“Stocks rebound but sentiment soft”
From Bob Doll at Nuveen Investments. His weekly top themes:
1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.
Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).
2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.
Agreed. Average hourly earnings are rising and inflation may follow.
3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.
This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.
4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.
Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.
5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.
Health care is a political football and may take longer to resolve than the trade war with China.
6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.
A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.
7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.
Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.
Robust US employment but global bear market warning
The US economy remains robust, with hours worked (non-farm) ticking up 2.2% in January, despite the government shutdown. Real GDP growth is expected to follow a similar path.
Average hourly earnings growth increased to 3.4% p.a. for production and non-supervisory employees (3.2% for all employees). The Fed has limited wiggle room to hold back on further rate hikes if underlying inflationary pressures continue to rise.
History shows that the Fed lifts short-term interest rates more in response to hourly wage rates than core CPI.
The Leading Index from the Philadelphia Fed ticked down below 1% (0.98%) for November 2018. While not yet cause for concern, it does warn that the economy is slowing. Further falls, to below 0.5%, would warn of a recession.
Markets are anticipating a slow-down, triggered by falling demand in China more than in the US.
S&P 500 volatility remains high and a large (Twiggs Volatility 21-day) trough above 1.0% (not zero as stated in last week’s newsletter) on the current rally would signal a bear market. Retreat below 2600 would strengthen the signal.
Crude prices have plummeted, anticipatiing falling global (mainly Chinese) demand. Another test of primary support at $42/barrel is likely.
Dow Jones-UBS Commodity Index breached primary support at 79, signaling a primary decline with a target of 70.
China’s Shanghai Composite Index is in a bear market. Respect of resistance at 2700 would confirm.
Bearish divergence on India’s Nifty also warns of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.
DJ Stoxx Euro 600 rallied but is likely to respect resistance at 365/370, confirming a bear market.
The UK’s Footsie also rallied but is likely to respect resistance at 7000. Declining Trend Index peaks indicate selling pressure, warning of a bear market.
My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.
Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.
~ Thucydides (460 – 400 B.C.)
It’s a funny kind of bear market
The US economy continues to show signs of robust good health.
Total hours worked are rising, signaling healthy real GDP growth.
Growth in average hourly wage rates is rising, reflecting a tighter labor market. Underlying inflationary pressures may be rising but the Fed seems comfortable that this is containable.
The Leading Index from the Philadelphia Fed maintains a healthy margin above 1.0% (below 1% is normally a signal that the economy is slowing).
But market volatility remains high, with S&P 500 Volatility (21-day) above 2.0%. A trough above 1% on the next multi-week rally would confirm a bear market — as would an index retracement that respects 2600.
The Nasdaq 100 is undergoing a similar retracement with resistance at 6500.
The primary disturbance is the trade confrontation between the US and China. There is plenty of positive spin from both sides but I expect trade negotiations to drag out over several years — if they are successful. If not, even longer.
I keep a close watch on the big five tech stocks as a barometer of how the broader market will be affected. So far the results are mixed.
Apple is most vulnerable, with roughly 25% of projected sales to China. Recent downward revision of their sales outlook warns that Chinese retail sales are falling. AAPL is testing its primary support level at 150.
Facebook and Alphabet are largely unaffected by a Chinese slowdown, but have separate issues with user privacy. Facebook (FB) is in a primary down-trend.
While Alphabet (GOOGL) is testing primary support at 1000.
Amazon (AMZN) is similarly isolated from a Chinese slow-down although there may be a secondary impact on suppliers. Primary support at 1300 is likely to hold.
Microsoft (MSFT) is the strongest performer of the five. Their segment reporting does not provide details of exposure to China but it appears to be a small percentage of total sales.
The outlook for stocks is therefore mixed. Be cautious but try to avoid a bearish mindset, where you only see problems and not the opportunities. Even if China does suffer a serious slowdown we can expect massive stimulus similar to 2008 – 2009, so the impact on developing markets and resources markets may be cushioned.
Best wishes for the New Year.
Significant divergence
Market commentators are sifting through the data, looking for reasons to explain the sharp sell-off in stocks over the last two months. But everything they examine is likely to be shaded by their bear-tinted spectacles after the S&P 500 broke primary support at 2550.
The Nasdaq 100 also broke primary support, confirming the bear market.
Of the big five tech stocks, Apple and Google are both testing primary support, threatening to follow Facebook into a primary down-trend. If the two break primary support, that would further strengthen the bear signal.
Volatility (21-day) is now close to 2% but the key is how volatility behaves on the next multi-week rally. If volatility forms a trough above 1% that would confirm the elevated risk.
Divergence? What Divergence?
Why do I say there is a significant divergence? Look at the fundamentals.
Fedex has just released stats for its most recent quarter, ended November 30. Package volumes are rising, not falling.
Supported by a very bullish Freight Transportation Index.
Consumption is strong, with Services and Non-durable goods rebounding. No sign of a recession here.
Light vehicle sales are at a robust annual rate of 17.5 million.
Retail sales growth (ex motor vehicles and parts) weakened in the last month but is still in an up-trend.
Housing starts and authorizations are still climbing.
Real construction spending (adjusted by CPI) is strong.
Manufacturers new orders (ex defense and aircraft) have rebounded after a weak 2015 – 2016.
Corporate investment is growing at a faster rate than the economy, with rising new capital formation over GDP.
The Fed is shrinking its balance sheet which is expected to impact on liquidity. But commercial banks are running down excess reserves on deposit at the Fed at a faster rate, so that Fed assets net of excess reserves (green line) is actually rising. Hardly a drain on liquidity.
Market pundits are watching the yield curve with bated breath, waiting for the 10-year to cross below the 2-year yield.
