Updated 10/2/17 – I’ve been of the opinion all year that the main thing keeping the stock market buoyant was hopes for a major cut in corporate income taxes. You can tell me no, it’s been earnings but I’ll respond by saying we priced in this year’s earnings gain last year. Well, I think the continued strength in markets this past week, particularly in the Russell 2000, confirmed my thoughts as the White House finally unveiled its tax reform outline. I’m not going to use this venue to discuss the details but only say that any analysis is not complete unless one models out what labor costs will do if the economy accelerates and how high interest rates will go. The impact on income statements from lower taxes will not happen in a vacuum. Lower labor costs and a sharp reduction in interest expense have been the two main drivers of profit margin expansion since the recession.
I said on day one of 2017 that the year would be a tug of war between tax and regulatory reform hopes and its positive impact on growth and profits on one hand and the monetary tightening that the Fed is engineering on the other. The former of course has won so far. At the end of the day though, it typically is monetary policy that wins the war, unfortunately because we want the Fed out of our markets and prevented from distorting and manipulating interest rates.
This brings us to an important week. QT is about to begin. That sucking sound of liquidity leaving the US financial system will be faint in Q4 with only $30b being removed but beginning today until year end 2018, it will total $450b and that is just to start. If continued it will then total $600b in 2019 and so on. Let’s assume the ECB begins their tapering in January of another 20b euros to 40b euros. And then let’s assume it drops off 10b euros per quarter and then ends by December 2018. From the current pace of 60b euros of monthly buying, that would equate to total ECB purchases of 300b euros (about $350b) in 2018 down from a 720b euro ($850b) run rate. At the current run rate of about 60T yen per year of buying ($550b), the BoJ will continue to dominate but because of FX, not all QE is fungible.
The point is, will the possibility of quicker growth and maybe a lift in earnings (assuming tax cuts offset higher labor costs and interest expense) offset a tightening of monetary liquidity in the US. I’ll argue no in that lower P/E multiples will offset any increase in earnings.
What amazes me is how asymmetrical many view the markets. When the Fed is easing, weak data doesn’t matter because of the ‘Don’t Fight the Fed’ mantra. When the Fed is no longer your friend and is tightening it doesn’t seem to matter either because ‘it’s for good reason because the economy is doing better.’ People, we live in a very overleveraged economy and a financial and economic system that has been addicted to QE, ZIRP and NIRP and really easy money for many years. I just can’t see QT and more rate hikes going smoothly. I don’t care what tax reform looks like.
Also, don’t forget the context of this tightening. It is with extraordinarily inflated valuations in just about everything.
I’ve said this before but will again. The earnings recovery seen in Q1 and Q2 (which about half resulted from a rebound in energy earnings) was priced in last year when the S&P 500 rallied 10% in a year that saw ZERO earnings growth. We can even extend this back 5 years where the stock market has risen higher at a far faster pace than earnings growth. This is otherwise known as multiple expansion and gets into the potential growing concerns with QT in that QE expanded multiples and QT now might compress them.
If you tell me that stocks are at current levels because the fundamentals are good, what is the message of the US Treasury market where the spread between the 2 yr yield and the 10 yr yield is near the lowest level in 10 years. What’s that saying? Nothing good about growth expectations. There is no question that the disaster in Houston and damage and rebuild in Florida is going to be highly influential in the economic data to come which will lead to an initial dampener on growth but an eventual rebound. On that 10 yr yield, we started the year at around 2.60%. Today it stands at 2.33%. What is the bond market telling us about who will win between fiscal and monetary policy in the short term.
With respect to your US equity exposure, it’s time to be taking chips off the table or at least putting in stops depending on one’s time horizon. A longer-term time horizon is an investors best friend but a short one is now fraught with risk. Is this the end of the bull market? I’ve been burned before trying to predict and I know it’s a fool’s game but I will say again, central bank largesse is turning the other way. Don’t forget what got us here.
While I completely understand that emerging markets will not be immune to any selloff in developed markets driven by central bank tightening, I remain a bull on many of these markets such as Brazil (EWZ) and India (INDA). Emerging markets have had a great run this year, better than US markets but I expect outperformance for years to come both from a growth and valuation perspective. US stock markets have just pulled forward so much in terms of future returns.
