Written by Jim Welsh
Macro Tides Monthly Review 04 March 2018
One of the oldest adages on Wall Street is that the stock market is a discounting mechanism that anticipates changes in the economy. It is not uncommon to hear a strategist proclaim that the stock market is telling him/her that the economy is in good shape since the S&P 500 has just made a new high, or potentially signaling a recession if the S&P 500 has been falling.
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Human beings project the recent past into the future and expect the prevailing trend to continue. As long as the prevailing trend persists, it certainly appears that the stock market is discounting the future. Eventually trends reverse and that’s why the majority of investors are usually caught flat footed and either over invested or under invested just as the stock market tops or bottoms.
The S&P 500 recorded a new all-time high in October 2007, which according to the ‘market is a discounting mechanism adage’, should have meant the economy was in good shape, and investors had nothing to worry about. By March 2009 the S&P 500 had fallen by 57% from its October 2007 high, which should have indicated that the economic outlook was dire, at least according to the ‘market is a discounting mechanism adage’.
Since the theory that the ‘market is a discounting mechanism’ fails to warn investors when the trend is changing, it is virtually worthless as an investment guide. At every top and bottom the market is always wrong because the market is not a discounting mechanism. That said you can if you listen to CNBC or Bloomberg hear an expert telling you that the ‘market is a discounting mechanism’ since it is accepted as a part of Wall Street wisdom.
Click on any chart below for large image.
On February 5 the Dow Jones Industrial Average lost 1,175 points which made it the largest point loss in history. On a percentage basis, the decline was -4.60%. While significant, the -4.60% loss didn’t even come close to making it into the top 20 all-time percentage losses.
This detail was overlooked by the media that instead chose to focus on the headline “Dow Plunges 1,175 Points in Biggest Drop Ever”. Jay Powell took over as Chairman of the Federal Reserve on February 5 and the coincident sharp decline in the stock market spawned numerous articles about how financial markets like to test new Fed Chairs. This story line was given birth after the stock market crashed on October 19, 1987 two months after Alan Greenspan assumed the helm on August 11, 1987. The loss on that day, with the DJIA dropping -22.6%, dwarfed the decline on February 5. Ben Bernanke became Chairman in February 2006 about two and a half years before the financial crisis exploded in September and October of 2008. The markets were far more patient with Bernanke than Greenspan but then they threw the kitchen sink at him. Janet Yellen took over in February 2014 and the markets never tested her since the largest decline for the S&P 500 was less than 15% on her watch, and the last 15 months of her tenure were the least volatile in stock market history.
The notion that the financial markets test new Fed Chairs is about as valuable as the theory that the market is a discounting mechanism. The topic may make for fill-in conversation at a cocktail party or provide an analyst a rearview mirror lame excuse for why the stock market declined. After the 11% decline in early February, one strategist at a major firm offered this assessment:
“Weakness after a new Fed chair is quite normal. The Dow tends to slide more than 15% on average within the first six months of new Fed leadership. There are many reasons why global markets tumbled over the past week; but it’s important to be aware that a new Fed chair adds yet another worry for markets as Powell becomes acquainted with his new job, and markets become acquainted with him.”
One of the reasons it is not unusual for the market to slide more than 15% in the first six months of a new Fed Chair is that the S&P 500 has experienced on average an intra-year decline of 14% since 1946. During the 71 year period from 1946 through 2017 there were 55 declines of more than 10% and 21 declines of more than 15%.
On December 23, 1913, President Woodrow Wilson signed the Federal Reserve Act which authorized the establishment of the Federal Reserve. Charles Hamlin was the first Chairman of the Federal Reserve and had the misfortune of starting one week after the onset of World War I. After the market recovered from the shock of war, the market subsequently rallied 80.5%.
Eugene Meyer took over just as the Great Depression was engulfing the U.S. and three months after the passage of the Smoot-Hawley Act. The Act ignited a wave of protectionism that caused global trade to fall by 60% in the following 18 months and certainly deepened the global economic contraction. The Fed also mismanaged its response to the sharp economic contraction by allowing the money supply to shrink by more than 30%. This was the lesson Ben Bernanke learned from his study of the Depression and why he instituted Quantitative Easing. There would be no shrinkage of the money supply on his watch.
