Why Last Week’s Price Action Was Worse Than It Seemed

Good morning,

What’s in this week’s Report:

  • Why Last Week’s Price Action Was Worse Than It Seemed
  • ECB Meeting Takeaways (It Was Slightly Hawkish)
  • Why The Debt Ceiling Deal Isn’t a Positive For Stocks
  • Weekly Market Preview
  • Weekly Economic Cheat Sheet

Futures are sharply higher this morning after Hurricane Irma dealt a “not as bad as feared” blow to Florida, while North Korea didn’t perform a missile test over the weekend.

Hurricane Irma didn’t make a direct hit on Miami/Ft. Lauderdale and as such the insurance stocks are rallying, and that’s leading the market higher.

Geo-politically, it was feared that North Korea could launch an ICBM test this weekend, but they held a parade instead.

Today there are no notable economic reports and no Fed speakers, so focus will be on the financials.  That sector (XLF and BKX) needs to rally throughout the day.  If the rally in financials stalls after the open, the market could give these early gains back.

Turning to Hurricane Irma, first, thank you for the well wishes we received ahead of the storm!

It appears we “dodged a bullet” down here in Palm Beach County but the report was written under less than ideal circumstances, so please excuse typos, etc.  Additionally, there is still damage and clean up to be done so our response to email, etc. will be slower than normal today.  But, assuming our offices did not sustain damage, I do expect us to be back to full strength tomorrow.






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This Week

Economic data on Thursday and Friday (CPI/Retail Sales/IP) will be the focus of the week, although there are a few other notable events. First, we get the latest Chinese economic data (also on Thursday). Additionally, AAPL unveils a new iPhone on Tuesday. Finally, concerns remain that North Korea could test another ICBM, potentially spiking geopolitical concerns again.

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

Stocks dropped modestly last week thanks to an uptick in political drama, and new lows in the dollar and Treasury yields. The S&P 500 fell 0.61% and is up 9.94% year to date.

Stocks started the holiday-shortened week lower, as the S&P 500 dropped 0.76% last Tuesday following the North Korea hydrogen bomb test.

Markets bounced back slightly as the S&P 500 rose 0.13% Wednesday after a temporary deal was reached to extend the debt ceiling and avoid a government shutdown. Markets digested those moves on Thursday as the S&P 500 was flat after Tuesday’s lows, as hurricane-related economic worries were offset by a lower dollar.

The S&P 500 resumed its decline on Friday thanks to extreme weakness in the banks and financials. The S&P 500 fell 0.15% to end the week with modest losses.

Your Need to Know

The near-4% collapse in bank stocks and near-3% plunge in financials was the story in the markets last week, and it’s potentially very important for two reasons.

First, banks and financials collapsed because of the decline in bond yields and the flattening yield curve, and those signals historically imply future economic slowing.

Second, if we are going to see an economic reflation, which is what we should be seeing in the economy at this point, then banks and financials should lead the market higher. We got a whiff of that earlier this summer, but that now has failed spectacularly, and it’s left this market again relying on defensive sector leadership, which is not what we want to see if we’re hoping for an economic acceleration. I view this breakdown in financials and banks as a potentially very bad sign for reflation prospects.

Bottom line

The price action and events of last week were actually more negative than the 0.61% decline in the S&P 500 would imply.

First, the price action in bonds and the yield curve is becoming downright unnerving, because they are signaling continued slow growth or, potentially, something worse.

Second, the collapse in financials again leaves this market without a cyclical sector leader, and that’s worrisome given valuations.

Third, politics got worse this week. The three-month debt ceiling extension only sets up a bigger drama in December, and it potentially reduces the chances of tax reform at year end. Additionally, there are multiple reports of a fractured relationship between Gary Cohn and President Trump. If Cohn leaves, the market will view that as a negative for tax cuts, and that will potentially remove one of the few positive catalysts for stocks this fall (leaving continued earnings growth as the only identifiable positive catalyst).

So, while the S&P 500 only saw modest declines, I view last week as a pretty bad week. From an allocation standpoint, the events of last week are not enough to make me raise cash or de-risk, but it does reinforce my preference to allocate to defensive sectors such as FDN, XLV, XLP, XLU, and also international equities such as emerging markets via IEMG and Europe via HEDJ and EZU.

But, we are holding allocations out of respect for the uptrend that’s been in place since early 2016. Staying the course and holding longs in this market through potential trouble has been the right move for two years, and I don’t see enough on the horizon to change that, yet. Though to be clear, my sense of concern is rising, and I do still advocate Sept./Oct. Nasdaq or Russell puts to protect YTD gains against a surprise “air pocket.”

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

Need to Know Econ from Last Week

The economic data remains remarkably consistent: Growth data remains good but not great while inflation data relentlessly disappoints. From a market standpoint, that means that the economy isn’t at imminent risk of a material loss of momentum, but at the same time there are no signs of the type of acceleration that would lead to a rising tide carrying stocks higher.