India remains an exciting long term story as the benefits of Modinomics takes hold. The new goods and services tax I believe is groundbreaking and will create a much more efficient economy. Technology has also taken over the country’s record keeping system where the history of every individual in the country is essentially being digitized which opens up the banking system to millions left out. Stocks here are not cheap but the long term story is compelling. A clean up of the banking system is also potentially a huge positive where bankruptcy laws are changing which would speed up the process and more quickly extinguish bad debt. India recently announced a moderation in its growth rate as the transition to the GST takes time and banks are still loaded with this bad debt but as stated, I believe these challenges are being dealt with.
I remain bullish on Brazil and EWZ is trading at the best level in almost 3 years. Michel Temer has successfully passed two of the important three key legislative goals when he took office. The first one was limiting government spending to the rate of inflation in order to slow the excessive rises in debts and deficits. Just two weeks ago labor market reform passed and this is a major step in liberalizing the Brazilian labor market. Within the bill, companies would be able to more freely negotiate with employees directly instead of thru collective bargaining. Also, union members would not be forced to pay union dues which instead would be voluntary. Having the ability to more freely fire an employee for cause without major repercussions makes companies more inclined to hire which results in a net improvement in job creation. The third key piece of needed change is reform to the pension system by extending out retirement ages. It remains to be seen if Temer has enough political capital to get this done but he did gather enough support a few weeks ago to not get impeached. The country is coming out of its two worst recession years since the Great Depression in the early 1930’s and many are still down on the Brazilian market. Reported three weeks ago, the Brazilian economy in Q2 grew on a y/o/y basis for the first time since Q1 2014.
Gold has had a modest pullback after the US dollar rally that came after China announced a measure that would help to stem the yuan weakness and that rally continued after Yellen hinted to the market that she wants to hike rates again in December and of course after the fiscal tax reform hopes. After this consolidation, I expect gold prices to resume its upward path because of low real rates and continued poor performance of the US dollar. I’m hoping we are on the cusp of the next leg higher in the precious metals because it seems that the fundamentals are coming together. I remain very bullish on gold and silver.
Keep in mind, central bankers will tighten us right into the next recession and bear market and will quickly halt and then reverse the process. That is when gold and silver really explode higher. In the last 13 rate hike cycles by the Fed since WWII, 10 put us into a recession. The gold idea can be played via PHYS, SLV and the miner etf GDX. As for the individual miners, I like GG, AEM and NGD in particular. NGD got some good news a few weeks ago in that their Rainy River project remains on track. If I am correct that a bull market in precious metals is now getting into gear, I expect them to take out the 2011 highs in the few years to come. That’s what bull markets do.
I continue to like agriculture and am playing it via POT, MOS and the broader MOO. What I thought was a possible trend change last month in agriculture prices, particularly wheat, corn and soybeans turned out for now to be a head fake as prices have since come back down again on better weather and more overseas supply. After closing at a one year high, the CRB food price index has pulled back about 10%. I still believe we are potentially seeing the beginning of the next bull market after 6 years of a bear as pieces are falling into place. The global demand for food is on a perpetual rise so it’s always the supply side that helps to drive prices. Also, ending stocks have fallen recently as demand is beginning to ‘eat’ into the supply of robust harvests seen over the past 5 years. The 2017/2018 harvest may result in the first fall in ending stocks for corn since 2010 and 2011. The International Grains Council said this last week specifically on soybeans, “Led by gains in leading producers, another season of record soyabean plantings is expected in 2017/18. However, with yields potentially retreating slightly, global output is projected to fall by 3m t y/y, to 348m. Since world use is set to advance to an all-time peak, aggregate end-season carryovers are predicted to contract by 6% y/y.”
