- Weekly Market Preview – All About Inflation This Week
- Political Analysis: 4 Events That Could Cause a Pullback
- Why Did An Analyst Report Cause a Drop in Stocks Last Thursday?
- Fed Takeaways
- Oil Analysis & Outlook
- Weekly Economic Cheat Sheet
Futures are basically unchanged following a relatively quiet weekend of market related news, and after more solid economic data.
Economic numbers from Europe remains good as European inflation firmed slightly (core HICP, their CPI, rose 1.2% yoy vs. (E) 1.1%, while unemployment was 9.1% vs. (E) 9.2%.
Chinese official July manufacturing PMI slightly missed expectations at 51.4 vs. (E) 51.5, but the number remains comfortably above the important 50 level.
Meanwhile, political noise and drama grew ever bigger over the weekend (NK missile launch, White House Chief of Staff change, Russian’s expelling US diplomats, Verbal attacks on China from the administration over North Korea) but from a market standpoint this is all background noise and it won’t move markets despite the headlines.
Today should be a relatively quiet day as there is just one economic report, Pending Home Sales (E: 0.9%), and no notable Fed speakers and the critical economic releases this week don’t start still tomorrow (the Core PCE Price Index). So, absent any easily identifiable catalysts this morning, we’re back to watching the tech sector – as it goes, so goes the market.
Earnings are largely “over” from a market influence standpoint, although there are still some big names to report (AAPL on Tuesday is this week’s highlight).
But the real focus of markets this week will be on economic data and specifically inflation metrics. Tomorrow’s core PCE Price Index (the Fed’s preferred measure of inflation) and Friday’s wage number in the jobs report will be key. Soft numbers will spark a “dovish” sector move, while strong numbers will push reflation sectors and assets higher.
Last Week (Needed Context as We Start a New Week)
Stocks were little changed last week as early gains, powered by strong earnings, were undone by soft earnings and a sharp pullback midday Thursday. That move was caused by a cautious note from a well-respected analyst. The S&P 500 slid 0.02%, and is up 10.42% year to date.
Trading was quiet at the start of last week, as stocks drifted slightly lower Monday despite strong July flash PMIs. Markets rallied on Tuesday following strong blue-chip earnings (the Dow led markets) and stocks were up modestly going into the middle of the week.
Wednesday was a day of digestion, as the FOMC meeting provided no real surprises (balance sheet reduction in September, probably a rate hike in December).
The week saw volatility on Thursday as an early earnings-related rally was undone by a cautious research report from J.P. Morgan quant analyst Marko Kolanovic. The Nasdaq went into mini-freefall midday Thursday, but steadied by the afternoon, and the S&P 500 managed to finish flat after being down nearly 1% intraday.
On Friday, markets opened modestly weaker on soft earnings and on carryover from Thursday’s volatility. Then the soft economic data (ECI) came in and led to a dip in bond yields, as stocks drifted higher to finish with mild losses (essentially flat on the week).
Your Need to Know
Last week was the peak of earnings season, so sector trade was dominated by corporate results. Generally speaking, the numbers were pretty predictable: Sectors that have seen massive YTD outperformance saw selling on decent earnings (SOXX). Conversely, sectors that have massively lagged YTD saw short covering on results (consumer discretionary and energy both outperformed last week). But, nothing in the results in aggregate appear to warrant any tactical sector buying or selling.
The one exception is the Dow Transports, which plunged more than 2% last week on bad UPS and LUV earnings/guidance. We watch Dow Theory closely, so the weakness there caught out attention, but that hasn’t prompted a trend change yet.
So, with earnings behind us, the focus returns to the tech sector, which remains the key to this market. Tech is over-owned and crowded, but fundamentals and momentum remain positive. So, as has been the case for all of 2017, as tech goes, so too goes the market near term. Last Thursday’s midday reversal did look scary for a bit, but by itself it’s not a reason to materially abandon tech allocations (although if you want to lighten up a bit in favor of international exposure, that certainly is understandable and we will likely do that this week. For now, tech (FDN and SOXX) are still in well-defined uptrends.
Is this as good as it gets?
It’s a legitimate question to ask as the macro outlook looks relatively benign (barring one major issue, which we’ll get to). First, Q2 earnings season is largely over and the results were strong, and the 2018 consensus S&P 500 EPS (per FactSet) is $139. That means we’re trading at 17.7X next year’s earnings, historically high (and unsustainable) but that’s where we’ve been all year, so by itself it’s not a reason to sell.