From a Fed standpoint, inflation remains lackluster, and that’s causing a reduction in expectations for a December rate hike. That’s not a medium/longer-term good thing for stocks, because it further throws into doubt the chances for reflation—and economic reflation remains the key to sustainably higher stock prices.

Looking at last week’s data, there weren’t many numbers, but the numbers we got reinforced the “slow growth/low-inflation” trend.

The ISM Non-Manufacturing PMI (or service sector PMI) rose to 55.3 from 53.9. So, there was acceleration in activity in August. But that acceleration missed estimates of 55.8, and while a number in the mid-50s is solid, it’s not the type of number that implies we’re seeing real acceleration.

The other notable number last week that was largely ignored by the media was August productivity and unit labor costs. An uptick in productivity, if it’s consistent and material, could lead to an economic acceleration. The reason for that is simple: The economy is basically at full employment. But, if those workers get more productive, the total economic output increases, and we get a stronger economy.

August productivity rose to 1.5% vs. (E) 1.3%, so that is a good sign. It’s not nearly the acceleration we need, but it’s a step in the right direction.

However, that productivity number wasn’t the important one from this release. The important number was unit labor costs. Rising unit labor costs is a precursor to larger inflation, so it’s an important number. And, unfortunately, it once again missed expectations. Unit labor costs rose 0.2% vs. (E) 0.3%, providing even more fodder for the “doves” on the Fed to not hike rates in December.

Finally, turning to the ECB meeting last week, you know by now it was slightly hawkish. Draghi signaled the ECB will reveal the details of QE tapering at the October meeting, and he again chose not to try and “talk down” the euro, which led to the euro hitting new multi-year highs (and the dollar hitting multi-year lows).

From a market standpoint, that dollar weakness is a slight tailwind on US stocks, although not a material one. Until we get better inflation or growth data here in the US, the trend of euro strength/dollar weakness will continue.

Important Economic Data This Week

All the important economic reports this week come out Thursday and Friday, which is nice because that gives us a bit of time to get ourselves squared away following all the hurricane issues from last week.

The most important number this week is CPI, out Thursday. As you know, inflation remains the key issue with the economy and Fed expectations. Frankly, we need CPI to start firming because it’ll give us hope of a looming economic reflation. If, however, this number disappoints, as it has for a few months, we’ll see new lows in the dollar and new lows in Treasury yields, neither of which are a good thing for stocks beyond the very short term.

After CPI, there are three important growth numbers out this Friday: Retail Sales, Industrial Production and Empire Manufacturing Survey.

Starting with the first two, remember there remains a large gap between “hard” economic data and surveys. Put plainly, actual economic data is not rising to the level that’s being implied by the PMIs and/or consumer confidence. The longer that occurs, the more likely it is that the surveys are exaggerating economic growth.

So, the sooner hard economic data begins to accelerate, the better. If retail sales and industrial production can beat estimates, that will be an economic positive.

Turning to Empire Manufacturing, that’s the first data point from September, and that’s always anecdotally important because we don’t want to see any steep drop off that might imply a loss of momentum.

Bottom line, this week gives us more color into the state of growth and inflation in August. We need to see both begin to accelerate if we are to hold out hope that we can see an economic reflation create a “rising tide” for stocks in Q4 ’17 or Q1 ’18.

Commodities, Currencies & Bonds

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In Commodities, the segment was mixed last week as refinery demand rebounded, helping oil rally but pressuring the products. In the metals, the copper rally took a breather but gold extended recent gains amid a weaker dollar and continued geopolitical angst. The commodity ETF, DBC, was basically unchanged on the week.

Metals were on the move last week as the falling dollar initially offered broad support to the space, but that changed on Friday when copper reversed sharply and finished the week lower for the first time since early July (it was the longest streak of weekly gains in a decade). Copper futures declined 2.53% on the week. The catalyst for the reversal was underwhelming Chinese Trade data that showed copper imports were unchanged M/M in August. The copper rally has been very pronounced, and was beginning to get extended, so the soft Chinese import data provided a good excuse for profit taking. For now, the primary trend in copper remains bullish; however, we could see some consolidation after the very strong eight-week run higher. Initial support lies between $2.90 and $2.95.

Gold rallied 1.59% thanks to a weaker dollar that was the result of central bank developments (the ECB), and more political uncertainty after lawmakers extended the debt ceiling. Additionally, geopolitical angst regarding North Korea and its apparent plans of another missile launch also kept a fear bid in the market last week. All those developments were bullish for gold, and like copper, the primary trend is still higher. Any resolution in the near term could see a profit-taking pullback like we saw in copper; however, the path of least resistance is still higher with a medium-term target of $1400/oz.

Turning to energy, the “Harvey Trade” continued to unwind as RBOB gasoline futures declined and oil futures churned higher thanks to the influence of refineries coming back online (demand for oil, more supply of products). WTI rose 0.44% and RBOB futures fell 7.27%.

