S&P 500: Rate cuts and employment

Ten-year Treasury yields rallied for the last two weeks but remain in a down-trend. Respect of resistance at 2.60% would warn of another decline.

10-year Treasury yields

Inflation is subdued and it would be difficult for the Fed to motivate a rate cut when inflation is close to its 2.0% target. The consumer price index (CPI) came in at 1.86% for the 12 months to March 2019, while the more stable Core CPI (ex- Food & Energy) remains close to target at 2.04%.

CPI and Core CPI

After price stability, the second part of the Fed’s dual mandate is to maintain maximum sustainable employment. A review of the last three cycles shows the Fed raising the funds rate (FFR) to curb inflation and then being forced to cut (red highlights) when growth in employment slows.

Payroll Changes and Fed Funds Rate

Total non-farm payrolls are currently growing at close to 2.0%. The Fed would normally need payroll growth to slow by at least 1.0% to motivate a rate cut. The exception is if inflation falls below target, then the Fed may act sooner.

The S&P 500 is headed for another test of its high at 2950, while Trend Index (13-week) recovered to signal moderate buying pressure.

S&P 500

The Nasdaq 100 is similarly testing its earlier high at 7700.

Nasdaq 100

Momentum is slowing and we can expect stubborn resistance at the former highs.

ASX 200 divergence

REITs and Utilities found support, partially recovering from their sell-off last week.

ASX 200 REITs

Financials continue to test support at 5800; breach would signal another test of primary support at 5300.

ASX 200 Financials

The RBA sums up the outlook for banks in its April 2019 Financial Stability Review:

“Analysts expect minimal growth in bank profits over the year ahead. Net interest income growth is expected to be below average as credit growth slows further and NIMs [net interest margins] remain under pressure. Bad and doubtful debt charges are also expected to pick up a little from their current very low level. The final cost of remediation for misconduct identified over recent years is uncertain, and could exceed existing provisions, while spending on compliance and IT may remain elevated in order to address some of the recommendations of the Royal Commission. Overall, there appears to be greater-than-usual uncertainty about the future profit outlook for banks because of the increased scrutiny on banks and the weaker outlook for property prices and housing credit growth.”

Materials encountered resistance at 13500, with a lower peak on the Trend Index warning of selling pressure. Another test of support at 12500 is likely.

ASX 200 Materials

The ASX 200 is heading for another test of resistance at 6350 but divergence with a declining Trend Index continues to warn of a correction. Expect stubborn resistance at 6350, followed by another test of 6000. Breach of 6000 would signal another correction to test primary support at 5400/5500.

ASX 200

I remain cautious on Australian stocks, especially banks, and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

S&P 500: Expect slower earnings growth but no sign of recession

Credit growth in the US above 5% shows no signs of tighter credit conditions from an inverted yield curve. Growth in the broad money supply (MZM plus time deposits) has also not slowed, remaining close to 5%.

Credit Growth and Broad Money Supply

Growth in hours worked has slowed to 1.71%, suggesting that real GDP growth will dip below 2% in 2019 but remain positive.

Hours Worked and Real GDP growth

The Fed is unlikely to cut interest rates when average hourly earnings are growing at 3.2% (Total Private for the 12 months ended March 2019).

Average Hourly Wage Rate

The Leading Index from the Philadelphia Fed fell below 1%, giving an early warning that GDP growth will slow.

Philadelphia Fed Leading Index

A similar dip below 1% occurred ahead of the last three recessions. A second, stronger dip would warn of recession ahead.

Philadelphia Fed Leading Index

The S&P 500 is advancing to test resistance at 2950/3000, while the Volatility Index crossed below 1%, signaling that risk is no longer elevated.

Treasury Yields

Real GDP is likely to slow this year but remain positive. S&P 500 earnings growth is expected to slow and the index is likely to meet stubborn resistance at 2950/3000. The Fed is still a long way off cutting interest rates (a strong bear signal) and there is no sign of recession on the 2019 horizon. An extended top is the most likely outcome.

