What’s in this week’s Report:
- Weekly Market Preview (Taxes Are Key This Week)
- Rates Are Rising: When Will the Fed Kill the Rally?
- Are the Dollar and Treasury Yields About to Diverge (If So, that’s Short Term Bullish for Stocks).
- Oil Market Update
- Weekly Economic Cheat Sheet
Futures are very slightly lower as European politics weighs slightly on sentiment.
German election results are being viewed as a mild disappointment as Merkel won a 4th term as Chancellor, but her party did much worse than expected in the Bundestag, endangering any further EU integration. That result is weighing modestly on the euro (down -.4%).
Economically, the German IfO Business Expectations Index slightly missed estimates at 107.4 vs. (E) 107.7 but that’s not moving markets.
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Today there are no notable economic reports but there are three Fed speakers, the most important of which is Dudley at 8:30 a.m. ET. Evans (12:40 p.m. ET) and Kashkari (6:30 p.m. ET) also speak today.
- DUDLEY SEES FED RATE HIKES; INFLATION WEAKNESS ‘FADING’
- EUROPEAN SHARES INCH HIGHER AS MERKEL HANGS ON TO POWER
- NFL players and owners defend anti-American protests as Trump calls for boycott
- Steelers Coach Didn’t Want Army Vet To Stand For Anthem
- National Anthem Protests Put Pressure On Bill To Defund Sports Arenas
From a trading standpoint, banks and “reflation” sectors remain the key. If banks can extend the rally (and tech holds in “ok,”) then this rally can continue.
S&P 500 Futures
U.S. Dollar (DXY)
Focus this week will be on politics and inflation. On Wednesday, Republicans are supposed to unveil a detailed tax cut proposal, so a lack of specifics will again disappoint markets. Additionally, the latest effort to repeal Obamacare faces a Sept. 30 deadline (this is unlikely to pass).
From a data standpoint, the key this week is inflation, as we get the flash EU HICP (their CPI) and the US Core PCE Price Index (the Fed’s preferred measure of inflation) both on Friday.
Last Week (Needed Context as We Start a New Week)
The S&P 500 was virtually unchanged last week after the Fed provided a slightly more “hawkish” decision than expected. The S&P 500 rose 0.08% and is up 11.76% year to date.
Stocks were up very small in quiet trade on Monday and Tuesday, as “pre-Fed paralysis” hit markets. The S&P 500 drifted slightly higher both days amidst little news.
On Wednesday, the Fed decision caused a mid-afternoon decline in stocks as investors reacted to the more-hawkish-than-expected announcement. In reality, the Fed decision almost perfectly met reasonable expectations, and as such the S&P 500 recovered late in the session and closed flat.
Thursday saw some mild selling that erased the marginal early week gains, as investors digested the reality of higher rates. That digestion continued Friday as the markets were again little changed following a slightly underwhelming flash composite PMI. But that number won’t change anyone’s outlook for growth or Fed policy, so it was largely ignored and stocks chopped sideways before closing basically flat on the week.
Your Need to Know
The key takeaway from the internals last week remains the outperformance of our “reflation basket” of cyclical ETFs. At the index level, small caps handily outperformed, rallying more than 1% while tech lagged (Nasdaq declined 0.33%).
On the sector level, banks, industrials, consumer discretionary and energy (more on the potential contrarian opportunity in energy later this week) all outperformed. Conversely, tech (especially super-cap internet), utilities, healthcare and consumer staples (which got hit on the GIS earnings miss) all underperformed.
So, it really was almost a perfect rotation from the sectors that had outperformed all year, and to the sectors that have lagged. Importantly, while last week’s performance did add to the momentum of cyclicals, there were no critical technical signals given that would imply a definitive end to the “defensive” uptrend and “cyclical” downtrend. For now, the dominant trend in defensives remains higher, and cyclicals lower, but again that could be changing soon… and that’s what we’re watching for.
The major issue facing investors right now isn’t macro-oriented, it’s micro-oriented, and it is specifically whether we are seeing (after several head fakes) a lasting important shift in sector leadership, as cyclical sectors (those contained in our reflation basket) have outperformed over the last three weeks.
Determining whether this sector shift is for real is important, because the key to outperforming the S&P 500 in 2017 has been sector selection.
We are wary to declare this shift “for real” given the number of head fakes this year, and as such we’re looking at two key signals that will tell us that it is indeed time to book profits in defensive sectors and rotate into cyclicals.
First, the KBW Bank Index needs to hit new 2017 high (basically close above 100).