Of the 8 Fed Chairs since Thomas McCabe in 1948, only 2 endured declines of more than 15% in the first six months. Arthur Burns had the poor timing of becoming Chairman in February 1970, after the Federal Reserve had increased the federal funds rate from 6.0% in December 1968 to 9.0% in February 1970. A recession began in December 1969 although that was not evident in February 1970. Paul Volcker was tasked with getting inflation under control and hiked the federal funds rate from 11.0% in August 1979 to 17.6% in April 1980. It’s amazing the market didn’t fall more than 15% during his first six months.
Before Alan Greenspan became Chairman on August 11, 1987, the Federal Reserve increased the federal funds rate from 6.50% in January 1987 to 7.25% in August, which was far less than the 50% increase that preceded Arthur Burns’ tenure (6% to 9%). During this period the yield on the 20-year Treasury bond climbed from 7.30% in January 1987 to 8.80% in August, double the increase in the federal funds rate. From the end of 1986 the DJIA soared from 1,896 to 2,722 when it topped on August 25, 1987, a gain of 43.5%.
After the Federal Reserve increased the Discount rate from 5.50% to 6.0% in early September, the DJIA dropped 8.4% to 2,493 on September 21. In the first week of October 1987, the 20-year Treasury yield topped 10.0%, up 37% from where it was at the beginning of the year.
Despite the increase in bond yields, the DJIA managed to rebound to 2,641 on October 2 less than 3.0% from its high. By the time the DJIA crashed on October 19, the DJIA had already fallen 17.4%, closing at 2,247 on Friday October 16. After the DJIA plunged 22.6% the following Monday, the Federal Reserve in its role of lender of last resort made the following announcement:
“The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system”.
This appropriate action inspired the concept of the Greenspan Put which assumes the Federal Reserve will step in to insulate the stock market from a major decline. The myth of the Greenspan Put lives on even though the Federal Reserve didn’t exercise its Put to prevent the S&P from losing 49.1% of its value in the 2000 – 2002 bear market or the Nasdaq Composite from plunging more than 78%.
In October 1987 the economy was in solid shape with GDP growth of 3.5% which was the reason the Fed began to increase rates in January. But the Fed didn’t withdraw liquidity from the banking system enough to cause the Crash or damage the economy since GDP grew by 4.2% in 1988.
The main culprit was portfolio insurance which was designed to help institutions hedge their portfolio using the sale of S&P 500 futures as the S&P 500 declined. This meant the institutions using portfolio insurance accelerated their selling of S&P 500 futures contracts as the S&P 500 cash index fell. Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price. With the S&P 500 futures selling at a discount, arbitrageurs bought the S&P 500 futures and simultaneously sold the 500 stocks in the S&P 500. This activity raised the value of the S&P 500 futures but lowered the value of the S&P 500 cash index.
The decline in the S&P 500 cash index led portfolio insurers to sell even more S&P 500 futures. On October 19, portfolio insurers continued to sell S&P 500 futures even as the futures dropped to a 10% discount to the S&P 500 cash. This resulted in a cascade of selling pressure and a decline of 22.6% in a single day that had nothing to do with the economy or the newly minted Chairman of the Federal Reserve. Needless to say the concept of portfolio insurance died that day.
Every 396 years the Sun, Moon, Mercury, Venus and Mars line up within 5-10 degrees of one another. On August 24, 1987 the Sun, Moon, Mercury, Venus and Mars were within 2 degrees of one another in the tightest planetary conjunction in at least 800 years. This tight alignment was called the Harmonic Convergence. Is it possible that the harmony in the heavens contributed to the manic surge of 43.5% in the DJIA in less than 8 months and the depressive Crash less than two months later? It’s easy to dismiss this possibility since it is outside our definition of normal; a definition that fails to acknowledge that Mother Earth is surrounded by infinity in every direction and the humility that recognition calls for.
