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.”
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 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.
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.
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.
Muted wages growth allowed corporate profits (the blue line below) to rebound after a threatened down-turn.
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.
In financial markets, risk premiums on corporate bonds (Baa minus Treasuries) have declined to below 2.0%, suggesting a healthy credit outlook.
Bank credit is recovering after faltering in 2017.
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.
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.
The Philadelphia Fed’s Leading Index remains healthy at above 1.0 percent.
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.
Valuations are high and investors are jittery but the bull market still appears to have further to run.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
“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.
The five-year breakeven rate (Treasury yield minus the equivalent yield on inflation indexed TIPS) has been climbing since 2016.
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.
Real GDP is likely to maintain its similarly modest growth.
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.
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
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Why is the Dollar falling?
The broad, trade-weighted US Dollar index has been declining since early 2017.
This is the best explanation I have found for current US Dollar weakness. From Bank of Montreal, BMO Nesbitt Burns:
The relationship isn’t perfect, but as a general rule of thumb, the USD declines in years when global growth is above potential. In such years, strong global growth causes commodity prices to rise, which lifts commodity currencies. In addition, strong global growth normally triggers a flood of investment out of developed economies and into emerging economies. As emerging central banks intervene to slow the appreciation of their currencies from these two factors, they sell the USD against EUR and other alternative reserve currencies, thereby causing the USD to decline against both developed and emerging currencies. That dynamic helps explains the USD depreciation in 2017 as well as the 2004-2007 period. The 10Y average of the IMF’s World GDP growth rate is 3.4% and we think that is roughly potential growth. The IMF estimates that global growth will come in at about 3.6% for 2017 and accelerate to 3.7% in 2018.
In addition, the US’s twin deficit fundamental (sum of the current account deficit and fiscal or federal budget deficit as shares of GDP) is another factor that is negative for the USD. Turns in the twin deficit normally precede turns in the USD by 1-2 years and then trends match thereafter. The US’s twin deficit fundamental has been deteriorating for the past two years and is likely to deteriorate further in 2018 and beyond due in part to the tax cuts. When looking at all these factors together with the fact that USD phases tend to last 5-7 years, we feel that we have to forecast a continuation of broad USD weakness—albeit at a slower pace. We project that the broad USD index will fall 1.5% in Q1 and then 1.0% per quarter in each of the remaining three quarters of 2018.
Hat tip to David Llewellyn-Smith at Macrobusiness.
The fall in the Dollar may also be self-reinforcing, as Enda Curran at Bloomberg highlights:
…..On top of the boost already coming from robust global GDP growth, the dollar’s fall over the past year may add over 3 percent to the level of world trade, according to Gabriel Sterne, global head of macro research at Oxford Economics Ltd. Tipping further dollar weakness, the risks are skewed to the upside for Oxford’s baseline forecast for 5 percent growth in world trade in 2018.
“Falls in the value of the dollar oil the wheels of the global financial system, boosting global liquidity by strengthening balance sheets and alleviating currency mismatches,” Sterne wrote in a note. “One important channel is variation in the differential between the cost of raising dollars onshore and offshore. Dollar weakness reduces the cross-currency basis, increases cross-border lending and boosts bank equities.”
The biggest winners will likely be emerging economies given the weaker dollar will lower the value of their dollar-denominated debt, taking pressure off their balance sheets and from credit conditions more generally…..
Finally, from Deutsche Bank (again hat tip to David):
How can it be that US yields are rising sharply, yet the dollar is so weak at the same time? The answer is simple: the dollar is not going down despite higher yields but because of them. Higher yields mean lower bond prices and US bonds are lower because investors don’t want to buy them. This is an entirely different regime to previous years.
Dollar weakness ultimately goes back to two major problems for the greenback this year. First, US asset valuations are extremely stretched. As we argued in our 2018 FX outlook a combined measure of P/E ratios for equities and term premia for bonds is at its highest levels since the 1960s. Simply put, US bond and equity prices cannot continue going up at the same time. This correlation breakdown is structurally bearish for the dollar because it inhibits sustained inflows into US bond and equity markets.
The second dollar problem is that irrespective of asset valuations the US twin deficit (the sum of the current account and fiscal balance) is set to deteriorate dramatically in coming years. Not only does the additional fiscal stimulus recently agreed by Congress push the fair value of bonds even lower via higher issuance and inflation risk premia effects, but the current account that also needs to be financed will widen via import multiplier effects. When an economy is stimulated at full employment the only way to absorb domestic demand is higher imports. Under conservative assumptions the US twin deficit is set to deteriorate by well over 3% of GDP over the next two years.
In summary:
- Rising global growth boosts commodity prices and emerging markets
- Central banks in emerging markets then sell Dollars to slow appreciation of their local currency
- Fiscal stimulus, such as US tax cuts and infrastructure spending, lifts inflation
- Higher inflation causes a bond bear market
- Fiscal stimulus also widens the current account deficit
- Central bank selling, higher inflation, a bond bear market and wider current account deficits all cause a weaker Dollar
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
How QE reversal will impact on financial markets
The Federal Reserve last year announced plans to shrink its balance sheet which had grown to $4.5 trillion under the quantitative easing (QE) program.
