Blame the Fed! (for following through on previously telegraphed guidance)

The Federal Reserve today reiterated it plans to continue what it has been doing and said it would continue to do, much to the chagrin of market participants.

While the last Fed minutes showed more dovishness, actual actions that are indeed ‘dovish’ have yet to occur.  Reducing expected rate increases from 3 to 2 in 2019 was widely interpreted as, ‘the Fed might stop raising rates’, for some reason.  History shows us that the Fed telegraphs well in advance what it intends to do.  Thanks to Alan Greenspan, this has been the case for more than 20 years now.

What has the Fed said it will do in 2019?  Raise rates two more times and continue to drain liquidity from the system via its bond roll-off program.  It is also expected that other nations’ central banks will also cease adding liquidity this year. China may not have gotten the memo though, as they just lower their Reserve Requirement Ratio by 1%, freeing up approximately $100 billion in bank liquidity.  This was announced on Friday, January 4, but was not even mentioned in the Saturday Wall Street Journal!

Here is a picture of global liquidity for 2019.  From adding more than any given year in 2017, to net withdrawal in 2019.   Adjust your expectations accordingly.

qt central bank 10 2018

 

Winter Solstice

They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.

There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S.  All these areas of concern have been with us for most of the year.  I have pointed out the Chinese credit impulse (slowing) more than a few times.  Housing and auto sales have been slowing for months.  The only difference is now there is a market decline and all these issues are being discussed.   If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.

In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth.  Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes.   That gave markets a boost and it was hoped that business investment, and wages would go up as a result.  Well it’s the end of 2018 and were still waiting.

The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2.   There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019.   The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic.   The Fed is in the process (as usual) of raising rates into the beginning of a recession.   Besides the yield curve, there are several other indicators that make recession in 2019 likely.  These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.

As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets.  During the bull market, a 2-4% pullback was common and quickly bought.  Today we see 2-4% intraday moves that continue to fall to hold support.  I expect several more percentage points south before a significant rally in stocks in the first few months of the year.   This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.

It Doesnt Take a Weatherman….

Volatility Continues

2018 is sizing up to be a very volatile year.  Including today, there have been 11 2% down days this year.  There were 0 in 2017, 0 in 2006, and 11 in 2007.

The major indices are currently holding their lows from late October and Thanksgiving week, approximately 2625 on the SP500.  The interim highs were just over 2800, a 6% swing.

The big question of the quarter is if the highs or lows will break first.  Volume today is extremely heavy, so if the markets can close in the top half of todays range, that should bode well for the next few days.

Looking at the big picture, the 200- and 100- day moving averages are flat, the 50 day is sloping downward.  We see the longer term trend is flat while the short term trend is down.  The 50 day and 200 day are at the same level and the 100 day is near 2815.   The averages are clustered together near current prices while the markets intraday are given to large swings in both directions.

Concurrent news topics are the recent good news item of a 90- day trade war truce, and the bad news topics are the problems with Brexit, and the arrest of the vice-chairperson of Huawei, China’s largest cell phone maker.  She is a Party member, daughter of the founder who is also a Party member and has close ties to China’s military.  Maybe not the best person to arrest if one is trying to negotiate a Trade Truce.

My forecast from late 2017 was for large swings in market prices and we have certainly seen this play out.  When compared to past market tops, 2001 and 2007, one can plainly see plus and minus 10% moves as the market tops out then finally breaks down.  Its my opinion that a bear market has likely started, and we have a few opportunities to sell at “high” prices, and get positioned for 2019.

Fundamentally while employment and earnings are good, these are backwards looking indicators.  These are the results of a good economy, not indicators it will persist.  Housing and autos are slowing; defensive stocks are outperforming growth stocks, and forecasts for 2019 earnings range from 0% to 8%, a far cry from 2018’s +20% earnings growth rate.

So, what to do?  Is it more difficult to ‘sell high’ or ‘buy low’?   One is fraught with fears of missing out, the other fears of further declines.   Selling into market strength and perceived ‘resolutions’ to our economic headwinds might be the best bet.  Especially considering the chart below, where in 2019 the global Central Banks will be withdrawing liquidity until further notice, while the Fed insists on raising rates further.

cb balance sheets QT

Market Volatility–October

I believe we’re seeing a large repricing of growth expectations. The one time tax reform boost will wear off into next year, and higher borrowing costs, fuel costs are reducing discretionary income. 

In addition there is a great deal of leverage in the markets which will exacerbate declines. 

Often, at the end of bull markets/beginning of bear markets we will see relatively large price movements, 6-12%, down and up. I believe this correction has a good chance of bottoming or at least slowing in the immediate term, and  it’s bounce back could be half the decline, maybe more, which will be several percentage points. 