Of the 15 Federal Reserve Chairs since the establishment of the Federal Reserve in 1914, only six experienced a 15% decline in the DJIA in their first six months. Two occurred during World War I, two were during the Great Depression, one (Arthur Burns) after the Fed had increased rates 50% and enough to tip the economy into recession just as he became Chairman, and Alan Greenspan.
This history suggests that circumstances (war and depression) and timing (recession after aggressive rate hikes) were far more important in determining whether a new Fed Chair would oversee a decline of 15% in their first six months than the simple assertion that new Fed Chairs are always tested by the financial markets based on Greenspan’s experience.
The odds of war seem low, although North Korea remains a wild card. The greater risk is in the Middle East as tensions between Israel and its neighbors have risen and the conflict in Syria has escalated, which makes them more likely as a flashpoint than North Korea.
Economic growth in the U.S. is good and the global economy is in better shape than at any time since 2006. The Fed has increased the federal funds rate five times since December 2015, but financial conditions are still quite accommodative and have improved with the recent rebound in the stock market.
Although Treasury yields have gone up, they have yet to breakout above the significant levels I’ve discussed and not enough to derail the economy (i.e. 3.03% on the 10-year Treasury and 3.22% for the 30-year Treasury). Spreads between corporate bond yields and Treasury yields are still historically low and not suggestive of stress in the financial system or an economic slowdown.
In sum, the historical conditions that have presaged 15% declines in the stock market during the first six months of a new Fed Chair’s tenure are not present. However, the risk of a 15% decline before Labor Day are more than 50/50 based on a number of other factors that were not present in the past.
The stock market is at one of its most expensive levels since 1900, only trailing the level reached during the dot.com bubble and comparable to 1929. The stock market capitalization to GDP ratio has become known as the Buffett Indicator in recent years as Warren Buffett commented to Fortune Magazine that he believes it is “probably the best single measure of where valuations stand at any given moment.” (Chart compliments of Advisor Perspectives and Doug Short.com)
While no single valuation measure is perfect, it is clear the stock market is priced in anticipation that everything will continue to proceed without any speed bumps. Any disappointment has the potential of causing the market to correct more than if it was less expensive. Low interest rates have been supportive of the stock market’s high valuation but the Federal Reserve is going to continue to increase rates. Even if the pace is gradual, higher rates have the potential of pressuring valuations despite higher corporate earnings.
As noted in the February Macro Tides:
“Despite the slow annual GDP growth rate since June 2009, the output gap between the economy’s potential and actual growth has finally been closed. This suggests that the economy is entering the final stage of the business cycle after 9 long years of mediocre growth.”
It is unprecedented to have significant fiscal stimulus this late in a business cycle. The tax cuts and the Budget Deal have the potential of adding 0.6% to GDP growth in 2018 and the first half of 2019. One of the concerns some members of the FOMC have is falling behind the inflation curve and the coming fiscal stimulus will only harden their resolve to proceed with the pace of hikes laid out in December.
The FOMC is not likely to increase the number of projected rate hikes in 2018 to 4 from 3 in the Dot Plot at the March 21 meeting. That change won’t happen until the FOMC is more confident that inflation is progressing toward its target of 2.0%.
The only other time that fiscal stimulus was implemented near the end of a business cycle was in the mid 1960’s when spending on the Viet Nam War escalated and after the Great Society was announced in March 1964 by President Johnson. The goal of the Great Society was the elimination of poverty and resulted in the implementation of Medicare, Medicaid, and expansion of social Security benefits.
In 1965 the budget deficit was – 0.19% of GDP and quickly grew to -2.67% in 1968. Inflation in January 1966 was 1.92% but was 3.79% in October 1966. The U.S. economy is very different today from the 1960’s so it is unlikely inflation will soar as it did in 1966. While the amplitude may be less, the direction will be the same – higher.
(The following paragraphs – ending this section of the report – were written on February 27 in response to the announcement on February 23 that President Trump was considering tariffs on steel and aluminum and that a final decision would be made in mid April. On March 1 President Trump confirmed he would proceed with the tariffs.)
