What’s in This week’s Report:
Three Catalysts and a Wildcard to Watch
Government Shutdown vs. Debt Ceiling – Which is More Important to Stocks?
Market Impact of Hurricane Harvey
Energy Market Update
Futures are trading moderately lower while international shares were mixed o/n due to heightened tensions between North Korea and the US over the weekend.
Economically, Global Composite PMI data were generally inline o/n while Eurozone Retail Sales were slightly underwhelming however focus remained largely on geopolitics.
In M&A News, UTX has agreed to buy COL for $30B.
- NORTH KOREA DETONATES ITS SIXTH AND MOST POWERFUL NUCLEAR TEST YET
- WHAT ENDING DACA WILL MEAN — CONGRESS ALREADY EYEING IMMIGRATION REFORM, OBAMA TO SPEAK OUT — AP: N. KOREA LIKELY ‘READYING LAUNCH OF A BALLISTIC MISSILE,’ MAYBE ICBM — B’DAY: BLAKE HOUNSHELL
- Trump Tweets: ‘Congress, get ready to do your job – DACA!’
- Reuters: China Pledges $80 Million for BRICS as Group Opposes Protectionism
- BREAKING NEWS: Hurricane Irma Strengthens To Category Five
As the abbreviated trading week gets underway, there is one notable economic report to watch: Factory Orders (E: -3.1%), and several Fed speakers: Brainard (7:30 a.m. ET), Kashkari (1:10 p.m. ET), and Kaplan (7:00 p.m. ET).
But, geopolitics continue to be the primary focus of the market and any developments for the worse with North Korea will spur a swift risk-off reaction from investors.
The key news over the weekend was the further escalation of tensions between the US and North Korea. But despite the uptick, foreign markets performed decently well as European markets were down only modestly while Asian markets ex-KOSPI (the Korean market) were mixed. For now, the ominous headlines from the weekend are being at least partially ignored.
Looking at last week’s performance, Stocks bounced back and closed not far from recent all-time highs as good economic data, benign inflation data, and hope for tax cuts pushed stocks higher. The S&P 500 rose 1.37% last week and is up 10.6% year to date.
Stocks exited last week not far from recent highs as decent economic data (ok growth metrics, benign inflation numbers) combined with upbeat tax cut comments by Treasury Secretary Mnuchin overcame more geopolitical worries regarding North Korea. Markets were flat through the early part of last week before they rallied Wednesday, Thursday and Friday to close with solid gains.
3 Catalysts for the Market, Plus a Wildcard to Watch
Ever since I started my career I’ve viewed the post Labor Day time in the market as the “make or break” period of the year—because I’ve found the September-December months provide an inordinate share of both risks and opportunities for portfolios… and I believe this year will be no different.
So, as we start this “stretch run” into the end of the year, the current market set up remains as follows: Stocks have had a great year from a return standpoint, and momentum and the benefit of the doubt remain with the bulls. Yet at the same time, cracks are appearing in this Teflon market, and as such I view the market as being at much more of a tipping point than most analysts.
I believe we will either get the positive catalysts that will send stocks higher between now and year end, or the forces that have powered stocks higher throughout 2017 (earnings growth, momentum) will begin to recede, potentially opening an “air pocket” like we saw in August 2015 and early 2016.
I want to spend time today focusing on the key catalysts that I believe will decide whether the market extends the 2017 gains between now and year end, or whether
we see a pullbac.
But before I go into these catalysts, with regards to the weekend’s news, it goes without saying that a military conflict with North Korea is a near-term bearish gamechanger.
To be clear, I do not think that it will happen, but at the same time the level of tension here is rising considerably. If there is a military strike against North Korea, reducing tactical positions will be prudent, and it’s one reason why I continue to advocate buying puts on the Nasdaq or Russell with September or October expirations.
Away from North Korea, the catalysts that, in our opinion, will make or break 2017 are: Tax cuts, earnings, and the ECB/Fed decisions.
Catalyst 1: Tax Cuts. Why This Matters—It Could Spark Another 5% Rally (Easily). Tax cut disappointment is a risk to the markets, but in reality, the likely market implications for the tax cut issue are either 1) Nothing, or 2) Positive.
