First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year. In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded. Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February. We may be seeing the first stages of the end of the 9-year-old bull market. Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%. This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline. Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward. At the same time for mostly the same reasons, interest rates are likely to be range-bound. Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil. Rising oil prices would be akin to a tax on consumers and hamper US growth.
Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%. At the bottom of the last correction in early 2016 this average was 23%. The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets. Sentiment is often a lagging indicator. Investors are most enthusiastic after large price gains. The opposite is true too in that sentiment numbers go low after a price decline. It can be helpful to take a contrarian view as sentiment measures move to extremes.
Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates. The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs. Analysts have been looking for wage pressures due to very low unemployment numbers for a long time. The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force. As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce. When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down. A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low. Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate. Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.
A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States. There are no seasonal adjustments etc. While we are growing, the rate of increase in the total number of people working, is slowing.
Forward guidance from companies will be critical. Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level. During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down. It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.
The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening). This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end. The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates. These are tightening liquidity. While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections. China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.
Over the past 9 years global liquidity additions has been the key driver to global asset prices. As these additions slow and become subtractions, one must assume it will impact financial markets. Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency. Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months. This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe. The cost to borrow US Dollars in Europe has gone up dramatically. A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity. The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate. The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely. The crux of it that they both measure the availability of funds in the money markets. If these rates go up, it is seen as a decrease in available funds.
The chart above tracks the TED spread and the US dollar. The relationship is loose but fits well over multiple quarters. If this relationship is correct, the US dollar should dramatically increase in value in the coming months. An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets. A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018. If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.
In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth. Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system. If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system. More money moving slowly can be like a small amount of money moving quickly. If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline. The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time. Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.
Adam Waszkowski, CFA
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