Client Note July 2021

August 5, 2021

July saw another positive month for most US equities.  The S&P500 gained 2.3%, led by growth stocks.  Top sectors were technology, healthcare, and utilities.  A return to growth stocks by investors aided technology shares, while a decline in interest rates gave a lift to utilities.   Energy and value stocks were down on the month, alongside emerging market equities.  And finally, large cap stocks dramatically outperformed small cap stocks. Essentially, it’s a moderate investors market.  The riskiest areas, like small cap and emerging markets, after a stellar start to the year, have been very much sideways the past few months, while the broad indexes continue to grind upward.   Energy is similar in having had a dramatic beginning of the year and now, since early June has been consolidating.   I am optimistic that the areas that have been languishing the past few months are near the end of this consolidation and should see higher prices into the third quarter.

Bond prices have generally risen as interest rates have fallen.  Junk bonds were flat while higher quality bonds saw price gains.  Given the weaker small cap performance and junk bonds underperformance, markets appear in a slightly risk-off mode, even as the major stock indexes continue to climb.  This is generally reflective of the doubt regarding the continued rapid economic growth experienced over the past 12 months.  Riskier stock price stopped going up in March, bond yields peaked in May, and only recently we have gotten worse than expected economic data in a lower revision of Q2 GDP growth and a few misses in employment data.  PMI and ISM indicators are meeting and beating slightly, almost exclusively due to ‘prices paid’ factors.  Higher prices are a positive, even if selling a similar amount of product.

Inflation, on a year over year basis is running “hot”, posting a 5.4% (CPI June). CPI for May was 5%. July is expected to be 5.3%.  There are two key items to remember when looking at inflation data.  The US was only starting to come out of lockdowns last summer (case effects) and the federal government was sending checks to all households (direct stimulus), working and non-working.  This glut of cash has caused serious anomalies in the CPI figures.  Used car prices up almost 100%.  New cars up 7% and travel costs up substantially, from depressed levels.  Today, supply chains and businesses have re-opened to a large extent and there are no more checks forthcoming.  I expect inflation numbers to come down substantially for the remainder of the year, which should support bonds, dividend paying stocks and to a lesser extent, precious metals.

Looking ahead, I maintain my upward bias towards stock prices, with the caveat that we will likely see more volatility, 2-4% weekly variations perhaps.   Interest rates could ease further as economic data comes in slower and slower, as we have now passed the peak growth period.  The US economy will continue to expand, albeit more slowly.   If we could see mid- and small- cap stocks do some catching up, it would give me more confidence that financial markets have more room to the upside, but this has yet to take hold.

Adam Waszkowski, CFA

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Client Note March 2021

April 13, 2021

The first quarter was marked by two distinct phases. The first phase was a continuation of markets climb from the late October early November lows which peaked in mid-February. The second phase was characterized by a distinct outperformance in value or cyclical areas of the market. This is the third instance in the past 16 months where we have seen value outperform growth.  Generally, this does not persist for more than a month or two.

The S&P 500 gained 5.5% during the first quarter while the aggregate bond index fell 3.7%.  Oil gained 26%, aiding the energy sector’s gains of 31% and gold fell by 10%    Corporate bond prices fell by 5.4%. Junk bond prices were unchanged.  This is a slightly odd relationship, but indicative of ‘risk-on’ alongside a rise in interest rates.   The gain in the general stock market and decline in bonds (and gold) left most balanced and multi-asset portfolios flat or in the low single digits.  With energy up, bonds and gold down, and seemingly only the largest companies are carrying the general stock indices higher.

Most recently, gold appears to have formed a “double bottom” in late March and has made slight gains. Stocks continue to grind up, but with the largest names leading.  This contrasts with the period from April 2020 to February where micro- and small-cap stocks dramatically outperformed large stocks.  If we do not see a re-rotation into smaller stocks and those outside the major indices may be the prelude to a larger market pause in the coming months.

Bonds too may have realized a bottom in mid-March as prices have been net sideways.  A bit more improvement in prices (rates lower) should begin a nice rally, giving a reprieve to the general investor who have gained in stock prices, but lost some on bonds, especially for the more conservative.

How could or would interest rates actually decline?  Again, we see in the media how ‘everyone’ knows rates are going higher and inflation is at the door due to either ‘cash on the sidelines’ (doesn’t exist), or bank savings, or ‘pent up demand’.  Once ‘everyone’ knows something its more likely the near-term trend is over or soon will be.  We may already see this in gold and bonds, as interest in these areas is low, while SPACSs and cryptocurrency are all the rage currently.