One issue that could upset the economic cart is trade. In January President Trump announced a 30% tariff on solar panels and a 20% tariff on the first 1.2 million washing machines imported into the U.S. President Trump acted under a provision of U.S. trade law authorizing global or “safeguard” tariffs, which had not been used since President George W. Bush levied tariffs on imported steel in 2002. The Solar Energy Industries Association estimates the tariffs would cause 23,000 installers, engineers and project managers to lose their jobs this year as billions of dollars in planned investment evaporates. China’s share of global solar cell production rose from 7% in 2005 to 61% in 2012 helped by massive Chinese government subsidies, according to U.S solar companies. Chinese suppliers flooded the U.S. solar market with panels at the end of last year, as customers sought to avoid paying the import tariff. Fourth-quarter deliveries from China were almost 11 times higher than in the first nine months of 2017, according to Bloomberg New Energy Finance. Clearly, U.S. solar panel makers have a legitimate beef but an onslaught of tariffs risks opening Pandora’s Box.
On February 23, the Trump administration indicated that the President was leaning toward imposing a 24% tariff on imported steel and a tariff of 10% on aluminum. The Commerce Department is using a provision of the 1962 Trade Expansion Act, Section 232, to make a case that the dumping of cheap steel and aluminum from China and other countries puts U.S. competitors out of business, risking national security. The argument that imports of steel and aluminum represent a national security risk is specious at best. According to The Wall Street Journal:
“There’s little risk that the U.S. couldn’t procure sufficient steel and aluminum for defense even during a war. Defense consumes 3% of U.S.-made steel and about one-fifth of high-purity aluminum. U.S. steel mills last year operated at 72% of capacity while aluminum smelters ran at 39%. Both have ample slack to raise production for defense and commercial demands.”
Furthermore, China accounts for only 2% of steel and 10% of aluminum imports. Tariffs are successful in one regard. They will increase prices for domestic industries that use steel and aluminum in their products. There are 140,000 steel workers in the U.S. but 16 times that many in all the industries that consume steel for their products. After George Bush imposed steel tariffs in 2002, economists estimated that 200,000 workers lost their job.
Besides being bad economic policy for the U.S., our trading partners are going to retaliate. China’s Ministry of Commerce is investigating whether to limit imports of U.S. sorghum, and other agriculture products such as cheese, orange juice, tomatoes, and potatoes. The European Commission issued a statement after the steel and aluminum tariffs were being considered:
“The EU stands ready to react swiftly and appropriately in case our exports are affected by any restrictive trade measures from the U.S.”
The EU is targeting products with political punch such as Harley-Davidson motorcycles, whose corporate headquarters is in House Speaker Paul Ryan’s home state of Wisconsin. Bourbon is another target. Kentucky exported $154 million worth of bourbon to the EU, up from $128 million in 2016. Kentucky just happens to be the home state of Senate Majority Leader Mitch McConnell. Protecting political interests is not a surprise but protectionism is a slippery slope.
In June 1930 the U.S. passed the Smoot-Hawley Tariff Act which levied tariffs on more than 20,000 products to protect jobs. After our trading partners responded in kind, global trade collapsed by 60% within 18 months, deepening and prolonging the Great Depression. A final decision on the prospective steel and aluminum tariffs is expected in April. If the prospect of tariffs becomes a reality, the stock market could easily shed 15% and it will have nothing to do with the new Fed Chair.
Economy
Here’s quote from the January Macro Tides:
“Economic expectations for 2018 have increased due to the fiscal stimulus provided by the tax cuts. There are a number of reasons why growth in the first quarter may disappoint investors and could lead to a correction in the stock market.”
I noted that
“The combination of low savings, higher credit card debt, and the delay in receiving the increase in net pay until February can be expected to lower consumer spending in the first quarter.”
The Atlanta Fed’s GDPNow forecast has fallen from 5.4% in January to 2.6% on February 27. Coming into 2018 the enthusiasm about the economy was supported by the Citigroup Economic Surprise Index which had made a multi-year high in December, but I expected that to change:
“Since bottoming in the spring of 2017, the Citigroup Economic Surprise Index has soared reaching a multi – year high in December. If I’m right and the economy slows in the first quarter, economic reports will come in lower than forecast and the Citigroup Economic Surprise Index will decline.”