 

Focusing on keeping portfolio declines to the single digits while raising cash to be able to redeploy later can aid longer term returns–one has to have cash in order to buy low!   There is a very large amount of ‘bond shorts’ in the market which could set up a large ‘short squeeze’. Bonds were positive today. This is reminiscent of other recent periods when many bond speculators saw bond prices move very rapidly against them (UP) as they rushed to cover their deteriorating short positions.

 

Inflation scare is not the culprit here as inflation rates are slowing in several areas.  Something recent is that with the Fed raising interest rates, the yield, on 1-year and longer bonds is greater than inflation,  a positive “real rate” which is new to this economic cycle and takes a lot away from the ‘bonds dont pay so buy stocks’ argument.  The Fed further reiterated that it currently plans to continue to raise rates through 2019–even though we have already raised rates MORE than in past rate-raising eras.  I will have a chart of this in my Observations and Outlook this weekend.

Please reach out to me with any comments or questions.

 

Adam Waszkowski, CFA

3rd Quarter Update: Earnings, GDP, U.S. Dollar All Higher

Earnings for companies in the S&P500 grew by more than 20% year over year during the second quarter, repeating first quarter’s Tax Reform-boosted performance.  Companies that beat estimates were rewarded, and companies that missed either on guidance or sales were pushed down, but not to the degree we saw in the first quarter.   The increase in earnings has taken the market (SP 500) trailing P/E ratio down from very expensive 24.3 to modestly expensive  22.6.   Sentiment remains constructive with investors mildly positive, but below average bullishness for stocks’ outlook over the next 6 months.

Economic data is coming in mixed.  While GDP for the second quarter (4.1%) came in at the 5th fastest pace over the past 9 years, a large portion of this can be attributed to increased govt spending and the ‘pull-forward’ effect the Trade War tariffs have had on areas affected by increased taxes.   Adjusting GDP for these areas to average still gives a GDP read in the upper 2% range which indicates growth in the second quarter was strong.    The last previous 4% reads were followed by sequentially lower GDP prints over the following year however.

Real wages have stagnated year over year as inflation has increased its pace.  Wages climbed 2.9% while inflation is running at 2.9% year over year.    Wages had been the feared cause of inflation arising from Tax Reform stimulus.   The 70% climb in oil prices, along with healthcare and housing costs and tariffs/taxes being passed along to consumers are the actual drivers over the past 12 months.

As I referred to in my January Observations and Outlook, the US Dollar was destined to climb in 2018 after an incessant decline throughout 2017 (despite many factors that should have supported the greenback).   In January large traders were certain the US Dollar would continue to fall, and European and Emerging stock markets would do at least as well as US stocks.   Now seven months later, indeed the US Dollar has climbed dramatically while most stock markets outside the US are negative year to date.    The strong dollar has also taken its toll on precious and base metals.  Given the price declines abroad (and attendant airtime and print space) and US Dollar rapid increase, pundits are talking about ‘how bad can it get’, and reasons why the US Dollar will continue to strengthen, it may be time to again take the contrarian side of the dollar argument.

Valuations in emerging markets look much more attractive at lower prices, and no one seems to own gold anymore.  Vanguard recently shuttered one of its metals and mining mutual funds.  The price you pay for an asset has a tremendous impact on the return one sees, and currently prices are low.

Observations and Outlook July 2018

July 5, 2018

Selected Index Returns Year to Date/ 2nd Quarter Returns

Dow Jones Industrials    -.73%/1.26%        S&P 500   2.65%/3.43% 

MSCI Europe   -3.23%/-1.27%         Small Cap (Russell 2000)   7.66%/7.75% 

Emerging Mkts -7.68%/-8.66%     High Yld Bonds  .08%/1.0%

US Aggregate Bond -1.7%/-.17%       US Treasury 20+Yr -2.66%/.07%  

Commodity (S&P GSCI) 5.47%/4.09%  

The second quarter ended with a sharp decline from the mid-June highs, with US stock indexes retreating about 4.5% and ex-U. S markets losing upwards of 6%.  This pulled year-to-date returns back close to zero in the broad stock market indexes.  The only areas doing well on a year to date basis are US small cap and the technology sector.  Equity markets outside the US are in the red year to date languishing under the burden of a strengthening US Dollar and the constant threat of a tit-for-tat Trade War.  Areas of the market with exposure to global trade (US large cap, emerging markets, eurozone stocks) have had marginal performances while areas perceived to be somewhat immune to concerns about a Trade War have fared better.

