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What’s the Specific Word Trump Said That Sent the S&P 500 Through 2300 Last Week?

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What’s the Specific Word Trump Said That Sent the S&P 500 Through 2300 Last Week?

Last week started off a little down on Monday, then flat on Tuesday and Wednesday. Thursday looked like it was going to be another boring day until President Trump made comments during an airline CEO meeting that he would present a “phenomenal” tax plan in a few weeks. Those comments were followed by a more legitimately positive article from The Hill that said Trump may be willing to cut entitlements to pay for tax cuts. Stocks jumped on the headlines and markets moved to all-time highs.

The momentum continued on Friday as political expectations continue to rise, and stocks rallied small in quiet trade. And with no news to break that momentum, stocks drifted higher into the close and with modest gains on the week.

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A More Hawkish-Than-Anticipated Federal Reserve: February 15, 2017

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An excerpt from the Sevens Report. Sign up for a two-week free trial of the full report at www.7sReport.com.

Yesterday I began profiling a couple of non-political risks to explore when making decisions for your clients and talking with prospects. Here’s the second:

Non-Political Risk 2: A More Hawkish-Than-Anticipated Federal Reserve

Profiling this risk seemed only natural, given Yellen’s Humphrey-Hawkins testimony yesterday, and her marginally hawkish comments served as a good reminder that the market is pretty complacent with regards to expected Fed rate hikes in 2017.

Yellen’s comments to the Fed on Tuesday, February 14th, were slightly hawkish.

Starting with Yellen, she was slightly hawkish in her comments mainly because of her upbeat assessment of the economy combined with her reiteration that waiting too long to hike rates would be “unwise,” and that the Fed will consider further increases at “upcoming meetings.” Finally, Yellen repeated that she expects a “few” rate hikes this year (she cited the median dots were three hikes in 2017).

While none of those comments were new, it was a reiteration that the economy is doing relatively well and that the Fed is focused on removing accommodation, and markets reacted slightly hawkishly as the dollar rose while Treasuries declined/yields rose.

From an equity standpoint, the fact that the Fed has not been hawkish so far in 2017 has helped stocks rally, as the 10-year Treasury yield has backed away from the 2.60% level. Above that we believe higher rates will start to become a headwind on stocks. But, there is clearly a risk that rates rise higher than current expectations, and as such we want to profile that risk.

Probability of 3 rate hikes this year (one more than expected)? > 50%. This is my opinion, and it’s higher than the current consensus, but to me it makes sense. If investors think that better growth is going to support the stock market, then why do they expect that acceleration in growth not to invite more interest rate hikes from the Fed? The answer is because the Fed has been ultra dovish for years, but I believe that is changing due to multiple factors.

First, growth is as good as it’s been in years. Second, dis-inflation/deflation is no longer a threat (we think this is an underappreciated change in the macro-economic dynamic). Even in ’13 and ’14, when growth had periods of acceleration, inflation was still trending downward and the Fed was in full QE mode. Now, inflation is trending upwards. Third, the composition of the Fed will change as Trump can nominate three Fed members this year, and it’s a good bet they will be more on the hawkish side. So, while it’s still Yellen’s Fed, the scales should start to tilt toward the hawks later this year.

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Economic Growth Slows: February 14, 2017

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An excerpt from today’s Sevens Report.

Non-Political Risk #1: Economic Growth Slows.

Stronger economic data remains an unsung hero of this post-election rally, and while Trump gets the headlines, it’s really the economic data that’s enabling this rally as better economic growth is allowing the market to continue to give Trump and the Republicans the benefit of the doubt.

I can go through the litany of reports, but whether it’s PMIs, the Jobs Report, or Business Investment, the data has been accelerating since mid to late 2016, and that’s created the proverbial “rising tide” that’s helped under-write both policy optimism and the rally in stocks.

But, while hope may be growing that there will be less drama from the administration (the reason for Monday’s rally), at the same time there’s growing evidence that actual policy reality will not meet market expectations.

So, in the near term, it’s going to be up to economic data to continue to provide a reason for markets to give Washington the benefit of the doubt, otherwise the sober reality of a market that now trades well over 18X current-year earnings will begin to cause problems.