The Citigroup Economic Surprise Index has been cut in half since the end of 2017 as a slew of economic reports have come in weaker than expected.
On February 2 the Labor Department reported that Average Hourly Earnings (AHE) increased 2.9% from a year ago which ignited selloffs in Treasury bonds and stocks. On January 24, I posted the following note on LinkedIn:
“After years of slow growth many have forgotten that the fiscal stimulus being added will make the economy more cyclical in terms of the business cycle than at any time during this recovery. If correct, the bond market is poised for a ‘recognition’ point when investors realize that inflation is actually moving higher. If this develops it could lead to an overreaction. I suspect that the stock market might not appreciate the competition higher yields pose.”
The increase in AHE was clearly a recognition point for the bond and stock market.
In the November Macro Tides I explained why wage growth was likely to accelerate in coming months:
“In the October employment report, the U6 rate fell to 7.9% and the U3 rate dipped to 4.1%, so the U6-U3 spread in October was 3.8%. This is the lowest in nine years, and if maintained in coming months, is at the level that has led to higher wage growth since 1994. Wage growth is finally likely to accelerate in coming months.”
The increase in AHE in January was as expected, although the actual improvement was likely overstated as I discussed in the February 12 Weekly Technical Review:
“State mandated increases in the minimum wage began on January 1 and were included in the January calculation for Average Hourly Earnings (AHE). But the average workweek was down 0.2% in January and hours worked were down 0.5% due to bad weather. Average Hourly Earnings for Production and Nonsupervisory workers, which represent 82% of the workforce, rose just 2.4% from January 2016. Conclusion – the 2.9% increase in AHE was likely overstated in the January employment report and could dip when the February employment report is announced on March 9.”
This suggests that AHE will come in lower than 2.9% for February which should enable bond yields to fall for a period of time. Since the employment report on February 2, the bond market has begun to price in a fourth Fed rate increase. If wage growth temporarily moderates, the bond market may scale back its expectations for a fourth hike.
There are technical reasons why Treasury yields could fall in coming weeks. The positioning in the 10- year Treasury futures market suggests the next major move in yields is down, not up as most investors expect.
Granted this is a tough call since the deck seems stacked against yields falling. Commercials are considered the smart money and are holding a near record long position. As of February 26, they were long 631,797 contracts. In January and late February of 2017, as the 10-year yield was topping near 2.60% they were long 644,599 contracts and 594,711 contracts (red line middle panel). This suggests that they will be buyers on any additional weakness in bond prices.
Large (green line middle panel) and Small (blue line middle panel) Speculators are holding a large short position that is almost as large as in January and February 2017. A decline in yields would generate losses on those short positions, which is what occurred after Treasury yields fell and bond prices rose after March 2017. To stem their losses Large and Small speculators would buy Treasury futures thereby pushing Treasury prices up and yields down further.
Longer term I still expect the yield on the 10-year Treasury bond to exceed 3.03% before Labor Day. The yield on the 10-year Treasury bottomed in July 2016 at 1.33% rose to 2.63% (+1.30%) in March 2017, before dipping to 2.03% in September. An equal move up of 1.30% targets 3.33%.
This suggests that after Treasury yields fall in the short term, a combination of factors – wage growth resuming its uptrend, import inflation rises, business investment improves, and fiscal policy boosts GDP growth – will resurrect inflation pressures and the potential that the Fed may increase the federal funds rate a fourth time in 2018. The European Central Bank (ECB) is also going to play a role.
European Central Bank
The European Central Bank has said it will continue its $30 billion of monthly purchases of European sovereign and corporate bonds through September 30. The ECB has previously tied it purchases to achieving its 2.0% inflation target. In coming months it is likely that the ECB will announce that it is delinking its target of 2.0% inflation and its QE program since the ECB does not expect inflation to reach its target until well after September 30. This announcement will represent another small step toward normalizing monetary policy.