Oil remains in the middle of its multi month range of $45-55. Oil stocks finally have lifted with XLE bouncing off the lowest level since April 2016. The aftermath of Hurricane Harvey in addition to pretty solid global demand for oil and falling inventory levels have been the main catalysts. As I don’t see much more downside as I truly believe that progress is being made on the supply side, I am holding on to COP and HP as two individual companies. Both pay good dividends and have had good rallies off recent levels. I added a new recommendation in early July, Williams (WMB), the large natural gas pipeline, gathering, processing and storage company last month. They own a large stake in the MLP Williams Partners which generates almost all of its revenues from fee based, toll booth type activity. Natural gas continues to take market share from coal and exports of LNG are becoming a large business. A few insiders, including the CEO, recently bought stock and I love that as an endorsement of current levels. Williams also pays a dividend of almost 4.5%. If there is a down and out sector outside of ag, it is energy.
Industrial metals prices, after an amazing run, have taken a breather over the past few weeks also in response to the US dollar bounce after the Chinese yuan reversal lower. The CRB raw industrials index came off its 3 year high. We also saw some disappointing Chinese economic data that reminded everyone that Chinese growth is being challenged by a major debt bubble and government attempts to reign that in. Again, I don’t believe it is the demand side but the supply side that continues to be under control, especially in China. I’m still not making any moves yet because Chinese growth uncertainties but copper stocks are on my radar screen. Copper is on the cusp of being referred to as a new economy metal as its used in electric cars and the transmission of solar.
As for individual industry themes, I continue to like the cruise line stocks as a play on an aging population globally and an emerging market (particularly in China) that is getting wealthier and who want to see the world. CCL and RCL are the best way to play this. The cruise line stocks saw a pullback because of the aftermath of Hurricane Irma where some business was lost. There is also some fear that terrorist concerns are impacting travel plans. These are short term concerns that shouldn’t impact at all the long term positive secular trends. Carnival in particular had a great quarter announced last week but lowered guidance in response to the hurricane as was expected.
I remain positive on Las Vegas Sands (LVS) and Wynn Resorts (WYNN) as a great way to play the rebound in Macau and the rise of the Las Vegas of Asia.
I still like Cameco. Cameco (CCJ) is the world’s largest private miner of uranium. The uranium market has been in a tailspin since Japan shut down every single one of their reactors after the Fukushima disaster a few years ago but some Japanese plants are coming back online with about 9 expected to be operating by year end with 5 currently open. Why like this stock now? The entire industry is underwater in that it costs more to dig it out of the ground than it can be sold for. Production is being cut and very slowly Japan is beginning to bring on more reactors online. At the same time, China and India are voracious builders of nuclear power because it’s safe, clean and a great source of stable power in big size. In total worldwide there are 57 plants under construction on top of about 450 on line.
General Electric remains compelling on a valuation and dividend basis with the possibility of major change with a new CEO. GE is down almost 20% year to date and has been dragged down by its exposure to the oil and gas industry. The lumpiness of their renewable business has also been a big factor and free cash flow has disappointed some. The company does though have a new CEO John Flannery who I have confidence in to reset expectations and further simplify the company’s businesses. I don’t believe there are any sacred cows. With more realistic earnings expectations, the stock trades around 15x forward earnings and with a near 4% dividend yield. Talk about a hated stock with almost no upside expectation built into its stock price. If you sense a pattern here it is that I like things that most others dislike.
I added a new recommendation a month ago, Johnson Controls (JCI). It is an industrial company that is mostly focused on commercial building management. They provide everything from HVAC products and services, to fire, safety and security. The stock trades at 15x earnings with a 2.5% dividend yield. An earlier than expected CEO change helped to boost the stock over the past few weeks but the potential cash flow turnaround is large and the new CEO is the man to deliver. We also have the higher likelihood that the company spins out its Power Solutions business which is a division that produces car batteries. This is a very consistent business but doesn’t fit strategically with building management.
I added AES, the global utility company, to my buy list last week. It is global because they currently do business in 17 different countries via regulated units and independent power producers. They have revenue of $15b and back in February announced the acquisition of sPower, the largest independent owner, operator and developer of utility scale solar assets in the US. The US utility group is trading a historical high P/E ratios near 20x. AES instead is trading at about 11x with a 4% dividend yield. It is a value play for a company that is shifting its focus on natural gas, wind and solar as the predominant forms of energy production. They have and will continue to cut debt in hopes of achieving investment grade status in the next 3 years.