Second, economic data remains uninspiring but it’s not rolling over materially, and the loss of momentum in inflation is making the Fed back off its hawkish rhetoric from earlier in 2017. Longer term this may cause a problem from a “too easy for too long” standpoint, but that won’t result in a near-term correction.
Third, the market has weathered the ever-increasing political soap opera in Washington with impressive resilience. Near term, with Obamacare repeal dead, and tax reform still months away from anything concrete (markets don’t expect action till Q1 2018), as long as Republicans don’t do the unthinkable and either 1) Shut down the government as the controlling party or 2) Have a debt ceiling scare, politics shouldn’t be a major influence on markets (as long as Trump doesn’t fire Mueller or introduce steel tariffs that trigger a trade war).
So, while there’s not a lot to push stocks materially higher, the outlook is at least benign… for now. However, the sense of complacency in the inevitability of a rally is growing, and we’ve seen that in the VIX at record lows, a concern mentioned in a key JPM quant report that took markets down Thursday.
There is a potentially enormous shift occurring over the coming months as 1) The Fed begins to reduce its balance sheet, and 2) The ECB announces the tapering of its QE program.
From a broad sense, if we admit that historical, decade-long easy policy from central banks birthed this current positive set up for markets, then it’s a legitimate concern to wonder how stocks will react once that accommodation begins to be withdrawn.
While the bulls will argue policy will stay very easy for a long time (and that’s true), often times in markets it is the second derivative (the rate of change of change) that moves stock and bond prices.
So, we are left with two concerns: 1) What positive catalyst is looming out there to push stocks materially higher? 2) Why are markets too complacent heading into balance sheet reduction/ECB tapering (i.e. low VIX).
Given this backdrop, we remain cautiously positive on markets and our preference remains towards more defensive sectors: Super-cap tech (FDN/SOXX), healthcare (XLV/IHF/IBB), and international exposure including Europe via HEDJ/EZU and emerging markets via IEMG. Japan also is becoming more attractive via EWJ. We are not adding to the small initial positions we took in our “Reflation” ETFs of KRE, XLI, IWM, TBT and TBF, although we are holding them.
For now, the outlook requires a “steady as she goes” mentality with focus on sector selection, although our eye remains to the macro horizon as we are afraid things are as good as they can get.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
Data has been remarkably consistent the last few weeks, including last week: “OK” but not great economic growth, and consistent signs that inflation is losing momentum. As such, the economic data continues to point to a “Stagnation” set up for stocks and other assets.
Given that inflation trends are more important than growth trends right now, I’ll start with the Quarterly Employment Cost Index, which, like many other inflation indicators in Q2, slightly missed estimates. The Q2 ECI rose 0.5% vs. (E) 0.6, maintaining a 2.4% yoy increase from Q1, but slightly disappointing vs. expectations.
Additionally on Friday, the PCE Price Indices from the Q2 GDP report showed deceleration in the pace of inflation. The PCE Price Index rose just 1% in Q2 vs. (E) 1.2%. Now, none of these inflation statistics are particularly bad. Yet from a policy standpoint, these numbers won’t make the Fed eager to tighten policy ahead of the current schedule (balance sheet reduction in September, rate hike, probably, in December).
Turning to actual growth data, it was “ok” but not great. Q2 GDP met expectations with a 2.6% yoy gain, and that was a true number as Final Sales of Domestic Product (which is GDP less inventories) was also 2.6%. Consumer Spending, or PCE as it’s known in the GDP report, rose 2.8%, again a solid but unspectacular number.
Similarly, June Durable Goods, while a decent report, wasn’t that strong. The headline was a big beat at 6.5% vs. (E) 3.5%, but that was because of one-time airline orders. New Orders for Non-Defense Capital Goods ex-aircraft, the best proxy for corporate spending and investment, was revised higher in May but dipped 0.1% in June. Point being, like most growth data recently, it wasn’t a bad report, but it’s not the kind of strength that will spur a reflationary rally.
Finally, the one economic data point that was strong last week was the July flash manufacturing PMI. It rose to 54.2 vs. (E) 53.2, but while that is a potential positive (it’s a July report so it’s the most current) the PMIs are surveys, and the gap between soft survey data and “hard” economic numbers remains wide.
