East to West: Trade tariffs spark rally

Commodities rallied and Asian stocks found support after a three-month sell-off.

DJ-UBS Commodity Index

From Reuters (September 19):

Copper jumped to its highest in three weeks on Wednesday, boosted by a weaker dollar after a new round of U.S.-China trade tariffs were not as high as previously expected.

China will levy tariffs on about $60 billion worth of U.S. goods in retaliation for U.S. tariffs on $200 billion worth of Chinese goods. Washington’s new duties, however, were set at 10 percent for now, rising to 25 percent by the end of the year, rather than starting immediately at 25 percent…….

“In some ways the bad news had been priced into the markets and, if anything, the news on trade had been slightly less severe than we had thought it would be,” said Capital Economic analyst Caroline Bain.

“It’s still too early to talk about this as sustainable … it just seems to be a bit of a relief rally after all of the bad news.”

The Shanghai Composite Index rallied off primary support at 2650, a slight bullish divergence on the Trend Index signaling short-term buying pressure. Penetration of the descending trendline would suggest that a bottom is forming.

Shanghai Composite Index

Japan’s Nikkei 225 is testing its January high at 24,000.

Nikkei 225 Index

India’s Nifty is testing support at 11,000. Long tails indicate buying pressure. Respect of support would signal another advance.

Nifty Index

Europe

Dow Jones Euro Stoxx 50 rallied off primary support at 3300 but is yet to break the down-trend.

DJ Euro Stoxx 600 Index

The Footsie also rallied, finding support at 7250, but a declining Trend Index warns of continued selling pressure.

FTSE 100 Index

North America

The S&P 500 rallied off the new support level at 2875 and is likely to test its long-term target of 3000.

S&P 500

The Nasdaq 100, however, continues to test support at 7700. Breach would warn of a correction to test 7000.

Nasdaq 100

Canada’s TSX 60 found support at 950 but declining peaks on the Trend Index continue to warn of selling pressure.

TSX 60 Index

Markets are dominated by one concern, a US-China trade war, and volatility is likely to remain high until a resolution is found.

How will a bond bear market affect stocks?

10-Year Treasury yields broke out of their triangular consolidation at 3.00%, while the Trend Index recovered above zero signaling a fresh advance.

10-year Treasury Yield

Importance of resistance at 3.00% is best illustrated on a long-term monthly chart. Yields declined for more than three decades (since 1981) in a bond bull market but the rise above 3.00% completes a double-bottom reversal, warning of rising yields and a bond bear market. Target for the advance is 4.50%.

10-year Treasury Yield

The yield differential between 10-year and 3-month Treasuries has declined since 2010, prompting discussion as to whether a flat yield curve will cause a recession.  Interesting that the yield differential recovered almost 20 basis points in September, with long-term yields rising faster than short-term. Penetration of the descending trendline would suggest that an imminent negative yield curve is unlikely.

10-year Treasury Yield

How would a bond bear market affect stocks?

Capital losses from rising yields on long-maturity bonds would increase demand for shorter maturities, driving down short-term yields and causing a steeper yield curve. A bullish sign for stocks.

Inflation is low and the rise in long-term yields is likely to be gradual. Another bullish sign.

The last bond bear market lasted from the early 1950s to a peak in September 1981. Higher interest rates were driven by rising inflation ( indicated below by percentage change in the GDP implicit price deflator). The 1975 spike in inflation was caused by the OPEC oil embargo in retaliation for US support of Israel during the 1973 Yom Kippur war.

1950 to 1981: 10-Year Treasury Yields and GDP Implicit Price Deflator

Stock prices continued to climb during the bond bear market, apart from a 1973 – 1974 setback, but the Price-Earnings ratio fell sharply in ’73-’74 and only recovered 10 years later, in the mid-1980s.

1950 to 1981: S&P 500 and PE Ratio

Alarmists may jump to the conclusion that a bond bear market would lead to a similar massive fall in earnings multiples but there were other factors in play in 1975 to 1985.

