CPI rises but US stocks rally

June consumer price index (CPI) jumped to 2.8% but forward estimates of inflation, represented by the 5-Year breakeven rate (5-year Treasury yield minus TIPS) remain subdued at 2.06%.

CPI and 5-Year Breakeven

Core CPI (excluding food and energy) is at 2.2% while average hourly earnings (total private: production and non-supervisory employees) annual growth, representing underlying inflationary pressure, is higher at 2.7%.

Core CPI and Average Hourly Earnings: Production and Nonsupervisory

Credit and broad money supply (MZM plus time deposits) growth remain steady, tracking nominal GDP growth at around 5.0%. A spike in credit growth often precedes a similar spike in broad money supply by several quarters.

Credit and Broad Money Supply Growth

And a surge in broad money supply growth, ahead of nominal GDP, flagged rising inflationary pressures ahead of the last two recessions, prompting the Fed to step on the brakes.

Nominal GDP and Broad Money Supply Growth

Overall, the inflation outlook appears subdued, with little urgency to hike interest rates at present.

The market is also getting more comfortable with the idea of trade tariffs. The S&P 500 is testing resistance at 2800. Breakout is likely and would suggest a primary advance to 3000.

S&P 500

The Nasdaq 100 followed through above 7300, confirming the primary advance, with a target of 7700.

Nasdaq 100

This is the final stage of a bull market but there is no sign of it ending. I am wary of the impact of a trade war on individual stocks and have reduced exposure to multinationals that make a sizable percentage of their sales in China.

Financial markets are supposed to swing like a pendulum: They may fluctuate wildly in response to exogenous shocks, but eventually they are supposed to come to rest at an equilibrium point…. Instead, as I told Congress, financial markets behaved more like a wrecking ball, swinging from country to country and knocking over the weaker ones. It is difficult to escape the conclusion that the international financial system itself constituted the main ingredient in the meltdown process.

~ George Soros on the 1997 Asian Financial Crisis and the need for greater regulation of global financial markets

S&P 500 and Nasdaq relief

June average hourly earnings growth came in flat at 2.74% for Total Private sector and 2.72% for Production and Non-supervisory Employees. This suuports the argument that underlying inflation remains benign, easing pressure on the Fed to accelerate interest rates.

Average Hourly Earnings Growth

The S&P 500 rallied off its long-term rising trendline. Follow-through above 2800 would suggest another primary advance with a target of 3000.

S&P 500

The Nasdaq 100 respected its new support level at 7000, signaling a primary advance. The rising Trend Index indicates buying pressure. Target for the advance is 7700.

Nasdaq 100

The Leading Index from the Philadelphia Fed is a healthy 1.51% for May. Well above the 1.0% level that suggests steady growth (falls below 1.0% are cause for concern).

Leading

Our estimate of annual GDP growth — total payroll x average weekly hours worked — is muted at 1.91% but suggests that earnings growth will remain positive.

Real GDP Estimate

Personal consumption figures for Q1 2018 show growth in consumption of services is slowing but durable goods remain strong, while nondurable goods are steady.

Consumption to Q1 2018

Declining consumption of nondurables normally coincides with a recession but is often preceded by slowing durable goods — below 5.0% on the chart below — for several quarters.

Consumption to Q1 2018

Conclusion: Expect further growth but be cautious of equities that are vulnerable to escalating trade tariffs.

We live in a global economy, but the political organization of our global society is woefully inadequate. We are bereft of the capacity to preserve peace and to counteract the excesses of the financial markets. Without these controls, the global economy, is liable to break down.

~ George Soros: The Crisis of Global Capitalism (1998)

Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

Low inflation risk keeps yield curve safe

The Fed is advancing interest rates at a measured pace, with the objective of restoring balance in financial markets rather than to curbing inflationary pressures. Only if inflation spikes is the Fed likely to adopt a restrictive stance.

Elliot Clarke from Westpac sums up the FOMC (Fed Open Market Committee) view from their latest minutes:

Beginning with inflation, whereas the market has recently been concerned that inflation may be getting away from the FOMC (given annual CPI inflation at 2.5%yr and persistent strength in the oil price), the Committee is unperturbed.

Instead of the CPI, the FOMC’s benchmark remains PCE inflation, which is currently 2.0%yr on a headline basis and 1.9%yr for core…..

To see upside inflation risks build, a stronger wage inflation pulse is necessary. At present the employment cost index is only reporting “a gradual pickup in wage increases”, and the signal from other wage measures is “less clear”. Two other important considerations for the pass through of wages to activity and thus inflation is that real hourly earnings growth is currently flat and the savings rate near historic lows. The capacity of households to boost consumption and thus inflation is therefore very limited.

Hourly wage rates are growing at a gradual pace.

Hourly Wage Rate Growth

Personal savings are low.

Personal Savings

And credit growth is modest.

Credit Growth

So not much sign of inflationary pressure.