Second, the 10-year yield needs to close above 2.40%.
Both of those signals will lead to us recommending medium- and longer-term investors shift exposure out of super-cap tech (FDN), healthcare (XLV/IHF/IBB) and defensive sectors (XLP/XLU) and into our reflation basket of banks (KRE), industrials (XLI), small caps (IWM) and inverse bond ETFs (TBT/TBF).
As we also mentioned last week, for more aggressive/nimble advisors or investors, frankly this move higher in cyclicals looks for real (because it’s being driven by the data), so if you want to be a bit aggressive, rotating some allocations now can be justified—although again, that comes with risks. For shorter-term and more agile advisors and investors, I don’t think you necessarily have to wait for both signals to be elected.
Looking at the macro, the general set up for stocks remains largely unchanged, at least in the near term.
From an economic data standpoint, the numbers need to continue to thread a needle of showing 1) Stable-to-accelerating growth and firming inflation but 2) Not so much growth and acceleration in inflation that it causes global central banks to become materially more hawkish. So far, data has largely done that, and that’s stabilizing the macro outlook and allowing this sector rotation.
From a “what could go wrong” standpoint, the main areas of focus need to be earnings and geopolitics.
Earnings season is fast approaching, and the numbers need to stay firm and show continued earnings growth. As I have said consistently, impressive earnings growth in 2017 has been an unsung hero for this rally, and if earnings growth looks like it’s peaked, investors might begin to book profits, seeing as the S&P 500 is still trading at 18X 2018 earnings.
On the geopolitical front, North Korea remains at the top of the news, but don’t sleep on Iran, either. President Trump needs to certify that Iran is in compliance with the nuclear deal every 90 days, and the next certification date is Oct. 15. If he does not certify, that will raise tensions (good for oil/energy stocks).
Bottom line, while the geopolitical wildcards could cause short-term, risk-off moves, the bottom line is that the macro outlook remains generally “ok” near term. So, the key remains getting this potential sector rotation “right” to maintain 2017 outperformance, and that’s what we’re very focused on doing going forward.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
The most important occurrence last week was that the Fed clearly signaled it still intends to hike rates in December, as long as inflation and economic growth don’t decline further, and that declaration weighed on stocks modestly but boosted reflation-sensitive sectors.
Looking at the Fed meeting, it wasn’t that it was surprisingly hawkish, it wasn’t. In virtually every way, the Fed met consensus expectations. It announced commencement of balance sheet reduction in October, it barely made any changes to the statement (other than referencing the hurricanes), and the “dots” were unchanged for both 2017 (median showing one more hike) and 2018 (median showing three hikes).
Yet as we have cautioned, the market had a somewhat illogically dovish expectation of the Fed, and as such we saw the Fed decision push bond yields and the dollar higher, and weigh modestly on stocks. Now, that dovish expectation has been corrected, as Fed fund futures are pricing in a 70% chance of a rate hike (which is probably about right at this point).
With the Fed confirming that rates are still moving higher, absent a roll over in inflation or growth data, that puts the onus on economic activity to accelerate and avoid a potentially “stagflationary” outcome, and unfortunately the lone piece of notable data last week wasn’t very good.
The September flash manufacturing PMI met expectations at 53.0 (up from 52.5 in August), but the composite number (manufacturing and services) missed estimates at 54.6 vs. 54.9.
Now, to be fair, these are all still strong readings on an absolute level, but the absolute level isn’t as important as the rate of change. Unfortunately, the rate of change in economic growth is not significantly positive (at least not hard economic data).
That is a potential problem, because if the market is going to accept the Fed is hiking rates in December, then we need economic growth to accelerate and create the economic reflation that will push stocks higher.
If that doesn’t happen, we’ve got the Fed hiking into a stagnant growth environment, and that’s not a great scenario for stocks.
Important Economic Data This Week
In many ways, this week is the relative “calm before the storm” of next week, which will contain the final global September PMIs and the September jobs report.
That said, there are a few important numbers we need to watch, primary of which is Friday’s Personal Income and Outlays Report.
The reason this report is important is because it contains the Core PCE Price Index, the Fed’s preferred measure of inflation. If it shows firming similar to what we saw in the recent CPI report, from a stock standpoint it will put more pressure on Treasury yields and the reflation trade, and from a macro standpoint it will put more pressure on economic growth to accelerate.