I say that for a simple reason… the market is expecting very little in the way of tax cuts (28% corporate rate, foreign profit repatriation). So, it’ll take literally no change to the tax code to really disappoint markets and cause a tax cut related pullback. Conversely, the market has not priced in 25% (or lower) corporate tax rates and aggressive foreign profit repatriation. If that happens, expected 2018 S&P 500 EPS will rise immediately to $145/share (conservatively), which should allow the S&P 500 to rally close to 5% and still not breach 18X 2018 earnings.
Key Dates: There needs to be a formal bill introduced into one of the chambers of Congress by mid-October if we’re going to get something done by early 2018. If there’s no bill by then, look for stocks to be mildly disappointed. If there’s nothing by year end, look for it to be a headwind.
Catalyst 2: Earnings. Why This Matters—It Could Make the Market Too Expensive on a Valuation Basis. The 2017 earnings estimate for the S&P 500 is about $131/share. The 2018 S&P 500 earnings estimate is $140/share. That’s about 7% yoy earnings growth—so that’s accounted for the vast majority of the S&P 500’s 10% YTD return.
But, there are some early signs that the growth rate of earnings is starting to peak. More specifically, a good Q2 earnings season failed to spark much of a rally in the market, so if Q3 earnings disappoint (even a little bit) that could cause some concern about that $140 2018 S&P 500 EPS, and investors might begin to book profits, which could easily snowball given extended valuations.
Key Dates: Oct. 9. That’s the unofficial start of Q3 earnings season (the big banks report that week).
Catalysts 3: Fed/ECB. Why This Matters—The Dollar. The ECB decision on the announcement of tapering (which will come this Thursday), and the Fed’s commentary at the meeting on Sept. 20, will be important for the markets for one main reason—currencies.
The Dollar Index is near multi-year lows on the expectation of ECB tapering, and that’s been an unsung tailwind on the markets so far in 2017. But, if the ECB surprises this Thursday and doesn’t announce its intention to taper QE starting in 2018, the dollar will surge and the euro will drop, and that could be a surprise headwind on U.S. stocks.
Additionally, since July the market has largely convinced itself that the Fed won’t hike rates in December, but it’s important to realize that Fed leadership (Yellen, Dudley, Fisher) haven’t really confirmed that expectation. If economic data gets better between now and then, even with low inflation, the market could have to price in another rate hike, which could also be a near-term headwind.
Key Dates: Sept. 7 (ECB Meeting), Sept. 20 (FOMC meeting).
Wildcard to Watch: Mueller Investigation. Why It Matters—No tax cuts. The media wants to link this investigation with possible impeachment, but that remains incredibly unlikely. Instead, the real threat to markets here is further reduction in the possibility of tax cuts. If there is some bombshell revelation it could cause further division in the GOP, and reduce the chances for tax cuts… and that would be a headwind on stocks.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
Economic data remained unbelievably consistent last week. Inflation continued to underwhelm, “soft” survey-based data (the PMIs) remain very strong, and actual hard economic data remains just “ok.” As such, nothing really changed last week from an economic standpoint. Growth is “ok,” but not enough to cause a “rising tide” in markets while inflation remains stubbornly low, and a December rate hike remains unlikely.
Looking first at inflation data, it was universally disappointing last week. The wage data in the jobs report again slightly missed expectations as wages rose 0.1% m/m vs. (E) 0.2%, and just 2.5% yoy vs. (E) 2.6%. Earlier in the week, the Core PCE Price Index met low expectations, showing a 0.1% m/m rise and rising 1.4% yoy, (again, as expected).
Bottom line, statistically there are just no signs of an acceleration of inflation. We’re not at risk of deflation at this point, but the bottom line is that we’re just not seeing the type of data that implies an economic reflation is taking hold. Practically, the chances of a December rate hike went down last week.
Looking at last week’s growth data, it was a mixed bag. The jobs report was slightly disappointing, as job adds were just 156k vs. (E) 180k while unemployment and wages also slightly underwhelmed. However, the reading in total was nowhere near our “Too Cold” scenario that would make us worry about the labor market.
Still, the soft jobs number was in stark contrast to the very strong August manufacturing PMI, which surged to 58.8 vs. (E) 56.6, and saw New Orders (the leading indicator) stay above 60 (a very strong reading).
Finally, the revised look at Q2 GDP was stronger than expected at 3.0% vs. (E) 2.8%, and the gains were driven by consumer spending (which make this a better-quality 3% than if the gains were driven by something else).