Updated 10/2/17 – After almost touching 2%, the US 10 yr yield is back above 2.30% as the Hurricanes have passed and we can better quantify the impact and damage. But the main reason was the excitement over tax reform. Of note too was the spike in the short end as the 2 yr yield got as high as 1.48% after Janet Yellen reminded us all in a speech that she wants to raise rates again, likely in December. We’ve also seen a lift higher in European bond yields as the ECB preps the market for QT and the Bank of England all of a sudden readies us for a previously unexpected rate hike. The week also ended with a slightly less than expected US PCE inflation print both headline and core after the previous week’s higher than estimated CPI.
As I’ve said many times, the European bond market, both sovereign and corporates, are in an epic bubble and as goes European yields, as might go US yields. Throw in of course Japanese JGB’s and we’re all in this bubble together. I’ll call right here that the next Big Short is the European bond market. The current ECB QE program is scheduled to end on December 31st but we all know that will never happen but they at least need to give us a blueprint of what comes next. We will get tapering details in October for a possible start date in January. Their obsession with near 2% inflation has them fearful of changing policy but the European economy is doing well (2% is considered ‘well’ in Europe), the political worries have dramatically subsided (even though Merkel’s win comes with questions on a coalition) and core inflation has been creeping higher. ECB monetary policy is currently madness, especially with negative interest rates.
As stated before the Bank of England finally came around to what I’ve been screaming about. It’s time to at least take back the emergency rate cut they initiated after the Brexit vote. Falling real wages because of near 3% inflation is making UK citizens poorer because wage growth remains modest. If wages rise in line with inflation, that is tolerable. If inflation rises without a commensurate rise in wages at the same time savers are earning zero on the savings, that is a destruction in people’s standard of living.
With respect to the Fed, QT starts this week. As stated above, the sucking sound of liquidity leaving the financial system will be modest at first but will get louder as the quarters progress. The Fed seems to believe that QT will be a smooth, boring, ‘watching paint dry’ type process. I think they are delusional but it’s that belief that will cause them to move forward. I want to be clear, this process must take place. The Fed must remove themselves from bullying and manipulating our markets but this will be highly disruptive to asset prices and the economy. A recession will most likely follow. As for when the next rate hike might come, tell me where the S&P 500 will be in December in response to QT and I’ll answer the question. It will be less influenced by where inflation is.
I still believe the 35 yr bull market in bonds ended in July 2016 when a panic low in yields was reached right after the Brits voted to leave the EU. Levels were reached globally in yields that we may never see again in our lifetimes. I’ll argue that we’ll never see a 7 bps yield in the Japanese 40 yr again. Today it’s near 1.10% and just off the highest level since early January 2016. But, the path to higher rates will still be a lumpy one as the global deflationary trends of too much debt and the progress of technology face off against the inflationary desires of central banks. I repeat that my main worry with global bonds is the upward pull in yields due to the removal of ECB largesse but acknowledge that a slow economy will be a natural suppressant to yields. Thus, stay in short term maturities. I don’t believe the reward of slightly higher longer term yields is worth the large potential downside as central banks are less influential in the market. The global bond bubble was the biggest bubble in the history of bubbles in terms of dollar size. That air is now coming out has major implications that cannot be ignored. And if US growth accelerates on tax cuts, watch out above on US yields.
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish as stated and have been as I believe European sovereigns are a train wreck waiting to happen. Corporate bonds are also vulnerable in the Euro Zone. The yields on European junk bonds are about the same as the US 10 yr Treasury note. Let that sink in for a moment. US corporates are very expensive with corporate debt levels relative to cash flow at historic highs. Spreads are very tight with little room for error. Stay short HYG. Further monetary tightening on top of a slowing US economy is not a good combination for high yield.
As for US Treasuries, they will be caught in the push and pull of lower yields due to weak growth (more so now in Q3 after the hurricanes) and modest inflation stats on one hand and at risk of getting dragged by a selloff in European bonds as we get closer to more tapering from the ECB and now maybe too on the possibility of growth stimulative tax policy.
