Why is the Dollar at New Lows? – Weekly Market Report

Good morning,

What’s in this week’s Report:

  • Why Is The Dollar At New Lows?
  • Tax Cuts – Where Do We Stand?
  • Oil Update
  • Momentum Indicators – More Signs of Weakness
  • Weekly Market Preview (A Lot of Important Numbers Are Coming)
  • Weekly Economic Cheat Sheet

Futures are fractionally lower following a generally quiet weekend for markets, outside of Hurricane Harvey.

Hurricane Harvey caused RBOB gasoline prices to spike to 2 1/2 year highs and pushed oil prices down 1%.  At this point, the economic impact of Harvey remains a local one for commodities markets and the region.  Refined product markets will recover in time, as will the resilient people of Houston.

The biggest non-Harvey story in markets this morning is the dollar, which sunk to a 16 month low while the euro surged to a 2 ½ year high.  The catalysts were two-fold:  Draghi didn’t talk down the euro in his speech Friday, while some traders are selling the dollar thinking Harvey will cause slower US economic growth (it shouldn’t – that’s a stretch).  In our view, neither event was really dollar negative – and these new lows are more a function of low liquidity and volumes more than any dollar negative catalyst over the past two days.

Economically, EU M3 (money supply) missed expectations at 4.8% vs. (E) 5.0%, but that number isn’t moving markets.

Trending News:

Today focus will remain appropriately on the situation in Houston, although there is one notable economic report today: International Trade in Goods (E: -$64.1 Bln).  From a market standpoint, the weak dollar has been mildly positive for US stocks, so if the declines continue, stocks can rally.






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This Week

Economic data will be the focus of markets this week, as there are no notable earnings reports. The Jobs Report Friday, August manufacturing PMI and Core PCE Price Index (Thursday), are the key numbers to watch here in the US.

Internationally, the Chinese PMIs (Wed night, Thursday night) and the flash EU HICP (Thursday) has the potential to move markets as well, if they disappoint vs. expectations.

Last Week (Needed Context as We Start a New Week)

Stocks bounced back a bit last week as the S&P 500 rallied on hopes of tax cuts amidst quiet summer trading conditions. The S&P 500 rose 0.72% last week and is up 9.12% year to date.

With no material economic data or earnings on the calendar last week, political rhetoric and headlines once again filled the news void and created modest volatility.

Tuesday was really the key day last week (markets were flat and boring Monday), as a Politico article implied that Republicans were much more on the same page regarding tax cuts. Remember, the market sell-off from two weeks ago was largely due to the perception that Republican infighting would prevent tax cuts, so this partially reversed that perception and move in the markets. Stocks rallied 1% on Tuesday in response to the article.

Wednesday and Thursday saw some of those gains given back, in part because of President Trump’s threat of a government shutdown at a campaign rally (although to be clear, that remains very, very unlikely).

Staying with politics, on Friday an FT interview with Gary Cohn revealed he considered resigning in the wake of Charlottesville, but while the media made a big deal of it Friday, it’s unlikely to move markets (he clearly said he’s staying, and Trump won’t fire him).

Beyond politics, stocks bounced slightly on Friday thanks to a falling dollar, and in quiet trade, to close with modest gains on the week.

Your Need to Know

Market internals were once again non-controversial last week, as the gains were pretty evenly distributed amongst indices and sectors. To that point, the S&P 500, Dow and Nasdaq all finished up about the same while the Russell 2000 slightly outperformed given.

From a sector standpoint, the gains were oddly uniform: Banks, financials, semiconductors, healthcare and utilities all closed up about 1%. The outlier was consumer staples (XLP), which dropped 1% on weakness in the grocery stocks following AMZN’s announcement it’s cutting Whole Foods’ prices.

The bigger issue from a sector standpoint remains whether we are seeing a rotation out of defensive sectors (which have outperformed YTD) and into cyclicals (which have lagged YTD). Last week provided no real insight into that rotation (which still isn’t happening).

But, we continue to watch for it, as we think getting that “switch” right, if and when it happens, will be the key to outperforming.

Bottom Line

With nothing else to focus on last week (no data, no earnings) markets remained at the whim of political headlines and commentary, but despite the continued uptick in volatility, the general outlook for this market remains the same.