Now, while there were gives and takes, the bottom line is that there isn’t anywhere near enough evidence to imply we’re seeing a broad economic acceleration. Yes, activity is solid, but 1) 3.0% GDP isn’t going to spur stocks to material new highs when they are trading at 17.5X 2018 EPS, and 2) There remains a sizeable gap between “survey” data like the PMI, and “hard” economic numbers like durable goods, retail sales, industrial production, etc. That gap must close if we’re going to see an uptick in economic activity.
Important Economic Data This Week
As is usually the case for the week following the jobs report, this week is pretty quiet from an economic data point, although we do get the all-important ECB meeting on Thursday.
Starting with the ECB, which is the undisputed highlight of the calendar this week, the question for this meeting is simple: Will the ECB announce that starting in 2018, QE will be reduced (or tapered)?
The answer is likely “Yes,” but on Friday there were a couple of press reports that implied that might not be the case. We’ll do an ECB preview in Wednesday’s issue that will detail the potential market reaction depending on the answer to that key ECB question. For now, despite Friday’s rumors, most everyone expects a tapering announcement.
Looking at the economic data this week, most of the key prints are already out. We got the global composite manufacturing PMIs yesterday, and this morning, and we get the US numbers tomorrow morning. However, given the strength in the manufacturing PMI from last week, it would take a shockingly bad number to change anyone’s outlook on US growth. Bottom line, this week is all about the ECB, as that is the first major event of September—and it has the potential to move the dollar, bond yields and stocks.
Commodities, Currencies & Bonds
In Commodities, Commodities were rather volatile last week as Harvey wreaked havoc in the energy complex while economic data and central bank expectations drove price action in the metals. The benchmark commodity tracking index ETF, DBC, rose 2.23% on the week.
Beginning with energy, the typical major influences on the oil market: OPEC and US supply and production data, took a backseat while Hurricane Harvey wreaked havoc on downstream oil industry operations across the Gulf Coast. WTI finished the week down 1.07% but RBOB gasoline futures were the big mover, as they ran up 12.82%. The September contract closed at a two-year-plus high before expiration on Thursday.
What happens next in the energy markets will be all about how quickly the refineries come back online, and when downstream operations are restored to normal. If the damage keeps refineries shut, expect further volatility and notable strength in the refined products while a return to normal operations would be demand-side bullish for oil, and would see the products’ bid unwind.
Additionally, Hurricane Irma is churning towards the US, and if the expected track begins to favor a Gulf landfall, expect speculation bids to come flowing into the energy space again, including natural gas, which traded well last week on the weather-related drama and a less-reported bullish development in supply. Nat gas rose 5.84% to end at a six-week high.
In metals, gold broke out to the highest level since the election, with futures adding 2.58% on the week. Technically speaking, gold is trending higher. Based on the most-recent data, the fundamentals are bullish as interest rates remain near the lows for the year while inflation still is very soft (a bullish scenario for non-yielding safe havens like gold). Copper traded well last week despite the late-week strength in the dollar. Industrial metals continue to paint a rosy picture for the health of the global economy, and that is supportive of continued gains in risk assets like stocks.
Looking at Currencies and Bonds, the Dollar Index hit a fractional new low for 2017 thanks to heavy selling Friday despite the fact that nothing actually dollar negative happened last week. The Dollar Index declined about 0.5%, with all the losses coming Friday.
The catalyst for the dollar weakness Friday was a lack of liquidity more than anything else. Neither Yellen nor Draghi said anything new, but, it was especially Draghi’s comments that sent the euro surging and the dollar dropping… on a Friday in late August at 3:00 p.m. Not exactly the busiest time in the currency markets.
The reason there was a positive euro/negative dollar reaction on Friday was because Draghi didn’t try and “talk down” the euro. We thought this could be a hawkish move, and we were partially right. It wasn’t so much that Draghi was dismissive of the higher euro in his comments. Instead, he just didn’t reference it as a problem, and between that and the lack of liquidity, it sent the euro to new, two-and-a-half-year highs, and the Dollar Index to fresh lows.
But, to be clear, nothing “happened” on Friday that meant a resumption of the euro strength/dollar weakness. That longer-term issue will be decided much more by the data this week and how explicit and aggressive the ECB is in its tapering at its meeting during the first week of September.
Turning to Treasuries, they largely ignored the drama on Friday. The 10-year yield dipped 2 basis points last week and spent the entire week largely churning sideways except for a brief pop above 2.20% following Tuesday’s rally in stocks.
