better economy=rising tide for products and more availability of capital), and consumer discretionary (better economy=more spending money) all are cyclical sectors.

Companies in those sectors usually make more money when the economy is getting better, and the anticipation of that attracts capital at the expense of bonds and “non-cyclical” sectors such as utilities, consumer staples, healthcare, and, increasingly, super-cap tech.

Up until June, the non-cyclicals outperformed because there was no evidence of higher rates or better growth. But in June central banks sent a shot of confidence into the markets, and since then, in anticipation of that economic acceleration, cyclical sectors have outperformed. And, if today’s jobs report is strong, beyond any short term “Taper Tantrum 2.0” that’s likely a trend that will continue, especially given the trend change in bonds.

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What Does Reflation Actually Mean for the Economy-

Earnings Season Post Mortem & Valuation Update, May 9, 2017

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The S&P 500 has been largely “stuck” in the 2300-2400 trading range for nearly 10 weeks, despite a big non-confirmation from 10-year yields, modestly slowing economic data and political disappointment. Given that less-than-ideal context, the market has been downright resilient as the S&P 500 only fell to around 2320ish. The main reason for that resilience is earnings and valuation.

While it’s true that stocks are at a valuation “ceiling” right now, and need a new macro catalyst to materially breakout, it’s also true that given the current macro environment the downside risk on a valuation basis for the market is somewhat limited. That’s why we’re seeing such aggressive buying on dips.

Here’s the reason I say that. The Q1 earnings season was better than expected, and it’s resulted in 2018 S&P 500 EPS bumping up $1 from $135-$137 to $136-$138. At the higher end of that range, the S&P 500 is trading at 17.4X next year’s earnings. That’s high historically to be sure, but it’s not crazy given Treasury yield levels and expected macro-economic fundamentals.

However, if the S&P 500 were to drop to 2300 on a macro surprise, then the market would be trading at 16.67X 2018 earnings. In this environment (low yields, stable macro environment), that could easily be considered fairly valued.

Additionally, most analysts pencil in any help from Washington (including even a small corporate tax cut and/or a foreign profit repatriation holiday) adding a minimum of $5 to 2018 S&P 500 EPS. So, if they pass the bare minimum of expectations, it’s likely worth about $5 in earnings, and that puts 2018 earnings at $143.

At 2400, and with $143 expected earnings, the S&P 500 is trading at 16.8X 2018 earnings. Again, that is high historically, but for this market anything sub 17X will elicit buying in equities (whether it should is an open question, but that is the reality).

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