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FOMC Takeaways, July 27, 2017

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FOMC Decision
• As expected, the Fed left rates unchanged and did not alter its balance sheet.

Takeaway
The Fed decision met our “What’s Expected” scenario, as the Fed said balance sheet reduction “relatively soon,” which is Fed speak for September.

To boot, as was also generally expected, the Fed slightly downgraded the outlook for inflation, saying that inflation was running “below 2%,” as opposed to the previous “running somewhat” below 2%. It’s a minor change that largely reflects the Fed’s recent cautious language on inflation. However, the Fed said that risks to the recovery remained “roughly balanced,” which is Fed speak for “We still can hike rates at any meeting.” That last point is important, because risks remaining “roughly balanced” leaves a rate hike in December on the table (Fed fund futures odds have it at 50/50).

Currency and bond markets reacted “dovishly” to the decision, but again that’s due more to a Pavlovian dovish response to any Fed decision rather than an accurate reflection of the Fed yesterday. In reality, the Fed wasn’t materially dovish.

Bottom line, the policy outlook remains the same: The Fed will reduce its balance sheet in September, and likely will hike rates again in December, barring any economic slowdown or further decline in inflation statistics (at which point both events will become less certain). That was the market’s expectation before the Fed meeting Wednesday, and that’s the market expectation
after the Fed decision.

 

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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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Oil Update & What It Means for the Market, July 20, 2017

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Yesterday’s weekly inventory report from the EIA was universally bullish on the headline level as there were sizeable draws in crude oil stockpiles as well as in the refined products. The market responded favorably to the supply drops and WTI futures finished the day up 1.61%.

Beginning with those aforementioned headlines, commercial crude oil stocks fell –4.7M bbls last week, larger than analysts expectations of –3.1M and opposite from the API report that showed a build of +1.628M bbls.

Gasoline supply fell –4.4M bbls yesterday, and while that was less than the draw reported by the API (-5.4M) it was much larger than the average analyst estimate of –600K bbls.

Distillate inventories also fell –2.1M vs. (E) -700K rounding out a broadly bullish set of headlines in the report.

The details of the report however, once again showed a continuation in the bearish trend of rising US production. Lower 48 production (which filters out the seasonally volatile Alaskan data) rose another +30K b/d last week, above the 2017 average pace of +26K b/d to

8.97M b/d. Lower 48 production is now up +729K b/d so far in 2017, the highest level since late July 2015.

Bottom line, a string of supply draws over the last three weeks in crude oil and gasoline stocks totaling –18.6M bbls and –9.8M bbls, respectively, has offered the market some support, and helped curb a decline that pushed oil prices down to new 2017 lows. And with sentiment being very bearish coming into the month of July, the market was due for an upside correction. But, the underlying fundamentals remain bearish and as of now, we believe this is a counter-trend rally in an otherwise still broadly downward trending energy market. We won’t fight the rising tide, and a run at $50/barrel in WTI is very plausible, but we will be looking for signs of the trend to break in the weeks ahead and for the market to turn back lower based on fundamentals, market internals (term structure), and longer term technicals.

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Chinese Data Recap and What it Means for Global Markets, July 18, 2017

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Chinese Economic Data

  • GDP held steady at 6.9% vs. (E) 6.8% in Q2
  • Fixed Asset Investment was 8.6% vs. (E) 8.4% in June
  • Industrial Production rose to 7.6% vs (E) 6.5% in June
  • Retail Sales rose to 11.0% vs. (E) 10.6% in June

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Takeaway

The headlines tell the story of yesterday’s data dump in China. The reports were universally better than expected, but GDP was the report that warranted the most attention as the headline growth rate held steady at 6.9% rather than pulling back as expected.

Quarter-on-quarter growth jumped to 1.7% from 1.3%, which suggests that the Chinese economy is starting to stabilize towards the top end of the government’s target range of 6.5%-7%.

Looking ahead, the solid growth level seems to be sustainable, and not just a short-lived spike in economic activity. Without getting deep into the details, the growth is consumption driven, and new government policy and reforms are poised to help continue fueling solid growth into H2’17.

