Updated 4/4/17 – Extreme US equity valuations don’t matter until they do. Now I believe they will because we are on the cusp of seeing all four major central banks this year pull back in some fashion from their extraordinary policies. Or as I like to refer to these policies as extreme monetary activism or monetary madness. After getting our 3rd rate hike from the Federal Reserve in March, we’ve heard from a flurry of them over the past few weeks and almost all expect at least two more this year and with a growing possibility that the process of balance sheet shrinkage might be upon us before year end. We also heard last month from BoJ Governor Kuroda who is acknowledging the risks to bank profitability due to his own policies and they are in the process of a subtle, silent taper. Beginning today, the ECB will cut its monthly QE purchases by 25% and I expect another taper after the summer at the same time talk will grow that negative deposit rates will get less negative. Mark Carney and the BoE have an inflation problem on their hands and chatter of a rate hike and/or end to QE might happen sooner rather than later even though their hands are tied over Brexit. They’re in a reall bad spot.
The bull case is that earnings are beginning to grow again and are expected to be up about 10% y/o/y in Q1. But, any analysis of earnings compared to stocks must look at what’s already happened. Let’s take earnings at the end of 2012 right as QE infinity was just about taking hold. As of Q4 2016, earnings grew by 10% for both GAAP and Non GAAP view points while the S&P 500 is up by 65%. Can you say multiple expansion? Like the market P/E going from 14x to 22x. Thus, because of higher rates and less QE, expect multiple compression that will overwhelm any earnings improvement from here.
I’m going to repeat my view that investors should look overseas for better opportunities. Emerging markets such as Brazil (EWZ), India (INDA), and South Korea (EWY) I believe provide better equity valuation opportunities. I also find parts of Europe attractive, such as Spain (EWP) and Italy (EWI). The European bank sector should also benefit from the inevitable end to negative interest rates and QE in Europe at some point in the 2nd half of 2017 and into 2018. Within EWP and EWI includes the largest Spanish and Italian banks that have had a tough go and would benefit from an end to ECB extremism. I’ll add an individual name this week, HSBC (HSBC). It’s the ADR of the London based global bank and as I’m bullish on the washed out British pound, any appreciation in Sterling will add to the gains in the ADR. About half of their business is in Asia and anyone with a 10 yr+ time frame should understand that is where the global economic center is shifting to. One also collects a healthy 6% dividend yield.
My opinion on commodity stocks is now more discriminating. After being bullish on industrial metals for the past year, I’m going to take a step back right now and only buy on sharp pullbacks, particularly in copper (SCCO). I continue to like agriculture and am playing it via POT, MOS and the broader MOO. The gold/silver bear market ended in December 2015 when the Fed finally raised rates for the first time in 10 years. Gold was then $1050. Today gold is at $1250 even after the 3rd rate hike. The strong dollar crowd is still way too crowded and investors should be watching REAL yields, not nominal. The 5 yr REAL yield is at -.16 bps vs +.43% when the Fed first hiked rates back in December 2015. The gold idea can be played via PHYS, SLV and the miner etf GDX. As for the individual miners, I like GG and NGD in particular. See my comments below on oil and oil stocks which I included under the ‘commodity’ section.
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. I’ll add 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.
Updated 4/4/17 – I’m going to repeat my viewpoint on bonds with some updates.
I believe the 35 yr bull market in bonds ended in July 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. Today it’s at 1.05%. I’ll list my reasons for being a bond bear:
- In the epicenter of QE, that being Japan, where the BoJ balance sheet is almost 100% of GDP, they are now allowing a steepening of the yield curve past 10 yrs while remaining committed to yield curve control that continues to damage the banks even though Kuroda admitted last month that he’s damaged bank profitability. This is just not sustainable. The Topix Japanese bank stock index is at a 4 month low.
- ECB has now trimmed their monthly QE by 25% and I expect another taper within the next 6 months. The ECB is running out of bonds to buy that meet their criteria. They are thus discussing ways of widening their pool of available assets. I call that desperation.
- Negative interest policy in Japan and Europe has reached its limits. Both central banks acknowledge the nasty side effects such as damaging the profitability of their banking system. See #1 on that.
- Inflation is moving higher globally, particularly in the Euro Zone, UK and US. Germany inflation in particular is spiking as it is in the UK due to the profound weakness in the pound. Core CPI is 2%+ for 15 months in a row and the PCE, the Fed’s preferred gauge, is now at 1.8%. Yes, the impact from higher oil prices will start wearing off but sticky services inflation remains an issue.
- I expect BoE QE to end this year and just might take away the last rate cut panic after Brexit.
- Foreign investors are large sellers of US Treasuries, particularly China and OPEC countries. Foreigners sold $342b of US notes and bonds in 2016, an unprecedented pace. They sold another $6b worth in January.
- This reason was in my last update in mid March but is not looking so much the case as we made get a watered down version. “Trump is about to throw fiscal kerosene on an economy that has only a 4.7% unemployment rate and inflation around 2%. Wage growth should accelerate from here.” I still expect wage growth to accelerate though as labor takes a greater share of profits.
- Can it not be more apparent that the Federal Reserve will still go very slow in raising rates which means the long end will do it for them. After all, doves still run the FOMC.
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish as I believe European sovereigns are a train wreck waiting to happen. Corporate bonds are also vulnerable in Euro Zone and in UK as QE eventually ends there. US corporates are very expensive and are exposed on US Treasury weakness. Spreads are very tight with little room for error. The US 10 yr yield range of 2.30-2.60% remains with us now at the lower end but I don’t see reason yet to break out of it. Be cautious on TLT and BWX and like TBF and TBT. While this may seem like a slow moving process, the trajectory of global interest rates is higher.
Updated 4/4/17 – As stated above, I remain a bull on some commodities unlike all in last months’ update. A supply driven bull market resumed last year but I’m taking some chips off the table with industrial metals (SCCO). I still think $45-$55 will remain the range which I think inevitably will be taken out on the upside as a result of the still large amount of capital expenditures being taken off line over the past few years. I like COP, HP, and XES (the oil service etf). COP had some great news last week after selling their Canadian assets for more than $10b and the stock was up sharply. Gold and silver are currencies not commodities but I’ll refer to them in this section. As inflation rises, central banks will be VERY slow to respond, thus real rates will fall and will then boost gold and silver. I touched upon real rates above. Mining cap ex has fallen sharply in a variety of industrial metals and that will continue to give a boost to them but they need to now take a breather. Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. I like DBA.
Updated 4/4/17 – The dollar is stuck in this contradictory vortex between the desire on the part of the Administration for a weak currency as expressed by officials on one hand but the possibility of a border adjustment tax being part of broad tax reform which needs a stronger dollar. As I’m most worried about a rising trend in inflation and a Fed that will very gradually respond with hikes, I’m a seller of the dollar. Again, REAL rates are still firmly negative in the US even with 3 interest rate hikes from the Fed and gives a good reason why the US dollar has stopped rallying. I’m still a buyer of the euro (FXE) as the ECB takes its first step toward the exit door. Mario Draghi is still very dovish but is finally beginning to acknowledge that inflation trends are moving up, the downside risks are basically gone and there is now even a discussion about when negative rates will start going on. With pressure growing on the BoE to take back the easing post Brexit because they have an inflation problem on their hands, I like the pound too as I believe it’s now very undervalued (FXB). I’m going to add a positive stance on Asian currencies, particularly the South Korean Won where the EWY stock etf will benefit from. I also like the Singapore dollar (FXSG) as its cheap relative to the US dollar.