Bottom line, if economic growth slows in the near term, that will cause a pullback in stocks. So, in today’s Sevens Report for subscribers, I go into detail on: 1) How likely is an economic slow down? 2) What are the leading indicators to watch? and, 3) How do we position if it happens?

First, how likely is an economic slow down? > 50%.

A probability that high may surprise people, but I have several reasons for it: First, we’ve seen an acceleration in economic activity, but we still haven’t really achieved the “breakout” pace of consistent 3% GDP growth that tends to feed on itself and further stimulate the economy. For all the excitement, we’re still in a 2%ish GDP regime (GDP Now from the Atlanta Fed has Q1 GDP at 2.7% in Q1). Point being, things down have to slow very much before the economy is right back in neutral.

Second, the consumer has powered this economic acceleration, but the consumer is tired. Credit creation is slowing, and retail sales reports have been lackluster of late. To boot, the job market remains basically at full employment and while wages are rising, they aren’t rising fast enough to power incremental acceleration consumer spending. Unless we see proof consumers are accessing the equity in their homes, I don’t see what will cause consumer spending to grind higher.

The Citi Economic Surprise Index rose steadily through Q4 of 2016 as economic data consistently beat expectations. Going forward, this index is now an important leading indicator for the market, as any material move back down towards zero will create a headwind on stocks.

Third, business investment has accelerated lately and that is good, but the uncertainty over the tax code changes (and trade in general) has the potential to be-come a headwind on business investment. Here’s my point: The tax changes being discussed in Congress could eliminate interest deductibility and change a host of other tax issues. If I’m a business and I’m thinking of getting a big loan to finance expansion, I’m likely going to wait until there’s more clarity on these and trade issues be-fore taking on too much risk.

Finally, leading indicator of growth for the global economy, China, is actively trying to slow its economy. China’s credit-fueled expansion back in February 2016 marked an inflection point in the global economy and things have been better since. But with a year of stimulus be-hind it, currency issues, and once again overheating property and asset markets, Chinese authorities are trying to cool their economy. The effects aren’t immediate or direct on the US economy, but the fact is that a slow-ing Chinese economy will become a headwind on the US at some point (how much of a headwind depends on how well the cooling is managed).

“Leading Indicators” and, “How do we position if it happens?” sections are restricted to subscribers.

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Economic Cheat Sheet: February 13, 2017

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Last Week:

There was very little incremental economic data last week, and what reports did come met expectations and importantly did nothing to change the perception that economic activity is legitimately accelerating—a perception that continues to support stocks broadly.

From a domestic data viewpoint, there isn’t a lot to talk about. Jobless claims continued to fall and hit another multi-decade low (a 43-year low), and that’s even more impressive when you consider how much the population has grown since then. Internationally, there was mixed data from China as their foreign exchange reserves dropped below the psychologically important $3 trillion level. While that was ignored by markets this week, China continues to bubble as a potential macro surprise in Q1/early Q2. These foreign currency reserves are a story we need to continue to watch.

But, January Trade Balance was much stronger than expected (exports up 7.9% vs. (E) 3.1%), and that data point early Friday helped alleviate some concern. Still, China’s currency reserves are declining, and authorities are actively trying to pull leverage from their economy and cool growth. More often than not, that leads to some sort of macro-economic growth scare—so just a heads up for the coming months.

Bottom line, economic growth remains an important pillar of this rally, and nothing last week changed that set up, which again was why at worst stocks were flat before the political headlines caused the late-week rally.

This Week:

As we’ve said, two of the biggest risks to the rally outside of Washington remain 1) Lackluster data and 2) A more hawkish Fed. Given those risks, the growth and inflation data this week is important.

Janet Yellen (AP Photo/Jacquelyn Martin)

However, the most important event of the week will be Fed Chair Yellen’s semi-annual Humphrey-Hawkins testimony to Congress, on Tuesday (the Senate) and Wednesday (the House). While she isn’t going to telegraph when the Fed will raise rates, her comments are still important considering the market remains complacent with regards to a Fed rate hike. There is no expectation of a March or May hike, and we continue to think the market is a little too complacent with regards to the potential for a May hike (we admit March seems remote).