Turning to the Fed meeting last week, the two takeaways were: 1) The Fed confirmed that they will reduce the balance sheet in September, barring any big economic or inflation surprises. 2) The Fed did slightly downgrade the inflation outlook, but importantly it kept open the option to hike rates at any meeting, and as such a December rate hike is still likely).
Important Economic Data This Week
As stated, inflation is more important than growth data right now, so that means two most important numbers this week will be tomorrow’s Core PCE Price Index (contained in the Personal Income and Outlays report) and Friday’s wage data in the jobs report.
Stocks have rallied since Yellen turned incrementally dovish at her Humphrey-Hawkins testimony, and soft inflation data will further that sentiment and underpin stocks. Conversely, if we see inflation bounce back, that will push bond yields higher and help reflation assets (banks, small caps, inverse bond funds, cyclicals).
But, inflation stats aren’t the only important numbers this week as we get the latest final manufacturing and composite US and global PMIs. They remain important because they will provide anecdotal insight into the pace of the US and global economy. But again, it would be a pretty big surprise if the data suddenly showed slowing in the global economy.
On the flip side, at least for the US, a strong report would be welcome, because strong economic data won’t cause the Fed to get more “hawkish” unless inflation ticks higher.
Commodities, Currencies & Bonds
In Commodities, the segment was mostly higher last week as weakness in the dollar following the Fed announcement buoyed the entire complex, particularly the metals. Energy also surged thanks to inventory draws in the US and bullish developments out of OPEC. The commodity tracking index ETF, DBC, added 3.46% on the week.
Beginning with energy, oil futures posted solid gains last week with WTI gaining 9.19% and making a run at the $50/barrel mark, a level not seen since late May. The headlines to the EIA report were bullish, with both gasoline and oil stockpiles showing another set of declines. Looking overseas, Saudi Arabia announced that they would be cutting their oil exports (not production, however) by 600K bbls to help ease the global glut. Both were bullish developments.
Going back to the EIA, the details were not so optimistic. Lower 48 production rose 35K b/d, bringing the figure to the highest in over two years, above the 9M b/d mark. Bottom line, futures prices are solidly trending higher, and for the time being the benefit of the doubt is with the bulls. Yet it’s hard to imagine oil gaining materially higher in the absence of a slowdown in US production, which leaves us cautious towards this uptrend in oil.
Natural gas futures declined 1.25% last week but finished off the worst levels as a combination of weather reports and bullish inventory data helped fuel a rally Thursday. Natural gas continues to establish a bottom in the mid $2.80s, an area that offers a solid risk/reward set up as both fundamentals and technicals are bullish.
In the metals market, gold rallied 1.64% last week as the net outcome of the Fed Wednesday was that we are in a stagnation period characterized by low inflation and sideways interest rates. Momentum continues to favor the bulls, but the longer-term technical outlook is neutral for gold following the early July breakdown in the 2017 uptrend. New highs above $1300 would turn the technical outlook back in favor of the bulls.
Looking at Currencies and Bonds, the Dollar Index hit new, 52-week lows last week thanks to a dovishly interpreted Fed decision, lackluster inflation data and hawkish rhetoric from ECB officials. The Dollar Index fell 0.6% with all the losses coming Friday.
Looking at last week’s three main catalysts, inflation (or lack thereof) remains the key influence on the currency and bond markets. Last week’s ECB and soft GDP Price Indices resulted in the dollar falling Friday, and that accounted for most of the week’s declines. That soft inflation also is what’s contributing to the Fed backing off its previous hawkish rhetoric. Until we see inflation firming here in the US, the dollar will remain under pressure as other global central banks are becoming, on the margin, less dovish.
Most foreign currencies rose similar amounts vs. the dollar last week, again reinforcing the point that last week’s dollar declines were US-data driven. The euro rose 0.65% aided by some hawkish comments from ECB member Ewald Nowotny, while the pound drifted 0.61% higher into their central bank meeting this week (no change to rates is expected, but there might be hawkish connotations in the inflation report).
Turning to bonds, Treasury yields drifted slightly higher (10 year up 4 basis points) but that was mostly due to an oversold bounce following the steep declines of two weeks ago.
Going forward, Treasury yields remain at the mercy of two main forces: 1) US inflation data and 2) Global bond yields (especially bunds). The former is weighing on yields, but the latter is putting upward pressure on yields. Barring a surprise economic slowdown, we do not anticipate US Treasury yields retesting the 2017 lows of 2.10%.