First, crude prices spiked after the OPEC oil embargo and only retreated in the mid-1980s.

1960 to 1985: West Texas Intermediate Crude prices

The rise of Japan also threatened US dominance in global markets.

1960 to 1985: Nikkei 225 Index

We should rather examine the period prior to 1973 as indicative of a typical bond bear market. The S&P 500 Price-Earnings ratio was largely unaffected by rising yields. Real interest rates actually decreased during the period, with the gap between 10-year yields and the inflation rate only widening near the 1981 peak.

At present, real interest rates are near record lows.

1981 to 2018: 10-Year Treasury Yields and GDP Implicit Price Deflator

We can expect real interest rates to rise over time but that is unlikely to have a significant impact on earnings multiples — unless there is a strong surge in long-term yields ahead of inflation.

 

East to West: Asian stocks find support

Asian stocks are finding support after a sell-off over the last three months.

The Shanghai Composite Index is showing a slight bullish divergence on the Trend Index. This is secondary in size and suggests a bear market rally.

Shanghai Composite Index

South Korea’s Seoul Composite Index displays a stronger bullish divergence. Breakout above 2350 and the descending trendline is still unlikely but would indicate that a bottom is forming.

Seoul Composite Index

Japan’s Nikkei 225 broke through resistance at 23,000, signaling an advance to the January high at 24,000.

Nikkei 225 Index

India shows strong buying pressure, with long tails on the Nifty suggesting another strong advance.

Nifty Index

Europe

Dow Jones Euro Stoxx 600 is trending lower. Support at 374 is secondary but the Trend Index near zero indicates hesitancy.

DJ Euro Stoxx 600 Index

The Footsie found medium-term support at 7250 but a declining Trend Index warns of another test of primary support at 6900/7000.

FTSE 100 Index

North America

The S&P 500 retracement respected support at 2875, suggesting an advance to the long-term target of 3000.

S&P 500

Canada’s TSX 60 on the other hand is undergoing a correction, perhaps exacerbated by concerns over NAFTA. Expect support at 935/940.

TSX 60 Index

Nothing much has changed. While Japan and India are bullish, China and South Korea remain in a bear market. Europe looks hesitant, while the S&amp:P 500 continues in a strong bull market.

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

~ George Soros

Capital spending on the rise

Just released July 2018 manufacturers’ new orders for capital goods, excluding defense and aircraft, show that the recovery is gathering speed.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft

Any fears that easy money has undermined capital budgeting restraints — and that the economy is entering the final heady stages of a boom before the bust — can be dispelled by adjusting the above graph for inflation.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft adjusted for Inflation

Adjusting manufacturers orders by the GDP implicit price deflator shows that the recovery in capital spending has barely started and is a long way from the excesses preceding the Dotcom crash and the GFC.

Wage increases haven’t made a dent in profits

Average hourly earnings growth continues to rise, albeit at a leisurely pace. Average hourly earnings for all employees in the private sector grew at 2.92% over the last 12 months, while production and nonsupervisory employee earnings grew at 2.80% over the same period. The Fed is likely to adopt a more restrictive stance if hourly earnings growth, representing underlying inflationary pressures, exceeds 3.0%. So far the message from Fed Chair Jerome Powell has been business as usual, with rate hikes at a measured pace.

Average Hourly Earnings

Rising wage rates to-date have been unable, up to Q2 2018, to make a dent in corporate profits. Corporate profits are near record highs at 13.4%, while employee compensation is historically low at 69.5% of net value added. Past recessions have been heralded by rising employee compensation and falling corporate profits. What we are witnessing this time is unusual, with compensation rising, admittedly from record low levels, while profits rebounded after a low in Q4 2016. There is no indication that this will end anytime soon.

Corporate Profits and Employee Compensation as Percentage of Value Added

Weaker values (1.17%) on the Leading Index from the Philadelphia Fed reflect a flatter yield curve. A fall below 1.0% would be cause for concern.