Staying on the theme of Fed expectations, the next most important number this week is the January CPI report out Tuesday. The Fed does not believe inflation is accelerating meaningfully (due to the data), but if inflation does pick up pace that will be hawkish and will send yields higher—and most likely stocks lower.

Looking at growth data, Wednesday and Thursday are the key days to watch as we get January Retail Sales (Wed), Empire Manufacturing (Wed), January Industrial Production (Wed) and Feb. Philly Fed (Thursday). Of those four reports, the retail sales number is the most important, because consumer spending has been the engine of growth for the US economy, and it needs to maintain a decent pace because while business investment has picked up, it won’t offset a continued moderation in consumer spending.

The Empire and Philly Fed Indices are the next most important numbers next week, as they will give us the first look at February activity. Since better growth is a key support to this rally, they need to show continued strength. Neither number needs to accelerate meaningfully, but we can’t see much of a retracement, either. Bottom line, strong economic data and benign inflation data (Goldilocks numbers) have been an important support for this market as Washington reverts to the mean (gets more dysfunctional), and that needs to continue if stocks can hold recent gains in the face of confusing political headlines.

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Stock Market Update: January 26, 2017

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Here is a “Stock Market Update” from The Sevens Report: Stocks finally moved Tuesday, as the S&P 500 staged a modest rally following good economic data and well received (but not really positive) political headlines. The S&P 500 rose 0.66%.

stock market updateStocks were flat to start Wednesday trade thanks to generally “ok” economic data from Europe (the European and German flash PMIs were light). There were also a lot of earnings reports, but they were the normal gives and takes, and none of the big companies reporting really moved markets beyond their specific sector (JNJ weighed on healthcare, but that’s it).

After the flat open, stocks started moving higher following a strong January flash manufacturing PMI, and the gains accelerated following several political headlines.

First, the Trump/auto company CEOs meeting was uneventful; then Democrats unveiled a $ 1 trillion infrastructure spending bill, and finally the president signed executive orders to reopen negotiations on the Keystone and Dakota Access pipelines. Stocks hit their highs early afternoon, and the S&P 500 made a new fractional all-time high before backing off just a bit into the close.

Stock Market Update: Trading Color

Yesterday was the first big Trump On day in markets since the first few days of 2017, as small caps and cyclicals handily outperformed.

The Russell 2000 rose 1.5%, more than doubling the S&P 500’s performance while cyclical sectors handily outperformed. Banks (KRE), financials (XLF), industrials (XLI) and basic materials (XLB) all rose more than 1%, with the

latter rising nearly 3% on a big DuPont (DD) earnings beat that pushed the Dow higher (they are heavily weighted in XLB, so the strength there was chemicals based, not commodity based).

Outside of DD earnings there weren’t really any big market movers, with the exception of JNJ weighing on the healthcare sector. XLV dropped 0.70% on the JNJ miss, although the weakness was somewhat isolated as the Healthcare Providers ETF (IHF) rose 0.29%.

Most of the remaining SPDRs we track were up about 0.60% (including consumer staples, which traded pretty well), although utilities were only fractionally higher on the rise in bond yields.

Bottom line, none of the political actions mentioned yesterday were surprises, but overall it was a generally business friendly day of headlines from Washington. That, combined with the PMIs, helped stocks rally.

 

S&P Chart: Strikes New All-Time High

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S&P Chart: “A new high” is the oldest confirmation signal of a bull market in technical analysis and the S&P reached a new all-time high yesterday leaving the path of least resistance higher still from here.

 

Stock Market Update: January 17th, 2017

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Stock Market UpdateStock Market Update excerpt from the Sevens Report: Foreign markets were open yesterday, and generally traded lower on consolidation, but overall the weekend was quiet and nothing negative occurred.

Stocks finished last week little changed, as a Friday rally helped recoup losses from earlier in the week. Some of the shine was taken off the “Trump Trade” following a disappointing press conference. The S&P 500 slid 0.10%.

The important price action last week didn’t come until Wednesday, when Trump’s first press conference as president-elect failed to deliver any specifics on timing for tax cuts, infrastructure spending or deregulation. Following the press conference on Wednesday, stocks immediately dropped and turned modestly negative, although buyers stepped in and the markets recovered in the afternoon to close slightly higher.

