President Trump continues to the center for market movements, but we believe the markets are adjusting. We have included a several special reports to give you a better understanding of the markets.
What’s in this week’s Report:
- Four Looming Market Catalysts
- Weekly Market Preview
- Weekly Economic Cheat Sheet (Inflation Is the Key)
- Is Earnings Growth Losing Momentum?
- Are Bank Stocks Breaking Out?
- China Trade Update – What Could Go Wrong?
Futures are very slightly higher following a mostly quiet weekend.
The most notable news from the weekend was the passage of UN sanctions on North Korea, which China supported. That move reduced the chances of a trade investigation of China by the US and removes, for now, a potential negative from the market.
Economic data was mixed as Chinese Trade Balance was in-line, while German IP was soft (-1.1.% vs. (E) -0.3%) but neither number is moving markets.
Today focus will be on whether the dollar and Treasury yields can continue the post jobs report rally. If bond yields move higher that could put a mild headwind on stocks.
Economically, it should be a quiet day as there is only one economic report, Consumer Credit (E: 16.0 bln), and two Fed speakers, Bullard (11:45 a.m.) and Kashkari ( 1:25 p.m.). But, barring any shocking surprises, that data and those Fed speakers shouldn’t move markets (Consumer Credit isn’t widely followed and neither Fed speaker is part of leadership).
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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.
S&P 500 Futures
U.S. Dollar (DXY)
Last Week (Needed Context as We Start a New Week)
Stocks were little changed last week, as multiple, conflicting elements of good vs. bad earnings; strong vs. soft data, and hawkish vs. dovish Fed outlooks all ended in a relative stalemate. The S&P 500 edged up 0.19% and is up 10.63% year to date.
Trading started quietly last week, as the S&P 500 was flat Monday amidst little news, and ahead of the first big economic report of the week… the Core PCE Price Index.
That number was released Tuesday, and was in line with expectations. As a result, the S&P 500 drifted 0.24% higher, helped by a good rally in Europe.
It looked like the rally would continue Wednesday given positive AAPL earnings, and dovish comments from Cleveland Fed President Mester. But news that President Trump was close to initiating an investigation into Chinese trade practices (a move that could lead to tariffs) pressured the S&P 500, which closed flat.
Thursday saw a modest decline in stocks thanks to a disappointing ISM Non-Manufacturing PMI, more trade worries (Trump was set to announce the investigation Friday) and a late-day headline that Special Counsel Mueller was assembling a grand jury (although that headline isn’t surprising, as it’s just the next logical step in the investigation). The S&P 500 dipped 0.22%.
Stocks drifted slightly higher Friday, helped by 1) The delay of any China trade investigation, and 2) A generally “Goldilocks” jobs report. The S&P 500 drifted slightly higher despite a rally in Treasury yields and the dollar, and closed up 0.19% on the day, and for the week.
Your Need to Know
Although most of the structurally important companies already released results, there remained a large volume of less-followed names that reported last week, and that largely drove sector trade… with two exceptions.
First, the profit-taking rotation out of tech and into banks continued. Nasdaq again lagged (-0.36%) while banks and financials outperformed (up 2% each). Again, that trend is potentially important because it implies a rotation towards more cyclical leadership, which could be a broader positive for stocks if the BKX can breakout. KRE remains our preferred bank ETF, although KBE also is becoming attractive.
Second, large, multi-national industrials continued to massively outperform. The Dow Industrials rallied 1.2% thanks to strong earnings, and a weaker dollar/rising international tide of growth. If the dollar decline is taking a breather (as Friday might imply) you should see some give back from industrials, although in general the sector remains attractive due to the global recovery.
Almost all the 2017 rally has been earnings and momentum driven, but with growing signs earnings momentum is potentially fading, we’re left with the question of “What’s Next?” to power stocks higher. Expected 2018 S&P 500 EPS has risen from around $133 at the start of the year to $140, and markets have maintained a 17.75ish multiple on stocks. So, that rising earnings number has largely carried stocks higher through political noise and lack luster growth.
But, as we discussed in Friday’s report, there are signs that earnings growth momentum appears to have slowed slightly in Q2. And, if we look past the 1% pop the “Dovish” turn in the Fed provided in early July, we’re left with a broadly stalemated market that’s in need of a catalyst to decide whether this rally can continue, or fade. As we look out over the remainder of 2017, as of right now, we think that catalyst (positive or negative) could come from one of four places:
1. Economic growth. It’s not particularly good, but it’s still consistently showing around 2%-3% GDP growth. If growth stays the same and inflation drops further, it could provide a modest tailwind for stocks near term (basically an extension of the mid-July rally). However, the key to a sustained medium/longer-term rally is a reflation, i.e., economic growth accelerating along with inflation.
