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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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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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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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Yellen and Draghi Speech Preview, August 25, 2017

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Both Fed Chair Yellen and ECB President Draghi will speak at the conference today, and while neither is expected to say anything market moving, there are always surprises, so we want to preview their remarks briefly.

Yellen’s Speech: 10:00 A.M. EST

Key question: Will Yellen give us any color on whether we get a rate hike in December?

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

What’s Expected: I’d give it about an 80% probability that Yellen does not even mention monetary policy
and instead just speaks broadly about the Fed’s role in helping ensure financial stability.

Wild Card to Watch: If there’s a risk of a surprise here, it’s for a “hawkish” surprise. Yellen could tie in the idea that in order to ensure future financial stability, the Fed needs to continue to remove accommodation and get interest rates back to normal levels.

Again, I think it’s unlikely she’d use this opportunity to discuss policy (unlike Bernanke, she’s never used Jackson Hole as a forum to discuss policy). Still, there is a chance  (20% if my other probability is 80%).

If she does surprise markets, though, look for a textbook (and potentially intense) “hawkish” market response: Dollar and bond yields up (maybe big), stocks down, commodities and gold down.

Draghi Speech: 3:00 P.M. EST

Key Question: Will Draghi forcefully hint at a tapering announcement in September?

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

What’s Expected: Nothing specific. Draghi is not expected to speak or reference policy, mainly because the ECB meeting is less than three weeks away.

Wildcard to Watch: Commentary on the euro. While Draghi likely won’t say anything about expected policy, he might comment on the strength in the euro. It’s widely thought that the surging euro (up 10% vs. the dollar this year) would cause the ECB to be “dovish” and potentially delay tapering.

But, Draghi has pushed back on this notion recently, saying that the euro appreciation is the result of a better economy and rising inflation (hence virtuous).

If he reiterates those comments, or downplays the impact of a rising euro, that will be “hawkish” and the euro and German bond yields (and likely US Treasury yields) will rise, while the dollar will fall. This outcome would likely be positive for US stocks (on dollar weakness).

Bottom Line
In all likelihood, Jackson Hole should be a non-event, as it’s simply too close to the September ECB Meeting (Sept. 7) or the September Fed meeting (Sept. 20).

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EIA Report & Oil Update, August 24, 2017

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Yesterday’s EIA data was relatively in line with expectations, and the market reacted accordingly with a very choppy and insignificant response. Gasoline stocks did fall more than expected, and as a result RBOB futures outperformed WTI futures, which closed up 1.72% and 1.09%, respectively.

On the headlines, crude oil stocks fell -3.3M bbls vs. (E) -3.1, which also roughly matched the -3.6M bbl draw reported by the API late Tuesday. The change in gasoline supply was the only real surprise in the data print as stockpiles fell -1.2M vs. (E) -500K. And compared to the API, which reported gasoline inventories rose +1.4M bbls, that data point favored the bulls.

The rising trend of lower 48 production remains the most important influence on the energy markets right now, and there was a potential sign of fatigue in that figure as it rose just 12K b/d vs. the 2017 average of 25K b/d. In theory that is a slightly bullish influence, but it is only one report and US output did hit another multi-year high in this most recent release, which is still longer-term bearish. Additionally, Alaskan production continued to stabilize and show signs of turning higher into the fall, as production rose 14K b/d to the highest level since mid-July.

Bottom line, US production continues to trend higher despite a slight pullback in pace last week. And as long as US production is grinding to new multi-year highs, it will be a headwind on the entire complex, and the $50/barrel mark will continue to be a stubborn psychological and technical resistance level for WTI.

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Is the Earnings Rally Losing Steam?

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Earnings have been an unsung hero of the 2017 rally, but there are some anecdotal signs that strong earnings may already be fully priced into stocks, leaving a lack of potential positive catalysts given the macro environment.

Now, to be clear, earnings season has been (on the surface) good. From a broad standpoint, the results have pushed expected 2018 S&P 500 EPS slightly higher (to $139) and that’s enough to justify current valuations, taken in the context of a calm macro horizon and still-low bond yields.

However, the market’s reaction to strong earnings is sending some caution signals throughout the investor
community. Specifically, according to a BAML report I read earlier this week, the vast majority of companies who reported a beat on the top line (revenues) and bottom line (earnings) saw virtually no post-earnings rally this quarter. Getting specific, by the published date of the report (earlier this week) 174 S&P 500 companies had beat on the top and bottom line, yet the average gain for those stocks 24 hours after the announcement was… 0%. They were flat. To boot, five days after the results, on average these 174 companies had underperformed the market!

That’s in stark contrast to the 1.6%, 24-hour gain that companies who beat on the revenues and earnings have enjoyed, on average, since 2000.

In fact, the last time we saw this type of post earnings/sales beat non-reaction was Q2 of 2000. It could be random, but that’s not exactly the best reference point.

So, if we’re facing a market that’s fully priced in strong earnings, the important question then becomes, what will spur even more earnings growth?