Inflation concerns are due to the recent and quick rise in rates that have its roots in price increases due to supply-chain problems and the Asian/China resurgence and stimulus.  Supply chains issues will be resolved on their own in short order.  High prices attract businesses to produce more/fix problems which lead to lower prices, the essence of a free market.   Very recent news tells us that China’s credit impulse/stimulus has begun to wane.  The past 10 years we have seen two previous large credit cycles in China.  China is a massive buyer of raw materials and we have seen prices in commodities rise the past year driven by easy money from China.  There is about a 3–6-month lag time until we see the impact of a change   in China’s rate of credit creation.   Given that this China credit data is already 4 months old should mean, as recent price action alludes, a decline in interest rates and commodity prices and thusly, inflation expectations.

While stocks look to have another 5-7% upside momentum, the asset classes that have faired worse recently should see gains alongside stocks.  As mentioned in the past Notes, its post July 4 that concerns me the most when we may see a flattening of economic growth and decline in expectations of rapid growth which can weigh on risk assets.

The reason I am concerned about the second half of the year comes from a few places.  Valuations are exceptionally high right now.  Many metrics are above 1999 levels.  This is commonly discounted due to the low interest rates.  If we are elevated over 1999 levels, how much more elevated should we accept? Another element to today’s market is the ever-present Fed liquidity.  Yes, the Fed could continue as long as there is dollar-denominated debt to liquify.   And finally, there is the current expectations that we are entering a new era of high growth.   Its this last item that is most sensitive to changes in short term economic and Covid data.

The high growth thesis stems from stimulus in the pipeline and the observations that inflation is occurring.   Stimulus, or government infrastructure spending will take years to filter through the economy.  Inflation as measured by the CPI varies greatly, while the PCE is smoother (and what the Fed watches).  One can clearly see the past overshoots of the CPI vs. the PCE, and PCE is trending down.  Once supply chain issues are resolved/lessened and Chinas credit impulse fade, its likely CPI will catch down to PCE.

If inflation expectations come down, while job growth and spending data come in cool, beginning in the next few months, we could see forward expectations and valuations come down, pulling ‘risk assets’ with it.  Add in any kind of Covid 4th wave or failure at herd immunity via vaccinations, we could see the most powerful driver of asset prices, optimism, take a hit; and along with it create a more volatile period for stocks.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note January 2021

February 4, 2021

January 2021 was certainly an intense month.  Not because the markets were wild, but the environment we find ourselves in.   COVID-19 super-spike, insurrection in the Capitol, impeachment, and debate on whether to pass additional relief to our most economically vulnerable filled the news every day.   Despite all this, the S&P, Dow, and Nasdaq all made new all-time highs—and at the same time, I had several people ask me if the market was about to crash.  There’s a lot of cognitive dissonance out there.

After hitting new all-time highs, the S&P500 pulled back into month end to end the month down 1%. Energy was the best performing sector, followed by Telecommunications which just edged out Healthcare, all with positive gains on the month while all other sectors were negative.  My moderate to aggressive portfolios saw just shy of 1% gains while conservative portfolios pulled back by about 1%, weighed down by bonds while gold was flat on the month.

GDP fell almost 4% in 2020 and the hope is that as COVID-19 gets under control with fewer hospitalizations, the economy will rebound strongly.  Longer term interest rates have risen over the past several months with this as the primary driver.   Vaccine doses are being produced at 10.5 million per week and almost 30 million have already been administered.  Very recent data shows cases and hospitalizations beginning to come down from super-peak levels.   If this trend persists, we should see more talk of re-openings and less talk of additional stimulus.  Half the US should be vaccinated by May as production and distribution continue to increase.   The economic activity will increase, stocks may see most of their climb prior to this trend is seen.

Governments and committees make decisions very slowly.   Expect to see a relief package passed by Congress even as COVID-19 numbers decrease, as Congress is reacting to data seen over the past couple of months.   If there is no further stimulus from Congress, and interest rates continue to rise, the Fed will be forced to reduce the $150B+/month its currently injecting into financial markets.  This brings us to a counterintuitive situation come late Spring:  rebounding economy and jobs, but less market intervention/support by the Fed and Congress, which may lead to a weak stock market by mid-year.