Bottom line, yesterday’s strong set of Chinese economic reports were welcomed by economists, as they underscored the positive outlook for the global economy going forward. But the reason the data did not ignite a more pronounced rally in global equities is the fact that growth in China has become more of an expectation, and global growth as a whole is no longer a great concern (as it was back in the summer of 2015).

Instead, very low inflation rates in the US and Europe are the most notable concern, and until those statistics begin to firm, weak inflationary pressures will be a drag on risk assets like stocks in the months ahead.

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Goldilocks Jobs Report Preview, July 6, 2017

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

Given the Fed’s newfound confidence in inflation and economic growth, the bigger risk for stocks will be if tomorrow’s number comes in “Too Cold,” and further implies the economy is losing momentum into a hiking cycle.

However, while a “Too Cold” scenario would likely be the worst outcome for stocks, “Too Hot” wouldn’t be ideal, either, as it would cause a resumption of the reflation trade we saw in June.

So, there are two-sided risks into tomorrow’s jobs report, and if it’s outside of the “Just Right” scenario, we will either see some important sector rotation, or a broader market movement.

 

jobs report

“Too Hot” Scenario (Potential for Two More Rate Hikes in 2017)

• >250k Job Adds, < 4.1% Unemployment, > 2.9% YOY wage increase. A number this hot will open the discussion for another rate hike, likely in September or November.

Likely Market Reaction: We should see a powerful reengagement of the “reflation trade” from June… (withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Just Right” Scenario (Confirms expectations of September balance sheet reduction & December rate hike)

• 125k–250k Job Adds, > 4.1% Unemployment Rate, 2.5%-2.8% YOY wage increase. This is the best-case scenario for stocks, as it would reinforce the current expectation of balance sheet reduction in September, and one more 25-bps rate hike in December.

Likely Market Reaction: This is the most positive outcome for stocks… (withheld for subscribers only—unlock specifics and ETFs by signing up for a free two-week trial).

“Too Cold” Scenario (Economic Growth Potentially Stalling)

• < 125k Job Adds. The key to a sustained, longer term breakout in stocks is stronger economic growth that leads to higher interest rates, and a soft number here would further undermine that outcome, and imply the Fed is hiking rates into an economy that is losing momentum.

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

Again, given the Fed and other central banks newfound hawkishness, this is the worst outcome for stocks over the coming weeks and months.

Bottom Line

This jobs report isn’t important because it will materially alter the Fed’s near-term outlook. Instead, it’s important because if it prints “Too Cold” it could send bonds and bank stocks through their 2017 lows. And while I respect the fact that stocks have been able to withstand that underperformance so far in 2017, I don’t think the broad market can withstand new lows in yields and banks.

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When Will the Decline in Bond Yields Matter?, June 27, 2017

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For three months, we and other macro analysts have been warning that the bond market, via falling yields and a flattening yield curve, was sending a worrisome signal about future economic growth and inflation. And, that falling bond yields would act as a headwind on stocks.

Over that three months, the S&P 500 has moved steadily higher.

when will bond market yields matter?

When will this chart matter? The S&P 500 (bar chart) has been diverging from yields (green line chart) for three-plus months. At some point, that gap must close.

Now, given that, it might seem like falling bonds yields don’t matter to stocks. However, decades of experience in this business combined with listening to experienced analysts and traders tells me that bond yields always matter to stocks… it’s just a question of “when” they matter.

Regarding when, most of us are working on a medium/longer-term time frame (i.e. quarters and years), so getting the bigger market signals right is more important than outperforming over a few weeks.

To that point, if bond yields do not reverse in the coming weeks/months, then I am quite sure that over the medium/longer term the stock market is in for a potentially significant pullback. Avoiding that pullback will be the key to multi-year outperformance.

So, the really important question is: “When will low bond yields matter?”

I believe the answer is: When investors realize bond yields are warning about a slowing economy, not lower inflation.

Right now, stock bulls are saying the drop in Treasury yields is just due to declining inflation—not because of potential slower economic growth.

Specifically, they’re pointing to statistical measures of inflation such as the CPI, PCE and the Price Deflator in GDP. Those measures of inflation are falling, which usu-ally means deflation (which is bad for stocks).