In the past this has served as a reliable early warning, normally 12 to 24 months ahead of a recession. But the St Louis Fed Financial Stress Index is well below zero, signaling an accommodative financial environment.
Why the mismatch? Fed actions — QE, Operation Twist, and even steps to shrink its balance sheet — have all suppressed long-term interest rates. We need to be wary of taking signals from a distorted yield curve.
Why have stocks reacted?
This is not a Pollyanna outlook. Never argue with the tape — we are clearly in a bear market. So why are stocks diverging from the economy?
The answer is China.
The impact of a trade war with the US would most likely cause a recession in China. Oil prices are already plunging in anticipation of falling demand.
Commodities are likely to follow.
The impact of a Chinese recession would be felt around the globe. Europe has its own problems and could easily follow.
The US is likely to emerge relatively unscathed but Wall Street is going to be exceedingly cautious until some semblance of normality is restored.
I do not suggest selling all your stocks but make sure that there is enough cash in the portfolio to take advantage of opportunities when they arise.
Buckley’s chance that rate hikes will slow
Average hourly wage rates are rising, with Production & Non-Supervisory Employees growing at an annual rate of 3.20% and All Employees at 3.14%.
This is a clear warning to the Fed that underlying inflationary pressures are rising. There is Buckley’s chance* that they will ease off on rate hikes.
The Fed adopts a restrictive stance whenever hourly wage rate growth exceeds 3%, illustrated below by a high or rising Fed Funds Rate.
The market is adopting a wait-and-see attitude ahead of Tuesday’s mid-term elections. Stocks like Apple (AAPL) have been sold down on strong volume despite good earnings results: earnings per share of $2.91 and revenue of $62.9 billion for Q4-18, compared to consensus estimates of $2.79 and $61.5 billion.
Optimism over a possible trade deal with China may not last the week.
A harami-like candle on the S&P 500 reflects indecision, while bearish divergence on Twiggs Money Flow warns of long-term selling pressure. Breach of 2550 is still unlikely but would warn of a primary down-trend.
The Nasdaq 100 tells a similar story, with primary support at 6300.
* William Buckley was an English convict transported to Australia. He escaped when the ships laid anchor in Port Phillip Bay in 1803. The nearest permanent settlement, Sydney, was more than 1000 km away and, considered to have no chance of survival, he was given up for dead. Thirty-two years later, having lived among the Wathaurung Aboriginal people, he emerged from the bush when a settlement was established at Port Phillip in 1835. “Buckley’s chance” is an Australian colloquialism meaning having no chance at all.
President Trump should look in the mirror
President Trump has repeatedly attacked the Fed and his recent appointee Jerome Powell for raising interest rates. In an interview with the Wall Street Journal, the President made clear his displeasure, stating that he sees the FOMC as the biggest risk to the US economy “because I think interest rates are being raised too quickly”.
What the President fails to grasp is that his actions, increasing the budget deficit when the economy is thriving, are the real threat. Alan Kohler recently displayed a chart that sums up the Fed’s predicament.
The budget deficit is normally raised when unemployment is high (the scale of the deficit is inverted on the above chart to make it easier to compare) in order to stimulate the economy. When unemployment falls then the deficit is lowered to prevent the economy from over-heating and to curb inflation.
At present unemployment is at record lows but Trump’s tax cuts have increased the deficit. The Fed is left with no choice but to steadily increase interest rates in order to prevent inflation from getting out of hand.
Real GDP growth came in at a robust 3.0% for the third quarter, while weekly hours worked are rising.
It’s the Fed’s job to remove the punch-bowl before the party gets out of hand.
Extraordinary times of low unemployment and low inflation
Unemployment fell to 3.7% for September, well below the long-term natural rate of unemployment. This normally signifies a tightening labor market, a precursor to higher inflation.
But growth in average hourly earnings dipped slightly, to 2.75% for the past 12 months. Underlying inflationary forces remain subdued.
As Fed Chairman Powell suggested, the Fed may be overestimating the natural rate. In his speech on Tuesday Powell summed up the current situation:
…Many of us have been looking back recently on the decade that has passed since the depths of the financial crisis. In light of that experience, I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same.
This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.
It’s a bull market
The US economy continues to show signs of a robust expansion. Net capital formation is rising (as a percentage of GDP) as it is wont to do during a boom. In layman’s terms net capital formation is the net growth in physical assets used in the production of goods and services, after allowing for depreciation.
The Wicksell spread has turned positive. When return on investment (we use nominal GDP growth as a surrogate) exceeds the cost of capital (reflected by low investment grade Baa bond yields) that encourages new investment and economic expansion as in the 1960 – 1980 period on the chart below.
Real bond yields, reflected below by Baa yields minus core CPI (blue line) on the chart below, are also near record lows. Low real returns on bonds support high stock earnings multiples.
Fed Chairman Powell summed up the situation in a speech on Tuesday this week:
…Many of us have been looking back recently on the decade that has passed since the depths of the financial crisis. In light of that experience, I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same.
This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.
The biggest risk is that investors get carried away and drive earnings multiples sky high, but gradual rate increases from the Fed and the threat of tariff wars appear to be keeping animal spirits in check.
Treasury yields confirm bond bear market
10-Year Treasury yields respected their new support level at 3.00%, confirming a primary advance.
Breakout above 3.00% also completes a double-bottom reversal, signaling the end of a three-decade-long secular bull market in bonds.
The yield differential between 10-year and 3-month Treasuries is declining but a flat yield curve does not warn of a recession. Only if the yield differential crosses below zero, with short-term yields rising faster than long-term, will there be a recession warning.
Real returns on long-term bonds — the gap between the green and blue lines below — remain near record lows.
Only if the gap widens (real returns rise significantly) are we likely to see downward pressure on stock valuations, with falling price-earnings multiples.