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posted on 23 November 2015

Macro Strategy Report For November 2015

by Jim Welsh, Forward Markets

--- this post authored by Jim Welsh and Jim Martin

Macro Factors and Their Impact on Monetary Policy, the Economy and Financial Markets

At the September 17 U.S. Federal Reserve (Fed) Federal Open Market Committee (FOMC) meeting, 13 of the 17 officials indicated they expected the Fed to increase interest rates once before year-end based on the published projections.

In an interview with the Wall Street Journal on September 28, William Dudley, president of the Federal Reserve Bank of New York, said:

"If the economy continues on the same trajectory it's on...and everything else suggests that's likely to continue...then there is a pretty strong case for lifting off " before 2015 ends.

All along Fed officials have repeatedly reminded investors that they are data dependent, irrespective of their expectations and projections. Given the Fed's consistency in recent years of forecasting better economic growth than what actually occurred, one can appreciate its dependency on data. After all, it's the only way the Fed can be wrong and still conduct monetary policy with an air of competency.

The data that the Fed is most dependent on are labor market conditions and inflation since they relate to the Fed's dual mandate of full employment and stable prices. In January, the 12-month exponential moving average of monthly increases in jobs was 260,000. After job growth fell in August and September, the average fell to 208,000, 20% lower than in January. Since June, the three-month average in job growth has plunged 45%, falling from 254,000 to 138,000 in September. Despite the slowing in job growth since January, the unemployment rate has dropped from 5.7% to 5.1% in August and September. This decline to such a low level normally would have transmitted upward pressure on wage growth, but the recovery since June 2009 has been anything but normal. According to data from the Federal Reserve Bank of Minneapolis, had the current recovery merely matched the median post-World War II recovery, total private employment would be 159.5 million rather than 132.4 million. Politicians can give speeches lauding the success of their economic policies and the Fed can tout the positive impact of its quantitative easing (QE) programs, but these numbers paint a different and unflattering picture of mediocrity. Had gross domestic product (GDP) growth matched the median growth experienced in the other 11 post-World War II recoveries, the U.S. economy would be $1.8 trillion larger, or 10% bigger than it is now.

One of the reasons why the unemployment rate is so low is because there are a record high of 94.6 million Americans older than 16 who are not in the workforce. The labor force participation rate includes those with a job or those actually looking for work, and it fell to 62.4% in September. This is the lowest rate since 1977, when the U.S. population was 220.2 million as compared to 320.1 million today. Since 2001, the Fed has kept the real federal funds rate below zero percent for a majority of the last 15 years. To assume that this extended period of extraordinary monetary accommodation has not resulted in negative unintended consequences doesn't jive with the economic reality of the recovery since June 2009. For more than five years, average hourly earnings have virtually flatlined at a 2.2% annual growth rate, a pattern that continued in September. Wage growth in this recovery has been 50% weaker compared to the average gain of 3.3% in all the other post-World War II recoveries. Despite the Fed's zero interest rate policy, job and earnings growth has been subpar.

In September, the consumer price index (CPI) was down -0.2% and unchanged from a year ago. The primary reason was a -29.6% plunge in gasoline prices, according to the U.S. Department of Labor. The core rate of inflation, which excludes food and energy, showed an increase of 1.9% from a year ago. However, a large portion of this increase was due to a 3.2% annual increase in shelter costs, which represent almost 40% of the core CPI index.

The Fed's preferred measure of inflation is the personal consumption expenditures index (PCE), which gives shelter a 20% weighting. According to J.P. Morgan, after adjusting for the difference in weighting for shelter, the PCE was up 1.3% from September 2014. The Fed has said that it expected the low level of inflation to be transitory, which may prove optimistic.

The producer price index (PPI) fell -0.5% in September, the largest drop in eight months and the eighth consecutive 12-month decrease. More importantly, the core PPI was down -1.1% from a year ago. This drop suggests there is more deflation in the pipeline, which will weigh on the PPI in coming months.

From an anecdotal perspective, according to global brokerage firm Convergex, the only time since 1980 that prices for the three main ingredients in a bacon cheeseburger have fallen by 3% or more were in 1991-1992 (Gulf War), 1998 (Asian debt crisis) and 2009. In response to the Gulf War and Asian debt crisis, the Fed lowered the federal funds rate, yet couldn't in 2009 since it was already at zero percent. This year's prices of ground beef, cheese and bacon have declined by more than 6% after falling -2.9% in June, -1.2% in July and -2.7% in August. As we have no idea how many members of the FOMC are vegetarian, this factoid may not even come up for discussion.