But, the bulls aren’t as concerned about falling statistical inflation because, in their view, inflation has changed. Specifically, there is a growing school of thought that in a technology-dominated world, the old inflation statistics (CPI/PCE/Price Deflator) no longer capture true inflation in the economy.

For instance, those inflation statistics are currently being driven down by 1) Lower oil, 2) The Amazon effect, where retail margins are relentless slashed, and 3) General technology making most everyday items cheaper and more efficient.

However, those price declines aren’t bad for the economy, and they don’t reflect the lack of consumer demand that usually accompanies falling prices. Technology and margin compression is making these prices fall, not an unwillingness of consumers to spend.

Meanwhile, asset and other forms of inflation are rising quickly. Over the past few years, home prices are up; rents are up, car prices are up, airfares are up, health insurance is up, tuition is up, the stock market is up and the bond market is up. So, the prices of all the things we “need” are up, but the prices of discretionary items (HD TVs, laptops, tablets, dishwashers, appliances) are down. Since CPI measures consumer goods heavily, inflation statistics are subdued.

Based on this logic, many investors aren’t sweating the decline in bond yields, because they believe, for now, that it’s just reflecting the decline in statistical inflation and not a future slowing of actual economic growth.

The key will be to recognize when investors begin to believe low bond yields reflect slower economic growth. That will be the time to get seriously defensive in asset allocations. Yet as Monday showed, with the market ignoring the soft Durable Goods report, we’re not there yet. But if this data doesn’t turn around, we will get there. Unfortunately, we don’t believe it’s different this time and if bond yields don’t start rising in the near term, then stocks will eventually suffer, like they’ve done virtually every time we’ve seen this type of stock/bond discrepancy.

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FOMC Preview and Projections plus the Wildcard to Watch, June 13, 2017

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The Fed meeting is more important than any other this year, for the simple reason that it could either exacerbate the glaring discrepancy between stocks and bond yields (which would be negative for risk assets medium term), or it could help close the gap (which would be positive for risk assets).

Specifically, the bond market has quietly been pricing in the expectation of a “dovish hike” for this meeting via the decline in yields. That “Dovish Hike” means the Fed does hike rates 25 basis points, but makes the statement dovish enough that it doesn’t cause longer-dated yields (i.e. 10- and 30-year Treasuries) to rise. If the Fed executes on that expectation, then we will see the 10-year yield dip and likely test the 2017 lows of 2.14%, and again that is a problem for stocks over the medium/ longer term.

Looking at the actual meeting itself, whether it meets expectations, is dovish, or is hawkish, will depend not only on the rate hike, but also the inflation commentary and any guidance regarding “normalization” of the balance sheet.

What’s Expected: A Dovish Hike. Probability (this is just my best guess) About 70%. Rates: It would be a pretty big shock if the Fed didn’t hike rates tomorrow, so a 25-basis-point hike to 1.25% is universally expected. Statement: In paragraph one, the Fed should include some additional soft language regarding inflation, noting that it’s been soft for a few months. However (and this is important), the Fed should still attribute sluggish inflation to “transitory factors,” implying Fed members are still confident they will hit their 2% inflation goal. Dots: No change to the 2017 dots (so, still showing three hikes as the median expectation). Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Dovish If: No Hike or a Very Dovish Hike. Probability (again, my best guess) About 10%. Rates: It’s widely expected that Fed will hike rates, but there’s always a possibility of a surprise. More likely, the Fed will hike 25 bps and accompany it with a very dovish statement. Statement: The Fed changes the characterization of risks from “balanced” to “tilted to the downside,” or some similar commentary, thereby signaling rate hikes are off the table again. This is a very unlikely, but possible change. More likely is the Fed adding considerable language regarding concerns about lower inflation. Dots: A reduction of the dots to reflect just two rate hikes in 2017. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Hawkish If: We get a regular hike, not a “Dovish” Hike. Probability About 20%. Rates: The Fed Hikes Rates 25 basis points. Statement: The Fed does not add softer language regarding growth or inflation in the first paragraph, and instead just largely reprints the May statement, which was dismissive of the recent dip in inflation and growth. Dots: The dots remain the same or even increase one rate hike in 2017 (this is unlikely, but possible). Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Wild Card to Watch: The Fed Balance Sheet

The market fully expects the Fed to elaborate on when and how it intends to reduce its balance sheet (i.e. the holdings of Treasuries it has purchased over the years through the QE program).