Then, stocks dropped nearly 1% in early Thursday trade, again on Trump disappointment. But support at 2250 held, and stocks were able to recover most of the day’s losses to finish down slightly (-0.28%).

On Friday, markets rallied thanks to generally “ok” economic data, and following the two resilient performances following the Wednesday/Thursday sell-off. Stocks were higher most of the day, although they gave back some of their gains Friday afternoon to finish slightly higher.

Stock Market Update: Trading Color

Tech and healthcare remain the two surprise star performers of 2017. Tech was driven higher by internet stocks (which have become the recipient of capital inflows again as investors search for value in an extended market) as (ETFs Restricted to Subscribers) our preferred internet ETF, rose more than 1%. Semiconductors also traded well despite a profit warning from TSM.

Healthcare, meanwhile, weathered a surprising negative comment by Trump and still rose last week. Healthcare remains one of our preferred contrarian allocations for 2017 based on too-negative sentiment, valuation and overdone political risk.

Looking at broad trends, the Trump trade sectors took a breather last week as banks rose slightly while energy declined on the fall in oil, and industrials underperformed. However, despite the slight decline in stocks, defensive sectors lagged as utilities and consumer staples finished modestly weaker. We expect that consolidation of the Trump trade to continue until there are hints of policy specifics.

Bigger picture, there was no clear rotation out of defensives and into cyclicals, and sector trading has been more catalyst driven in 2017. From an activity standpoint, volumes have returned to pre-holiday levels and we expect that to continue.

Stock Market Update: Bottom Line

Some shine came off the Trumpenomics rally last week due to his lack of specifics on tax cuts, deregulation and infrastructure spending at his press conference. But as we said in the Report last week, and as the resilient price action confirmed, the market will continue to give Trump/Republicans the benefit of the doubt through most of Q1. As a result, policy disappointment alone will likely not cause a near-term pullback in stocks. However, it is important to realize that the single-biggest medium/longer-term threat to the markets is political disappointment (which could cause a steep pullback in Q2/Q3).

Focusing on the near term, there are two specific reasons that the market is giving the new administration/government leeway. First, economic data was getting better pre-election, and if the data continues to improve, that means that one of the two reasons behind the Q4 rally will remain in place. Second, the market knows Washington is slow, even with one party in power. So, it’ll take something besides lack of policy clarity to cause a near-term pullback in stocks, (some risks to watch there are slowing economic data, more than three Fed rate hikes in 2017, or Chinese trade tensions).

On the flip side, if stocks are to break materially higher, we will have to get specifics on corporate tax cuts in the coming weeks. The other two pro-growth initiatives championed by Republicans (deregulation and infrastructure spending) aren’t as critical as corporate tax cuts, and that remains the key to helping the S&P 500 break materially above 2300.

From a tactical standpoint, we would continue to hold broad allocations to stocks. If you’re putting new money to work, we would focus on the value sector of the market (ETFs Restricted to Subscribers) over cyclicals or defensives.

Tactically, Europe (ETFs Restricted to Subscribers) and healthcare (ETFs Restricted to Subscribers) are two attractive contrarian opportunities, in our opinion, while banks (ETFs Restricted to Subscribers) remain attractive longer term but seem to be consolidating. We therefore wouldn’t initiate a position here (we’re holding our position and waiting for a further pullback to add to it). Bottom line, lack of policy specifics won’t reverse the rally, but some specifics have to emerge soon if this rally can continue.

This Week

Earnings come into focus this week, as it’s the first week of major company reports from virtually every sector. Unless the results are terrible or fantastic, they shouldn’t move markets too much, as potential fiscal stimulus remains the key focus right now.

From a macro standpoint, there is consistent economic data throughout the week, but CPI on Wednesday is the key number. Then we have Yellen making two speeches (Wednesday and Thursday), and comments on policy could pop up given the topic of both speeches.

Finally, as if I needed to remind anyone, Inauguration Day is Friday, and though it likely won’t have any direct market impact, it is a positive in so much as we will move forward (hopefully) towards some policy clarity.

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Stock Market Update: Trumponomics

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Wednesday was volatile as Trump’s press conference induced a mid-day sell off, but stocks recovered after lunch to finish with moderate gains.  The S&P 500 rose 0.28%.