2. Tax Cuts. The market still expects some corporate tax cut in early 2018. If that idea is confirmed by Washington this fall, that could be a boost to stocks because 2018 EPS will rise. Conversely, if the market thinks tax cuts are in doubt, that will be a headwind because it removes possible upside from 2018 EPS.
3. Fed Policy. If the Fed stays dovish due to low inflation (as they have since July), that’s a tailwind. However, if the Fed focuses on low unemployment and gets more “hawkish” in tone again, that will pressure the broad markets (we’re going to cover the Fed outlook more in tomorrow’s report).
4. Politics. The market expects both the debt ceiling and budget to be extended, so those two events won’t really be positives (assuming they happen). However, if dysfunction in Washington grows or the Russian investigation takes a surprise turn, it could hit stocks.
Bottom line, currently this is not an environment fraught with risk, but there aren’t a lot of discernable positive catalysts looming, either… especially given valuations and potential earnings trends.
Given that, we remain cautiously positive on stocks and still hold tactical allocations that have worked all year (the “Stagnation” portfolio), including super-cap tech (FDN), healthcare (IHF/IBB/XLV), Europe (HEDJ/EZU) and emerging markets (IEMG).
Looking ahead, the most interesting question now for markets is whether this tech vs. banks rotation continues. KRE remains our preferred way to own banks, although given rising global yields KBE is getting more attractive, too (KBE has more multi-national bank exposure). We are holding the KRE position we bought several weeks ago, but we’ll need to see a breakout before adding to it or KBE.
In sum, this is a market moving towards some sort of resolution (higher or lower). For now, the prudent action remains to simply go along for the ride until we have more color on which way it looks like the break will go.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
Friday’s jobs report caused a mild reversal of the week’s long downtrend in yields and the dollar, but that was more a function of “covering shorts” on the news rather than it was a function of the jobs report being materially hawkish (it met our “Just Right” scenario).
In total, while unemployment dipped further and wages were steady, in aggregate the economic data from last week largely reinforces the “stagnation” outlook for markets (slow-but-steady growth, low inflation).
Starting with the jobs report, as mentioned, it hit the upper end of our “Just Right” scenario. The headline job adds was stronger than expected (209k vs. 178k) while the June revisions were positive (up 9k to 231k).
Meanwhile, unemployment and wages met expectations: 4.3% unemployment and 0.3% wage gains, with a 2.5% yoy increase. In all, it’s a pretty Goldilocks jobs report, as job adds remain strong and the downtrend in wage inflation appears, at least in July, to have stopped.
That’s why we saw the rally in the 10-year Treasury yield and dollar. It wasn’t that the report was hawkish, but it did stop the trend in lower inflation stats. And, with a market as stretched to the downside as the Dollar Index and 10-year yield both are, it caused a snap-back rally.
Importantly, other than potentially making a December rate hike slightly more expected, Friday’s jobs report did nothing to alter the outlook for the Fed (still balance sheet reduction in September).
Looking at the economic data the rest of last week, it was more of the same: Not particularly impressive, but not implying a slowdown, either.
The ISM Manufacturing PMI slightly beat estimates at 56.3 vs. (E) 56.2, and that remained well above the important 50 mark. So, while there was a decline from June, it remains indicative of a manufacturing sector that is seeing growth accelerate.
The one disappointing economic data point last week was the ISM Non-Manufacturing (or service sector) PMI. It declined to 53.9 vs. (E) 56.9, and was the weakest reading since August 2016. However, the private sector Markit Services PMI rose to 54.7 from 54.2, so there is a conflicting message there (ISM is one firm that produces PMIs, and Markit is a competitor. Usually, their PMIs are generally in agreement, but not this month… and it has to do with the survey questions each use and the makeup of the final indices. It’s an oddity that there was a discrepancy, but it’s not an economic red flag (at least not at this point).
Bigger picture, economic growth through June and July appears consistent with the slow-but-steady growth we’ve become accustomed to over the past several years. It’s certainly not a negative for stocks, but it’s not going to create a rising tide that propels us to new highs.
Important Economic Data This Week
As is usually the case for the week following the jobs report and the PMIs, this week will be quieter from an economic data standpoint, although there is a very important report coming this Friday… CPI.
As we’ve said consistently, inflation is much more important right now (because it’s declining) than economic growth (which remains steady), so inflation numbers will have the potential to move markets more than growth numbers, as we saw on Friday with the jobs report.
To that end, Friday’s CPI has the potential to send bond yields and the dollar higher, if it confirms Friday’s wage number that implies inflation steadied in July. Conversely, if the CPI report is soft we’ll see Friday’s rally in bond yields and the dollar undone, quickly.
Outside of CPI Friday (and PPI on Thursday) the next most-important data point this week will be the Productivity and Costs report Wednesday. In Friday’s Report, I listed a number of events that could push stocks higher if earnings growth has peaked near term. Increased productivity was one of those events, so a strong productivity number will be positive for markets.