Away from the Core PCE Price Index, the next notable number is Durable Goods (Wednesday). Remember, while regional PMIs have been very strong, actual hard economic data has not, and we’ve still got a big discrepancy between surveys and real activity. If durable goods bounces, that will be a good sign that actual economic growth is rising to meet the strong survey data.
Outside of those two reports, the next most important event is the Chinese September PMIs, out Thursday and Friday night. Chinese data has been a touch underwhelming lately, but growth expectations haven’t changed. If they do start to be changed lower that could be a surprise headwind on stocks. Bottom line, this week we get more color on the state of inflation and growth, but really, it’s next week’s data that will be the next major economic influence on markets.
Commodities, Currencies & Bonds
In Commodities, there was some notable movement in the space last week, as crude oil traded up to multi-month highs amid OPEC/Non-OPEC policy speculation while both gold and copper fell to multi-month lows in the wake of the Fed announcement midweek. The commodity ETF, DBC, rose 0.52%.
Beginning with energy, there were several moving pieces affecting the oil market last week, but at Friday’s settlement, WTI futures had risen 1.67% for the week and closed above $50/barrel for the first time since May. Traders eyed the OPEC/Non-OPEC producer meeting in Vienna, which ended up being largely a non-event as there were no changes to current output caps.
Despite the lack of development regarding the global production cap deal headed up by Saudi Arabia, the still-depressed US oil production figures since Hurricane Harvey, and slightly higher demand expectations (from the IEA) have been bullish developments. Until US production jumps to new highs (and the average weekly output increase tops 25K b/d per week again) the bid in the market will likely continue. Oil remains largely range-bound between the low $40s and low $50s.
Gold drifted sideways ahead of the Fed before selling off and breaking down through psychological support at $1300 Thursday, as the mildly hawkish Fed was digested. Gold fell 1.74% on the week.
In a similar move to copper, gold has retraced much of its early September rally, but the reason for the pullback was more fundamental as real interest rates have moved higher and made non-yielding safe havens like gold less attractive than something like a 2-year T-Note. The trend in gold is bullish thanks to the recent new highs, but the price action in 2017 is less convincing than industrial metals like copper. Specifically, the new “lower low” in July is a concern on the charts, and because of that we are very cautiously optimistic on gold. And if the reflation trade really takes hold (and rates rise significantly) then gold will decline in the weeks ahead.
Looking at Currencies and Bonds, because the Fed was interpreted as hawkish, that helped push bond yields higher last week, although the Dollar Index was held back by a buoyant euro and strong pound. The Dollar Index rose 0.4% while the 10-year Treasury yield rose 6 basis points to resistance at 2.27%.
The Fed meeting was obviously the key event last week, and it helped to push bond yields higher because, with a 10-year Treasury yield sub 2.20%, the market simply wasn’t pricing in a December rate hike.
Now, with the 10-year yield in the upper 2.20s, that rate hike is at least partially priced in. However, it’s going to take better inflation data or growth data in the US or Europe to help yields move higher.
As such, the Core PCE Price Index and the EU Flash HICP (Friday and Thursday, respectively) are the key numbers to watch this week for bond yields. Remember, though, that while we’ve seen an impressive bounce off the recent lows of 2.03%, we need a break of near-term resistance at 2.27%, and medium-term resistance at 2.40%, before we can declare this downtrend in yields over.
Turning to the dollar, the fundamental news was positive for the greenback this week, but it’s not resulting in any material gains because, on the margin, the ECB and BOE are getting more hawkish too.
To that point, despite the Fed, the euro rallied small last week while the pound saw very mild profit taking following the big run of two weeks ago both on expectations of less accommodative policies. The only major currency that fared badly vs. the dollar this week was the yen, which fell 2% on a risk-off move combined with some dovish comments at the BOJ meeting (this is potentially positive for DXJ).
The bottom may be in for the dollar, but it’s going to take better inflation or growth data to get the dollar to break resistance (currently around the mid-94.00 level). For now, the near-term outlook for the dollar is at best neutral.
Special Reports and Editorial
Is It Time to Allocate to Our “Reflation Basket”?
There’s a simple question that we need to address following the Fed’s hawkishly interpreted announcement: Is it time to rotate out of defensives (super-cap internet, healthcare, utilities, staples) and into cyclicals/reflationary sectors?
I bring that up because Wednesday we saw a classic “reflation rotation.” Tech, utilities and consumer staples (sectors that have outperformed YTD) all lagged the market while cyclical sectors (which have badly underperformed) rose.