I covered why the balance sheet is important back in April (a link to that report is here) but the bottom line is that when and how the Fed begins to reduce its balance sheet (the term “normalize” is just Fed speak for “reduce Treasury holdings”) could be a substantially hawkish influence on the bond market, regardless of rate hikes.

Specifically for tomorrow, the key detail the market will be looking for is at what level of interest rates does the Fed begin to reduce its Treasury holdings. The number to watch here is 1.5%. It’s widely expected that at 1.5% Fed funds, the Fed will begin to reduce its balance sheet. If we get one more rate hike this year, then that puts balance sheet reduction starting in early 2018 (likely March).

For a simple reference, if the Fed statement or Yellen at her press conference reveals the Fed will reduce holdings before 1.5%, that will be hawkish. If it’s revealed that the Fed will reduce holdings after rates hike 1.5% that will be dovish.

Bottom Line

This Fed meeting is likely the most important of the year (so far), not just because we will get updated guidance on expected rate hikes and the balance sheet, but also because it comes at a time when we are at a tipping point for bond yields (if they go much lower and the yield curve flattens, more people will start talking recession risk). We also are potentially seeing a shift in stock sector leadership (from defensives/income to cyclicals/ banks), so understanding what the Fed decision means for rates will be critically important going forward. You’ll have our full analysis, along with practical takeaways, first thing Thursday morning.

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Weekly Market Cheat Sheet, June 12, 2017

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Weekly Market Cheat Sheet

Last Week in Review:

There were only a few economic releases last week and the Fed circuit was silent ahead of this week’s Fed events.

The headline of the ISM Non-Manufacturing PMI was largely in line with expectations at 56.9 for May, and the details matched as well. The one outlier was a sharp dip in the prices category, which fell to 49.2 from 57.6. It was the first sub-50 reading in 13 months. And while the one number by itself is not very alarming, pairing it with other soft price data of late, including the weak unit labor cost on Monday, inflation data is beginning to gain some attention. For now, it is just something to monitor and will not have a material effect on Fed policy yet.

Looking overseas, the EBC decision was the big event last week. As expected, rates were left unchanged and there were no changes in the QE program. The ECB changed their risk assessment to “balanced” and also removed the potential for lower interest rates going forward. Overall, the meeting was anti-climactic as a step was taken towards eventually ending QE, but no update on the timeframe was offered.

This Week’s Preview:

Focus will be on central banks this week as the Fed takes center stage Wednesday, the BOE is Thursday and the BOJ is Friday. The Fed will obviously attract the most attention as a rate hike is expected, but the outlook for future policy has grown cloudier. The market will be looking for any clues as to the number of rate hikes remaining in 2017, or whether the committee’s sentiment towards the economy has changed in recent months. We will have our full FOMC Preview in tomorrow’s Report.

As far as economic data goes, CPI and Retail Sales will both be released pre-market ahead of the FOMC on Wednesday (which we will provide a preview for, as always).

Later in the week we get the first look at June data from the Philly Fed Business Outlook Survey and the Empire State Manufacturing Survey as well as Industrial Production data for May. The latter will be important to see if the recent bounce in manufacturing data has continued at all in Q2 or not. Lastly on Friday, Housing Starts data for May will provide the latest update on the housing market.

Overseas, there are some important releases to watch beginning on Tuesday night with Chinese Fixed Asset Investment, Industrial Production, and Retail Sales all due at 10:00 p.m. ET. There are several second-tiered reports that may move market modestly if there are any surprises, but the only other report overseas really worth watching is the Eurozone HICP (their CPI) to see if inflation is firming at all or actually rolling over as some individual European country reports have shown (German CPI was -0.2 vs. E: -0.1% in May).