Stay short BNDX. It’s the Vanguard Total International Bond ETF. I’m adding this, get short TLT or buy TBT or TBF.
Updated 10/2/17 – As stated above, I remain a bull on some commodities. I’ve recently been on the sidelines with industrial metals until we get better clarity on the economic situation in China. I did catch much of the industrial metal move off the 2015. China’s economy after signs of stabilization saw weaker than expected data this past week. They also announced a step that reversed the relentless yuan rally and that also helped to cool industrial metal prices off their 3 year highs. I’m particularly intrigued by copper again as demand is now coming from new emerging sources.
Oil continues to mostly be stuck in its multi month range of $45-55. See above for more comments. Longer term, I’m no fan of oil as the rate of growth in its global usage should continue to slow as alternatives gain greater share. In the median term (1-3 years) however, there is a lot of long term supply that is being taken out of the market and I believe oil has one last bull run left in it in coming years. Bottom line, below $40 I’m a buyer of oil, above $60 I’m a seller.
Gold and silver are currencies not commodities but I’ll refer to them in this section again (see equities for more color). I continue to remain a huge bull and you can see my arguments above. Gold and silver prices were awoken from their stupor and gold is now at a one year high.
Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. As stated above, wheat, corn and soybean prices spiked a few months ago and have since moved lower again. I still believe though that a trend change might be upon us. I like DBA and added CORN, the etf to my buy two months ago. In July I added SOYB, the soybean etf. China has recently ramped up their imports of soybeans and demand for soybeans are at a record. The global demand for food is on a one way trip higher. The CRB food stuff index has corrected and the space remains frustrating but I believe this is part of a major bottoming process.
With my bull case for Cameco listed in the equity section, I also like uranium but that is just easier to play via CCJ.
Updated 10/2/17 – The US dollar bounced a few weeks ago against most currencies and the main reason was the news last month that China was eliminating the reserve requirement of 20% that banks needed to set aside for doing FX forward trades for non bank clients. That in turn would make it easier (less expensive) for participants to short the yuan. The yuan was on an amazing roll ahead of that and has since sold off. On the other hand, the dollar got smacked this week against the British pound after the news that the BoE wants to start raising rates. The dollar continued its rally in the beginning of last week on hopes for US tax cuts and off Yellen’s comments that I deemed more hawkish.
My bear case on the US dollar has been the right one so far but I said a few weeks ago that it might be getting a bit too crowded in the short term. I want to emphasize short term because I still believe the US dollar is in a secular decline. The US dollar still can’t get out of its own way and our President is one of the reasons. We’ve also had 4 rate hikes from the Fed and they are getting closer to embarking on quantitative tightening and even this can’t boost the US dollar as REAL rates are still subdued. I too believe the market is getting worried about US economic mediocrity at the same time we are seeing this tightening along with the uncertain political situation. If growth accelerates due to tax reform and Fed tightening speeds up, I’ll reevaluate. But, while the BoJ and ECB are still dovish, they are a bit less so with a subtle tapering going on with the former and more to come for the latter this year or for certain in 2018. The ECB will tell us in October that some tapering will take place soon and the European economy continues to perform at its best rate since the recession. On any pullbacks from here after being bullish for a while, I’m still a buyer of the euro (FXE) as the ECB takes its first step toward the exit door and the European economy right now is growing faster than the US. I expect the US dollar to trade much lower from here against a broad basket in coming years.
I still like Asian currencies, and have been a particular bull on the South Korean Won which has traded well this year. With my recommendation a few months ago to sell EWY, I’ll also say to sell the Won and take profits. I still like the Singapore dollar (FXSG) as its cheap relative to the US dollar and is at the highest level since last September. After the news from the PBOC, I don’t know what to do with the yuan here and am now neutral on it.
I still like the Canadian dollar (FXC) as its benefiting from the rise in commodity prices and from another expected rate hike from the BoC in the months to come. Also, the BoC never fell for the drug that was QE. Kudos to them.