Client Note September 2021

September 30, 2021

Stock markets ended the 3rd quarter of 2021 with a thud as we find ourselves in the middle of a correction. Markets saw the end of a 7-month streak of positive monthly gains.  The SP500 has been up 14 of the last 18 months, and 7 of the last 8.  Looking across asset classes, the SP500 is down 5% for September, and essentially flat on the quarter.  Gold is down 3% on the month, and down almost 1% for the quarter.  The 20yr Treasury bond is down 3.6% on the month and 0% on the quarter.  Small cap US stocks fell less, at -2.9% for September, and -4.3% on the quarter.  Emerging markets lost 3.8% on the month, and -8.6% on the quarter.   This generally flat to negative quarter was anticipated this Spring as economic indicators began to roll over before Q2 was over.  A 7-10% correction should set up a good buying opportunity going into year end.  Year to date gains remain solid.   After this correction completes, I am optimistic for a solid end to the year.

Growth in the economy is still with us, however, at a slower pace than had been hoped for earlier in the year.  Economic data points to a levelling out of growth.  Current GDP, for Q2 2021 is 6.5%, and current expectations for Q3 are just under 5%.  Our real GDP is still a few percent below 2019 levels.  Employment has gained over 2020, but growth in employment has flattened, compared to 2020, as wages rose.  New orders for manufacturing have been level all year after the huge rebound in 2020. 

The levelling off growth, and perhaps the Covid surge in the South this summer, has reduced Consumer Expectations.   The elevated growth compared to 2019 is purely backfilling the Covid recession.  I expect the US to work through the supply chain issues and to add workers at a modest pace over the next year.  Counterintuitively, that may mark the end of this growth cycle as wage pressures and prices decrease, which are dis-inflationary.  That period would be characterized by slowing growth but increasing profits.  That’s still a couple years out though.

Wages were growing at 1% month over month in January 2021, slowed to a negative .43% in March, and picked back up in June at +.43%, and September at +.56%.  Wages are rising at about 5.5% annual rate.  Number of hours worked at 34.7/wk, is the same as it was in January.  2021 is seeing slightly higher hours worked than 2020 (34.6), but much higher than 2019 (34.4).  Finally, the number of employed persons in the US is at 153.15 million.  This is down from 2019 average of 157.62million.  While our population has grown over the past 2 years, there are 4.5 million fewer people working.  What we have is fewer people working a similar number of hours throughout 2021 for higher wages.

If employment and wages continue to gain, we could see persistent inflation.  The core of the current inflation is supply chain issues, simply a lack of goods pushing prices higher.   In addition, the nature of the past recession had a much smaller impact on higher income earners.  There was little displacement of white-collar workers, and thusly, demand for homes and other big-ticket items never receded while factories were idled across the globe.  Prices are higher while less ‘stuff’ is out there, stagflation. Regardless, interest rates have risen and should remain elevated, but may not rise too much further, especially if we see these supply chains get back in line.  The reversal of a trend, like the amount of supply chain chatter in the press, often comes when everyone fully expects the trend to endure.  Don’t be surprised if factories suddenly come back to life early 2022.

How will solid, but slowing growth and tempered interest rates affect the stock market?  Probably in a positive manner.  As long as expectations or hope of increased profits and backfilling the GDP gap from the recession persist, investors will take on risk, and stock prices should climb.   Its when we have ‘fixed’ the last problem AND investors are highly optimistic that actual market risk is around the corner.

Finally, a couple thoughts on the status of Covid 19.  The summer surge we saw in the South and Florida is ending.  Cases and hospitalizations are down dramatically from this recent super peak.  The concern now is for the rest of the country.   Fortunately, a by-product of a Covid surge is that more people get vaccinated and take precautions.  Also, the rest of the country already has a higher level of vaccinations.  While there will be a lot of cases as the weather cools, hospitalizations and deaths should be much lower than we saw in Florida.   As we enter the ‘living with Covid’ era this topic should fade from the headlines.  Schools back in session should allow for more people to go back to work since they wont need childcare as much.  On the other hand, the level of influenza, given we saw almost none last year has scientists concerned that there is lessened resistance to this year’s strains.  Since there is no appetite for large scale closures, anticipate a heightened awareness of flu/covid symptoms and continued efforts to wear masks and social distancing.  If we can have an idea on what to expect, when it happens, it won’t be that much of a disturbance.