The markets are now experiencing “Trumponomics.”  The Sevens Report, a daily macro-economic report for financial advisors, just released it’s “Stock Market Update:  Investors Guide to Trumponomics.”

Stock Market Update

stock market updateStocks were basically flat throughout the morning yesterday in what was very quiet trading.  Trump really dominated the narrative all day yesterday as the Russian “dossier” story weighed on sentiment slightly pre-open on Wednesday, and that was made worse by the fact that there was no economic data or corporate news to distract from the Trump story.

So, stocks opened basically flat and chopped sideways ahead of the Trump press conference at 11 a.m..

As we said earlier this week, this event had the potential to move markets and, at least temporarily, it did not disappoint.

The press conference was full of figurative fireworks but the fact that there was absolutely no mention of fiscal stimulus or tax cuts hit stocks (as we cautioned it might in our preview on Wednesday). First, Trump’s left field comment about reducing the cost of drug prices sent biotechs into mini free-fall, and that took healthcare lower which weighed on the whole market.  Then, after a brief rebound, stocks rolled over again after Trump failed to imply a timeline for tax cuts of fiscal stimulus.

But, the market is giving Trump and the Republicans the benefit of the doubt and his omissions weren’t damming yesterday (yet).  So, stocks rebounded after lunch and rallied throughout the final two hours of trading to close basically at the higher of the day.  Oil, which accelerate higher during the afternoon, also helped stocks rally, as oil remains an important short term influence over stocks.

Stock Market Update: Trading Color

Trump dominated sector trading as well yesterday as this comments about “bidding” for drug prices hit biotech stocks (NBI dropped nearly 3%) and healthcare more broadly (XLV fell 1%).   XLV the only SPDR we track to finish negative yesterday.

But, it wasn’t just the biotech comments as the quasi disappointing press conference did cause some defensive outperformance as utilities rose 1%. Besides energy (XLE), which was up on the oil rally, utilities were the best performing SPDR in the markets yesterday.

Continuing that cautious theme, cyclical sectors also rose (again every SPDR except healthcare was higher yesterday) but banks, tech and industrials were up just .5%., so clearly there was no real, cyclical outperformance.

So, Trump’s comments (or lack thereof regarding tax cuts of stimulus) took some wind out of the cyclical led “Trump Trade” sails yesterday.

Bottom Line

Yesterday’s price action after the press conference gave us some important insight into how we can expect stocks to trade over the next few weeks:

The fact that there was no mention of tax cuts, infrastructure spending or de-regulation by Trump weighed on stocks temporarily Wednesday, and bigger picture that lack of specifics does threatens to undermine the post Election rally.

But, while stocks are lower this morning mostly because of that disappointment, yesterday’s press conference likely won’t cause a material unwind of the “Trump Trade” because the market is still willing to give Trump/Republicans the benefit of the doubt on a lack of policy specifics.  So, this morning’s dip aside, don’t expect lack of policy clarity alone to cause a pullback near term (it’ll take something additional like Chinese currency volatility, bad economic data, etc.).

But, beyond the short term (and I mean the next 2-4 weeks) the biggest risk to stocks is the gap between market expectations of tax cuts and pro-growth policies, and the potential political reality.  And, yesterday’s press conference did nothing to reduce that risk.

As I said in the Trump Press Conference Preview, if the market does not get some evidence that corporate tax cuts are progressing and forthcoming by the middle of Q1, that will begin to weigh on stocks.

In the mean time, the benefit of the doubt remains with the bulls but the S&P 500 is still at a valuation ceiling at 18X forward earnings, and it’s going to take evidence of looming pro-growth policies to help stocks punch materially through recent highs.

Thoughts on Healthcare

Trump’s surprise comments on bidding for drug prices caught markets by surprise and hit healthcare and biotech stocks yesterday, but at this point that general rhetoric isn’t enough to make me abandon my long position.

That may change once we get some actual policy specifics but for now that comments seemed more like populist rhetoric than anything actually concrete, and I imagine the complicated Obamacare repeal will likely dominate any healthcare related policy in the first half of 2017.  Put another way, they will have enough to worry about ensuring that coverage continues for Obamacare recipients, never mind changing national drug pricing structures to the detriment of biotech firms.