Earnings and economic data have powered this market higher in 2018, and both remain healthy on an absolute level. But, markets always focus on marginal changes, and there are some doubts about the future growth rates of both—and those doubts are being reflected in our momentum indicators (NYSE A/D Line, SOXX, FDN) showing signs of fatigue. Put differently, this is a market that is searching for a new positive catalyst to push stocks higher. And, right now, that search isn’t coming up with anything compelling.

Over the past three weeks, that lack of a discernable positive catalyst combined with an uptick in geopolitical drama (North Korea, Charlottesville) to cause this mild dip in stocks (the S&P 500 is down about 2% from the highs).

Looking forward, the biggest takeaway from the last three weeks for me is that taxes will be a critical issue this fall. If earnings growth and economic acceleration have peaked, then tax cuts are the only identifiable positive catalyst over the next few months. And, given current low expectations, tax cuts (done in 2017) would be a legitimate, positive surprise to stocks because they’d conservatively boost 2018 S&P 500 EPS by $5-$10 (depending on whose research you’re reading).

So, from a research standpoint, we are very focused on getting the tax cut outcome “right” ahead of the street, so we can be positioned accordingly (for either a positive or negative outcome). But, the tax cut process will take time, so for now the bottom line remains that despite some concerning signs from momentum indicators and bond yields, the trend in markets remains higher, and this market’s resilience must be respected.

We continue to advocate more defensive equity allocations—lower beta, higher yield and non-cyclical sectors: Super-cap internet (FDN), healthcare (XLV/IBB/IHF), consumer staples (XLP), utilities (XLU). We also remain bullish on Europe (HEDJ/EZU) despite recent underperformance. Europe is experiencing a potentially rising economic tide (albeit from a lower level), and we think over the medium/longer term that market continues to outperform the US.

Finally, from a tactical standpoint, I’ll again point out that buying September or October puts on the market is, in my opinion, a reasonable move given 1) Strong YTD gains and 2) Low liquidity, low volatility, and the potential for a political, macro or economic surprise over the coming months. This market hasn’t seen a real pullback in nearly two years. If tax cut hopes get smashed, or there is some geopolitical or political shake up, a trap door on the averages could open, similar to August 2015/January 2016… and I just want people to be aware that risk is real.

Economic Data (What You Need to Know in Plain English)

Need to Know Econ from Last Week

There were only two notable economic reports last week, and neither were particularly controversial… and neither did anything to change the current market expectation of 1) High 2% to low 3% GDP growth in Q3, or 2) Fed reduction of the balance sheet in September. Neither data point gave us any incremental color on whether the Fed will hike rates in December, although we’ll get a lot more color on that issue this week.

Looking at the data, the most important number last week was the August flash composite PMIs. The headline number beat at 56 vs. (E) 54.3, but that strong aggregate number hid some pretty significant discrepancies in the details.

The reason the PMIs beat was because of a surge in service companies. Flash service sector PMI rose to 56.9 vs. 54.8. But, the more important manufacturing PMI dropped to 52.5 vs. 53.2 (the manufacturing PMI is just a better reading of activity, so it’s more heavily weighted in the minds of economists).

So, despite the headline beat, this number was actually a disappointment, although I want to be clear that it was not an outright negative (PMIs need to drop below 50 before they imply economic activity is slowing). Bottom line, this is not the type of August reading that would make us think we’re seeing an economic acceleration.

Turning to Durable Goods, they were in line. Yes, the headline reading missed expectations as orders for Durable Goods fell -6.8% vs. (E) -5.8%. But, longer-time readers of this publication know you should ignore the headline as it’s massively skewed by airplane orders. The more important number is New Orders for Non-Defense Capital Goods ex Aircraft (NDCGXA) and it rose 0.4% vs. (E) 0.5%, although June data was revised 0.1% higher, so it was an in-line reading.

Again, we watch NDCGXA because it’s the best proxy for business spending and investment. And, similar to the flash PMI, while the number isn’t an outright negative, it’s not the kind of number that makes us think a broad economic acceleration is coming. Bottom line, both numbers last week implied continued steady, but unspectacular, economic growth, and that’s simply not enough to cause a rising tide and push stocks higher.

Important Economic Data This Week

This will be one of the busiest weeks of the year from an economic data standpoint, and it will come during one of the lowest liquidity weeks of the year… so the potential for data-based volatility this week is high.

The key reports this week (in order of importance) are: Jobs Report (Friday), Personal Income and Outlays (Thursday) and Global Manufacturing PMIs (Thursday night/Friday morning).