This week, economic data will be key for the dollar and bond yields, especially the wage number contained in the jobs report on Friday.
Special Reports and Editorial
Cutting Through the Political Noise: 4 Events That Could Actually Cause a Pullback
The political noise and theatre has officially reached a new level, with Russia, pardons, impeachment and other such terms of significant connotation being bandied about in the media seemingly every day. And if we were just reading the media headlines, it would cause someone to go into serious risk-off mode in their portfolio, especially given the tenor of the major news outlets.
But as we and others have been saying all year long, the market has so far successfully insulated itself from all the political drama, as it doesn’t have anything to do with earnings or (as of yet) the economy.
We’ve been consistent in our coverage of the political landscape, and I feel that we’ve done a good job cutting through the distracting noise. Yet given the recent uptick in political fervor across the media (including financial media), I think it’s helpful to identify, clearly, what political events could actually cause a pullback in stocks.
Absent one of four events happening (as it stands right now), politics will remain a distraction, but not a bearish influence. To be clear, we do not think any of these events are likely at this time; however, we are watching for any hints they might become more probable and cause us to reduce risk and equity exposure.
Political Pullback Event #1: Trump Fires Mueller. There are rumors and speculation swirling that President Trump will fire Robert Mueller, the special counsel in charge of the Russian election tampering investigation. So far, he is not expected to fire him, but Trump is unpredictable. If Trump were to do it, that would cause a risk-off move in markets, as everyone would take it as a tacit admission of some guilt on Trump’s part (i.e. fire the investigator before he finds something).
But even if Trump wanted to fire Mueller, he actually can’t. Only the acting Attorney General can fire Mueller. So first, Trump would need to fire Attorney General Sessions, and then the deputy Attorney General (Rosenstein). Then he would keep firing people until he found someone in the Justice Department that would fire Mueller. If this sounds familiar, it should, because that is what Nixon did when he fired Watergate Special Counsel Archibald Cox.
Given that history (rightly or not) people and markets would take the firing as a de facto admission of guilt that the president did something wrong, even if it’s not true. To boot, Congress would likely reappoint Mueller to the same job immediately, resulting in a massive standoff between the executive and legislative branches of the federal government. Nothing here would be positive for stocks, and a “sell first, ask questions later” mood could sweep across the markets.
Political Pullback Event #2: Steel Tariffs. The idea that the Commerce Department could impose sweeping steel tariffs (likely aimed at China) is a potential negative for markets, because it could ignite a trade war, which would be bad for US and global economic growth. Whether steel tariffs would result in retaliation from China or other nations remains to be seen, but the fact is that macro-economic risks would rise, and once again we’d have a “sell first” reaction from stocks.
Political Pullback Event #3: Government Shutdown. The current budget for the operation of the government ends on Sept. 30. Now, the probability of a shutdown remains low because the Republicans control the government. So, they’d literally shut down the government as the majority party a year ahead of elections, a move so politically stupid that it’s almost inconceivable.
However, this is Washington, and right now the budget being advanced through the House contains $1.6 billion in funding for the Mexican border wall, and a lot of cuts to domestic program. So, we can expect united Democratic opposition and (importantly) some moderate Republicans (Collins, McCain) to potentially oppose the budget, which makes passage in the Senate uncertain.
Political Pullback Event #4: Debt Ceiling. We’re getting a lot closer to the mid-October deadline, and there’s been no progress made. Like the government shutdown, political common sense implies this won’t be a problem given it would be politically disastrous for Republicans. Congress has until mid-October to extend the debt ceiling, or face another default drama.
The Fed left rates unchanged and did not alter its balance sheet, as expected. The Fed decision met our “What’s Expected” scenario, as the Fed said balance sheet reduction “relatively soon,” which is Fed speak for September.
To boot, as was also generally expected, the Fed slightly downgraded the outlook for inflation, saying that inflation was running below 2%, as opposed to the previous “running somewhat” below 2%. It’s a minor change that largely reflects the Fed’s recent cautious language on inflation. However, the Fed said that risks to the recovery remained “roughly balanced,” which is Fed speak for “We can hike rates at any meeting.” That last point is important, because risks remaining “roughly balanced” leaves a rate hike in December firmly on the table (Fed fund futures odds have it at 50/50).
Currency and bond markets reacted “dovishly” to the decision, but again that’s due more to a Pavlovian dovish response to any Fed decision rather than an accurate reflection of the Fed yesterday. In reality, the Fed wasn’t materially dovish.