Early in the third quarter the ECB will endeavor to communicate its intention to scale back its QE program, if not at the end of September then certainly by the end of 2018, since the European economy is growing at a 2.4% annual clip. GDP is reported on a quarterly basis in Europe rather than annually as it is in the U.S. A 0.6% quarterly increase translates into an annual growth rate of 2.4%.
One of the more positive developments is the increase in lending which is now growing faster than at any time since the financial crisis. This indicates that the rise in business and consumer confidence is translating into an increase in business spending and investment.
The improvement in the European economy has staying power and likely pressure the ECB to remove the excess monetary accommodation its QE program represents if growth continues at its current pace.
As I have discussed previously, European bond managers are not going to wait for the ECB to hit them over the head. As noted last September:
“When the Fed and ECB wanted to repress interest rates they could enlist the help of market participants to ride their coattails since investors would profit from the collaboration. Unwinding negative real interest rates and curtailing bond purchases will cause interest rates to rise and create losses for bond holders. Rather than being coconspirators, market participants will be combatants with the central banks and more importantly with each other.”
As I noted in the December Macro Tides:
“This is a significant change which has yet to manifest itself but is likely to emerge in 2018 as the bond vigilantes reclaim a role in the global bond market.”
I hadn’t heard the phrase ‘bond vigilantes’ in many years, but after the U.S. Treasury market cracked in early February I heard and read it a number of times. The phrase is likely to appear sometime in the third quarter when the European bond vigilantes begin to ponder the reality of 2.4% GDP growth, rising inflation, albeit from low levels, and the ECB ending its QE and interest rate repression program. The increase in European bond yields is likely to coincide and contribute to U.S. Treasury yields breaking out above their recent highs and resistance.
Exports only comprise 12% of GDP in the U.S. but more than 40% in the European Union. The 14% decline in the Dollar since January 2017 has resulted in an increase in U.S. import inflation. Since January 2017 the Euro has soared more than 20% versus the Dollar and is up nicely versus the currencies of other developed countries.
The appreciation of the Euro is a double negative. It depresses import inflation which puts downward pressure on inflation, which means it is working against the ECB’s goal of higher inflation. The strength in the Euro makes European exports more expensive which has the potential to slow export growth and overall economic growth given the European Union’s dependence on exports.
The ECB is understandably concerned that the Euro could strengthen further as the ECB moves toward less monetary accommodation. However, the positioning in the Euro futures suggests that the Euro either topped on February 16 or will in the next few months after a bit more strength.
When positioning becomes extreme, with Large Speculators holding a large long or short position, the odds are high that the trend is about to change. Large Speculators are trend followers so by definition as a group they hold their largest long position as an uptrend is nearing a high and the largest short position after a large decline that is close to a bottom. The unwinding of large long positions held by Large Speculators contributes to a decline as they sell, and pushes prices higher as they buy to cover a large short position.
As the Euro was bottoming below 1.040 in December 2016, Large Specs were short -114,556 contracts. Rather than falling more, the Euro zoomed to 1.20 by August 201, which forced Large Specs to buy to limit losses. As of February 26, 2018 Large Speculators were long 126,126 contracts since they think the Euro is headed higher even though it has already risen significantly.
Commercial Speculators (red line middle panel) are considered the smart money and the track record supports that claim. When the Euro was bottoming below 1.04 in December 2016 Commercial Specs were long 126,616 contracts and were rewarded with a big rally in the Euro. Commercial Specs are now holding a near record short position in anticipation of a decline in the Euro.
Trump’s tariff announcement could knock the Dollar down in coming weeks and allow the Euro to rally and potentially test an important long term trend line.
As I discussed in the January 29 Weekly Technical Review:
“The Euro topped on May 5, 2014 at 1.3993 and dropped .3652 until bottoming on January 2, 2017 at 1.0341. A 61.8% retracement of that large decline would carry the Euro back up to 1.259. The longer term chart of the Euro suggests it could rally back to the down trend line connecting the highs of April 2008 at 1.6008, May 2011 at 1.4938, and May 2014 at 1.3993. This trend line comes in near 1.2770 and will decline modestly in coming weeks.”