In recent months, job growth has slowed materially, wage growth has remained stagnant and PCE inflation remains well below the Fed's target of 2%. If the Fed remains data dependent, job and wage growth will need to pick up to justify raising rates in December. Even if growth improves, the Fed may be reluctant to act if the European Central Bank (ECB) expands its quantitative easing program at its December meeting as ECB President Mario Draghi had hinted at after the ECB's October 22 meeting. Dollar strength has been a headwind for the U.S. economy, causing exports to decline and import prices to fall. In response to Draghi's less than subtle hint, the dollar strengthened by more than 2.0% on October 22 and 23. The Fed may choose to wait to raise rates so the dollar doesn' t rally further.

U.S. Economy

The Federal Reserve of Atlanta's GDPNow model estimates that third quarter GDP has dipped to 0.9% as of October 20, a marked slowdown from the 3.9% pace in the second quarter, and retail sales rose just 0.1% in September. The national average retail gasoline price was $2.26 a gallon on October 19 - the lowest since 2006. The majority of consumers are still using most of the extra cash flow from lower gas prices to save and to pay down debt rather than ramping up spending. In the context of five plus years of weak wage growth, the unwillingness of consumers to loosen up and become spendthrifts is understandable, even if most economists remain befuddled by consumers' behavior.

The preliminary University of Michigan Consumer Sentiment Index for October improved to 92.1, up from 87.2 in September. Historically, 82 has been the demarcation between recession and recovery. The current level of confidence is consistent with an annual increase in consumer spending of 3.0%, suggesting that consumer spending will contribute roughly 2.1% to GDP since consumers account for 70% of GDP.

The Institute of Supply Management (ISM) Non-Manufacturing Index was 56.9 in September, well above the expansion level of 50. Although the index fell 2.1 points in September from August, it is virtually unchanged from its September 2014 level. Services account for more than 80% of GDP and the steady strength in the ISM Non- Manufacturing Index indicates that a meaningful slowdown in the U.S. is not going to happen in coming months.

While consumer confidence and the ISM Non-Manufacturing Index are supportive of economic growth, there are headwinds that will prevent a real acceleration in growth in coming months. The National Federation of Independent Business (NFIB) Small Business Optimism Index was 96.1 in September.

Over the last 30 years, readings of 97.0 and higher have been coincident with sustained economic expansions while readings below 97.0 have been indicative of recessions. Small businesses account for more than 60% of new job creation. The decline in the NFIB index since it reached 100.4 last December is consistent with the 12-month moving average of job growth falling from 278,000 last December to 208,000 this September. Small businesses represent the troops on the ground in terms of what really matters regarding the economy. The top concerns in the September NFIB index survey are therefore instructive in terms of policy and how economic growth could be improved.

The number one concern in this month's survey was government regulation and red tape, which 22% of respondents identified. A study by the National Association of Manufacturers in 2012 found that regulations cost the industry nearly $20,000 per worker. The tab for small firms was almost $35,000 per worker. We don't feel that we're going out on a limb by assuming that the cost of regulation has risen since 2012 given the study predates the implementation of the Affordable Care Act and an avalanche of new regulations from the Environmental Protection Agency.

The second most common concern was taxes, according to 21% of respondents. Since very few members of Congress have ever dared to start a small business, we doubt the concerns of small businesses are understood or even appreciated by those responsible for the increase in regulation and taxes during the weakest post-World War II recovery. That won't stop politicians from giving 2016 election speeches bemoaning the loss of well- paying manufacturing jobs or the lack a real income growth for the middle class.

The ISM Manufacturing Index fell 0.9 to 50.2 in September, the lowest since May 2013 and barely above 50.0, the level that divides expansion from contraction. Of the 18 sectors in the survey, 11 contracted while only seven expanded. The index for export orders was 46.5 this month, the lowest level since April 2009. The twin culprits are the plunge in oil, which has resulted in a significant cut in spending by oil companies, and dollar strength, which has hurt exports.

According to the Federal Reserve, industrial production was up 1.16% in September from a year ago, but down -0.76% since December 2014. Capacity utilization peaked in the current recovery at 79% last December and has fallen -1.9% since then and -1.2% from September 2014.

Although the dollar index has moderated since mid-March, it is still up more than 18% since May 2014 while oil prices are down by 50%, hovering not far above the lows. These numbers suggest business investment is not likely to improve much, nor is job growth in this once vibrant sector. Since last December, oil and gas drillers have shed 102,000 jobs while 9,000 manufacturing jobs were eliminated in September. Although manufacturing accounts for just 12% of GDP, jobs lost in these two sectors pay significantly more than the average job.

