Equities
Updated 6/27/17 – As my readers know, my biggest worry about most US stocks has been the potential combustible nature of excessively high valuations (which mean nothing in the short term for stock market performance but are hugely relevant for future returns) and the removal of monetary policy accommodation. As I believe the only way to explain very high multiples is due to the extreme stance of easy money, it then extends to a potential reversal when monetary tightening further progresses. We can debate the economy and the earnings outlook all we want but I remain firm in my belief that central bankers are still driving the equity bus.
Thus, we are possibly entering into a more treacherous time for stocks as the Fed most likely begins quantitative tightening in September and the ECB most likely announces a further tapering of its QE purchases. This then begs the question, ‘if we know this to be the likely progression of events, why then haven’t stocks cared?’ Great question but look at the markets response to previous times when QE ended and the Fed raised rates.
The Fed defined the exact amount of purchases and the deadline for its maturation for both QE1 and QE2. About two weeks after the completion of each, the S&P 500 sold off between 15-20%. Near the end of QE3 when the tapering was well under way, equities had more than a 10% correction. What happened in the two months after the first rate hike? A sharp selloff in stocks that ended in mid February 2016. What has kept the market buoyed in the face of more rate hikes recently has been the massive QE by the ECB and the BoJ. Thus, just because we know what is headed our way, doesn’t mean there won’t be any breakage. The Fed wants to ease the cushion of QT so desperately that weekly communication on the subject is part of their verbal tool kit. It still won’t change the market reaction. I want to emphasize, stocks are no longer the discounting mechanism they used to be. They are much more reactive instead in a world of central bank dominance in our markets.
The earnings for Q1 saw a nice rebound y/o/y for S&P 500 companies with almost a 15% gain. But it was mostly from the energy and financial sectors and the sales derived from overseas for US multinationals. Looking at the profit picture on a broader perspective as seen in the National Accounts data released with the Q1 GDP revision, after tax profits with adjustments were higher by only around 4%. The difference is a muted US domestic picture because profit margins continue to contract because of rising labor costs. I cannot emphasize enough what a peak in profit margins means for corporate earnings as they rose to record highs in this recovery with the helping hand of lowered interest expense and the lowest share of the profit pie going to labor since WWII. That latter point is ending as is the former for many companies that borrow LIBOR based.
Q2 earnings reports are just around the corner and with the recent decline in oil prices, an energy driven rebound in earnings is now at risk not just for Q2 but for Q3 as well if oil prices don’t recover. Also, Q2 GDP growth didn’t see the hoped for rebound after the punk performance in Q1 (1.2%) and in 2016 (1.6%). Evidence of the disappointment in the data is seen in the US Citi Surprise index which has essentially collapsed over the past two months to a 6 year low. As for the mega big cap names that we all know that have been amazing performers, the bar is very high for their earnings releases.
The trajectory of the yield curve (flatter) must also be on everyone’s radar screen as it is a great messaging signal of the Treasury market’s belief in the US economies ability to handle rate hikes. I’ll touch more on this below.
I’ll repeat what I keep saying on stocks this year. The removal of the proverbial punch bowl must not be ignored. The liquidity spigot is being toned down and this has potentially dramatic implications for stocks that are wildly overvalued based on a variety of metrics. These worries haven’t mattered because of the QE still rolling out of the BoJ and the ECB but as stated many times, there is less coming out of this spigot. I’ll give another analogy. Imagine QE, NIRP and ZIRP as the air blowing up the balloon, there is now less air going in. There is also of course the optimism over what Trumponomics will bring but there is now a growing question as to when and to what extent this fiscal stimulus/reform will take place. As the timing issue continues to be a concern, it will help to slow down corporate decision making.
With Trumponomics, the healthcare reform bill has already been delayed. We’ll see what’s next because the timing of this then leads to the timing of tax reform. I’m confident reform will take place but it’s becoming clear that the real effects won’t be felt until next year and it’s highly uncertain as to how aggressive it might be.