In March 2014 Mario Draghi noted that the strength in the Euro from July 2012 through March 2014 had shaved .4% off the EU’s inflation rate. This was Mario’s way of telegraphing that he would welcome a decline in the Euro. The ECB will be pleased if the Euro falls in coming months, and may at some point give it a shove with a comment from Mario Draghi.
Dollar
If the Euro declines in coming months the Dollar Index will rally since the Euro comprises 57.6% of the Dollar. The recent low was 88.25 (cash) and could be retested amid trade discussions that include retaliatory actions by other countries in response to U.S. steel and aluminum tariffs. Once the top in the Euro is confirmed, the Dollar chart suggests a rally to near 95.00 is possible in coming months. This would represent an increase of almost 8.0% from its low at 88.25.
A Dollar rally of this magnitude could prove a headwind for U.S. stocks, some commodities, and Emerging Markets, especially if Treasury rates breakout before Labor Day and are joined by higher rates in Europe.
Emerging Markets
On a valuation basis Emerging Markets are far less expensive than U.S. equities and economic growth in the majority of EM countries will be stronger than in the U.S. or Europe. However, the combination of higher interest rates in the U.S. and a stronger Dollar could prove a heavy burden on the $10 trillion of EM debt denominated in Dollars between now and Labor Day.
Money flows into EM soared in January before the markets got clipped. The inflow suggests a bit too much enthusiasm and leaves EM funds vulnerable. A retest of the February low near $45.00 on the Emerging Market ETF (EEM) is possible.
Oil
Last month I discussed why oil was poised for a meaningful decline:
“Based on the positioning in the futures, market sentiment is wildly bullish. As of January 22, Commercials were holding their largest short position of -738,974 contracts in history. The smart money is clearly positioned for a decline in oil prices. The main message from technical analysis is that the rally in oil is close to at least an intermediate high that could lead to correction down to $55.00 or lower by mid-year.”
WTI oil quickly fell from $65 a barrel to under $58.00 within a week before rebounding to $64.24. The intermediate outlook is still negative. Once WTI oil closes below its rising trend line, a decline to $56.00 and potentially to $53.00 is possible in coming months.
Gold and Gold Stocks
The positioning in Gold futures is still not supportive of an intermediate rally in Gold. If the February employment report on March 9 shows that wage inflation receded from January’s level of 2.9%, some of the near term concerns about inflation could diminish which may prove a negative for Gold.
Although Gold may test $1350, the next larger move is likely to be lower. A close below $1306 could be followed by a quick decline to $1250. Additional Dollar strength could also weigh on Gold. Gold stocks as measured by the gold stock ETFs GDX and GDXJ have continued to underperform Gold.
Bloomberg Commodity Index
The symbol for the ETF that tracks the Bloomberg Commodity Index BCI is DJP. In last month’s letter I discussed DJP:
“After a pullback to $24.50, there is a good chance DJP could break out above the long term black down trend line in coming months, which could be followed by a rally to near $30.00.”
During the shakeout in early February, DJP spiked down to $23.58 before rebounding to $24.86. If the Dollar strengthens in coming months and leads to a decline in oil and gold, it could spill over into other commodities as well. There is a risk that DJP could fall to the lower black trend line which is near $22.50.
Another broad selloff could swamp the markets this summer if interest rates spike again. It would be negative if DJP closed below $24.00, and a close below the red trend line at $23.60, could be the harbinger of a drop to $22.50. A close above the declining black trend near $25.50 would be quite positive.
Trade
Trade has been a major contributor to the global economy for more than 5 decades. Since 1965 global trade has soared from less than 25% of global GDP to more than 60% in 2007, according to the World Bank and the Organization for Economic Co-operation and Development (OECD). After rebounding after the financial crisis, it has slipped back to roughly 57% in 2016. The increase in global trade was entrenched well before NAFTA in 1994, China’s admission to the World Trade Organization (WTO) in 2001, and the original Trans-Pacific Partnership (TPP) in 2005.