Potential answers are: 1) A rising tide of economic activity, although that’s not currently happening. Another is 2) A surge in productivity that increases the bottom line. But, productivity growth has been elusive for nearly a decade, and it’s unclear what would suddenly spark a revival. Finally, another candidate is 3) Rising inflation that would allow for price and margin increases. Yet as we know, that’s not exactly threatening right now, either.

Bottom line, earnings have been the unsung hero of this market throughout 2017, but this is a, “What Have You Don’t For Me Lately” market, especially at nearly 18X next year’s earnings. If earnings growth begins to slow and we don’t get any uptick in economic growth or pro-growth policies from Washington, then it’s hard to see what will push this market higher beyond just general momentum (and general momentum may be fading, at least according to the price action in tech). To be clear, the trend in stocks is still higher, but the environment isn’t as benign as sentiment, the VIX or the financial media would have you believe.

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Weekly Market Cheat Sheet, July 31, 2017

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Last Week in Review

Data has been remarkably consistent the last few weeks, including last week: “OK” but not great economic growth, and consistent signs that inflation is losing momentum. As such, the economic data continues to point to a “Stagnation” set up for stocks and other assets.

Given that inflation trends are more important than growth trends right now, I’ll start with the Quarterly Employment Cost Index, which, like many other inflation indicators in Q2, slightly missed estimates. The Q2 ECI rose 0.5% vs. (E) 0.6, maintaining a 2.4% yoy increase from Q1, but slightly disappointing vs. expectations.

Additionally on Friday, the PCE Price Indices from the Q2 GDP report showed deceleration in the pace of inflation. The PCE Price Index rose just 1% in Q2 vs. (E) 1.2%. Now, none of these inflation statistics are particularly bad. Yet from a policy standpoint, these numbers won’t make the Fed eager to tighten policy ahead of the current schedule (balance sheet reduction in September, rate hike, probably, in December).

Turning to actual growth data, it was “ok” but not great. Q2 GDP met expectations with a 2.6% yoy gain, and that was a true number as Final Sales of Domestic Product (which is GDP less inventories) was also 2.6%. Consumer Spending, or PCE as it’s known in the GDP report, rose 2.8%, again a solid but unspectacular number.

Similarly, June Durable Goods, while a decent report, wasn’t that strong. The headline was a big beat at 6.5% vs. (E) 3.5%, but that was because of one-time airline orders. New Orders for Non-Defense Capital Goods ex-aircraft, the best proxy for corporate spending and investment, was revised higher in May but dipped 0.1% in June.

Point being, like most growth data recently, it wasn’t a bad report, but it’s not the kind of strength that will spur a reflationary rally.

Finally, the one economic data point that was strong last week was the July flash manufacturing PMI. It rose to 54.2 vs. (E) 53.2, but while that is a potential positive (it’s a July report so it’s the most current) the PMIs are surveys, and the gap between soft survey data and “hard” economic numbers remains wide.

Turning to the Fed meeting last week, the two takeaways were: 1) The Fed confirmed that they will reduce the balance sheet in September, barring any big economic or inflation surprises. 2) The Fed did slightly downgrade the inflation outlook, but importantly it kept open the option to hike rates at any meeting, and as such a December rate hike is still likely).

This Week’s Preview

As stated, inflation is more important than growth data right now, so that means two most important numbers this week will be tomorrow’s Core PCE Price Index (contained in the Personal Income and Outlays report) and Friday’s wage data in the jobs report.

Stocks have rallied since Yellen turned incrementally dovish at her Humphrey-Hawkins testimony, and soft inflation data will further that sentiment and underpin stocks.

Conversely, if we see inflation bounce back, that will push bond yields higher and help reflation assets (banks, small caps, inverse bond funds, cyclicals).

But, inflation stats aren’t the only important numbers this week as we get the latest final manufacturing and composite US and global PMIs. They remain important because they will provide anecdotal insight into the pace of the US and global economy. But again, it would be a pretty big surprise if the data suddenly showed slowing in the global economy.

On the flip side, at least for the US, a strong report would be welcome, because strong economic data won’t cause the Fed to get more “hawkish” unless inflation ticks higher.

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What Caused The Mid-Day Selloff?

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The most likely “cause” of the midday reversal and selloff (which frankly looked ugly for an hour or so) was a cautious report from JPM quant analyst Kolanovic, and the reasons it caused a dip are twofold. First, Kolanovic is very respected on the Street, and he was one of the first analysts to correctly identify the role of “Risk Parity” funds in the violent market declines of August 2015.

Second, he outright suggested investors hedge equity exposure.

Now, to be clear, it wasn’t a bearish report, as he did note there are strong, positive fundamental factors supporting stocks including a rising economic tide and growing earnings.

However, he made the point that, in his opinion, market volatility is now at an all-time low. The specific accuracy of this claim can be debated, but let’s all agree market volatility is close to, if not at, all-time
lows.