Beyond those two numbers, the domestic calendar is quiet this week, and none of the reports coming (NFIB Small Business Optimism Index, jobless claims) should move markets too much.
Commodities, Currencies & Bonds
In Commodities, the segment was mostly lower last week as oil prices pulled back from the $50 level, and a rally in the dollar on Friday weighed broadly on the space, especially the metals. The commodity ETF, DBC, fell 0.87% on the week.
Beginning with the precious metals, gold was in focus last week as it rallied to a six-week high on more stagnation money flows and positioning into the July jobs report. But, when the jobs report came in hot and Treasury yields spiked higher, gold came for sale and closed the week down 0.89%.
Technically speaking, the outlook for gold still is tipped in favor of the bears after futures broke down to new lows in early July. And last week’s failure to retest the $1300 level also is less than encouraging. Meanwhile, a potential hawkish shift in Fed policy outlook would be fundamentally bearish for the precious metal. If gold were able to break out through the $1300 level that would be a bullish development, and would have us reconsider our cautious stance.
It was a choppy week in copper, as futures traded in a roughly 5-cent range before closing up a modest 0.28% thanks mostly to the dollar strength on Friday. The outlook for copper remains bullish, and that is a solid indication that sentiment towards the global economy is positive (an encouraging sign for risk assets).
In the energy space, natural gas continued to trade heavy, falling 5.02% on the week as the prospects for weather-driven demand faded as most analysts and meteorologists believe the hottest portion of the summer is already behind us. Looking ahead, natural gas futures will likely continue to drift lower with the next notable support level below at $2.69.
Turning to oil, futures were rather volatile last week; however, by Friday afternoon they had not moved much. WTI finished down 0.54%. The $50 mark is acting as a substantial psychological resistance level right now, as the trend of rising US production and OPEC doubts continue to weigh on sentiment. Until we see US output begin to level off, or a materially bullish development out of overseas producers (such as a sizeable and collaborate cut), it will be hard for WTI to rally meaningfully through the low-to-mid $50s.
Looking at Currencies and Bonds, there were multiple conflicting influences on markets last week, but the net effect is that the downtrend in the dollar and bond yields may have been halted if this week’s CPI is firm. If that is the case, it’s positive for “reflation” sectors such as banks (KRE), small caps (IWM), industrials (XLI) and inverse bond funds (TBT/TBF). The Dollar Index gained 0.6% on the week while 10-year Treasury yield dipped three basis points, but finished off the lows of the week thanks to the big post-jobs-report rally.
Looking at last week’s catalysts, initially the dollar and bond yields were solidly lower on the week following lackluster US economic data (not bad, but not very strong, either), strong EU data and dovish comments by the Fed’s Mester (she lowered her the lowest level she’d tolerate unemployment to 4.75% from 5.0%, which is dovish).
But, those dovish influences (which had the Dollar Index down 0.8% and 10-year yields down 5 basis points by Friday morning), all were reversed by the jobs report. Specifically, as mentioned, it was the drop in unemployment rate to 4.3% and the firm wage number (0.3% m/m) that caused the reversal. Now, to be clear, it wasn’t that those numbers were hawkish, but they did stop the trend in lower inflation stats. And with a market as stretched to the downside as the Dollar Index and 10-year yield, it caused a snap-back rally. Now, whether last week’s rally can extend will depend on Friday’s CPI.
Looking internationally, news was relatively sparse outside of the Bank of England, which issued a “not hawkish” decision last Thursday that sent the pound down 0.7% on the week. However, we don’t see it as a shift in policy, just a correction of the market’s “too hawkish” expectations. We still expect a rate hike from the BOE some time in 2H, 2018.
Bottom line, the major question in the currency and bond markets remains: Will the dollar and the Treasury yield declines reverse? This week could provide an answer via Friday’s CPI… and that will have implications for the stock market.
Special Reports and Editorial
Are Strong Earnings Already Priced In?
Earnings have been an unsung hero of the 2017 rally, but there are some anecdotal signs that strong earnings may already be priced into stocks, leaving a lack of potential positive catalysts given the macro environment.
Now, to be clear, earnings season has been (on the surface) good. From a broad standpoint, the results have pushed expected 2018 S&P 500 EPS slightly higher (to $139) and that’s enough to justify current valuations, taken in the context of a calm macro horizon and still-low bond yields.
However, the market’s reaction to strong earnings is sending some caution throughout the investor community. Specifically, according to BAML, the vast majority of companies who reported a beat on the top line (revenues) and earnings (bottom line) saw virtually no post-earnings rally this quarter. Getting specific, by the published date of the report (early last week) 174 S&P 500 companies had beat on the top and bottom line, yet the average gain for those stocks 24 hours after the announcement was… 0%. They were flat. To boot, five days after the results, on average these 174 companies had underperformed the market!