I’ve been saying for a while that valuations don’t matter until they do which is not a revelation to market watchers and investors but important to acknowledge. The question is always searching for the catalysts that make them matter. Was Friday June 9th the beginning of the end of this bull market when the largest of the large stocks took it on the chin? Who knows but at the least, a case of acrophobia finally afflicted the names we all know so well that the whole world seems to have piled into. There is no room for error here in US stocks. Valuations are extreme, the Fed is tightening policy and US growth is slowing. WATCH YOUR BACK.
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. South Korea I believe will experience a re-rating of its P/E multiple higher. The country has experienced the lowest multiple in the region because of the dominance of the large corporate conglomerates that operate in almost every industry under the sun and have very low returns on equity and capital. I believe we might be on the cusp of a ‘break up’ or a least a slimming down of many of these conglomerates or chaebol’s that could lead to much higher ROE’s and better focus. Even after the amazing performance of the Kospi, the multiple is still only about 11 times earnings.
India remains an exciting long term story as the benefits of Modinomics takes hold. The new goods and services tax, however difficult it will be to implement, is a potential game changer in making the marketplace much more efficient as it replaces a multitude of taxes at every stage of the supply chain. 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 a potentially a huge positive.
Brazil is a real tough one because every time they are on the cusp of positive change, another scandal rocks the nation. This time Michel Temer’s place as President is under threat because of corruption charges but I really believe it’s only during crisis that tough choices get made and I believe that many realize that. It is with this that I hope that pension and retirement reform gets passed and labor market reform does as well. 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 markets there.
I’ve been bullish on Europe and that has worked out. I’ve particularly liked Spain (EWP) and Italy (EWI). Raise your hand if you ever thought of investing in Spain and Italy. 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. There is now a love affair with European stocks so I now have one foot out the door and will recommend selling these ETF’s on any further strength. In case you missed it, Barron’s ran a front page story on European stocks last month highlighting their attractiveness. That’s usually a pretty good sell signal or at least a sign that a lot has been priced in. France remains intriguing with the political earthquake that Emmanuel Macron and his wide support now in Parliament as a business friendly attitude in a the heart of a welfare state might be game changing. Make France Great Again!
I will repeat this commentary on gold from my last Ideas piece with some changes: There is this persistent belief that gold is a safety play and I need to reiterate that it is not. It is just a currency that happens to be yellow, weighs more than paper and is really tough to get out of the ground. 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. Investors should be watching REAL yields, not nominal. The 5 yr REAL yield has been creeping higher but still remains well below the +.43% when the Fed first hiked rates back in December 2015. The US dollar doesn’t trade well and I keep finding holes in the bull case. 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. 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 want to make an important point here too. I thank my friend David Rosenberg for this stat. In the last 13 rate hike cycles by the Fed since WWII, 10 put us into a recession. I firmly believe that this one will too. How will the Fed respond? With more rate cuts and QE which will then be hugely bullish for the precious metals.
I continue to like agriculture and am playing it via POT, MOS and the broader MOO. POT reported much better than expected earnings last earlier this month and these two fertilizer stocks are really washed out. Demand is good and supply is getting under control. Mosaic took it on the chin after their earnings report but I believe many of the issues were only short term in nature. Two insiders believe the same thing as we saw some insider buying which is always a good sign. See my comments below on oil and oil stocks which I included under the ‘commodity’ section. Deere is a big component within MOO and they reported a much better than expected Q1 because of sharply higher demand from South America. Too many only focused on their North American business. After touching a one year high three weeks ago, corn has since backed off but the CRB food stuff index is just off its highest level since August. Make sure to read the June 21st article in the FT on soybeans that says “As China’s meat consumption rises, the soybeans that feed livestock have become the world’s fastest growing crop, outpacing corn and wheat. Farmers in the US and Brazil are racing to plant more.”