The strength in the dollar is contributing to a widening of the trade deficit and deflation, just as we forecast months ago. The trade deficit exploded in August, surging to $48.3 billion from $41.8 billion in July. As we have noted, the largest dollar rally in 40 years packed a one-two punch. A stronger dollar makes American products more expensive, which has depressed exports. Imports have risen since the decline in other currencies versus the dollar, which allows foreign competitors to sell their products for less than American producers.

The competitive disadvantage created by the increase in the dollar's value has forced U.S. producers to cut prices on goods for export and goods for domestic consumption just to maintain market share. So even if companies are successful in holding onto market share, profit margins are reduced.

Import prices excluding energy have fallen -3.3% from a year ago while prices including energy are off a whopping -10.7%. Export prices were -7.4% lower than in September 2014 after falling -0.7% in September.

One measure that illustrates how much export volume has decreased is the number of empty containers that are shipped out of U.S. ports. In September, the Port of Long Beach handled 197,076 outbound empty container boxes representing nearly one third of all outbound containers. September was the eighth straight month that the number of empty containers have increased. So far this year, empty containers are up more than 20% from a year earlier at the Port of Long Beach, the Port of Oakland, and the Port of Los Angeles - the U.S.'s largest single container port. At the Port Authority of New York and New Jersey, empty container exports rose by 31.5% in the first eight months of this year. The huge increase in empty containers is a result of the stronger dollar, but it is also a reflection of weak demand from China and throughout the global economy.

Exports and imports are the arteries and veins of the global economy and a reflection of its health. Over the last 20 years, the increase in merchandise trade has added significantly to global GDP growth. According to the World Bank, merchandise trade was 31.53% of global GDP in 1994 and by 2008 was 51.90%, an increase of 64.6%. In 2009, it plunged to 42.35% of global GDP before rebounding to 50.74% in 2011. The slowing in China's economy and in other developing economies has resulted in a drop to 48.46% at the end of 2014. Overall, the U.S. has benefited from the increase in merchandise trade, especially when it grew to 23.15% of GDP in 2014 from 16.44% in 1994, a gain of 42.9%.

Although the U.S. and other advanced economies benefited from the surge in global trade, developing economies benefited even more. As low-cost producers, Brazil, China, India, Mexico and Vietnam experienced strong economic growth from exporting goods to consumers in advanced economies. In 1994, the GDP of developing countries represented 18.0% of global GDP. In 2015, it will reach 40.0%, an increase of 122.2% in just 21 years. Since 1994, advanced economies' share of global GDP has shrunk from 82.0% to 60.0% in 2015, a decline of 26.8%. The change in the ratio of advanced and developing economies' contribution to global GDP - from 4.5-to-1 in 1994 to 1.5-to-1 in 2015 - illustrates the profound transformation that has occurred.

Like most changes of this magnitude, there have been positives and negatives. The most obvious negative was the loss of jobs in advanced economies as production of goods shifted to developing countries with far lower production costs. This negative was partially ameliorated by the social safety nets advanced economies could provide to displaced workers and by the lower cost of goods advanced economies imported from developing countries. A 2005 study by Global Insight found Walmart saved American families almost $2,500 a year through lower prices. The most significant positive was that the standard of living for hundreds of millions of people in developing countries was significantly raised. In many of these countries, incomes have doubled, tripled and quadrupled. This increase in incomes has led to better living conditions, including access to electricity in homes, better diets and an increase in lifespan. It is easy to forget that in 1900 the average life span for an American was 47 years. As the standard of living improved in the U.S., so did the quality of life and longevity, so the average American now lives to 80 years old. There are a number of economic theories - communism, socialism, capitalism - but the one that works best for the average human is economic growth. A rising tide does lift all boats.

Emerging Economies

The financial crisis exposed distinct problems in advanced and developing economies that had been brewing for years. Advanced economies are overburdened by debt. The debt-to-GDP ratio in Japan is 640%, which means for each $1.00 of GDP Japan must service $6.40 of debt. The debt-to-GDP ratio in the eurozone is 450% and it is 330% in the U.S. Government spending in advanced economies is also at high levels, which minimizes the impact of the private sector on growth. Government spending consumed 38.7% of U.S. GDP in 2013 (latest data available), 42.4% of Japan's GDP and 50.7% of eurozone GDP, according to Organisation for Economic Co-operation and Development data. Policymakers in advanced economies have forgotten that it is the private sector that supports government, not the other way around.

These figures do not include the cost of government regulation, which has been estimated to be 10% of GDP in the United States. Since some regulations provide benefits, such as clean air, safe food, etc., we would propose lowering the regulatory cost to 5% of GDP. A labyrinth of regulations has made it more difficult for advanced economies to adapt quickly to changes in the global economy.