Bottom line, the policy outlook remains the same: The Fed will reduce its balance sheet in September, and likely will hike rates again in December, barring any economic slowdown or further decline in inflation statistics (at which point both events will become less certain). That was the market’s expectation before the Fed meeting Wednesday, and that’s the market expectation after the Fed decision.
EIA Analysis and Oil Update
On the inventory headlines, last week’s EIA report was bullish. While the -7.2M bbl print in oil stocks fell short of the API’s -10.2M, it was much greater than the consensus analyst estimate of -2.6M bbls. The drop in gasoline stocks of -1.0M bbls was largely in line with estimates, but was also seen as bullish, as it was less than the API’s +1.9M bbl build.
The huge 10M bbl draw in crude stocks was the fourth sizeable weekly drop in a row totaling more than 25M barrels, which suggests that refiners are ramping up operations to satisfy the new “real demand” from the East Coast and other “consumer areas.” Digging into the details of the report, there was a shift in the gasoline data in the prior week’s EIA report that showed a significant weekly decline in PADD1 (East Coast) inventories, which is generally seen as “real demand” vs. a draw in PADD3 (Gulf Coast), which can be more a function of refining, production and logistics activities. That bullish trend continued in this week’s report as PADD1 supply was -2.2M bbls.
The production data was bullish at first glance, as total US output fell for the first time in a month with a decline of 19K b/d. That was being paired with bullish industry comments from earlier this week suggesting that US producers are poised to dial down their production growth efforts. The headline was misleading, however, as the drop was due to a sharp pullback in Alaskan production (-54K b/d), and lower 48 production actually rose 35K b/d to break through the 9.0M b/d mark for the first time in over two years.
Bottom line, the near-term trend of falling oil stocks is helping fuel a rally in the energy space; however, the trend of rising US oil production remains relentless. Until that trend begins to show signs of slowing, the upside gains in the energy market will be limited. On the charts, the psychological $50 level will be magnetic, as options’ traders push the market to where the high-volume contracts are (generally round numbers like $50 see higher volumes). Beyond that area, there is significant resistance between $51 and $52/barrel.
Why Did a Research Report Cause a Reversal Thursday?
The most likely “cause” of Thursday’s midday reversal (which frankly looked ugly for an hour or so) was a cautious report from JPM quant analyst Kolanovic, and the reasons it caused a dip are twofold. First, Kolanovic is very respected on the Street, and he was one of the first analysts to correctly identify the role of “Risk Parity” funds in the violent market declines of August 2015. Second, he outright suggested investors hedge equity exposure.
Now, to be clear, it wasn’t a bearish report, as he did note there are strong, positive fundamental factors supporting stocks including a rising economic tide and growing earnings.
However, he made the point that, in his opinion, market volatility is now at an all-time low. The specific accuracy of this claim can be debated, but let’s all agree market volatility is close to, if not at, all-time lows.
The all-time lows in volatility have caused funds to use increasingly leveraged strategies to generate outsized returns. Selling volatility options is one of the simplest leveraged strategies, but the point is this: Quant funds and traders will ratchet-up leverage in low volatility environments to increase returns amidst perceived lower risk. And, since volatility is at or near all-time lows (and has been for some time) these leveraged strategies are both abundant and large.
And, this all-time low volatility and explosion of leveraged strategies is coming right at a time when global central banks are reducing monetary accommodation for the first time in, well, a decade.
So, while the analogy of fireworks sitting on top of a powder keg is a bit over the top, it does illustrate the general idea behind Kolanovic’s caution.
Bottom line, in my opinion, this report by itself isn’t a reason to materially de-risk, as the same argument could have been made about this market over the past few months (as it’s made new highs). But, Kolanovic is a smart guy, so his caution should be noted.
Finally, two anecdotal points. First, I believe what really spooked markets Thursday was Kolanovic referenced this current set up as being similar to “Portfolio Insurance,” a strategy that failed miserably and contributed to the crash of 1987. Obviously, that’s not an uplifting analogy.
Second, for those of us watching the tape yesterday, the mini-freefall we saw in tech and specifically SOXX and FDN, was a bit unnerving. Things steadied, but the pace of the declines midday Thursday was a bit scary. That tells me these are very, very crowded trades, and I am going to have a “think” on potentially lightening up some exposure to that tech sector in favor of shifting it internationally (Europe, Japan, and perhaps emerging markets). Food for thought.
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