That’s in stark contrast to the 1.6%, 24-hour gain that companies that beat on the revenues and earnings have enjoyed, on average, since 2000.
In fact, the last time we saw this type of post-earnings/sales beat non-reaction was Q2, 2000. It could be random, but that’s not exactly the best reference point.
So, the question becomes, what will spur even more earnings growth?
Potential answers are a rising tide of economic activity, although that’s not currently happening. Another is a surge in productivity that increases the bottom line. But, productivity growth has been elusive for nearly a decade, and it’s unclear what would suddenly spark a revival. Finally, another candidate is rising inflation that would allow for price and margin increases. Yet as we know, that’s not exactly threatening right now, either.
Bottom line, earnings have been the unsung hero of this market throughout 2017, but this is a, “What have you done for me lately” market, especially at nearly 18X next year’s earnings. If earnings growth begins to slow and we don’t get any uptick in economic growth or pro-growth policies from Washington, then it’s hard to see what will push this market higher beyond just general momentum (which appears to be facing a headwind, at least according to the price action in tech). The trend in stocks is higher, but the environment isn’t as benign as sentiment, the VIX or the financial media would have you believe.
China Trade Update
Last week, we listed four political events that could cause a pullback in stocks, and some movement is occurring on one of the four: Potential steel tariffs on China.
Now, there are no proposed tariffs on China yet, but according to multiple reports, President Trump is considering encouraging US Trade Representative Robert Lighthizer to launch an investigation of Chinese treatment of US corporate intellectual property and general trade practices.
The reason this is important is because Lighthizer might launch the investigation into potential Chinese infractions under the 1974 Trade Act Section 301. The reason that’s important is because if the investigation shows China violated that law, the president has unilateral authority to levy tariffs or impose trade restrictions. This is a potential legitimate first step to tariffs and escalated trade conflict with China.
That notion pressured stocks modestly Wednesday, but some context is needed. And, this is just a potential first step, not a reason to de-risk. Nonetheless, lost in the political soap opera that has been 2017 is the fact that trade has largely been a quiet topic so far in the administration. If that changes, it will be a new headwind on stocks. If this were to go through, multi-national industrials (XLI) and consumer companies (especially large-cap tech) would be the hardest hit.
EIA Analysis and Oil Update
Last week’s EIA report was much less dramatic than those of the past month, as the change in supply levels was much less significant, especially for crude oil. On the headline, crude stocks fell 1.5M bbls, which was less than expected but contradictory to the 1.8M bbl rise reported by the API on Tuesday evening (so, net slightly bullish). Gasoline and Distillate supplies both fell less than the API report, so their influence was less bullish.
Looking to the all-important production numbers, lower 48 production rose another 25K b/d last week to the highest level since mid-July 2015. The fifth-consecutive rise brought the output level in the lower 48 to 9.03M b/d, a total 2017 increase of 789 b/d. Meanwhile, Alaskan production is down 129K b/d so far this year. The reason that’s important is that the pullback in Alaskan output is not unusual for this time of year, and the potential for a rebound in the next two months is relatively high. Such a rebound amid the continued grind higher in lower 48 production would push total US production towards the 10M b/d mark, which would be very bearish for oil.
Bottom line, the oil market is buoyant right now thanks to the recent string of supply declines. However, the overarching supply and demand dynamic has still not turned bullish. With US production continuing its relentless climb; OPEC compliance dropping off, and Saudi Arabia seeming to lose its grip on the cartel, it will take a material catalyst to get oil moving up through the low-to-mid $50s, which will act as a price ceiling near term.
Are Banks About to Break Out?
Banks were a highlight last week, as BKX jumped 2%, which pulled the Financials SPDR (XLF) up 2%. The bank stock strength came despite the decline in yields, which we think is notable. In fact, last week, bank stock performance has decoupled from the daily gyrations of Treasury yields, and we think that potentially signals two important events.
First, it implies bank investors are starting to focus on the value in the sector and on the capital return plans from banks, which could boost total return. Second, it potentially implies that investors aren’t fearing a renewed plunge in Treasury yields (if right, that could be a positive for the markets).
Regardless, this price action in banks is potentially important, because this market must be led higher by either tech or banks/financials. If the former is faltering (and I’m not saying it is), then the latter must assume a leadership role in order for this rally to continue.
This remains a market broadly in search of a catalyst, but absent any news, the path of least resistance remains higher, buoyed by an incrementally dovish Fed, solid earnings growth, and ok (if unimpressive) economic data.
Nonetheless, complacency, represented via a low VIX, remains on the rise, and markets are still stretched by any valuation metric. Barring an uptick in economic growth or inflation, it remains unclear what will power stocks materially higher from here. For now, the trend remains higher.
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