As we have discussed for more than a year, developing economies have their own set of burdens. Although not as onerous, the debt-to-GDP ratio in developing economies has soared from 117% in 2007 to 167% in 2014, according to the Bank of International Settlements. An unhealthy portion in the increase in debt was used to build domestic facilities to produce goods for exports. The challenge is that the demand for their products from advanced economies has weakened in the wake of the financial crisis and economic growth is not likely to pick up much from current levels in coming years in the U.S., eurozone and Japan.

This situation has left many emerging market (EM) countries with an overhang of excess capacity that is unlikely to be absorbed until the second half of 2016 or later. The amount of dollar-denominated debt has jumped from $6.0 trillion in 2009 to $9.6 trillion in June 2015. The increase in total debt has made emerging economies more dependent than ever on exports and domestic growth to service their debt.

Wages have grown significantly in many EM countries during the last decade, so domestic consumption is helping to cushion the decline in exports. However, the middle class in developing economies is not yet large enough to completely offset the dependence on exports. The quandary is that export growth fueled the increase in domestic wages and, with the decrease in export growth, wage growth is also likely to slow, which will hold back the growth in domestic demand. The virtuous cycle that lifted living standards in EM countries has decelerated and is not likely to reaccelerate for some time.

As we have noted in prior Macro Strategy Reviews (MSRs), the cost for EM companies to service unhedged dollar-denominated debt has increased proportionately by the amount the local currency has depreciated, especially for companies whose revenue is derived from the local currency. If a company receives dollars for its products (e.g., oil, gold and other commodities), it would be less adversely affected. However, the significant decline in commodity prices almost mirrors the amount many currencies have fallen, so there really is no place to hide from the burden of accumulated debt.

According to the Bank of International Settlements, international banks now have $3.6 trillion of loan exposure to developing countries, three times the exposure they had just a decade ago. This increase in EM debt suggests that an extended slowdown in EM growth will likely lead to loan losses, a prospect banks have already recognized.

As we noted in the October MSR, banks in Asia and Latin America tightened lending standards in the second quarter and likely tightened them further in the third quarter. The heavy burden of dollar-denominated debt, depreciated currencies, lower commodity prices and tighter lending standards is undoubtedly going to squeeze corporate cash flow throughout EM countries. As this squeeze persists, unemployment is likely to climb in many EM countries, which will further depress domestic demand. This cycle is the prescription for more widespread credit problems throughout developing countries.

At the time of the Asian debt crisis in 1997-1998, developing countries represented 21% of global GDP compared to 40% today. According to Oxford Economics, the proportion of global manufacturing performed by developing economies has grown from 38% fifteen years ago to 52%. Given this increase, advanced economies will not be able to decouple or be immune from the slowdown gripping EM countries. The potential for a mini-crisis remains irrespective of the ECB's plan to increase its QE program or the People's Bank of China (PBOC) lowering rates for the sixth time since last November. We don't think some investors understand or appreciate the importance of what's happening in developing economies and the potential negative impact it could have on global financial markets in coming months.

Although many EM currencies have experienced a decent bounce since September 29, the bounce pales when compared to the declines since May 9, 2014, and the economic challenges facing many EM countries.

Emerging Markets - Technical

As this is being written on October 22, the iShares MSCI Emerging Markets ETF (EEM) is approaching an important technical level of support that has been in place since 2011 - the area around $36.50. When this level was broken in August, EEM quickly plunged to $30.00 on August 24 before rebounding smartly. We think the rally since the August 24 low is merely a bounce within the context of a longer-term decline.

Last month we presented chart analysis of EEM that concluded that the low at $30.00 was not THE low and that a decline into a range of $24.73 - $28.84 was possible in coming months. When the fundamental and technical analysis is aligned, we have more conviction in our outlook. Fundamentally, the outlook for EM economies still looks challenging. That said, if EEM is able to trade above and hold above $36.50, it would suggest that the challenges we have discussed will be handled better than we expect. If EEM trades above $36.50 and subsequently falls below that level, we would infer that the fundamental weaknesses will reassert themselves and potentially lead to a decline below $30.00 in the first half of 2016.


In the October MSR we noted that the ECB's Governing Council had laid the groundwork to expand its QE program. The ECB voted on September 3 to increase the share of an individual bond issue it can purchase from 25% to 33%. This change will make it easier for the ECB to increase the $66.7 billion in its monthly purchases of government bonds. We thought one of the triggers would be inflation remaining well below the ECB's 2% inflation target. In September, the consumer price index was -0.1% and core inflation was 0.9%. In the September MSR we said:

"If a decline of 10% or more occurs in global equity markets, we would expect the central banks around the world to respond with more verbal and actual monetary stimulus."