The reason those reports are ranked like that is because of inflation. Remember, barring a shockingly week Jobs Report on Friday, nothing is going to stop the Fed from reducing the balance sheet in September.

But, whether they hike rates in December remains uncertain, and the key variable that will decide that is inflation. So, that means that the wage number in Friday’s Jobs Report, and the Core PCE Price Index (the Fed’s preferred measure of inflation, which is contained in the Personal Income and Outlays report) will be the two key numbers this week.

If they run hotter than expected, you will see markets begin to price in the chance of a December rate hike, which would likely be a near-term headwind on stocks as a rate hike is not priced in to bond yields, the dollar or equities.

Turning to measures of economic growth, the August manufacturing PMIs are always important, but again there really shouldn’t be any major surprises here. A firm number in the US that refuted the soft flash PMI from last week would be welcomed as we need better growth to push stocks higher, but really the focus will be on inflation this week.

Looking at the dovish possibilities, we could easily see the data this week push the 10-year Treasury yield to new lows if the inflation data is underwhelming, and we would view that as a negative for stocks broadly.

Bottom line, I know this is a heavy vacation week, but it’s important one for Fed and ECB expectations, and that has the potential to move markets, especially given the precarious technical situation the S&P 500 is sitting in.

Commodities, Currencies & Bonds

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In Commodities, the segment was in aggregate flat last week as the widely held commodity ETF DBC was down fractionally. Oil and energy was volatile last week thanks to inventory data and Hurricane Harvey.

Initially, oil rallied midweek on a larger-than-expected drop in gasoline inventories, and despite continued growth in US production. But, a lot of those gains were undone by the approach of Hurricane Harvey, which resulted in the shut in of refining capacity in the Gulf, a move that will reduce short-term demand for oil.

So, that resulted in a surge in RBOB Gasoline (up about 3% on the week) while oil closed lower (down about 1.2%, but off the lows).

Hurricane Harvey will likely cause more short-term volatility in the energy market and, likely be a short-term net positive. But, any effect of the storm will likely be temporary, and the bigger issue remains rising US production. That is by far the biggest trend in the oil and energy markets over the medium and longer term, and as long as US oil production keeps rising, it will be hard to generate any meaningful upside in oil over the longer term.

Turning to gold, it traded up about 0.5% last week, and gold continues to trade relatively well. Gold surged to just under resistance at $1300 initially on North Korea angst, but while that has subsided, gold has remained firm. Point being, based on geopolitics alone, gold should have gone down over the past two weeks, and it hasn’t. We find that notable.

Going forward, if we see dovish inflation data this week from the PCE Price Index or wage number in the jobs report, gold could break above $1300, and a potentially substantial short squeeze could ensue. For those that are watching it, GLD, GDX and GDXJ remain the easiest way to play a potential rally in gold.

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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.

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Special Reports and Editorial

Political Update: Where Do We Stand on Taxes?

What a difference a few days can make. By Thursday’s close (Aug. 17), the S&P 500 was at a one-month low, and the prospects for any tax cuts or foreign profit repatriation tax holiday were dim.

Now, thanks to one Politico article, happy days are here again, as the S&P 500 surged on the idea that the leaders in Washington are actually making progress on tax cuts! Hopefully, you can sense my sarcasm.

The lack of liquidity and attendance in the market is making these tax-related market mood swings worse than they otherwise should be, so I wanted to step back and provide a clear, unemotional update on the tax cut situation.

Starting with Tuesday’s Politico article, there were two reasons it was positive: The “Big Six,” and 22% to 25%.

Starting with the latter, you know from this publication that right now, the market is expecting a corporate tax cut in Q1 2018 down to 28%. If that happens, it likely isn’t a materially positive or negative catalyst.

However, the Politico article implied consensus was coalescing around a corporate rate between 22% and 25%, obviously less than 28%. If that happens, it will represent a positive catalyst and a boost to corporate earnings, which will send stocks higher.

Now, on to the former. The “Big Six” is apparently the nickname that a key group of Republican leaders have given themselves in regards to tax negotiations. For clarity, the “Big Six” are: Treasury Secretary Mnuchin, National Economic Council Director Cohn, Senate Majority Leader McConnell, Speaker of the House Ryan, House Ways and Means Committee Chair Brady, and Senate Finance Committee Chair Hatch.