Additionally, the bond market has only recently seen a slight reprieve as interest rates have eased as economic data has consistently come in below expectations—still expanding, but not expanding more rapidly.   Job creation, wage growth, and GDP growth all continue to expand but only at a similar pace that we have seen over the past several years.  The stronger US Dollar has wreaked havoc on emerging market bond indexes have fallen by more than 12% year to date.  And in the U.S., investment grade bond prices have fallen by more than 5% year to date, hit by a double whammy of higher interest rates and a widening credit spread (risk of default vs. US treasuries) has edged up.

On the bright side, per share earnings continue to grow more than 20%, with second quarter earnings expected to climb more than 20%, thanks in large part to the Tax Reform passed late in 2017.    As earnings have climbed and prices remain subdued, the market Price to Earnings ratio (P/E) has fallen making the market appear relatively less expensive and sentiment as measured by the AAII (American Assoc. of Individual Investors) has fallen from near 60% bullish on January 4th to 28% on June 28th, a level equal to the May 3 reading when the February-April correction ended. The Dow is approximately 800 points higher than the May 3 intraday low.

With reduced bullishness, increasing earnings, and expanding (albeit slow) GDP growth, there is room for equities to move up.  Bonds too have a chance for gains.  The meme of Global Synchronized Growth which justified the November-January run in stock prices and interest rates has all but died, given Europe’s frequent economic data misses and Japan’s negative GDP print in the first quarter.   This has taken pressure off interest rates and allowed the US 10-year Treasury yield to fall from a high of 3.11% on May 15 to 2.85% at quarter end.  I would not be surprised to see the 10-year yield fall further in the coming weeks.  Muted economic data with solid earnings growth would be beneficial to bonds and stocks respectively.

In my January Outlook I mentioned how the rise in ex-US stock markets followed closely the decline in the US Dollar.   The Dollar bottomed in late February and has gained dramatically since April.  This has been a weight around European and emerging market share prices and has been at the core of the emerging market debt problems mentioned above.  Fortunately, the Dollar’s climb has lost momentum and appears ready to pull back, likely offering a reprieve to shares priced in currencies other than the US Dollar.  It may also aid in US company earnings. So, while global economic and market conditions have changed since January, hindering prices of most assets, I believe we will see an echo of the 2016-2018 conditions that supported financial asset prices globally.   A declining dollar, muted investor bullishness, slowing global growth all should conspire to allow stock, bond and even precious metal prices to rise over the coming weeks, at least until investor bullishness gets well above average and the expectation of new lows for the US Dollar become entrenched again.

Looking Ahead

As second quarter earnings begin in earnest in mid-July, expectations are for approximately 20% climb in earnings.  A large portion is estimated to be due to tax reform passed late in 2017.  With market prices subdued and earnings climbing, the market’s valuation (Price to Earnings ratio) is looking more attractive.  While not cheap by any metric, this should give investors a reason to put money to work.  In the first quarter, analysts underestimated profits and had raised estimates all the way into the start of earnings season.  This is very rare.  The chart below shows us that generally analysts’ estimates decline going into earnings season.  Estimates start off high and then get lowered multiple times usually.   Second quarter of 2018 is setting up to be another rare event where we see again earnings estimates being raised into reporting season.
factset earnings 7 2018

The downside to the effect tax reform is having on earnings will be seen in 2019.   When comparisons to 2018 and 2019 quarterly earnings start to come out (in late 2018) the impact of lower taxes on the change in earnings will be gone.  In 2019 we will only see the change in earnings without the impact of tax reform.   Earnings growth will likely come down to the upper single digits.   How investors feel about this dramatic slowing in 2019 will dictate the path of stock prices.

Quantitative Tightening (QT) will dominate the headlines towards the end of the year.  Over the past 9 years central banks have pumped more than $12 trillion in liquidity into financial markets.  The US Fed stopped adding liquidity and has begun to let its balance sheet shrink, removing liquidity from financial markets.    During 2017 and 2018 the European Central bank and Bank of Japan more than made up for the US absence.   Europe and Japan are scheduled to reduce and eventually cease all new liquidity injections during 2019.  Combined with the Fed’s liquidity reductions, global financial markets will see a net reduction in liquidity.   This will have an impact on markets.  It is argued whether this will cause bond prices to fall (rates to rise) or it will have an impact on equity markets.   I believe it is likely this will impact both areas and the likelihood of falling bond and stock prices at the same time is significant.

US Dollar liquidity is another topic just starting to show up in the press.   The rise in 2018 of the US Dollar after a long decline has taken many market participants by surprise.  The “short US Dollar” and “short Treasury” trades were the most popular at the beginning of the year and have been upended.  It is often that once ‘everyone’ knows something, like that the US Dollar will continue to weaken, its about the time that area reverses and goes against how most are positioned.   The mystery really was given rising interest rates in the US and a stronger economy, why was the US Dollar weak to begin with?  Now the causes of a stronger Dollar are the weakness in Eurozone and Emerging market growth.    But which came first, the stronger Dollar or the weaker economies?