Looking at bonds, whether we see new 2017 lows in the 10-year yield will be dependent on the Fed (whether they hike in December or not) and on tax cuts (if they do pass before year end, the 10-year yield is going to surge). So, until we get more clarity on those issues (which could come this week) expect more sideways churn in yields just above the 2017 lows.
The Dollar Index and 10-year Treasury yield hit fresh 2017 lows last week, but recovered to finish the week little changed. The Dollar Index was basically flat while the 10-year Treasury yield dipped 2 basis points.
The major influence on the currency and bond markets last week was the North Korea rocket launch over Japan. It caused a knee-jerk, risk-off move in currencies and bonds that pushed the dollar below 92.00 and the euro above 1.20 for the first time in 2 1/2 years.
But, just like it’s effect on the stock market, the effect of North Korea on the currency and bond markets was transitory. By the close on Friday, the Dollar Index had recouped all the early losses, and the euro had given back the early week gains. That makes sense, because the major influence on the dollar and euro remains whether the ECB announces tapering of QE this week, and whether the Fed hikes rates in December.
On that topic, there were some headlines Friday that implied the ECB may not announce tapering this week, in part because of the large rally in the euro (the strong euro is a headwind on EU economic growth).
Those reports on Friday were just rumors and innuendo, nothing concrete, but it brings up an important point as we start this week. A tapering announcement is already priced in to the currency markets with the dollar sub-93 and the euro above 1.18. If the ECB delays this tapering, that could easily end the months’ long dollar downtrend (although again, that is not the likely scenario).
Turning to the bond market, the 10-year yield hit 2.09% on the flight to safety following the North Korea news. But yields bounced back, and the 10-year yield closed down only slightly on the week.
Bonds also will move off the ECB this week, but inflation and economic growth remain the bigger influences on the bond market. Until we see upticks in both, bond yields will remain at uncomfortably low levels (especially given what that implies about future economic growth).
Special Reports and Editorial
Shutdown vs. Debt Ceiling
Washington will be at the epicenter of markets in September, and for four reasons: Progress (or lack thereof) on tax cuts, Fed balance sheet reduction, debt ceiling increase and government shutdown. I’ve covered the first two in the ACS, but I haven’t spent a lot of time on the latter two. And, once media coverage moves on from the tragedy of Hurricane Harvey, as it undoubtedly will shortly, it will re-focus on Washington, and specifically the debt ceiling and government shutdown, as both are coming up fast. The shutdown and debt ceiling fight have the potential to cause a pullback in stocks, and both will undoubtedly be referenced by scary headlines on the financial media.
In reality, the chances of either event actually hitting stocks is low, and I want to spend a few minutes to give you the “need to know” on each event, and what needs to happen for either event to push stocks lower.
Deadline Dates: Sept. 30. Why It’s A Potential Problem: The border wall.
What Needs To Happen: Congress must pass a budget by that date or begin to close non-essential government services. Last Time It Happened: 2013. Will It Cause A Pullback? Almost certainly not.
The fight here seems to revolve around Trump’s border wall. The president wants funding for the wall included in the budget, but Democrats have vowed to vote against any budget that includes the border wall. That stalemate could cause a shutdown as Republicans would have to vote as a block to pass the budget over Democrat opposition, and that’s just not something that’s likely to happen. What Likely Happens: Sept. 30 isn’t a hard deadline, as Congress can pass short-term “continuing resolutions” to keep the government funded and open while the negotiations get settled. Probability of a Shutdown: 20%.
Debt Ceiling. Deadline Date(s): Sept. 30, mid-October. Why It’s a Potential Problem: Because it’s Washington, and they can’t do anything easily (at least not so far). What Needs to Happen: Congress must pass a debt limit extension by the deadline. Last Time It Happened: Never.
The government has never failed to raise the debt ceiling, although there was a big scare in 2011 that spooked markets. Will It Cause A Pullback? Almost certainly not. There isn’t any specific issue that could cause the debt ceiling to not be extended, but again, it’s Washington—so nearly anything is possible. What Likely Happens: Of the two issues (government shutdown and debt ceiling) the debt ceiling is the much more serious one, because there isn’t the ability to kick the can down the road like there is with funding the government (i.e. no shortterm extensions). So, I’d expect the debt ceiling will be raised with (relatively) little drama.
Probability of a Default (i.e. not raising the debt ceiling): 15% (and that’s probably a mild over estimation). Bottom line, these two events will dominate headlines in the coming weeks, but a cold, unemotional look at the facts strongly suggest these are not going to be material headwinds on the markets this fall. Progress (or not) on tax cuts, earnings, economic data and geopolitical dramas are the major threats to this 2017 rally as we enter the stretch run into year end.