The Politico article implied the “Big Six” have been working much closer than previously thought, and that they have made a lot more progress on the structure of tax cuts (although plenty of details remain).

Bottom Line

The noise on this topic is officially deafening, but I want to cut through it and give you some hard takeaways on the outlook for tax cuts and the impact on the market.

1. Expect more tax-related volatility. If January through August is any guide, we can expect the ever-growing Washington soap opera to fully engulf the tax cut issue this fall. Like healthcare, there are multiple moving pieces, a lot of important, TV happy players (I’m not even including Trump), and a lot of pressure—as this is basically the Republicans’ last chance to get any legislative priorities accomplished before focus on the midterms starts in 2018.

2. The outlook for tax cuts wasn’t as bad as it seemed last Thursday, and it’s not as good as it seems right now. The Politico article was positive, but it didn’t contain anything ground breaking. To boot, it appears that substantially controversial issues are being discussed in the tax cut package, including: Capping mortgage interest deductions, eliminating the deduction of state and local taxes against federal, corporate interest deductibility and other issues. These are foundational pieces of the current tax code, and removing them won’t be easy.

3. The sector winners from potential tax cuts remain the same as they’ve been all year: Super-cap tech (on foreign profit repatriation), healthcare (on foreign profit repatriation), retailers (they pay high corporate taxes) and oil and gas (high tax rates). FDN/QQQ, XLV/IBB/IHF, RTH and XLE/XOP are all ETFs that should outperform if taxes surprise to the upside.

4. A prediction: Tax cuts happen in Q1 2018. I’m in the business of generating conclusions and opinions, so I’ll give one about this tax issue. I’d give it about a 65% chance that tax cuts/foreign repatriation holiday gets done by Q1 2018, and about a 50/50 chance those tax cuts positively surprise (i.e. the corporate rate drops below 28%). I do not expect any changes to personal taxes. The reason for this opinion, as I’ve said several times before, is self-preservation. Congressional Republicans are on the ballot in 2018, President Trump is not. If they fail to accomplish anything (no healthcare repeal, no tax cuts) and this Washington soap opera continues, then it’ll be Congressional Republicans who are out of a job. So, they have to get something done if they want to save their jobs. There’s no better predicator of action in Washington than the rule of self-preservation.

FDN and SOXX: Closer to Support

FDN and SOXX both closed lower yesterday (the former falling fractionally while the latter dropped 0.74%).

Now both ETFs, which again have led markets higher for all of 2017, are getting very close to breaking recent lows… and that would be a negative technical signal.

For FDN, a break below support at $96.00 would be a clear, negative signal, while for SOXX, a close below $144.60 would be a fresh two-month low.

Bottom line, the NYSE Advance/Decline line is clearly flashing a warning sign, as it has been over a week (and it’s hitting fresh lows). If SOXX and FDN break to fresh one-month lows, that will reflect a real deterioration in market momentum—and that will make us considerably more nervous in the short term.

For those wanting some near-term protection, September out-of-the-money Nasdaq, S&P 500 or Russell 2000 puts are not the worst idea here, especially if we see SOXX and FDN breakdown further.

EIA Report and Oil Update

Last week’s EIA data was relatively in line with expectations, and the market reacted accordingly with a very choppy and insignificant response. Gasoline stocks did fall more than expected, and as a result RBOB futures outperformed WTI futures, which closed up 1.72% and 1.09%, respectively.

On the headlines, crude oil stocks fell -3.3M bbls vs. (E) -3.1, which also roughly matched the -3.6M bbl draw reported by the API late Tuesday. The change in gasoline supply was the only real surprise in the data print as stockpiles fell -1.2M vs. (E) -500K. And compared to the API, which reported gasoline inventories rose +1.4M bbls, that data point favored the bulls.

The rising trend of lower 48 production remains the most important influence on the energy markets right now, and there was a potential sign of fatigue in that figure as it rose just 12K b/d vs. the 2017 average of 25K b/d. In theory that is a slightly bullish influence, but it is only one report and US output did hit another multi-year high in this most recent release, which is still longer-term bearish. Additionally, Alaskan production continued to stabilize and show signs of turning higher into the fall, as production rose 14K b/d to the highest level since mid-July.

Bottom line, US production continues to trend higher despite a slight pullback in pace last week. And as long as US production is grinding to new multi-year highs, it will be a headwind on the entire complex, and the $50/barrel mark will continue to be a stubborn psychological and technical resistance level for WTI.

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