According to its June 2017 Normalization Plan, the Fed will scale back reinvestment at the rate of $10 billion per month and step this up every 3 months by a further $10 billion per month until it reaches a total of $50 billion per month in 2019. That means that $100 billion will be withheld in the first year and $200 billion each year thereafter.
How will this impact on financial markets? Here are a few clues.
First, from the Nikkei Asian Review on January 11:
The yield on the benchmark 10-year U.S. Treasury note shot to a 10-month high of 2.59% in London, before retreating later in the day and ending roughly unchanged in New York. Yields rise when bonds are sold.
The selling was sparked by reports that China may halt or slow down its purchases of U.S. Treasury holdings. China has the world’s largest foreign exchange reserves — holding $3.1 trillion, about 40% of which is in U.S. government notes, according to Brad Setser, senior fellow at the Council on Foreign Relations.
Chinese officials, as expected, denied the reports. But they would have to be pondering what to do with more than a trillion dollars of US Treasuries during a bond bear market.
Treasury yields are rising, with the 10-year yield breaking through resistance at 2.60%, signaling a primary up-trend.
On the quarterly chart, 10-year yields have broken clear of the long-term trend channel drawn at 2 standard deviations, warning of reversal of the three-decade-long secular trend. But final confirmation will only come from a breakout above 3.0%, completing a large double-bottom.
Withdrawal or a slow-down of US Treasury purchases by foreign buyers (let’s not call them investors – they have other motives) would cause the Dollar to weaken. The Dollar Index recently broke support at 91, signaling another primary decline.
The falling Dollar has created a bull market for gold which is likely to continue while interest rates are low.
US equities are likely to benefit from the falling Dollar. Domestic manufacturers can compete more effectively in both local and export markets, while the weaker Dollar will boost offshore earnings of multinationals.
The S&P 500 is headed for a test of its long-term target at 3000*.
Target: 1500 x 2 = 3000
Emerging market borrowers may also benefit from lower domestic servicing costs on Dollar-denominated loans.
Bridgewater CEO Ray Dalio at Davos:
We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws…
If there is a downside, it is likely to be higher US inflation as employment surges and commodity prices rise. Which would force the Fed to raise interest rates faster than the market expects.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Leading Index gives early warning
One of the better composite indicators in the US, the Leading Index from the Philadelphia Fed, points to a slow-down in the US economy. A dip below 1.0% is often early, as in July 2000 and May 2006, but serves as a reliable warning of an economic slow-down.
The Leading Index predicts the six-month growth rate of the Philadelphia Fed Coincident Index. In addition to the Coincident Index, it includes variables that lead the economy: housing permits (1 to 4 units), initial unemployment insurance claims, delivery times from the ISM manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.
The Coincident Index combines four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing and wages and salaries.
The Leading Index signal does seem early. Low corporate bond spreads and VIX near record lows continue to indicate low market risk, typical of a bull market.
Monetary policy remains accomodative, with money stock growing at close to 5% p.a. (MZM = cash in circulation, travelers checks, money market funds and deposits with zero maturity).
The yield curve has flattened, with the spread between 10-year and 3-month Treasuries falling to 1.0% on the above graph. That is what one would expect when the Fed hikes interest rates in a low inflation environment: short-term rates will rise faster than long-term rates. But a negative yield curve, where short-term rates are higher than long-term rates, is a reliable predictor of recessions in the US economy. Each time the yield differential on the above graph crossed below zero in the last 50 years, a recession has followed within 12 months.
Underlying inflation remains low, with average hourly earnings growth below 2.5% p.a., and the Fed should be careful about single-mindedly raising interest rates without considering the yield curve.
The bull market continues but investors need to keep a weather eye on interest rates and the yield curve.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Fed flunks econ 101?
Caroline Baum’s opinion on the Fed’s approach to inflation:
For all the sturm und drang about the Fed debasing the dollar and sowing the seeds of the next great inflation, the public’s demand for money has increased. The increased desire to hold cash and checkable deposits has risen to meet the increased supply. Velocity, or the rate at which money turns over, has plummeted.
The Fed has two choices. It can adopt the Dr. Strangelove approach and learn to stop worrying and live with low inflation and low unemployment. Or it can do something about it, which runs counter to its stated intention to raise the funds rate and reduce the size of its balance sheet.
Option #1 involves learning to live with a low, stable inflation rate about 0.5 percentage point below the Fed’s explicit 2% target.
Not only has the Fed has achieved price stability in objective terms, but it has also fulfilled former Fed Chairman Alan Greenspan’s subjective definition of price stability: a rate of inflation low enough that it is not a factor in business or household decision-making.
Option #2 means taking some additional actions to increase the money supply by lowering interest rates or resuming bond purchases. The Fed is taking the opposite approach. It began its balance sheet normalization this month, allowing $10 billion of securities to mature each month and gradually increasing the amount every quarter. And it has guided markets to expect another 25-basis-point rate increase in December….