Banks surged 1.1%, energy rose 0.35% and industrials rose 0.73%, while consumer discretionary rose 0.34%. Additionally, small caps (which have been laggards YTD but are playing catch up in a hurry, rose 0.35% and the Russell 2000 was again the best-performing major index.
To answer the question of whether we need to rotate, for medium- and longer-term investors, I continue to believe the answer is “no,” although for more aggressive, tactical investors legging into some reflation/cyclical sectors at these levels could make sense.
For the less-nimble investors/advisors, I’m looking for two key indicators to tell me when to rotate into cyclicals.
First, I want to see the bank index ($BKX) hit a new high for the year. That means trading above 99.77, and closing above 99.33 (so call it 100 to make it easy).
Second, I want to see 10-year yields close above 2.40% (currently 2.28%).
If those two signals are elected, then for medium- and longer-term advisors/investors, I would advocate booking (large) profits in healthcare (XLV/IHF/IBB), super-cap internet (FDN), consumer staples (XLP) and utilities (XLU).
And, I would advocate allocating those dollars to our “reflation basket” we introduced earlier this summer: KRE/KBE (bank exposure), XLI (global industrials), IWM (small caps), TBT/TBF (short bonds). And though not for the faint of heart, I might even include XLE/XLB in that mix, although that’s more a strategy based on a wide-ranging bounce in cyclical sectors (energy and basic materials are facing fundamental headwinds).
Again, for those investors who are nimble and can stand some pain, establishing positions now does make some sense. But, for the remainder (again medium– and longer-term investors) I’d wait until those two indicators (BKX and 10-year yield) have been elected.
Regardless, we are witnessing a sea change in the outlook for central bank policy, and that’s going to require more vigilance on the part of advisors and investors, because if the global rate-hike cycle is underway, then the hourglass just got flipped and the sand is now running out on the eight-year bull market.
When Will the Fed Kill the Bull Market? (Or, What is the Neutral Fed Funds Rate?)
A lot of clichés on Wall Street aren’t worth the paper they’re printed on, but one saying I have found to be quite accurate is: Bull Markets Don’t Die From Old Age. It’s the Fed that Kills Them.
At least over the last 20 years, that has largely proven true.
The general script goes like this: First, the Fed starts raising rates because financial conditions have become too easy. In this cycle, rate hikes began in December 2015.
Second, those rate hikes cause the yield curve to invert. That happens as bond investors sell short-term Treasuries and send short-term yields higher (because the Fed is raising short-term rates), and buy longer-dated Treasuries, pushing those yields lower because investors know the rate hikes will eventually cut off economic activity. In this cycle, this process has already started, as the 10s—2s yield spread has fallen from over 2% in late-2017 to fresh, multi-year lows recently at 0.77% (as of Sept. 5).
Third, the inversion of the yield curve is a loud-and-clear “last call” on the bull market. The rally doesn’t end when the curve inverts, but it’s a clear sign that the end is much closer to the beginning. In this cycle, we are not at that inversion step yet, although we are getting uncomfortably close.
Fourth, the Fed keeps hiking rates until economic momentum is halted. During the last two economic downturns (2001/2002 and 2008/2009) the Fed was able to hike rates to 6.5% and 5.25%, respectively, before effectively killing the bull market.
But just as the Fed cuts rates after the economy has bottomed, it also hikes rates after economic growth has stalled. So, it’s reasonable to assume the actual rate which caused the slowdown/bear market is at least 25 to 50 basis points below those levels, so 6% or 6.25% in ’01/’02 and 4.75% or 5% in ’08/’09.
In this cycle, the most important question we can ask is: At what level of rates does the Fed kill the expansion and the rally? That number, which the Fed calls the “neutral” rate (but it’s not really neutral, it’s negative), is thought to be somewhere between 2.5% and 3% this time around (at least according to Fed projections).
However, we’ve never come out of a cycle where we’ve had:
1. Four separate rounds of QE
2. The maintaining of a multi-trillion-dollar balance sheet
3. Eight-plus years of basically 0% interest rates
4. Eight-plus years of sub-3% GDP growth
So, common sense would tell us that this “neutral” Fed funds rate is going to be much, much lower than it’s been in the past.
How much lower remains the critical question (2.5%? 2.0%? 1.5?)
This is really important, because if the answer is 1.5%, we’re going to hit that early next year (it likely isn’t 1.5%, but it may not be much higher).
And, what impact will balance sheet reduction have on this neutral rate?