On September 29, the STOXX Europe 600 Index had fallen by more than 16%, after hitting a top in April. In the October MSR we thought Mario Draghi would drop a few more hints that the ECB would consider extending the September 2016 deadline on the ECB's QE program or increase the amount of its monthly purchases and that foreign currency traders would jump on the sell-the-euro-short bandwagon. After the ECB's meeting on October 22, Draghi stated:

"The degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available."

Although economic activity has remained steady, the ECB decided that it may need to increase accommodation sooner than expected. We suspect that the ECB is concerned about the slowdown in China and how it will negatively impact developing countries and the fragile recovery in the eurozone. Financial markets responded strongly to Draghi's comments with global equity markets jumping higher, bond yields dipping and the euro losing almost 2% of its value.

In recent years, equity investors have been trained to buy stocks based on central bank intervention, so the knee-jerk reaction is not a surprise. The real question is how long investors will continue to believe that central bankers are a modern day fairy godmother. One would think that the failure of the multiyear QE programs by the Bank of Japan (BOJ) and Federal Reserve to ignite a self-sustaining recovery in their respective economies would at least temper equity investors' almost mindless enthusiasm, more so since Draghi's comments are an implicit acknowledgment that economic growth remains subpar and at risk in the eurozone despite all of the ECB's efforts to date. It seems incredulous that investors would believe that another decline in interest rates - maybe 10 or 20 basis points (bps) - could make all the difference in the world. We don't presume to know why investors would behave this way, but we do believe a degree of healthy skepticism is warranted unless solid economic growth materializes. Objectively, it seems more a question of when , not if, investors will be forced to accept that there are no modern-day fairies to help.

Euro - Technical

In the May 2014 MSR, we suggested shorting the euro when it was trading above 138.000. In the April 2015 MSR, we suggested covering a portion of the short position when the euro traded under 106.500, which it did in mid-April, since we thought the euro could rally to 111.000 - 115.000. In the July 2015 MSR, we thought the euro would exceed the 114.720 high it recorded on May 15 and rally to 117.000 - 118.500, which would complete the countertrend rally from the mid-March low. We suggested using a portion of the short trade that was covered below 106.500 to reshort the euro above 117.000. On August 24, the euro traded above 117.000 before reversing lower. We would now lower the stop from 115.750 to 114.250.

As noted previously, the euro declined sharply after Mario Draghi strongly hinted the ECB might adopt an even more accommodative policy at its December meeting. Short term, the euro may hold above 109.000 and bounce. We think longer term it will fall below 109.000, which will increase the odds of the euro making a new low in coming months. We would look to cover at least half of the short position established above 138.000 if and when the euro approaches the March low of 104.620.


According to the International Monetary Fund (IMF), the Chinese economy was responsible for roughly one-third of world growth over the past seven years, making it clear that what happens in China doesn't stay in China. Much of the economic growth since 2007 was financed by a surge of debt as China's total debt rose from $7.4 trillion to $28.2 trillion. Despite robust economic growth, China's debt-to-GDP ratio has soared from 158% to 282% as of June 2014. To relieve some of the burden of servicing all that debt, the People's Bank of China has cut interest rates six times since last November, lowering rates from 6.00% to 4.35% as of October 23. Lowering borrowing costs will certainly help some things, but not the structural problems that are weighing on growth.

Much of China's growth was driven by trade. China imported enormous amounts of raw materials to build up its production capacity so it could expand its exports to Europe and the U.S. and expand its domestic infrastructure. In recent years, China was consuming 60% of the world's cement, 54% of its aluminum, 50% of its nickel, 49% of its coal and 48% of its copper. This is why any slowing in China's economy has had and will continue to have such a profound impact on commodity prices and on the countries that were supplying the raw materials.

In September, imports were down -20.4% from a year ago after being down -13.8% in August. Exports in September were lower by -3.7% from a year ago, a modest improvement from August's -5.5% decline. Compared to the 10% - 30% increases that were routine before the 2009 recession, the decline in demand for raw materials is stunning. Since 2011, imports and exports have dropped from 48.61% of China's GDP to 41.53% at the end of 2014 and likely even lower in September.

Since January, China has approved more than 200 rail, highway and energy projects, seven valued at $283.3 billion, in an effort to stimulate its economy. During the post-recession boom years, real estate grew to represent 23% of China's GDP, according to Moody's Analytics, as local governments built entire new cities and wealthy Chinese speculated on more growth and higher home prices. According to official statistics, China's inventory of unsold homes is equal on a square foot basis to more than six Manhattans. As with other Chinese economic statistics, the "official" government numbers may not be accurate. The IMF estimates that at the end of 2013, China's housing inventory was about three times what China had reported.