I stated this four weeks ago but will again. Here are some more statistics that I believe will eventually buoy corn and soybean prices which in turn will boost the ag stocks. The International Grains Council (IGC) has downgraded its expectations for global grain stocks at the end of the 2017/18 crop year by 12 million to a three-year low of 479 million tons. Relative to last year, stocks are expected to decline by 34 million tons, mostly due to a large supply shortfall in corn. This deficit might total 28 million tons after the IGC raised its estimate for global corn demand by 8 million tons but left its forecast for the global corn crop the same. According to the IGC, the increased corn demand is due mainly to the growing industrial use of corn to make ethanol in the US and starch in China. Also, China has implemented incentives to stimulate the industrial use of corn to reduce the country’s high inventory levels. The result of these factors the IGC forecasts will lower global corn stocks to under 200 million tons by the end of 2017/18.
Energy stocks have been taken to the woodshed as the price of WTI broke below its multi month range of $45-55. While I don’t see much more downside as I truly believe that progress is being made on the supply side, I recommend selling and taking a loss on XES. I am holding on to COP and HP as two individual companies. Both pay good dividends. I want to add a new recommendation, Williams (WMB), the large natural gas pipeline, gathering, processing and storage company. 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%.
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. CCL reported earnings last week that exceeded expectations. 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 do want to emphasize though that all 4 stocks have had great moves and as I never like to chase things, I’d wait for pullbacks to add but that pullback may only come with a broader market selloff.
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. 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. The CEO said this last month in the midst of the tough conditions, “Six years is a long time to be in a down market. But that’s where it’s at. We can’t control the market; all we can control is how the company operates in it … We’re going to work our way through this.” We did get one piece of negative news in the nuclear space this week when the new president of South Korea said he wants to stop using nuclear power but that could take decades to unfold.
Successful investing long term is buying things when the news is bad and there is light at the end of the tunnel. Chasing what everyone else loves is not investing, it is just momentum driven speculation.
Bonds
Updated 6/27/17 – The rally in long end bonds is sending a clear message to investors. If the market could talk it is saying “The Fed rate hikes are slowing the US economy and will continue to.” Quantifying this, the US Citi Surprise Index this past week fell to a multi year low. While Q1 GDP was revised up to a gain of 1.2% vs the initial print of .7%, Q2 GDP estimates have fallen. The Atlanta Fed GDPNow estimate is down to 2.9%. Should the Fed back off then from raising rates? I want to emphasize that the interest rate normalization process needs to happen because doing otherwise would just be repeating the mistakes of Japan but the timing of a more aggressive rate hike cycle could not have come at a worse time. The Fed is behaving this way because of their rear-view mirror obsession of two lagging indicators, employment and inflation.
We did get some more color from Fed Presidents this week, Evans and Harker in particular, that seem to want to start QT next and then add the 3rd rate hike of the year to December. Either way, QT is another form of tightening and possibly a more disruptive one. How long end yields perform when the QT begins will be interesting to watch. In theory, yields would go up as the market loses a large buyer but if the market is worried about the economic impact, we could see further flattening. I can’t make a call here on what the reaction will be because we are in such unchartered territory.
I still 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 around 1%. But, the path to higher rates will still be a lumpy one as the global deflationary trends of too much debt face and the progress of technology face off against the inflationary desires of central banks. My main worry with global bonds is the upward pull in yields due to central bank activity (or a reduction thereof) 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 potentially downside as central banks are less influential in the market.
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 the Euro Zone and in the UK as QE eventually ends there and these bonds trade at egregiously tight spreads. 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. Noteworthy in HYG this past week was its weakness driven by a selloff in energy high yield. As for sovereign bonds, the UK gilt short end got hit after another BoE member said its soon time to raise rates. UK short end gilts should be sold short with yields at just .24% even after this recent move higher.