Global economic growth has slowed from 5.4% in 2007 to 3.6% in 2017, which has provided a fertile environment for an increase in trade frictions. More attention has been paid to the negative unintended consequences of increased trade enflaming those who have been adversely affected. This issue likely played a far greater role in determining the U.S. Presidential election in 2016 than Russian interference, but don’t expect CNN to focus on it anytime soon. The OECD has analyzed global growth prospects under different trade conditions and forecast a significant blow from rolling back the trade liberalization seen over the last 15 years:
“The global loss in GDP would be about 1.3%, but for the countries that impose the restriction, in other words, the US, China and the EU, the loss in their GDP would be closer to 2%. The countries that impose the restrictions damage themselves more.”
The OECD noted that more than 25% of jobs depend on foreign demand in many of the 35 countries in the OECD group:
“This economic outlook suggests that protectionism and inevitable trade retaliation would offset much of the effects of the fiscal initiatives on domestic and global growth, raise prices, harm living standards, and leave countries in a worsened fiscal position.”
History indicates that trade expands the economic pie as trade barriers and tariffs are lowered or removed. The problem has been that the gains from trade have been distributed unevenly. Shoppers at WalMart might save $2,000 a year on the products they purchase, but that doesn’t mean much to the worker who lost their job when the factory they worked in closed and moved overseas.
Job training programs were not implemented to address the downside of freer trade in the U.S. Instead the U.S. government guaranteed $1.3 trillion of student loans irrespective of whether the students were getting a degree that would enable them to find a job after graduating. The U.S. probably has the best educated baristas in the world.
Imports into the U.S. of cars and trucks from Japan, the European Union, and other vehicle producing nations are levied a 2.5% tariff by the U.S. Exports of U.S. made cars and trucks are saddled with a tariff of 10% by the European Union and 25% by China. This is just one example of the disparity between the U.S. and its trading partners.
The trade imbalances that have developed during the last 20 years are significant and warrant a serious effort to correct them. I just don’t think a frontal assault is the best approach if one wants our trading partners to make changes and be able to sell them back home. How can our trading partners negotiate and make concessions without looking weak to their countryman after President Trump issues such a very public gauntlet? By their nature trade negotiations are complicated and difficult and President Trump just raised the stakes with comments like this:
“Trade wars are good and easy to win.”
History has taught a very different lesson. Trade wars are never good and no one wins.
Stocks
Although Treasury yields are likely to hold below the cited levels in coming weeks, which would normally be supportive of the stock market, the issue of protectionism has the potential to create enough concern, confusion, and fear to cause the S&P 500 to not only drop back to the low on February 9 but below it.
In January measures of bullish sentiment reached multi-decade highs, which is always a warning that the market could be vulnerable to a correction, if provided a good reason. For months investors had nothing to worry about which is why the S&P 500 set all-time records for going the longest time without a 3% or 5% pullback.
Investors can now worry about inflation, Fed policy, and the risk of a trade war. Although the S&P 500 has the potential to fall to 2450 and potentially 2340, there are reasons why the 2009 bull market did not end on January 26.
True bear markets are associated with a recession as was the case in 2008, 2001, 1990, 1981, 1974, and 1969. The economy shows no signs that a recession is likely before the end of 2018. Monetary policy is still accommodative, unemployment has not been trending higher, spreads between corporate and Treasury bonds are still quit narrow, and the economy is going to get a shot of stimulus from tax cuts and government spending in coming months.
That doesn’t mean the S&P 500 can’t decline by more than 20% with the economy remaining healthy. That’s what occurred in 1998 and 1987. Although the sharp decline in early February has subdued a portion of the bullishness evident in January, sentiment seems a bit too complacent. If the S&P 500 does drop back to the February 9 low of 2533, the odds are high that it will chastise the buy-the-dippers by declining more than expected.
This suggests that becoming more defensive is appropriate. I would consider going short the S&P 500 if it pushes above the February 27 high of 2789, using a close above 2840 as a stop. A close below 2647 would likely signal a retest of the February 9 low was forthcoming.