Fundamentally, inventory and production data was largely written off last week as Harvey skewed the figures, but nearly all the US production gains for 2017 were wiped out thanks to shuts related to Harvey. Looking ahead, it will be important to see production rebound swiftly and close to completely, otherwise, the biggest headwind for oil in 2017 will be lifted and the fundamental backdrop for the energy market may not be as bearish going forward.

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Looking at Currencies and Bonds, the Dollar Index plunged to new 2017 lows last week while the euro surged to multi-year highs thanks to multiple events. The Dollar Index sank 1.7%.

The event most responsible for last week’s dollar decline was the ECB meeting, which was slightly hawkish. The announcement that QE tapering details will be given in October was the headline hawkish event, but equally, if not more important, was the fact that Draghi again didn’t “talk down” the euro. His refusal to address euro strength is being taken by the market as a tacit endorsement of the euro at 1.20, and that, more than anything, is what’s causing this relentless euro rally.

That will continue until 1) The ECB acknowledges the euro strength is a risk for growth, or 2) We get better inflation data here in the US.

Looking internationally, there was universal strength vs. the dollar. The yen surged 2% on a combination of dollar weakness and risk-off buying in the yen ahead of a potential North Korea missile launch. Meanwhile, the loonie also rose 2% after the Bank of Canada surprised markets and hiked rates 25 basis points.

Yet it wasn’t just the ECB that sent the dollar lower last week. The resignation of Fed Vice Chair Fischer, the three-month debt ceiling deal (which will cause a potentially bigger problem in December) and the deteriorating Cohn/Trump relationship (which reduces the chances for tax cuts) all weighed on the dollar, and more importantly, bond yields.

To that point, the most important thing that happened in markets last week was that the 10-year yield hit new 2017 lows, and the 10’s-2’s Treasury yield spread also hit 2017 lows. Both of those events imply 1) Slower economic growth and 2) Lower inflation on the horizon. That’s clearly not good for a market trading near 18X next year’s earnings.

Bottom line, the currency and bond markets continue to flash medium- and longer-term caution signs on the economy and the equity markets—and while not a reason to sell right now, those caution signs should not be ignored.

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Special Reports and Editorial

The ECB Decision Takeaways

Last week’s ECB decision was on the “hawkish” side for two reasons. First, Draghi specifically sighted an “autumn” release of the details of tapering of QE, so that means the October ECB meeting (not December). That was a mild hawkish surprise, but not really a shock.

Second, Draghi once again passed on the opportunity to “talk down” the euro, implicitly implying that the ECB does not mind its current strength.

He did make the vanilla comments that it must be “monitored,” but the important point is he gave no indication that the strong euro would cause the ECB to rethink tapering QE, and that’s de facto euro positive.

From a market standpoint, the impacts of this are clear; i.e., more of the same euro strength and dollar weakness. Near term, that dollar weakness will continue to be a mild tailwind on stocks, but it’s not a bullish gamechanger.

For Europe, the news is positive in an absolute sense. The ECB is going to taper QE because of better economic data, although the currency is a concern. From a position standpoint, while I think it to be long-term cheap, in the near term the dollar is making new lows, so that will be a headwind on HEDJ. It won’t be a headwind on EZU. Given I have a longer time frame, I am not selling HEDJ, in part because I believe the dollar is cheap and the euro is expensive.

However, if I were going to make a move, I’d likely keep the same overall allocation to Europe, and move some out of HEDJ and into EZU (at least in the near term). Again, for longer-term investors, this will result in short-term underperformance, but it doesn’t invalidate the “Long Europe” thesis.

Fischer & the Debt Ceiling: Not Market Positives

Two big news items last week were the resignation of Fed Vice Chair Fischer, and the agreement on a three-month debt ceiling extension/government funding deal.

Starting with the former, Fischer’s resignation makes the Fed very slightly more dovish (Fischer was a modest hawk) but really the future path of Fed interest rates depends a lot more on inflation data than it does Fed personnel.

From a market standpoint, the odds of a December rate hike appropriately declined slightly. But again, Fischer’s departure isn’t a dovish gamechanger, and if inflation metrics move higher between now and December we’ll still get a rate hike. From a stock standpoint, other than the temporary pop, I don’t see this news as an influence.

Turning to Washington, as usual, politicians have kicked the can down the road. On a positive note, we won’t see a debt ceiling drama or shutdown drama in late-September.

On a negative note, we likely will see an even more intense budget battle into the year-end. This will be all the more contentious because now tax cuts will be thrown into the mix, assuming Republicans have a concrete plan by then.

From a market standpoint, this is a very short-term positive in so much as it removes the possibility of a crisis over the next few weeks.

However, it sets up an even bigger potential negative into the end of the year. Bottom line, the debt ceiling/government funding agreement is not an incremental positive for markets, and we don’t expect it to push stocks higher from here.

In sum, both of Wednesday’s headlines had no real impact on our overarching macro view. We remain cautiously positive on stocks, but continue to believe that tax cuts and earnings hold the key to performance for the remainder of 2017.

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