 

 

Stock Market Update: January 10th, 2017

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Stock Market Update excerpt from the Sevens Report: Stocks gave back most of Friday’s gains on Monday thanks mostly to digestion of last week’s rally ahead of some important catalysts later this week (Trump’s speech Wednesday specifically). A sharp drop in oil also weighed on the averages. The S&P 500 fell 0.35%.

Stocks started Monday mostly flat following a quiet weekend. There were actually macro positives yesterday, primary of which was the Chinese currency reserve data. But economic numbers from Germany were also strong Monday morning.

Then a drop in oil offset those positives, and as a result stocks opened lower and fell basically to the lows of the day within the first 30 minutes of trade, again thanks almost entirely to oil.

From those lows, stocks basically traded sideways for the remainder of the session. There were potential catalysts including Fed speakers and the Consumer Credit number at 3:00 p.m. yesterday, but none of it provided any material surprises, and nothing changed the general outlook for markets. Stocks chopped sideways in the afternoon before closing near the lows of the day.

Stock Market Update: Trading Color

Healthcare and super cap internet stocks were again the positive story yesterday, and five trading days into 2017 they are the clear surprise winners so far.

Healthcare was the lone positive SPDR yesterday, rising 0.42% again mainly on biotech strength. Meanwhile, super cap internet stocks (think FANG—FB/AMZN/NFLX/GOOG) rallied again yesterday and FDN, our preferred super cap internet ETF, rose 0.25%.

Away from healthcare and internet names, selling was broad yesterday as eight of the nine SPDRs we track declined. Energy was an obvious laggard due to the drop in oil, as XLE fell 1.45%. Oddly, utilities also fell sharply (down 1.3%) despite the decline in bond yields.

Financials, industrials and consumer staples all relatively lagged the S&P 500, but didn’t fall by more than 1% while tech was again another relative outperformer, with XLK down fractionally.

Single stock news was virtually non-existent yesterday,  and trading from an activity and volume standpoint was very quiet. General digestion remains the best way to describe yesterday’s price action.

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Stock Market Update: January 6, 2017

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Stock Market Update from The Sevens Report: Stocks declined for the first time in 2017, but the losses were small, as disappointing retailer earnings offset more decent economic data ahead of the first big catalyst of the year… the December jobs report. The S&P 500 declined 0.08%.

Stocks were flat at the start of Thursday trade, as very poor results from KSS and M offset more decent global economic data. US data yesterday was mixed, but generally “fine,” as jobless claims dropped sharply (ADP missed estimates, but not terribly so) and ISM Non-Manufacturing PMI slightly beat estimates. In total, none of the data points altered the narrative around the economy or Fed expectations, and stocks opened flat and chopped sideways with small gains until the oil inventory number.

stock market updateThe weekly oil inventory report was taken initially as bearish, and that caused a pullback in stocks as the drops in oil at 10:30 and 11:00 led the break lower in the major averages, as oil remains a shorter-term influence over the stock market. But both oil and stocks bottomed for the day right around 11:30, and both began rallies that lasted until oil’s close at 2:30. With no other notable news (and an important jobs report this morning) stocks chopped sideways before closing slightly lower.

Stock Market Update: Trading Color

From a sector standpoint it was quiet outside of financials and retailers (more on those in a second). No SPDR we track moved more than 0.50% yesterday, and trading was mixed excluding financials. Three of the SPDRs we track traded higher (led by healthcare (XLV +0.45%) while five SPDRs were lower (led by industrials, XLI -0.30%). There was no notable news that caused the moves in these sectors, and most of it was just general positioning.

The same cannot be said for financials and retailers, as banks dropped 1.7% and financials fell 1.2% on the drop in bond yields, as the 30-year Treasury yield hit a one-month low.

Retail, meanwhile, got hammered courtesy of KSS and M, which plunged 19% and 14%, respectively. That dragged down XRT, the retail ETF (-2.4%). Notably, though, the broad consumer discretionary SPDR, XLY, declined only 0.11%, and that reinforces what I said earlier Wednesday that the KSS and M prints are a retail business model problem (i.e. too much brick and mortar, not enough online) not a consumer spending problem (and that’s a positive for the economy broadly). The traditional retail sector continues to face stiff structural headwinds, and I’m not interested in buying dips.