The path taken by the PBOC since last November is similar to what advanced economy central banks have done to spur growth and inflation. It has lowered interest rates to the lowest level in China's history, cut the reserve ratio that banks must keep in order to spur lending and allowed banks to use existing loans as collateral for new loans, which is a variation of quantitative easing. Despite the stimulus, China's CPI was 1.6% in September, about half its official target of 3%.

The PBOC's push to get banks to increase lending is working as bank loans soared in September to $165.4 billion, up 29.7% from August. However, the annualized growth of M2 money supply was 13.1% in September, down from 13.2% in August, so the liquidity being pushed into the financial system has yet to show up in the real economy.

Despite the increase in infrastructure spending since January, the annual increase in fixed investment has fallen from 13.5% to 6.8% in September, far below the average of 19% over the past five years. This data suggests the mandated increase in local government spending is being offset by a decline in private investment. Profits at Chinese industrial companies plunged -8.8% in August from a year ago due in large part to excess capacity and falling prices, which have been negative on a year-over-year basis for 43 consecutive months.

The PBOC can cut rates and push for more lending, but the demand for loans is weak and too much of the additional lending is going to firms that are merely rolling over existing loans just so they can keep their doors open. This predicament suggests that the PBOC's accelerated accommodation is starting to look like it is pushing on a string as weak demand overcomes the benefit of cheaper money and more credit availability. When the BOJ and ECB reached the same impasse, they exercised the only option available: the devaluation of their currencies. We have no doubt that the PBOC will follow the same path and gradually lower the value of the renminbi by 8% - 10% over the next 18 months. It's the only option if the PBOC wants to revive export and GDP growth.

It is noteworthy that the PBOC lowered its benchmark interest rate and the reserve ratio within days of China reporting that GDP grew 6.9% in the third quarter. If 6.9% was remotely close to the reality, the PBOC would not have followed so quickly with more accommodation; actions speak louder than "official" Chinese statistics. The PBOC's actions confirm a high level of concern regarding the economy within the highest levels of China's government. As discussed last month, it usually takes six to nine months for monetary accommodation to begin to have a positive effect, so China's economy will show signs of stabilizing in coming months. We are not suggesting growth is likely to accelerate in the near future. If correct, the drag on developing countries will persist. More importantly, the short-term period of stability from the increase in infrastructure spending funded with more debt will borrow growth from the future and not address China's underlying imbalances of excess capacity, falling prices, a shrinking workforce and an overreliance on debt to generate growth.

Oil - Technical

In the October MSR we explained why banks are likely to cut credit lines and potentially refuse to roll over existing loans for energy companies as their hedges on production expired and the value of oil reserves declined. This squeeze on cash will lead to more bond and bank loan defaults, mergers and bankruptcies in the first half of 2016. We also discussed why another decline in oil prices was likely in October as refineries shut down for their annual maintenance, which would lower demand for oil by as much as 1.3 million barrels a day. As we said:

"We doubt the oil market will greet the increase in stockpiles as good news when it is reported by the Energy Information Administration (EIA) each Wednesday in October."

Oil prices topped on October 9 and have declined after the EIA reported stockpiles have increased by millions of barrels each week. As this commentary is being written on October 23, a close below $44.00 a barrel for West Texas Intermediate (WTI) oil should lead to more weakness and potentially new lows. If WTI oil does test its low, it should remind everyone that global growth remains weak despite central bank manipulations. If a dislocation in an emerging market country develops that disrupts global financial markets, WTI oil could make a run at the 2008 low near $34 a barrel.

Gold - Technical

In the August MSR we laid out the reasons why we thought that gold would make a trading low between $1,050 and $1,081. Gold bottomed on July 24 at $1,077.25, rallied above $1,160 and then pulled back to $1,098.45 on September 11. We have expected gold to rally to $1,185 - $1,224 with a chance it could rally up to $1,300 as long as it held above $1,085. On October 15, gold traded as high as $1,191.70 on the December futures then pulled back to $1,158.60 on October 23. We think gold will challenge $1,200 in coming weeks as long as it holds above $1,140. We still think there is a chance that gold could challenge the January high and trade up to $1,300 in the first half of 2016 if it closes above $1,238.

Dollar - Technical

In the April MSR, we thought the dollar index had entered a consolidation/corrective period that would include a fair amount of choppy trading. We thought the dollar index would decline to 92.60 - 94.77 from the mid-March high of 100.38 before another rally took hold. In the July MSR, we revised our downside range to 90.20 - 93.30 and thought a decline into this range would complete the correction that commenced after the mid-March high. The dollar reached a low of 92.52 on August 24 before reversing higher.