….Turning to financial conditions, as yet there is no concern of them becoming an impediment to growth or policy. The 10yr yield has moved back to the highs of 2013, but the US dollar has only partly retraced its 2017 depreciation. Further, asset markets remain near recent highs.

Equally significant however is the reference to being nearer neutral and a clear desire to keep the yield curve’s positive slope…..

We do not believe that the yield curve will invert in this instance, in part because higher deficits should see the term premium rise. However, the curve will remain comparatively flat versus history, restricting both the timing and the scale of further rate hikes. This is a key justification for both the market’s and our own view of only two further hikes in 2018 and two more in 2019 – a stark contrast to the FOMC’s seven hikes to end-2020.

Yield Differential

A negative yield curve — when 10-year minus 3-month Treasury yields falls below zero — would give a strong recession warning. But the yield curve is only likely to invert if the Fed steps up interest rate increases. With little sign of rising inflationary pressure at present, the prospect seems remote.

No Fed Squeeze in Sight

In January I warned that the Fed’s normalization plan, which will shrink its balance sheet at the rate of $100 billion in 2018 and $200 billion a year thereafter, would cause Treasury yields to rise and the Dollar to weaken.

10-Year Treasury yields are now testing resistance at 3.0 percent. Breakout would signal the end of a decades-long bull market in bonds and start of a bear market as yields rise.

10-Year Treasury yields

The Dollar Index is in a primary down-trend but the recent rally above the descending trendline suggests that a bottom may be forming.

Dollar Index

Commodity prices, which I suggested would climb as the Dollar weakened, are strengthening but remain in an ascending triangle, testing resistance at 90 on the Dow Jones – UBS Commodity Index.

Dow Jones - UBS Commodity Index

Crude, however, is surging and commodities are likely to follow.

WTI Light Crude

Rising commodity prices — especially crude — would lift inflation, raising the threat of tighter Fed monetary policy.

Until now, financial markets have absorbed the Fed shrinking its balance sheet. Primarily because there hasn’t been any contractionary effect at all.

The orange line on the chart below shows Fed assets net of excess reserves of commercial banks on deposit at the Fed. If commercial banks withdraw excess reserves at a faster rate than the Fed shrinks its balance sheet then the net effect is expansionary, with a rising orange line as at present. There are still $2 trillion of excess reserves on deposit at the Fed, so this could go on for years.

Fed Assets Net of Excess Reserves

The Fed funds rate is climbing, but at a measured pace. I doubt that the market will be too concerned by the FFR at 2.0 percent. The threat is if the Fed accelerates rate hikes in response to rising inflation, as in 2004 to 2006.

Fed Funds Rate and MZM Money Stock

Inflationary forces remain subdued, with the average hourly wage rate growing at a modest 2.6 percent a year.

Average Hourly Wage Rate Growth

A spike above 3.0 percent would spur the Fed into action but there is no sign, so far, as rising automation and competition from offshore labor markets ease upward pressure despite low unemployment.

Bob Doll: First quarter earnings continue to impress

Bob Doll

More positive news on earnings from Bob Doll’s weekly newsletter:

…..2. First quarter earnings results continue to impress, helped by tax cuts. With 85% of companies reporting, earnings are ahead of expectations by an average of 7.3%.1 Earnings-per-share growth is on track for 25%.1 Were it not for the effects of tax cuts, that number would be only 18%.1

3. Even if earnings are peaking, that does not necessarily mean the equity bull market is ending. According to one study, since the 1950s, a cyclical peak in earnings growth has tended to be followed by stock prices moving higher: From a peak in earnings-per-share growth, stock prices were still higher six months later 74% of the time and were higher 12 months later 68% of the time.2.

Fears of an earnings peak may be overblown, with inflation low, rate hikes at a measured pace, consumption strong and inflation contained despite low unemployment. Upside and downside risks appear balanced in this summary adapted by Nuveen from Morgan Stanley:

Reasons to be optimistic

1) First quarter earnings are very strong.
2) Equity valuations are reasonable.
3) Corporate America is flush with cash.
4) U.S. growth momentum may be plateauing, but is not slowing.
5) Trade restrictions have not been as severe as feared.
6) Global monetary policy remains accommodative.
7) North Korea risks have eased.

Reasons to be cautious

1) Margin pressures could hurt future earnings.
2) Higher rates could represent a headwind for valuations.
3) Political risks may rise as the midterm elections approach.
4) Global growth may start to slow in the coming years.
5) Trade policy remains a long-term risk.
6) Investors may be too complacent about monetary tightening.
7) President Trump’s legal issues could escalate.

But it would be foolish to ignore either upside or downside risk. Adopting a balanced strategy may be the most sensible approach.

1Source: Credit Suisse.
2Source: BMO Capital Markets

Life left in US stocks

According to market pundits, the latest stock sell-off was fueled by concerns over rising bond yields and slowing growth for Caterpillar (CAT).

From CNBC:

….Caterpillar shares reversed lower during the call, when Chief Financial Officer Brad Halverson said first-quarter adjusted profits per share will be the highest for the year because of increased investment later in 2018.