In the immediate term, as long as the S&P 500 stays over 3750, this uptrend is intact, and I expect to see a continuance of the trend that started late October.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note December 2020

January 12, 2021

2020, despite a massive pandemic and a severe global recession, central banks, with some fiscal assistance from governments, have managed to keep financial asset prices elevated.  Significant declines in revenues, profits and employment arguably the worst since the 1930’s alongside surging stock index price levels, have conspired to give us the most overvalued market since 1929 or 2000 (some argue “ever”).    How long can this endure?  Depends on when central banks begin to whisper about ‘normalization’.

For 2020, the SP500 gained 18.4%, the aggregate bond index gained 7.5%, and gold gained 26%.  European shares eked out a positive year while the Asian indexes fared very well.  My conservative portfolios gained mid to upper single digits while the average moderate portfolio gained a bit more than 13% on the year.   The pullback in Moderna and precious metals provided a weak end and lackluster start to the year.    The energy sector was the worst sector in the SP500, losing 28% and the tech sector fared the best gaining 48%.  Healthcare and energy are likely to be strong outperformers in 2021.  The addition of TSLA to the SP500 has increased the risk of market volatility. Past observances of new additions to the index show they generally perform worse than prior to their addition.  TSLAs outrageous market value (valued more than the 9 largest global auto makers combined; selling at 28x sales) and the 7th largest company in the index, put the index and any sector it is in at risk of increased volatility.

Gold and gold miners are at risk of starting another correction.  Recent lows at Thanksgiving are being approached.  The rally from late November to January 6 was the largest run up since gold’s consolidation began in August.  However, IF we can hold the longer-term uptrend, upside potential is significant.   Bonds too, are seeing prices under pressure as metals/lumber/agriculture/oil prices’ surge is generating calls of “Inflation!”.   It’s quite early to claim prices are going up due to renewed growth.

Asia came out of the COVID-19 lockdowns much quicker and effectively than western nations.  This re-opening (as a result of very stringent testing/tracing/ and effective lockdowns) allowed those economies to re-stock and re-open driving up demand and prices for raw commodities.   From 2015 to late 2017 base metal prices and oil were moving up quickly.  Cries of inflation were heard then as well.  Inflation never showed up (unless you count 2.1% as INFLATION).  This is due directly to US consumer spending growth, or lack thereof.

Aggregate consumer spending is significantly below trend.    Dig a little deeper and you can see many economic indicators picked up in 2015 through 2017, then rolled over during summer 2018, after the brief impact of tax reform (most of the benefits went to the top where additional money isn’t spent). Current total annual spending was $14.8trillion and growing at 4.2% for the past few years (income at almost the exact same rate).  MOST recently spending has declined the past few months while aggregate income also is declining.  Today we can see the next few months will likely show a spending gap of $1trillion.  A $1trillion gap is almost 7% of total spending and reflects the concurrent GDP output gap and an outright decline in GDP of around 4% year over year.  Looking ahead, the real problem may lie in the US inability to deal with the virus effectively.  Yesterday, an article stated that in Ohio, 50% of nursing home workers are refusing the vaccine.   Layer in low compliance with mask mandates (>70% compliance in order to be effective), and I truly wonder if an end to the virus is, in fact, in the offing.

As a consumer driven economy, the point is, while one can find prices of products higher (or packaging smaller at the same price), we spent a lot less in 2020 and will continue into 2021.  And unless personal spending increases, we should not see a difference in the economy or inflation going forward.  This may bode well for bonds.  TLT the 20-yr treasury bond elf, gained more than 15% in 2020, but has fallen a similar amount off its highs this summer.  Expectations for higher rates may have gotten ahead of itself and we could be near a low in prices.  Layer in the fact that bets against prices are near extremes may indicate the decline in bond prices is nearing an end.

In addition, or perhaps running parallel to the decline in spending is the truly massive amount of people on unemployment insurance.  In 2006, Continuing Claims for unemployment insurance hit a low of 2.35 million.  This began to increase in early 2007 and hit a high of 6.62million in June 2009, after the Great Financial Crisis. By June 2010, this fell to below 4.5million, and continued to decline into October 2018 to 1.65million. Claims remained flat until February 2020.  May 9, 2020 claims hit 24.91million.  And over the past 8 months has receded to only 5.1million.  It was only in November that our current Continuing Claims for Unemployment Insurance fell below the GFR Peak in 2010.  The number and duration of unemployment today has not been seen in the post WWII era.  Fortunately, today, we have unemployment insurance and a Federal Reserve acting to support financial markets (almost perpetually since 2009).