Again, common sense would tell us that balance sheet reduction makes the neutral rate lower than in the past, because balance sheet reduction is a form of policy tightening that will go on while rates are rising (so it’s a double tightening whammy).
There are two important takeaways from this analysis.
First, while clearly the tone of this analysis is cautious, it’s important to realize that the yield curve has not inverted yet, so we haven’t heard that definitive “last call” on the rally. But, just like at an actual last call, there’s still some time and momentum left afterwards, so an inverted curve is a signal to get ready to reduce exposure, not a signal to do so that minute. None of this analysis contradicts anything I’ve said about a reflation rebound, because we’re dealing with two different time frames.
Second, on a longer-term basis, if the Fed really is serious about hiking rates, then this bull market is coming to an end, and the risk is for it happening sooner rather than later. Because the level at which rates cause a slowdown and kill the bull market is likely to be much, much lower than anything we’ve seen before (unless there is a big uptick in economic activity).
That is why I’ve said we are at a fork in the road in this market, and that the “hourglass” may have finally been flipped on the bull run. Hitting that “Neutral” Fed funds rate Is likely at least a few quarters away (unless things are way worse than we think). So again, this isn’t a call to sell now, but it’s my job to watch for these types of tectonic shifts in the market so that we’re all prepared to act when the time is right.
Are the Dollar and 10-Year Yield About to Diverge?
For all of 2017, the Dollar Index and 10-year Treasury yields have been very highly correlated, as both have fallen together. But over the past few weeks, really starting with the surprise inflation stats from China, we’ve seen a mild divergence. That divergence could get worse over time, and be positive for stocks. More specifically, we could see yields rally while the dollar stays in the low 90s, and the reason is the ECB and BOE.
With the ECB tapering QE and the Bank of England on the verge of a rate hike (whether it’s now or in the next few months), the market will treat every meeting as “live.” That will be a headwind on the Dollar Index, because those two currencies account for nearly 70% of the weighting. Under this scenario, it would take an uptick in growth and inflation data to power the Dollar Index materially higher.
However, the fact that the ECB, BOE and Fed are all at or nearing rate hikes will be a tailwind on US Treasuries, because as German bund and British Gilt yields rise, it will cause European investors who “hid” in Treasuries for the higher yield to rotate back into their native bonds. That, in a nutshell, is why we saw Treasury yields flat yesterday while the Dollar Index gave back almost half of Wednesday’s gains.
From a stock standpoint, this potential outcome could be positive, as rising yields imply accelerating reflation, but the dollar shouldn’t rally too much in the near term, and should not be a headwind on exports or foreign demand.
The wild card for this set up remains data, both in the US and Europe. If US economic data accelerates, then the market will begin to price in more Fed rate hikes, and the dollar will rise. Conversely, if economic data falters in Europe, the euro and pound will drop. But, barring either one of those surprise events, the set up in the currency and bond market (from the viewpoint of stocks) is potentially turning more positive… at least near term.
EIA Analysis and Oil Update
Oil futures were range bound last week, with WTI largely stuck between $49.75 and $50.75. And while the US benchmark did make a new high above $51, futures failed to close above the upper end of that range at least partially thanks to the details of the EIA report (and partially thanks to the dollar).
Beginning with the headlines, oil stockpiles rose 3.0M bbls, which was more than analysts’ expectations (+2.6M) and more than the API Report showed (+1.4M). In the products, gasoline remains the main focus in the wake of Harvey. The print showed an in line -2.1M bbl decline in inventories, yet that was much smaller than the API’s -6.1M bbl draw. On balance, the headlines were slightly bearish as oil rose more than expected and gasoline fell less than estimated.
In the all-important details of the report, domestic oil production continued to rebound following the adverse effects of Hurricane Harvey. Lower 48 production rose 179K b/d, which brings the two-week total increase to 761K; almost all the 783K b/d knocked offline due to Harvey. At first glance, this seems bearish. Yet in reality the market views it as slightly bullish. That’s because, as far as markets are concerned, it is as though US production has been edging lower since late-August. Over the last month, the average weekly output increase fell from 25.5K b/d to 21.8K b/d. That doesn’t seem like much, but annualized, that is over 190,000 barrels per day less than the trend suggested as recently as mid-August.
Looking ahead, it will continue to be important to see whether the rebound continues and if the weekly average increase edges back towards recent levels and total production makes new 2017 highs, or if things continue to level off in the US oil production complex. The former scenario would obviously have bearish implications while the latter would be supportive of a retest of the 2017 highs in the mid-$50s.
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