Hurricane Harvey Market Impact
We got a couple of questions last week from advisors about the market impact of Hurricane Harvey, so we imagined you might be getting similar calls from your clients. So, I wanted to clearly and briefly outline the market impact of the storm.
Macro Impact: Not Much. From a macro standpoint (Fed policy, GDP growth, inflation) Hurricane Harvey won’t have much of an effect. While clearly a significant human tragedy for Houston and Southeast Texas, storms simply don’t have a lasting effect on markets. Katrina and Sandy had impacts on the local economies, but again, the broader macro influence wasn’t big. Harvey does not change our “cautiously positive” stance on markets.
Micro Impact: The more palpable impact of Hurricane Harvey will be on specific market sectors, although I will not provide a list of “winners” given the damage wrought upon Houston and other parts of Texas. That said, companies that likely will see increased demand due to the storm are: Refiners (HFC, DK), trucking companies (KNX), and equipment rental companies (URI). Unfortunately, there’s not a clean ETF for these sectors, and the only tradeable infrastructure ETF is a global ETF, so I don’t think it’s applicable here. Companies that are likely to see business decline because of Harvey are: Natural gas and oil E&P companies due to a lower production and lower prices (ETF is XOP), and insurers. Looking at insurers, the focus needs to be on property and casualty insurers. The big insurance ETF, KIE, is about 42% property and casualty insurance from an allocation standpoint. The ETF traded down 1% last week, but in some ways, I view this as a potential opportunity to buy insurers on a dip (if this continues).
First, P&C insurers are just 40% of the ETF. Yes, there will be more exposure through reinsurance (10.8%) of assets, but that still leaves about half the assets unaffected. Additionally, 24% of the exposure of the fund is to the UK, which clearly should have little exposure to Harvey. Point being, I’m not saying buy it today by any means, but being long insurance companies are like betting with the house in a casino—over the longer term, they always win. If Harvey creates an unreasonable downdraft in KIE, we will likely allocate capital to it for longer-term accounts. We’ll be watching this one going forward.
Energy Market Update (Harvey and the EIA)
It has certainly been a wild ride in the energy markets since Harvey first hit. Last week, the EIA reported weekly inventory numbers, and on balance the data was slightly bullish thanks to a large oil draw and decline in lower 48 production. WTI crude oil prices rallied in response, but soon rolled over, as Harvey remains the most pressing influence on the energy markets. The headlines in the EIA data were mixed, as products were only little changed vs. expectations of modest draws while the headline oil number was bullish with a draw of -5.4M bbls vs. (E) -1.8M bbls. In the details of the report, lower 48 production fell -12K b/d, the first decline since mid-June.
But, the drop was from a two-year high, and was largely expected as the production side of the industry in the Gulf braced for Harvey. The trend of rising US production is still well intact, and long term that remains a considerable headwind on the market from a supply standpoint. The real focus of the energy markets right now remains on Harvey, and the implications for downstream industry operations, most notably refineries. Most experts on the ground are saying it will take another week, minimum, just to get a reasonable assessment of the damage and condition of oil and refining infrastructure. Until that time, traders are fearing the worst and gasoline futures are the biggest beneficiary of the storm’s damage.
Secondarily, WTI is trading heavy as near-term demand has been dramatically reduced by the refinery outages. Yet at some point, the gains in RBOB gasoline futures will be supportive of crude oil, because once back online, refineries will be running at the highest capacity possible to make up for the days (or likely weeks) operations have been down. That spike in physical demand will likely carry over to oil, but only once we gain some clarity on when refining operations will come back online.
So, here are the takeaways: 1) Harvey had a bullish impact on the “crack” or refining spread, which is the relationship between RBOB gasoline futures and WTI crude oil futures (think of it as a currency pair like USD/JPY but RBOB/WTI). 2) The longer refineries are shut, the more that trade will continue to support gasoline price outperformance. 3) The longerterm market fundamentals remain bearish, as lower 48 production is just barely off of 2017 highs and OPEC’s influence has faded substantially. The wildcard to watch will be US production in the coming weeks. It is not likely that Harvey will have had a material impact on upstream operations, but if that turns out to be the case (especially in the Gulf), then longer-term fundamentals could get bullish, as relentless growth in US production finally takes a breather.
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