In the October MSR, we thought that Mario Draghi would drop a few more hints that the ECB would consider extending the September 2016 deadline on the ECB's QE program or increase the amount of its monthly purchases. Since the euro represents 57% of the dollar index, additional easing by the ECB would lead to a decline in the euro and a rally in the dollar. On October 22 after Draghi indicated the ECB would consider changes at its December meeting, the dollar rallied by more than 2% and pushed above short-term resistance at 96.80 on the December futures contract. A close above 98.74 should lead to a quick run to the March high of 100.38 in coming months. A decline below 95.00 would be a short- term negative. Longer term, our guess is that the dollar index can reach 103.00 - 106.00 in the first half of 2016. The dollar could reach this price range even if the Fed does not raise rates since the euro is likely to fall if the ECB expands their QE program.

Bonds - Technical

Our analysis of the U.S. 10-year Treasury yield is pretty straightforward. The 10-year Treasury yield has traded within a downward channel, as indicated by the red trend lines on the nearby graph, for most of the past two years. We think it is significant when the yield rises outside the channel, which it has done for most of the time since June 2. The odds of a further increase go up when the yield is above the channel. As we wrote in the September MSR, we don't think the move higher in yields will begin in earnest until later this year or early 2016. This suggests being short bonds is the right side of the market to be on, using the upper boundary of the channel as a stop.

Given the slowing in the U.S. and global economy, the potential for the 10-year yield to drop back into the channel has increased, so using the top line of the channel as a stop is important. Last month, the top line of the channel indicated that the stop would be 2.07%, but it has fallen to 2.02% as this is being written on October 23. The yield has been whipsawed above and below the top trend line based on volatility in the stock market, which reinforces its importance in our view.


According to Thomson Reuters, companies in the S&P 500 Index are expected to report that third quarter profits fell -4.4%, with revenues dropping -3.5%. Excluding energy companies, revenues are expected to be up 2.1%, with earnings growing 2.1% - resulting in the weakest quarter since the third quarter of 2012. In order for the stock market to make much headway, growth will have to come from an expansion in the price-earnings ratio rather than a nice lift from profits. With the market arguably at the third most expensive level of the past 100+ years, valuations are on a shaky foundation given the outlook for U.S. and global growth.

Over the last 12 months, 75% (375) of S&P 500 companies paid a dividend and bought back stock while another 65 companies just bought back their stock, according to FactSet. During this 12-month period, companies spent more on buybacks than they generated in free cash flow. The last time this occurred was in October 2009 when free cash flow plunged due to the deep recession. Between 2005 and the end of 2014, the 458 companies remaining in the S&P 500 spent $3.7 trillion on buybacks representing 52.5% of net income, plus another 36% of net income on dividend distributions, according to the Center for Industrial Competitiveness at the University of Massachusetts.

In the January 2015 MSR, we discussed "Monetary Policy and Business Investment" and noted that one of the negative unintended consequences from the Fed's zero interest rate policy has been the misallocation of capital by corporations. Through September, corporations have sold more than $1.2 trillion in corporate debt, much of it being used to buy back stock or pay dividends. We have often criticized the Fed for this distortion, especially since corporate profits as a percentage of GDP have been at the highest level of the past 60 years while employee earnings are at a 60-year low. This disparity shows why average hourly earnings have grown 50% more in every other post-World War II recovery besides this one and why business investment has been so anemic. Why should companies assume the risk of investing in research and development to boost future earnings when they can borrow so cheaply and buy back their stock? The obvious answer is they don't. We floated this idea in the January 2014 MSR and repeated it in the January 2015 MSR:

"Rather than buying back $567.2 billion in their stock in 2015 as they did in 2014, public companies might consider, and be better served in the long run, if they gave all their employees earning between $30,000 and $70,000 a 5% pay increase. In total, it would cost the 500 companies in the S&P 500 around $450 billion, less than what they're spending on buybacks now."

We have noted on several occasions that Henry Ford was considered a genius for the development of the assembly line, which lowered the cost of each car produced; but paying his workers enough so they could afford to buy the cars was also pure genius. In an interview with Barron's on September 28, Jeremy Grantham, a widely respected macro strategist and co-founder of GMO, said:

"The capital spending that is going on at this stage, six years into a recovery, is dismally low. Insufficient capital spending means less GDP growth, fewer jobs, and downward pressure on wages."