ASX 200 offshore investors retreat

The ASX has undergone a sell-off in the last two days, presumed to be offshore investors withdrawing from Australian investments.

Bell Direct equities analyst Julia Lee (Thursday) said it appeared that overseas investors – or even just one large player – had pulled their money from the Australian market, as losses were concentrated among the ASX’s top 20 companies. (thebull.com.au)

Worst hit were REITs.

ASX 200 REITs

Followed by Utilities.

ASX 200 Utilities

ASX 200 Financials are testing support at 5800, while the Trend Index warns of a correction. Breach of 5800 would signal another test of primary support at 5300.

ASX 200 Financials

Materials continue their advance, benefiting from the iron ore windfall.

ASX 200 Materials

The ASX 200 retreated from resistance at 6350. Declining Trend Index warns of a correction. Breach of 6000 would confirm.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

Australia: Headwinds persist

From Elliot Clarke & Simon Murray at Westpac:

…the take home from Budget 2019 is that, while supportive of activity over the long-term, the near-term impact on incomes and activity is limited. Labor’s alternative proposals, as per the budget reply, are also spread out over time. So no matter which party wins in May, the headwinds of persistent weak income growth and declining house prices are set to hold growth well below trend through 2019. This is clear justification for interest rate cuts from the RBA, which Westpac believes will come in August and November.

While the RBA is yet to adopt an easing bias, the April meeting decision statement did emphasise the fluidity of the situation…

The last sentence is important: the RBA has not yet adopted an easing bias. Perhaps because of the housing debt bubble.

Australia: Household Debt and Disposable Income

Business investment has already failed to respond to interest rate cuts.

Australia: Business Investment

10-Year AGB yields are already below US Treasuries but have failed to significantly weaken the Australian Dollar.

Australia: Difference to US 10-Year Bond Yield

House prices are falling.

Australia: Housing Prices

Plunging high-density housing approvals promise a sharp slow-down in housing construction.

Australia: Building Approvals

Dwelling Investment is likely to join Mining Investment in the red, detracting from GDP growth. Windfall iron ore prices (Exports) are keeping the economy afloat, while they last.

Australia: GDP Components

Bank’s impaired and total non-performing assets are low, but likely to rise if the housing fall (and construction down-turn) continues.

Australia: Bank Non-Performing Assets

Bank capital ratios are modest at just over 10% of common equity (CET1) against risk-weighted assets. But that falls to about 5.5% without risk-weighting (leverage ratio). Not a lot of room for comfort.

Australia: Bank Capital

ASX 200 continuation likely

Weak red candles on the ASX 200 Financials index indicate support at 5900/6000. Rising troughs on Twiggs Money Flow flag buying pressure. Falling housing prices have not yet made a dent in investor confidence. Penetration of medium-term support at 5800 would warn of another test of primary support at 5300 but a rally is more likely.

ASX 200 Financials

Materials respected their new support level at 12500, benefiting from high iron ore prices.

ASX 200 Materials

The ASX 200 is consolidating at 6200 but continuation to test resistance at 6300/6350 is likely.

ASX 200

Expect stubborn resistance at 6350, followed by a correction.

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

S&P 500: Treasuries warn of a bear market

10-Year Treasury yields plunged Friday, to close at 2.45%, warning of a decline to test primary support at 2.0%.

10-Year Treasury Yields

The yield curve is now likely to turn negative. The 10-Year/2-Year yield differential has already fallen to 0.13%. Below zero signals a negative yield curve, a reliable predictor of oncoming recession within the next 12 to 18 months.

10-Year minus 2-Year Treasury Yields

The S&P 500 retreated Friday and is likely to breach its new support level at 2800. Follow-through below 2600 would warn of a bear market.

S&P 500

ASX 200: Financials & Materials test support

Financials are testing their new support level at 5900/6000. Falling housing prices are likely to drag the index lower. Penetration of the rising trendline at 5800 would warn of another test of primary support at 5300.

ASX 200 Financials

Materials are also testing their new support level at 12500/12600 but respect is far more likely, given the tailwind from iron ore prices.