Philadelphia Fed Leading Index

Our surrogate for real GDP, Total Payrolls x Average Weekly Hours Worked, is lagging behind recent GDP growth (1.9% compared to 2.9%) but both are rising.

Real GDP and Total Payroll*Average Hours Worked

Another good sign is that personal consumption expenditure, one of the key drivers of economic growth, is on the mend. Services turned up in Q2 2018 after a three-year decline. Durable goods remain strong. Nondurables are weaker but this may reflect a reclassification issue. New products such as Apple Music and Netflix are classified as sevices but replace sales of goods such as CDs and videos.

Personal Consumption

There is no cause for concern yet, but we will need to keep a weather-eye on the yield curve.

Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.

~ George Soros

East to West: Bonds & tariffs hurt developing markets and crude prices

10-Year Treasury yields are consolidating in a triangle below long-term resistance at 3.00 percent. Breakout above 3.00 would signal a primary advance, ending the decades-long bull market in bonds. This would have a heavy impact on developing economies, including China, with a stronger Dollar forcing higher interest rates.

10-year Treasury Yields

A Trend Index trough above zero would signal buying pressure and a likely upward breakout.

Crude oil prices, as a consequence of higher interest rates and the threat of trade tariffs, are starting to form a top. Bearish divergence on the Trend Index warns of selling pressure. Breach of support at $65/barrel would signal reversal to a primary down-trend.

Nymex Light Crude

Commodity prices are leading, breach of support at 85.50 already having signaled a primary down-trend.

DJ-UBS Commodity Index

China’s Shanghai Composite Index is in a primary down-trend. Trend Index peaks below zero warn of selling pressure. Breach of support at 2700 is likely. The long-term target is the 2014 low at 2000.

Shanghai Composite Index

Germany’s DAX is headed for a test of primary support at 11,800. Descending peaks on the Trend Index warn of secondary selling pressure. Breach of primary support is uncertain but would offer a target of 10,500.

DAX

The Footsie also shows secondary selling pressure on the Trend Index, warning of a test of primary support at 6900/7000.

FTSE 100

In stark contrast, North American tech stocks have made huge gains in the last four months, but are now retracing to test support. Breach of the rising trendline and support at 7400 would warn of a correction; a test of the long-term rising trendline at 7000 the likely target.

Nasdaq 100

The S&P 500 has also made new highs. Penetration of the rising trendline would warn of a correction to the LT trendline at 2800.

S&P 500

North America leads the global recovery, developing markets including China are falling, while Europe is sandwiched in the middle, with potential loss of trade from East and West if a trade war erupts.

From the AFR today:

President Donald Trump said he’s ready to impose tariffs on an additional $US267 billion in Chinese goods on short notice, on top of a proposed $US200 billion that his administration is putting the final touches on.

“….I will say this: the world trading system is broken.” Trump is “dead serious” in his determination to push China to reform its trade policies, [White House economic adviser Larry Kudlow] added.

Can’t say he didn’t warn us.

East to West in three charts

The S&P 500 is making new highs while a rising Trend Index indicates buying pressure. Target for the advance is 3000.

S&P 500

China’s Shanghai Composite Index is in a primary down-trend. Trend Index peaks below zero warn of selling pressure. Breach of support at 2700 is likely and would offer a long-term target of the 2014 low at 2000.

Shanghai Composite Index

The Footsie broke support at 7600. Follow-through below 7500 warns of a correction to test primary support at 6900/7000.

FTSE 100

North America leads the global recovery, China is falling, while Europe is sandwiched in the middle, with potential loss of trade from East and West if a trade war erupts.

Gold reacts to Dollar weakness

The Yuan continues to find support at 14.5 US cents.

CNY/USD

The Dollar Index is testing support at 95. Respect of support would confirm another advance, with a long-term target of 103, but declining Trend index peaks warn of selling pressure.