Commodities
Updated 6/27/17 – As stated above, I remain a bull on some commodities. I remain on the sidelines with industrial metals until we get better clarity on the now shaky situation in China. Oil continues to lag badly, breaking below its multi month range of $45-55 as OPEC’s production cut deal was not enough to stem the inventory glut, or the perception of one. Oil at current levels then is really tricky from a trading standpoint as the market now questions OPEC’s resolve. Libya and Nigeria, OPEC members but not part of the deal, have increased their production. 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.
Gold and silver are currencies not commodities but I’ll refer to them in this section again (see equities). I continue to remain a huge bull and with the continued flattening of the US yield curve and poor performance in the US dollar, gold and silver have again perked their heads up. We are at a point that if the Fed keeps tightening policy, which they seem intent on doing, the US economy is headed for a recession as that is typically the end result of these cycles. See my comment above on where rate hike cycles tend to leave the economy, with the answer mostly starting with the R word. This scenario should be great for the precious metals. If on the other hand the Fed either before this or during, backs off and then reverses themselves, that will be great for gold and silver as well.
Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. I do think we might be on the cusp of upside in corn prices if the most recent USDA report is any indication as well as the IGC data I discussed above. To add to the IGC news, the USDA said “The global coarse grain outlook for 2017/2018 is for lower production, increased use and sharply reduced ending stocks…Global corn ending stocks are down from last year’s record high and if realized would be the lowest since 2013/14.” I like DBA and added CORN, the etf to my buy list two weeks ago. With respect to China’s voracious appetite for commodities but with worries about their debt bubble, I worry too on the demand side but believe the supply side has responded enough over the past year that any declines in prices will be muted. Also, the global demand for food is on a one way trajectory higher. Corn did break out to a one year high a few weeks ago but has since backed off while the CRB food stuff index is just off the highest level since August. Not many are paying attention. See above my comments on soybeans as China is really ramping up its imports of this important crop.
The Dollar
Updated 6/26/17 – The US dollar continues to trade poorly I believe. We’ve had 4 rate hikes from the Fed and they are getting closer to embarking on quantitative tightening. I believe the market is getting worried about the US economic slowdown that is underway at the same time we are seeing this tightening. Also, the BoJ and ECB are still dovish, but a bit less so with a subtle tapering going on with the former and more to come for the latter this year. We also have a growing mutiny within the BoE that wants to hike rates and at least take back the emergency rate cut implemented after Brexit last year. I’m still a seller of the dollar BUT with one caveat, the sentiment has gotten very anti dollar so we may be on the cusp of a contra trend rally. On any pullbacks though, 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. 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 up.
Four weeks ago I said this: “The BoE is done with expanding their balance sheet and will now only be maintaining its size but I’m going to take my chips off the table on my long pound trade (FXB) after nice move that took the pound from about $1.20 to $1.30. The UK economy seems very vulnerable here as inflation damages real wage gains and businesses lack visibility on what Brexit will look like.” We can now add the huge unknown with the UK economy and the Brexit process post election where Theresa May’s gambit to call an early election has backfired. The offset now, as stated, is the growing likelihood that the BoE might hike rates in the 2nd half of this year. Maybe as Mark Carney is a huge dove. Either way, I’m neutral on the pound after riding the rally from about $1.20 to near $1.30.
I still like 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. The Chinese seem to be backtracking on its move to liberalize the trading of the yuan and the yuan has rallied sharply in response as they added ‘counter cyclical measures’ as a factor in determining its daily reference rate. At least for now, the weakness may have ended.
I’m going to add a currency long today, the Canadian dollar (FXC). The main catalyst is the hawkish comments from both the Governor Poloz and one of its other members who believe that a rate hike is in order. Now Canada has some challenges here with a housing bubble in Toronto and Vancouver and the depressed price of oil but their economy continues to perform admirably and even with the recent lower than expected inflation print of 1.3%, their benchmark rate remains well below it.
Peter is the Chief Investment Officer at Bleakley Advisory Group and is a CNBC contributor. Each day The Boock Report provides summaries and commentary on the macro data and news that matter, with analysis of what it all means and how it fits together.