The all-time lows in volatility have caused funds to use increasingly leveraged strategies to generate outsized returns. Selling volatility options is one of the simplest leveraged strategies, but the point is this: Quant funds and traders will ratchet-up leverage in low volatility environments to increase returns amidst perceived lower risk. And, since volatility is at or near all-time lows (and has been for some time) these leveraged strategies are both abundant and large.

And, this all-time low volatility and explosion of leveraged strategies is coming right at a time when global central banks are reducing monetary accommodation  for the first time in, well, a decade.

So, while the analogy of fireworks sitting on top of a powder keg is a bit over the top, it does illustrate the general idea behind Kolanovic’s caution.

Bottom line, in my opinion, this report by itself isn’t a reason to materially de-risk, as the same argument could have been made about this market over the past few months (as it’s made new highs). But, Kolanovic is a smart guy, so his caution should be noted.

Finally, two anecdotal points. First, I believe what really spooked markets yesterday was that Kolanovic referenced this current set up as being similar to “Portfolio Insurance,” a strategy that failed miserably and contributed to the crash of 1987. Obviously, that’s not an uplifting analogy.

Second, for those of us watching the tape yesterday, the mini-freefall we saw in tech and specifically SOXX and FDN, was a bit unnerving. Things steadied, but the pace of the declines midday yesterday was a bit scary. That tells me these are very, very crowded trades, and I am going to have a “think” on potentially lightening up some exposure to that tech sector in favor of shifting it internationally (Europe, Japan, and perhaps emerging markets). Food for thought.

Getting back to the markets today, the Employment Cost Index is the key number to watch. If it’s hot, we could see yields rise, and that might pressure stocks mildly. Meanwhile, a soft reading will send yields lower and likely push stocks higher short term. Inflation remains a much more important influence on the markets right now than measures of economic growth.

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Weekly Market Cheat Sheet, July 24, 2017

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Last Week in Review

The economic calendar picks up this week beginning with the flash PMI today (9:45 a.m. ET), as we continue to get an initial look at the July data. So far, the data has been a bit underwhelming as both the Empire and Philly Fed surveys came in light last week.

As far as hard data goes, Durable Goods comes out Thursday, and the preliminary second-quarter GDP number comes out Friday.

Housing data also picks up this week, and after last week’s mixed results (remember the Housing Market Index missed but Housing Starts was solid) economists will be looking for a better read on the current status of the real estate market. The two big reports this week are Existing Home Sales on Monday, and New Home Sales on Wednesday. However, the S&P CoreLogic Case-Shiller HPI also will be worth watching (due out Tuesday). If the housing data is more in line with the strong Housing Starts data we saw last week, that will be an underlying positive for the economy and supportive for risk assets near term.

Turning to the central banks, the FOMC meets Tuesday and Wednesday, and the meeting will be concluded with an announcement on Wednesday at 2:00 p.m. There are no material changes expected to come from the meeting, and it would be a shock if rates were not left unchanged. There is no press conference or forecasts released with this meeting, but language in the statement will be closely watched for any further clues on the Fed’s plans to reduce the balance sheet, or on when rates will be raised. Right now, expectations are for a December hike, but based on the trend in other central bank rhetoric the risk is for a dovish development due to the complete lack of inflation acceleration.

This Week’s Preview

Economic data was thin last week, but we did get our first look at July data in the form of regional Fed outlook surveys as well as a few reports on the housing markets.

Beginning with the Fed surveys, the Empire State Manufacturing Survey was released on Monday, and despite the bad headline it was not a terrible report. The headline missed estimates (9.8 vs. E: 15.0), but the forward looking New Orders component remained solidly above 13. The reason the report was not that bad was the fact that it had started to run hot at unsustainable level recently, and was due for a dip. And the correction we saw in the June data wasn’t too deep, and the details remained encouraging.

The Philly Fed Survey out on Thursday was not as bad a miss as the Empire data on the headline (19.5 vs. E: 22.0), but the details definitely dimmed the outlook for the Mid-Atlantic manufacturing sector. The forward-looking component of the report, New Orders, fell more than 20 points to just 2.1. The survey Philly data last week finally started to show a decline in enthusiasm from the extremely strong survey reports we’ve seen since the election. If these reports are foreshadowing a pullback in the broader US economy, that would be very bad for stocks, as solid growth is still priced into the market at current levels.

Housing data was mixed last week as the Housing Market Index missed expectations, but Housing Starts and Permits were very solid. Data on the real estate market has been all over the place recently, and it will take more data to try to decipher where the trends actually are in the sector. But if the strong Starts and Permits data from last week are any indication (this is a more material data point than the Housing Market Index) that will be a sign of confidence in the US economy.

Lastly, jobless claims were very solid last week as new claims fell back towards a four-decade low. The very positive weekly report was significant, because the data collected corresponds with the survey week for the July BLS Employment report. So, based on jobless claims alone we can expect another very strong official employment report early next month.

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