“We expect the targeted investments for future growth to be higher over the remaining three quarters,” Halverson said. “The outlook assumes that first-quarter adjusted profit per share will be the high-water mark for the year.”

Caterpillar (CAT)

The stock fell 6.2% on Wednesday, ignoring the earnings report:

In the earnings report, the Illinois-based machinery manufacturer raised its 2018 profit outlook by $2 a share over the previous quarter, to a range of $10.25 to $11.25 per share. The rosier guidance exceeds a Reuters analyst survey that expected a range of $8.39 to $10.60 a share. The company cited better-than-expected sales volume as the main driver of its improved full-year guidance.

Since when has “better-than-expected sales volume,” upward earnings revision and increased new investment been a bear signal? The market is unusually jittery at present, focusing on any semblance of bad news and ignoring the good.

Even concern over rising bond yields is nothing new.

10-Year Treasury Yields

10-Year Treasury yields are testing resistance at 3.0%. Breakout would complete a double-bottom reversal, warning of a bear market in bonds as yields rise. But rising long-term rates are not bad news for stocks, especially when off a low base as at present. I would go so far as to say that, over the last 20 years, rising 10-year yields have been bullish for stocks. The chart below compares annual percentage change in 10-year Treasury yields and the Russell 3000 Total Market index.

10-Year Treasury Yields and Russell 3000 Index 12-Month Rate of Change

There is plenty more good news that the market seems to be ignoring.

First quarter 2018 corporate earnings have so far impressed. According to S&P Indices, 117 stocks in the S&P 500 had reported results by the morning of April 24th. Of those, 91 (77.8%) beat, 10 (8.5%) met and 16 (13.7%) missed their estimates. Misses are largely concentrated in Materials ( 3 of 5), Industrials (4 of 26) and Consumer Discretionary sectors (5 of 13).

Freight activity remains strong, signaling a reviving economy.

S&P 500

Wages growth remains tame, with average hourly earnings of production and non-supervisory employees increasing at an annual rate of 2.42%. Growth above 3.0% would warn that underlying inflation is rising and the Fed will be forced to tighten monetary policy. But that does not appear imminent.

S&P 500

Muted wages growth allowed corporate profits (the blue line below) to rebound after a threatened down-turn.

S&P 500

Consumption has recovered. Per capita consumption of non-durable goods is recovering after a flat spot in 2017, consumption of durable goods has been rising since 2016, while services remain strong.

S&P 500

In financial markets, risk premiums on corporate bonds (Baa minus Treasuries) have declined to below 2.0%, suggesting a healthy credit outlook.

S&P 500

Bank credit is recovering after faltering in 2017.

S&P 500

The yield curve is flattening as the Fed gradually raises interest rates. A flat yield curve is not a threat. Only if it inverts, when the yield differential (gray line on the chart below) falls below zero, is the economy at risk of falling into a recession. Growth in the money stock (green MZM line on the chart below) has slowed but remains healthy.

S&P 500

The Fed has committed to shrinking its $4 trillion investment in Treasuries and mortgage-backed securities (MBS) run up by quantitative easing (QE) between 2009 and 2014. So far the decline has had no impact on financial markets as bank excess reserves on deposit at the Fed are declining at a similar rate. The effect is that net assets (Fed Assets minus Excess Reserves) are holding steady at $2.4 trillion.

S&P 500

The Philadelphia Fed’s Leading Index remains healthy at above 1.0 percent.

S&P 500

And our estimate of real GDP is rising (2.14% in March 2018), suggesting that the economy is recovering from its flat spot in 2016/2017.

S&P 500

Valuations are high and investors are jittery but the bull market still appears to have further to run.

“Headwinds have turned into tailwinds”

“While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds. Fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory.”
~ New Fed Chair Jerome Powell in his first testimony before Congress

Two very important sentences for investors. Expect further rate hikes but at a moderate pace.

Bond yields have climbed in anticipation of higher inflation. Breakout above 3.0 percent would warn of a bond bear market, after the bull market of the last 3 decades, with rising yields.

10-Year Treasury Yields

The five-year breakeven rate (Treasury yield minus the equivalent yield on inflation indexed TIPS) has been climbing since 2016.

Fed Excess Reserves

But core CPI (CPI less Food & Energy) remains subdued.

And average hourly wage rates, reflecting underlying inflationary pressures, continue to grow at a modest 2.5 percent a year.

Private Sector Average Hourly Wage Rate Growth

Real GDP is likely to maintain its similarly modest growth.

Real GDP and Estimates

While the Fed is sitting on a powder keg of more than $2 trillion of commercial bank excess reserves, no one is playing with matches. Yet.

Federal Reserve Bank: Excess Reserves of Depositary Institutions

Those excess reserves on deposit at the Fed have the potential to fuel a massive bubble in stocks or real estate. But investors remain wary after their experience in 2008.

We should be careful to get out of an experience only the wisdom that is in it — and stop there; lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again — and that is well; but also she will never sit down on a cold one anymore.

~ Samuel Clemens