The Fed faces a delicate balancing act. Unemployment is low but capacity utilization is also low, indicating an absence of inflationary pressure.
Janet Yellen understandably wants to normalize interest rates ahead of the next recession but she can afford to take her time. The economy is unlikely to tip into recession unless the Fed hikes rates too quickly, causing a monetary contraction.
I believe the Fed chair is relying on the outflow from more than $2 trillion of excess reserves held by banks on deposit with the Fed to offset the contractionary effect of any rate hikes.
If pushed, the Fed could lower the interest rate paid on excess reserves in order to encourage banks to withdraw excess deposits. But so far this hasn’t been necessary. The attraction of higher interest rates in financial markets has been sufficient to encourage a steady outflow from excess reserves, keeping the monetary base (net of reserves) growing at a steady clip of close to 7.5% p.a. despite rate hikes so far.
Makes you wonder why Donald Trump would even consider replacing the Fed chair when she is doing a great job of managing the recovery.
Source: Fed flunks econ 101: understanding inflation – MarketWatch
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
How long will the bull market last?
US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.
Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.
Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.
Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.
The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.
Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.
At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Why is it so hard to forecast interest rates? | San Francisco Fed
Interesting paper by Michael Bauer at the San Francisco Fed:
….The difficulty of predicting changes in interest rates mainly arises from two features that characterize their evolution over time. First, like other financial variables, interest rates vary widely from day to day, which makes them difficult to link to economic fundamentals such as monetary or fiscal policy. This well-documented “excess volatility,” was first pointed out in Shiller (1979), and it reflects the importance of frequent changes in investor sentiment due to a never-ending stream of economic data releases and other news.
Second, as evident from 10-year Treasury yields since 1971, seen in Figure 1, interest rates have not fluctuated around a stable average level over this period. Instead of “mean reversion” around a constant average, they exhibit slow-moving trends, such as the rise during the “Great Inflation” period of the 1970s, and the long-lasting decline since then.
….the gap model does not assume that the level of the series will revert to some constant mean, but instead that the gap between the series and its trend component will revert to zero. Estimating trend components and gaps underlies most macroeconomic forecasting, and Faust and Wright (2013) recently demonstrated the gap model’s excellent performance for inflation forecasting.
….Since inflation is ultimately determined by monetary policy, the long-run inflation trend corresponds to the perceived inflation target of the central bank. This can be estimated reasonably well from surveys. Figure 1 plots the publicly available and mostly survey-based inflation trend estimate (red line) that underlies the Federal Reserve Board’s structural model of the U.S. economy, FRB/US. For the trend in the real interest rate, also called the natural or equilibrium real interest rate, Laubach and Williams (2003) suggested a way to estimate it from macroeconomic data and popularized its use in policy analysis (see also Williams 2016). Figure 1 includes an estimate of the equilibrium real interest rate (green line) taken as the average of several popular estimates, as discussed in Bauer and Rudebusch (2017).
Figure 1 also plots the sum of these two trends (red line); this estimate of the trend component in interest rates has exhibited a very pronounced decline since the 1980s. The 10-year yield generally fluctuated near this trend, and both are currently very low in historical comparison, with important consequences for policymaking (Williams 2016). Figure 1 suggests that it may be useful to take into account the level of the trend when forecasting interest rates.
….the final piece required for a practical forecast rule is an assumption about the transition of interest rates to their trend. Based on how quickly interest rates have historically reverted back to the trend, a reasonable assumption to make for this forecasting exercise is that 20% of the remaining gap is closed each quarter. But the precise speed of reversion to the trend is typically not crucial for forecasting performance (Faust and Wright 2013). Furthermore, it becomes essentially irrelevant for long-horizon forecasts, since forecasts are approximately equal to the estimated trend…..
Bob Doll: Lack of infrastructure stimulus might benefit stocks
Bob Doll at Nuveen makes a good point about Trump’s failure to get infrastructure spending through the House.
Washington, D.C. seems mired in gridlock, despite the fact that Republicans control the House, Senate and White House. No significant economic legislation has been passed, and the optimism from January about health care reform, infrastructure spending and tax cuts has all but vanished. Political attention will soon be focused on the 2018 midterm elections, and the window for pro-growth policy action is closing.
The lack of fiscal stimulus is disappointing, but it comes with a silver lining: We are unlikely to see the significant and sharp advance in interest rates or in the U.S. dollar that would probably result from such stimulus. The lost opportunity on the political front might therefore have the ironic effect of prolonging the bull market in stocks.
It seems crazy when you consider that both Clinton and Trump campaigned on a platform of major infrastructure programs to boost the economy. Just shows how dysfunctional Washington has become.
But I agree with the silver lining. Infrastructure spending would have boosted employment — the US is already below its long-term natural rate of unemployment — and upward pressure on wage rates. Which would have drawn a sharp increase in interest rates from the Fed, to combat inflation. Populist policies often ignore the hidden/unforeseen consequences and can produce the opposite result to that intended.
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