Finally, looking at tech, semiconductors continued to fall but they held support at 900 in the SOX. A break of that makes me short-term nervous on stocks. Meanwhile, our old friends the FANGs (FB/AMZN/NFLX/GOOGL) all traded well and FDN rose 1.1%. While not as powerful as they were in 2015, owning super-cap internet stocks continues to make sense for longer-term investors, as those companies continue to be on the edge of innovation in tech.

Looking ahead to today, the risk here is for a soft jobs report due to ADP and if the report but unless the S&P 500 breaks support at 2239 the short term trend remains higher.

 

Why Chinese Yuan Volatility Matters to You

One of the more important, but underfollowed, stories in the financial media this week has been the surge higher in the Chinese yuan. That move caused the dollar drop yesterday, and it’s an uncomfortable reminder of yuan-inspired stock volatility in January 2016.

Understanding yuan trading dynamics is about as exciting as reading stereo instructions (and in some cases just as complicated), so I’m not going to bore you with the details.  But, it is important you understand 1) What’s happening with the yuan, 2) Why it’s a risk to stocks and 3) How to hedge against a yuan-inspired decline in stocks.


What Happened: Since the election, the yuan weakened relentlessly vs. the dollar. And as we started 2017, it was in danger of breaking the psychologically important $7.00 level. A break of that level is a problem for two reasons. First, it would provide fodder for China hardliners in the Trump administration to get tough on trade, because the currency would be so weak. Second, it would put stress on China’s ability to control the yuan, as a break of the level would invite more selling of the yuan.

So, to support the yuan, Chinese authorities intervened in the markets starting on Wednesday, and continued on Thursday, and the results were significant—the yuan surged nearly 2% in two days, the biggest two-day move since 2010.

Why It Matters: There have been two periods in the last two years where we’ve seen this level of yuan volatility: Aug/Sept ’15 and Jan ’16.  Both periods saw deep, sharp and scary stock market pullbacks, because the yuan gyrations caused a loss of confidence in the Chinese economy/authorities. Fearing a Chinese “hard landing,” global investors sold first and asked questions later.

Today, the causes of yuan volatility are different, and I don’t think we’re on the precipice of a yuan-inspired pullback in stocks just yet. But, the chances are rising.

The reason why is the yuan declines aren’t over. That’s because the decline in the yuan is a product of 1) Fears of trade disputes with a Trump administration hurting the Chinese economy and 2) A relentlessly rallying dollar, which will force the yuan lower and risk a recession in China.

Everyone knows both these longer-term trends (higher dollar/weaker yuan), which is why Chinese citizens are trying to exchange yuan for dollars or other currencies. And it’s why the Chinese government has imposed capital controls preventing citizens and companies from doing just that!

Near term, Chinese authorities can support the yuan and continue to defend the $7.00 level by selling foreign currencies from their massive forex reserves (when you sell a currency against the yuan, the yuan goes up). But that can’t last forever, and if their forex reserves drop below $3 trillion, markets will start to get nervous about China’s ability to keep the yuan stable. This is particularly important, as over the weekend China will release its currency reserves for December. That number better be above $3 trillion, or Monday could be a down open.

How We Position for It:  Again, I’m not saying this yuan volatility will cause a pullback, but the chances of a one-time, large yuan devaluation are rising, and that could cause global macro volatility in Q1. From a positioning standpoint, the best way to hedge against a China-inspired pullback in stocks is EUM, the inverse emerging market ETF. That ETF protected portfolios in Sept/Aug ’15 and Jan ’16, and I’m confident it will do so again if China/yuan volatility causes a pullback in stocks.

Bottom line: The yuan volatility is not a problem for stocks yet, but I do want everyone to understand the context in case we do see a big, one time devaluation of the yuan in Q1 2017, as that might cause a knee-jerk, “risk off” trade of lower stocks/lower commodities/lower dollar/higher Treasuries.

Going forward, the two key numbers to watch are $7.00 yuan/dollar (a break above that level is bad) and $3 trillion Chinese Foreign Cash Reserves (a break below that number would be bad). If either occur, chances of another China-inspired pullback in stocks will rise.

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