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

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Client Note June 2020

As we close June and the first half of 2020, financial markets continue their rebound from the first quarter’s corona-crash.  In very volatile markets there will be many “best/worst X since Y”.  The close at 3100 on the SP500 reflects the best quarter in the sp500 since 1987, with a gain of 19.9%.  After a 36% decline off the all-time high and subsequent 40% gain, puts the SP500 at -4% year to date and -9% below the all-time highs.  Our average moderate portfolio gained almost 15% for the quarter and is up 4% on the year.  While further upside is possible but in the short term, US equity markets are in a downtrend since June 23.  On a larger time, frame, we have downtrends since June 8 and off the highs on February 19thGetting over 3200 should open the door towards 3400+, but if we lose the 3000 level, my medium-term outlook will change.  Our individual stocks continue to do very well.

International equities continue to sorely lag US equities.  European shares gained 2.5% on the month, and currently sit at -14% year to date.  Japan gained 1% and China ebbed 1.6% on the month and both fall well short of the SP500 at -7% and -9%, respectively, year to date.  Emerging markets were the winner on the month at +6% but also have made far less progress recovering post-crash, coming in at     -11% year to date. We sold the last bits of emerging and international equities towards the end of the month.

In credit markets, treasuries have dominated over all other areas of the bond markets.  The long bond/20-yr treasury ebbed by 2.25% during the month, is flat for the quarter and up a massive 20% for 2020.  Even with equivalent maturities, treasuries are outpacing investment grade and junk bonds by 5% and 17%(!) respectively.  The investment grade corporate bond etf, LQD is up 5.1% ytd, while junk bond etf, JNK is -7.7% ytd.   This disparity is due to the rapid credit deterioration seen during this severe recession.  Given this, and spike in covid19 cases, its unlikely rates will rise appreciably in the near term.  Our long treasury position was reduced late March at slightly higher prices.

Economic data released in June continue to show improvement over the April/May shutdown (naturally).    The pace at which the economy would rebound after reopening is a hot topic.  We are seeing rapid improvement in some areas but the estimates versus data are showing extremely poor forecasting ability by economists in the short term.  I am watching year over year data to see how much rebound we are getting.  If July and August data show similar growth as May and June, we could see 90% of more of the economy back by Labor Day.  The trend of economic recovery is far more important than the level.  Ideally, we will trend higher and higher until full recovery.   At the end of July, we will get the first read on GDP for the second quarter.  The Atlanta Fed current estimate has risen to   -36%. 

Looking forward, the recent spike in virus cases has opened the door to the risk that the re-opening of the economy will be slowed, as we are more likely to see county or regional shutdowns.  Continued support from the Fed and continuation of stimulus programs are critical.  A bit higher in equities may provide some momentum to get to 3400 and Fed intervention can keep rates low.

Adam Waszkowski, CFA

Client Note May 2020

June 1, 2020

Like April, equity markets started the month of May off slowly, but over the past 10 days, the S&P500 has gained roughly 4.5% on the month putting it at -5.7% year to date.    International equity indices gained a bit more for the month but continue to lag the U.S. by a wide margin.     Bonds were generally flat, with junk bonds moving up alongside stocks, while a small move up in interest rates pushed the long bond (TLT) down slightly on the month.   Gold moved up almost 3% on the month, after being up almost 4% mid-month.  And our individual stocks continue to do well, enabling our average moderate portfolio to add just over 3.5% for May and for year to date returns approaching 4%.

Looking ahead, it appears investors are pricing the market in expectation of a solid second half recovery and near full economic recovery into 2021.  While investors have bid up prices in anticipation, there is a loooong way to go to recover from the sinkhole we are in.   Current earnings estimates for second quarter are expected to drop 35%, reflecting a full year estimate of around $100/share of the SP500. If that occurs and the expected earnings bounce in Q3 and Q4, we have a forward Price to Earnings ratio of 30x, which is extremely expensive.  We will see earnings in mid-July; first read on GDP at the end of July; and all the while we will see employment numbers each week.   On going jobless claims have now exceeded 20 million, reflecting an unemployment rate a bit under 15%.   Economic data will remain dire.  The hope is that employment and spending figures rebound rapidly in the coming weeks. 