Dollar Index

Gold rallied to $1200/ounce but failed to make further progress. Respect of the descending trendline would warn of another decline with a long-term target of the 2015 low at $1050/ounce.

Spot Gold in USD

The Australian Dollar respected resistance at 73.50 US cents, warning of another decline. Trend Index peaks below zero reflect selling pressure.

Australian Dollar/USD

The All Ordinaries Gold Index (XGD) continues its downward path, tall shadows on the last two candles reflecting selling pressure. Breach of short-term support at 4550 is likely and would offer a long-term target of 4000/4100.

All Ordinaries Gold Index

Does the yield curve warn of a recession?

There has been talk in recent months about the narrowing yield curve and how this warns of a coming recession, normally accompanied by a graph of the 10-year/2-year Treasury spread which fell to 0.22% at the end of August 2018.

Yield Differential 10Year minus 2Year

I have always used the 10-year minus the 3-month Treasury spread to indicate the slope of the yield curve but, although this shows a higher spread of 0.71%, both warn that the yield curve is flattening.

Yield Differential 10Year minus 3Month

Is this cause for alarm?

First of all, what is the yield curve? It is the plot of yields on Treasuries against their maturities. Long maturity bonds normally have higher yields than short-term bills, to compensate for the increased risk (primarily of interest rate changes). If you tie your money up for longer, you expect a higher return. That is a rising yield curve.

A steep yield curve is a major source of profit to banks as their funding is mostly short-term while they charge long-term rates to borrowers, pocketing the interest spread.

The Fed sometimes intervenes in the market, however, restricting the flow of money to the economy, to curb inflation. Short-term rates then rise faster than long-term rates and the yield curve may invert — referred to as a negative yield curve.

At present we are witnessing a flattening yield curve, as short-term rates rise close to long-term rates.

A recent paper from Michael D. Bauer and Thomas M. Mertens at the San Francisco Fed concludes that a narrow yield differential has zero predictive ability of future recessions:

In light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession. First, the evidence suggests that recession predictions based on the yield curve require an inversion (Bauer and Mertens 2018); no matter which term spread is used to measure its shape, the yield curve is not yet inverted. Second, the most reliable summary measure of the shape of the yield curve, the ten-year–three-month spread, is nearly 1 percentage point away from an inversion.

I was pleased to see that Bauer and Mehrtens find the 10-year/3-month Treasury spread more reliable than other spreads in predicting a recession within 12 months, with 89% predictive accuracy. They also refer to another study that came to a similar conclusion:

Engstrom and Sharpe found that their short-term spread statistically dominated the 10y–2y spread, and our findings are consistent with this result.

But both studies conclude that a negative yield curve (when the yield differential is below zero) is a reliable predictor of recessions. And Bauer and Mehrtens observe that, while the 10 year/2 year spread is less accurate, it is still a reliable predictor.

Are we just 22 basis points away from a recession warning? Let’s weigh up the evidence.

First, a negative yield curve is a reliable predictor of recessions. In the last 60 years, every time the 10-year/3-month spread has crossed below zero, a recession has followed within 12 months. There is one arguable exception. In 1966 the yield differential crossed below zero, the S&P 500 fell 22% and the NBER declared a recession, but they (the NBER) later changed their mind and airbrushed it out of history.

Yield Differential 10Year minus 3Month

Second, while there is strong correlation between the yield curve and recessions, the exact relationship is unclear.

The most convincing explanation is that bank interest margins are squeezed when the yield curve inverts. When it is no longer profitable for banks to borrow short and lend long, they restrict the flow of new credit. Credit is the lifeblood of the economy and activity slows.

That was clearly the case in the lead up to the 2008 crash, but why are net interest margins of major US banks now widening?

Bank Net Interest Margins

The flow of credit also slowed markedly before the 1990/1991 recession but did not ahead of the last two recessions.