In last month's MSR we wrote:

"The risk of a recession in the U.S. is low, but that doesn't mean U.S. financial markets are not vulnerable. The S&P 500 rallied from a low of 1,074 in October 2011 to a high of 2,134 in May 2015. A 38.2% retracement of the 1,060 point rally would bring the S&P 500 down to 1,729. We have no idea if this is what lies ahead. We do know that the market's technical health deteriorated for months prior to the sharp sell-off in August."

The S&P 500 retested its August 24 low of 1,867 on September 29 when it fell to 1,872 and has since rallied smartly. The rally has been fueled by short covering, additional central bank accommodation and significant earnings from a few big name technology stocks. On October 23, the S&P 500 rose 1.1%, but three stocks - Microsoft, Google and Amazon - contributed more to the increase than the other 497 stocks combined. This fact underscores how narrow, although impressive, the recent advance has become. As of October 23, the S&P 500 was just -2.80% below its prior high, but broader indices like the New York Stock Exchange Composite Index (NYSE), which includes about 1,900 stocks, and the Russell 2000 Index were -6.60% and -10.00% below their respective highs. This narrowing of breadth is especially evident in the NYSE advance- decline (A/D) line, which is significantly below its April peak, and the percentage of stocks that are above their 200-day average on the NYSE. On October 23, only 33% of the stocks on the NYSE were above their 200-day average - an incredibly low number with the S&P 500 so close to a new high - compared to 61% in late April. To further put it into perspective: at the low last year on October 13, 2014, the percentage of stocks above their 200 - day average bottomed at 27%! This deterioration indicates that the market's internal strength has weakened even more despite the near vertical rally over the past four weeks. Should the S&P 500 post a new high in coming weeks, the technical divergences will be significant and numerous.

As we discussed last month, our proprietary Major Trend Indicator (MTI) turned negative on August 20 for the first time since November 30, 2011. The MTI suggested that the stock market was vulnerable to a decline of more than 10% and potentially a bear market. The S&P 500 declined -12.5% from its high of 2,134 on May 20 to the low of 1,867 in late August. On October 8, the MTI gave a bear market rally buy signal, so for now, the short-term trend is up.

  1. Introductory statement to the press conference, Mario Draghi, President of the ECB, October 22, 2015.

  2. Sarah Max, "Stock Buybacks: Too Much of a Good Thing," Barron's, September 26, 2015.

Definition of Terms

10-year U.S. Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year but not more than 10 years.

Advance-decline line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

Affordable Care Act is the federal statute signed into law in March 2010 as a part of the healthcare reform agenda of the Obama administration.

Basis point (bps) is a unit of measure that is equal to 1/100th of 1% and used to denote a change in the value or rate of a financial instrument.

Consumer price index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percentage change in the CPI is a measure of inflation.

Debt-to-GDP ratio is a measurement of a country's federal debt in relation to its gross domestic product (GDP). By comparing what a country owes to what it produces, the debt-to-GDP ratio indicates a country's ability to pay back its debt.

Devaluation is a monetary policy tool whereby a country reduces the value of its currency with respect to other foreign currencies.

Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.

Futures are financial contracts that obligate the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.

Institute of Supply Management (ISM) Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries based on surveys of more than 300 manufacturing firms.

NFIB Small Business Optimism Index is a monthly survey conducted by the National Federation of Independent Business (NFIB) that measures the health of small businesses based on plans to increase employment, expansion, capital outlays and inventories as well as expectations for sales, inventory and earnings.

NYSE Composite Index covers the price movements of all common stocks listed on the New York Stock Exchange, including American depositary receipts, real estate investment trusts, tracking stocks and foreign listings.

Personal consumption expenditures (PCE) is a measure of price changes in the goods and services consumed by individuals.

Price-earnings (P/E) ratio is a measure of the price paid for a share of stock relative to the annual income or profit earned by the company per share. A higher P/E ratio means that investors are paying more for each unit of income.

Producer price index (PPI) is a family of indices that measures the average change in selling prices received by domestic producers of goods and services over time.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Russell 3000 Index represents approximately 98% of the investable U.S. equity market.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Short selling is the practice of selling a financial instrument that a seller does not own at the time of the sale with the intention of later purchasing the financial instrument at a lower price to make a profit.

STOXX® Europe 600 Index represents 600 large, mid and small cap companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Thomson Reuters/University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly and based on answers from 500 telephone interviews of persons living in the continental United States.

U.S. Dollar Index is a measure of the value of the U.S. dollar relative to six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.

Zero interest rate program (ZIRP) is a policy instituted by the Federal Reserve in 2008 to keep the federal funds rate between zero and 0.25% in order to stimulate economic activity during times of slow economic growth.

One cannot invest directly in an index.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

ETFs are shown for illustrative purposes only and are not an offering of sale.

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