As mentioned last month, the expectations and sentiment that direct short term prices are well ahead of actual improvements in employment or spending (declining).  We have made significant progress in flattening the curve with the virus.  We have seen stock prices climb dramatically alongside the hope of a rapid economic recovery. However, we are seeing an even more stretched disparity between current prices and reality on the ground.  This does keep markets at risk of wide price vacillations.

Attaining and holding 3000 on the SP500 does allow for further upside in the markets and while I rotate out of individual stocks that have lost their ‘mojo’ (or take profits), there is another handful I am tracking and may show up in portfolios in the coming days.  In my April Observations and Outlook, with tongue firmly in cheek, I outlined a path for stocks to 4000 if the Fed continues to add liquidity/monetize debt. Since that writing, the Fed has covered a quarter of that quantity.  The rise in the Fed balance sheet has paralleled a rise in equity prices. The Fed continues to plan for and express willingness to continue its balance sheet expansion in pursuit of its stated mandates: full employment and stable prices.

Prices across virtually all asset classes remain constructive considering Fed actions and optimism towards renewed economic vigor.  State re-openings have occurred, and the expectations are for rapid improvement in employment and spending.  There is a nascent uptick in the outperformance of equal-weighted and value indexes versus the general market.  This market characteristic often shows up at the beginning of economic expansions and longer bull markets.  June’s economic data and market price action should give us a great deal of insight into the remainder of the year.

Adam Waszkowski, CFA

Client Note April 2020

Equity markets moved up strongly in April.  The S&P500 moved up 12%, and currently off 3% from the April 29th intraday high.  Gold jumped early in the month, then flat for a gain of 7% in April.  Long treasury bonds moved up in price by 1% but have been on the wane since April 21st.   Most asset classes have been rangebound (+/-3%) since early to mid-April, reflecting a decrease in market momentum.  The average moderate portfolio gained approximately 9% vs the SP500 gains of 12% in April.  Year to date, through April 30, SP500 is off 9.9% while most portfolios are very close to 0% year to date. 

Economic data continues to come in at extremely negative levels.  Auto sales fell by 45% April 2020 vs April 2019.  China, in February saw a 90% drop.  Current market sentiment is bearish and consumer confidence declined from 101 in February to 71 in April.  This is similar to the decline from February 2007 to June 2008 (the month Fannie and Freddie’s first attempted bailout, after losing 50% of their value that month), which saw a decline of 35%.  This could be another reflection on how this recession is being ‘front-loaded’.   We have seen already how GDP and employment has fallen as much as the entire 2008 Great Financial Crisis, but now expect robust rebound by year end.

In light of all this, equity markets have remained buoyant, after the March decline.  This may further indicate the front-loaded- ‘ness’ of this economic period.  And at the root of it all is the expectation that the economy will rebound strongly in the second half and especially in the 4th quarter of 2020.  While GDP estimates for Q2, which will come out at the end of July, range from -10% to -30% (annualized basis), some estimates for Q4 are as high as +20%.    I believe that we are again priced for perfection.  The past few years saw valuations (price to earnings, price to sales, etc.) elevated with expectations of an acceleration in earnings and wages to justify the then-current prices.  Today a significant economic rebound is priced into the market.   If the economy in late May and June isn’t picking up quickly enough it could put pressure on equity prices.  It depends on re-opening the economy and that depends on subduing the pandemic.

We have seen momentum decline recently and thus increases the potential for volatility in equity markets.  If the S&P500 cannot breakout above 3000 in the near term, we’re likely to remain rangebound vacillating +/- 6%.  Bonds and gold are at a point where they are testing support and have the potential to move several percent as well.  If we are to remain rangebound, my preference would be to reduce risk until there is more confidence in further upside.

On a side note, I have significantly reduced the amount of cable and national news I watch on TV.  It’s the same sad and fearful story we’ve heard the past 6 weeks.  I have noticed I feel better doing this.  A client went back north recently and was surprised/disheartened at the difference in the local news in Naples vs the local news in the tri-state area.  Avoiding the bad news TV and enjoying the good news of spending time with family/projects/hobbies/exercise can be an important factor in getting through this time and being ready to embrace the other side of this crisis.

Stay safe and thank you,

Adam Waszkowski, CFA

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.

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

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

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