Bank Net Interest Margins

And growth in the broad money supply — zero maturity money (MZM) plus time deposits — accelerated ahead of the Dotcom crash and 2008 banking crisis.

Broad Money Supply: MZM plus Time Deposits

Third, consider the Wicksell spread. Swedish economist Knut Wicksell argued in his 1898 work Interest and Prices that the economy expands when return on capital is higher than the cost of capital, with new investment funded by credit, and it contracts when the expected return on capital is below the cost of capital.

I was first introduced to Wicksell by Neils Jensen, who uses the Baa corporate bond yield as a proxy for the cost of capital and nominal GDP growth for the return on capital. Neils argues that the economy is near equilibrium when the Wicksell spread is about 2.0% — when return on capital is 2.0% higher than the cost of capital.

Wicksell Spread: Nominal GDP Growth compared to Baa Corporate Bond Yield

The above graph shows that 1960 to 1980 was clearly expansionary, with nominal GDP growth exceeding the cost of capital (Baa corporate bond yield). But the last almost four decades were the opposite, with the cost of capital mostly higher than the return on capital. Only recently has this reversed, suggesting a new expansionary phase.

One could argue that low-grade investment bond yields are a poor proxy for the cost of capital, with rising access to equity markets in recent decades. Also that nominal GDP growth rate is a poor proxy for return on capital. If we take the S&P 500, the traditional method of calculating cost of equity is the current dividend yield (1.8%) plus the dividend growth rate (8.0%), giving a 9.8% cost of capital. If we take the current S&P 500 earnings yield of 4.0% (the inverse of the P/E ratio) plus the earnings growth rate of 15.1% as the return on capital (19.1%), it far exceeds the cost of capital. You can understand why growth is soaring.

New capital formation is starting to recover.

New Capital Formation

Fourth, Fed actions over the last decade have distorted the yield curve. More than $3.5 trillion of Treasuries and mortgage-backed securities (MBS) were purchased as part of the Fed’s quantitative easing (QE) strategy, to drive down long-term interest rates. In 2011 to 2012, the Fed also implemented Operation Twist — buying longer-term Treasuries while simultaneously selling shorter-dated issues it already held — to further bring down long-term interest rates. Long-term rates are still affected by this.

In addition, Fed efforts to shrink their balance sheet may further distort the yield curve. The Fed has indicated that it will not sell Treasuries that it holds but will not reinvest the full amount received from investments that mature. If we consider that short-term Treasuries are far more likely to mature, the result could be that the maturity profile of the Fed’s Treasury portfolio is getting longer — a further extension of Operation Twist by stealth.

Conclusion

A flat yield curve does not warn of a coming recession. A negative yield curve does. Both the 10-year/2-year and 10-year/3-month Treasury spreads are reliable predictors of a recession within 12 months, but the 10-year/3-month spread is more accurate.

The correlation between the yield curve and recessions is strong but the actual relationship between the two is more obscure. Links between the yield curve, bank net interest margins, bank credit growth and broad money supply growth are more tenuous, with lower correlation.

Also, return on capital is rising while cost of capital remains low, fueling strong capital formation. The economy is starting to grow.

Fed actions, through QE, Operation Twist, and even possibly steps to unwind its balance sheet, have suppressed long-term interest rates and distorted the yield curve. While the yield curve is still an important indicator, we should be careful of taking its signals at face value without corroborating evidence.

Lastly, we also need to consider the psychological impact. If the market believes that a negative yield curve is followed by a recession, it most likely will be. Beliefs lead to actions, and actions influence outcomes.

Treat yield curve signals with a great deal of respect, and be very wary of how the market reacts, but don’t mindlessly follow its signals without corroboration. The economy may well be entering a new growth spurt, with all its inherent dangers — and rewards.

I contend that financial markets never reflect the underlying reality accurately; they always distort it in some way or another and the distortions find expression in market prices. Those distortions can, occasionally, find ways to affect the fundamentals that market prices are supposed to reflect.

~ George Soros