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Weekly Market Cheat Sheet, June 5, 2017

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Last Week in Review:

Until Friday’s jobs report, the economic data last week was mildly encouraging, as multiple economic reports showed a mild bounce in activity during May. Unfortunately, that momentum was lost thanks to Friday’s jobs report, which missed estimates on virtually every level.

As we start a new week, the outlook on the economy remains as it’s been for two months. The absolute levels of activity are generally “ok,” but there is a decided lack of positive momentum. And though stocks continue to hit all-time highs, they are now well beyond any sort of fundamental foundation (i.e., this is not the same quality rally we saw in Q4 ’16/Q1 ’17) and that is a growing concern.

From a Fed standpoint, it’s unlikely that Friday’s jobs report will result in no hike at the June 15 meeting, although the issue is a bit more in doubt. Nonetheless, the expectation is still for a 25-basis-point rate hike.

Looking more specifically at last week’s data, the jobs report was the big (negative) surprise. Every measure of the jobs report missed expectations. May job adds were 138k vs. (E) 195k, and the unemployment rate fell to 4.3% vs. (E) 4.4% (but that was because of a 0.2% drop in the labor participation rate). Average hourly wages rose 2.5% vs. (E) 2.6% yoy, and the revisions were negative at -66k.

So, like most recent data, while the absolute level of employment remains “ok” (138k isn’t a bad number) the momentum and direction remain a concern… especially with markets so stretched on a valuation basis.

Looking outside of the jobs report, as mentioned, last week’s data was mildly encouraging. May ISM Manufacturing PMI (54.9 vs. (E) 54.6), May Auto Sales (16.7M vs. (E) 16.9M), and March Core PCE Price Index (0.2% vs. (E) 0.1%) all basically met or slightly beat expectations, implying
initially that there was some bounce back in both inflation and economic growth (which is critical to a continued reflation rally).

Unfortunately, that data was undermined by the jobs report, and as we start June legitimate doubts still linger about whether the economy is starting to lose momentum. Those doubts are not big enough to hit stocks yet, but I’ll remind everyone that stocks had a delayed reaction to the uptick in economic growth during the late summer/early fall of 2016.

This Week’s Preview:

As is typically the case for the week following PMIs and the jobs report, the economic calendar will be mostly quiet except for a few releases this week.

First, today’s global composite PMIs are already out, and the big number of the week domestically will come at 10:00 a.m. via the ISM Non-Manufacturing PMI. Again, given the sour taste the jobs report left at the end of last week (at least from an economic standpoint), a “beat”
here will be welcomed.

Outside of that ISM Non-Manufacturing PMI, the next most important event will be Thursday’s ECB meeting, where the central bank is widely expected to give a mildly hawkish signal by saying that risks to growth and inflation appear “balanced.” In Fed speak, that statement means a rate hike is coming, but in ECB speak it just means that the ECB is beginning to prep the market for tapering of QE, which should begin in early 2018.

Normally, the ECB meeting wouldn’t move US markets, but if the ECB surprises hawkishly or dovishly it will impact Treasury yields, which will improve or make worse the gap between yields and stocks.

Finally, the latest Chinese data comes Thursday night via CPI and PPI. China remains out on the relative macroeconomic back burner, but trends there aren’t encouraging. The May Caixin Manufacturing PMI dropped below 50 for the first time in months, joining a nowgrowing
list of other disappointing economic data.

Meanwhile, the Chinese yuan is starting to experience volatility again, as it has surged in the last few weeks to a multimonth high vs. the dollar (adding a bigger headwind to the Chinese economy). To be clear, China is not a macro risk that warrants caution, yet. However, the trend isn’t going in the right direction, and we will continue to watch that region for you.

 

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Tom Essaye on “The Bell” Podcast with Charles Nenner of Goldman Sachs and Adam Johnson

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Bullseye Brief with Charles Nenner, Tom Essaye, Adam Johnson

Thanks to Adam Johnson for having me on his podcast “The Bell” again last week. We talked with Goldman Sachs Strategist Charles Nenner on Cycles, Shorts, and Sunspots. We also talk about the data deluge, incredibly high credit scores, and the very busy week in economic data. Plus, find out who’s shorting Costco… and why? What’s the secret to retail?


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