Below we can see the relationship of the US Dollar (UUP) and the TED Spread which is the difference in short term rates in the US and Europe.  The recent spike in funding costs (rates) parallels the rise in the Dollar index.  The rapid Dollar rise in 2014 was partly responsible for the Earnings Recession we saw in 2015.  There’s about 6 months to a year lag from when the Dollar strengthens to its impact on earnings.

ted spread july 2018

Ironically, part of the Tax Reform passed is a cause of poor Dollar liquidity (higher short-term rates result) and the strengthening Dollar.  The ability for US firms to repatriate earnings from abroad at a lower tax rate is causing Dollars to move from Eurozone back to the US.  Additionally, the $1 trillion plus budget deficit the US will run in 2018 and on into the future is also soaking up liquidity.  Repatriation, US deficits, and Fed tightening are all pushing the US Dollar up, and will likely see the Dollar stronger in 2019, which may impact US earnings in 2019.

Finally, there is China.   China is the largest consumer of raw materials.  Besides US PMI, the China Credit Impulse impacts base metals and other raw materials that other emerging market economies export.  When China is creating more, new credit we can see a rise in prices and in the growth of raw material exporting countries and a rise in US PMI with about a 12-month lag.  The chart below indicates that beyond the first half of 2018 the impact from the past China impulse will be fading.   This fade is happening at the same time global Central banks will be withdrawing liquidity and the US Dollar likely strengthening.   This scenario doesn’t bode well for risk assets in 2019.

china credit impulse pmi

Adam Waszkowski, CFA

April Recap: Narrative Changes

Stocks rose a fraction of a percent, gold fell 1%, and the bond index fell 1% in April, continuing the very choppy sideways price movement we’ve experienced this year.   The month ended just below middle of the price range we’ve seen since the market top on January 26th.

Over the past few weeks, earnings have been spectacular, growing over 20% on an annual basis.  Unfortunately, stock prices have not reacted well to this great news.  Earnings season appears to have a ‘sell the news’ feel to it.  This could support the notion that stocks were priced to perfection going into reporting season.    The decline in prices and increase in earnings has reduced the market P/E (Price to Earnings) multiple, which could allow stocks to rise back to January levels.   Tax Reform has accounted for about 1/2 of the earnings growth.  There are two issues going forward.  One is that continuing

to grow at that pace will be difficult since we cannot cut taxes every year (and the tax changes to individuals are front loaded—the reductions we have seen will fade in the coming years). Secondly, earnings’ growth slowing, even from 20% to maybe 12%, can be seen as a negative: “slowing earnings growth”.   Surprising positive economic data because of tax reform needs to show up immediately, otherwise, the ‘hope’ baked into stock prices may be removed in the coming months.

Through the month of April, the narrative of ‘global synchronized growth’ has changed as European economic data has come in softer than expected and the US economy has pressed on.  So now we see the US as a main driver of global growth.  In the very short term, this narrative change has given the US Dollar a boost up.   Over the past few months, ‘dollar short’ and ‘rates higher’ have been very popular trades and have begun to unravel.   A stronger dollar will do harm to future US corporate earnings, make $-denominated emerging market debt more difficult to pay back, and serve as a headwind to ex-US assets (emerging, Asian and European stocks and bonds).  And slower growth will not support higher rates for longer term bonds.

The change in the growth narrative/data has been substantial enough for the Federal Reserve to remove from its FOMC Statement, “The economic outlook has strengthened in recent months.”   Often the Fed will change a word or two in certain sentences.  They could have change it from ‘strengthened’ to ‘remains strong’ or ‘continues to expand’.  Instead they dropped it altogether.   This is influencing perceptions of how many times more this year the Fed will raise short term rates.  In the WSJ today the front-page headline, “Fed is On Course for Rate Increases”.  Given the boldness of this headline, its odd to see in the article an inference that even if inflation was stronger, the Fed wont raise rates more than already indicated, which is twice more this year.  There is a dichotomy in the Fed’s statement: taking out the growth story but keeping to the idea that rising inflation is OK, or even good.  Last time I checked, slowing growth and rising interest rates weren’t a good combination: stagflation.   The Fed needs to review the difference between ‘cost-push’, and ‘demand-pull’ inflation.

AAII sentiment for the week ending May 2 came out this morning and Bullishness declined, and Bearishness increased.  This is as expected given that stocks were down over those survey days.  Bullishness isn’t quite as low as I’d like to see for a good bottom, but if stocks can undercut February’s lows, we should see Sentiment get negative enough to support a rally in stock prices going into the late Spring.

Adam Waszkowski, CFA