ASX 200 Materials

The ASX 200 is consolidating at 6200 but continuation to test resistance at 6300/6350 is likely. Expect stubborn resistance, followed by a correction.

ASX 200

I remain cautious on Australian stocks and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

Buybacks, interest rates and declining growth

The Fed did a sharp about-turn on interest rates this week: a majority of FOMC members now expect no rate increases this year. Long-term treasury yields are falling, with the 10-Year breaking support at 2.55/2.60 percent. Expect a test of 2.0%.

10-Year Treasury Yields

While the initial reaction of stocks was typically bullish, the S&P 500 Volatility Index (21-day) turned up above 1.0%, indicating risk remains elevated.

S&P 500

The reason for the Fed reversal — anticipated lower growth rates — is also likely to weigh on the market.

Stocks are already over-priced, with an S&P 500 earnings multiple of 21.26, well above the October 1929 and 1987 peaks. With earnings growth expected to soften, there is little to justify current prices.

S&P 500 Price-earnings (PEmax)

The current rally is largely driven by stock buybacks ($286 billion YTD) which dwarf the paltry inflow from ETF investors into US equities ($18 billion YTD). We are also now entering the 4 to 6-week blackout period, prior to earnings releases, when stock repurchases are expected to dip.

Why do corporations continue to repurchase stock at high prices? Warren Buffett recently reminded investors that buybacks at above a stock’s intrinsic (fair) value erode shareholder wealth. If we look at the S&P 500 in the period 2004 to 2008, it is clear that corporations get carried away with stock buybacks during a boom and only cease when the market crashes. They support their stock price in the good times, then abandon it when the market falls.

S&P 500 Buybacks
source: S&P Dow Jones Indices

Shareholders would benefit if corporations did the exact opposite: refrain from buying stock during the boom, when valuations are high, and then pile into the stock when the market crashes and prices are low. Why doesn’t that happen?

The culprit is typically low interest rates. It is hard for management to resist when stock returns are more than double the cost of debt. Buybacks are an easy way of boosting stock performance (and executive bonuses).

Treasury Yields: 3-Month & 5-Year

Corporations are using every available cent to buy back stock. Dividends plus buybacks [purple line below] exceed reported earnings [green] in most quarters over the last five years.

S&P 500 Buybacks & Dividends compared to Earnings

That means that capital expenditure and acquisitions were funded either with new stock issues or, more likely, with debt.

Corporate debt has been growing as a percentage of GDP since the 1980s. The pace of debt growth slowed since 2017 (shown by a down-turn in the debt/GDP ratio) but continues to increase in nominal terms.

Corporate Debt/GDP

Low interest rates mean that stock buybacks are likely to continue — unless there is a fall in earnings. If earnings fall, buybacks shrink. Declining earnings mean there is less available cash flow to buy back stock and corporations become far more circumspect about using debt.

S&P forecasts that earnings will rise through 2019.

S&P 500 Earnings

But forecasts can change. Expected year-on-year earnings growth for the March 2019 quarter has been revised down to 3.5%. Forecasts for June and September remain at 12.0% and 11.4% (YoY growth) respectively.

S&P 500 Year-on-Year Earnings Growth Forecast

If nominal GDP continues to grow at around 5% (5.34% in Q4 2018) and the S&P 500 buyback yield increases to 3.0% (2.93% at Q3 2019 according to Yardeni Research) then earnings growth, by my calculation* should fall to around 8.2%.

*1.05/0.97 -1.

With an expected dividend yield of 2%, investors in the S&P 500 can expect a return of just over 10% p.a. (dividend yield plus growth).

But the Fed now expects growth rates to fall by about 1.1% in 2019 and 1.2% in 2020, which should bring investor returns down to around 9% p.a. Not a lot to get excited about.

I knew something was wrong somewhere, but I couldn’t spot it exactly. But if something was coming and I didn’t know where from, I couldn’t be on my guard against it. That being the case I’d better be out of the market.
~ Jesse Livermore

“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).

Leading Index

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.

Hourly Earnings Growth

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.

Money Supply & Nominal GDP growth

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.