We should not expect any kind of normalization in the economy or improving numbers at least until employment, and thusly spending, improve rapidly.  This is completely dependent upon containing the spread of covid-19.

Due to the length and depth of the declines in spending and employment, the longer-term collateral damage will not be seen until things begin to normalize. Once all the rent and loan deferments, PPP loans, random stimulus checks, and enhanced unemployment benefits disappear we will be able to see the extent of the long -term damage.   Ironically, that knowledge will come at the same time we declare victory over this virus-recession and may be concurrent with a market decline.

In the meantime, let us hope the Fed does not mention ANYthing about tapering the current $120billion per month they are pumping into the financial markets, hoping that the Wealth Effect is more than theory.  So, while prices continue to climb, we will participate and listen intently for any signs the Fed is “confident” enough to reduce the variety of market interventions currently underway.

 

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Give your Portfolio a Non-Correlated Gift this Year!

Adding a non-correlated investment theme to a portfolio may be the perfect holiday present this year to consider.

In addition, ESG type investments have become popular because investors want to know the property they own will have a positive impact on the local community and the broader environment. This allows real estate investments to align with what matters most to investors and their families.

One example, is what McLemore is doing in northern Georgia.  Adhering to a strong ESG program, McLemore and its management team strives to provide a profitable return by balancing the Company’s economic goals with good corporate citizenship:

  • Economic Development Incentives: The Company has worked with local and state officials to secure millions of financial incentives.
  • Employment: The Company is targeting over 1,000 new full-time employment opportunities within Walker County, Georgia.
  • Good Stewardship: The Company has remodeled and rebuilt an existing golf course, which now includes the “Best Finishing Hole in America since 2000” by Golf Digest magazine.
  • Visitors: The Company is attracting many more visitors into Walker County, Georgia, where they can enjoy existing parks and protected wilderness areas, including Cloudland Canyon State Park, the Crockford/Pigeon, Mountain Wilderness Area, and many others.
  • The Company is the owner and operator of the McLemore Community, which is an upscale residential golf community that is in the process of developing a Hilton Curio Collection hotel, resort and conference center as well as other amenities. The McLemore Community sits on approximately 825 acres of real property, is located on Lookout Mountain, Georgia and currently consists of the
    many planned components, click here to view the McLemore Executive Summary Overview Deck 10.28.20.

This blog post nor any links above are a solicitation of securities, that may only be performed by a private placement memorandum.  To view McLemore Due Diligence files, including their Private Placement Memorandum and learn more “How to Invest” type information, click here. This offering is for Accredited Investors only. 

The Positive Impact of ESG Investing

ESG type investments have become popular because investors want to know the property they own will have a positive impact on the local community and the broader environment. This allows real estate investments to align with what matters most to investors and their families.

One example, is what McLemore is doing in northern Georgia.  Adhering to a strong ESG program, McLemore and its management team strives to provide a profitable return by balancing the Company’s economic goals with good corporate citizenship:

  • Economic Development Incentives: The Company has worked with local and state officials to secure millions of financial incentives.
  • Employment: The Company is targeting over 1,000 new full-time employment opportunities within Walker County, Georgia.
  • Good Stewardship: The Company has remodeled and rebuilt an existing golf course, which now includes the “Best Finishing Hole in America since 2000” by Golf Digest magazine.
  • Visitors: The Company is attracting many more visitors into Walker County, Georgia, where they can enjoy existing parks and protected wilderness areas, including Cloudland Canyon State Park, the Crockford/Pigeon, Mountain Wilderness Area, and many others.
  • The Company is the owner and operator of the McLemore Community, which is an upscale residential golf community that is in the process of developing a Hilton Curio Collection hotel, resort and conference center as well as other amenities. The McLemore Community sits on approximately 825 acres of real property, is located on Lookout Mountain, Georgia and currently consists of the
    many planned components, click here to view the McLemore Executive Summary Overview Deck 10.28.20.

This blog post nor any links above are a solicitation of securities, that may only be performed by a private placement memorandum.  To view McLemore Due Diligence files, including their Private Placement Memorandum and learn more “How to Invest” type information, click here. This offering is for Accredited Investors only. 

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

Observations and Outlook April 2018

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.

aaii rolling bulls 4 2018

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.

total employed 4 2018

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.

% change in total employed 4 2018

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.

ted spread and us dollar 4 2018

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.

fredgraph

Adam Waszkowski, CFA

awaszkowski@namcoa.com    239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.