Updated 7/10/17 – It’s been a wild two weeks as the monetary tectonic plates really started shifting after Mario Draghi hinted that the ECB would soon taper its QE purchases again. I expect the groundwork to be laid at its next July 20th meeting and then followed by actual implementation in September. I’ll talk more about this under the bonds category as I’ve made it clear how bearish I’ve been on European bonds. So, the question here is what this means for stocks.
I’ll repeat this paragraph as it’s what I’ve been saying for a while as the two pressure points of high valuations and tightening of monetary policy meet up. “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. There has been a pickup in volatility in stocks as the daily percentage moves are increasing. European stocks which have been loved also have seen some squishy trading, particularly the German DAX which touched a two month low this past week. High valuation tech stocks have of course also been vulnerable to the rise in interest rates.
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. Just remember how excited investors got when QE was on. I continue to believe there will be an equal reaction to the downside when it reverses and which will also be joined by the ECB and other central banks.
Q2 earnings reports begin this week 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 based on stats seen so far after the punk performance in Q1 (1.4%) 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. With nominal GDP growth so modest (3-4%), it’s getting very hard to generate faster earnings growth. I believe expectations are high that earnings will save the day but with rising interest rates, there is very little room for error. There will be no tolerance for any disappointments as investor beer goggles clear up.
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 seems completely bogged down. I mean it is completely bizarre that we are hearing talk that some Republicans that ran on ‘repeal and replace’ now want to work with Democrats to fix what is broken rather than overhauling the entire system. Honestly, who knows at this point on how this unfolds from here. As for tax reform, that will likely be easier to pass but the size and complexion remains up in the air as is the timing. While I think we’ll get it by year end, the impact won’t be felt until 2018.
I’ll bottom line my view on stocks by saying this again: “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.”
There is some concern with emerging markets now with the rise in interest rates and tightening of monetary policy but I’m going to repeat my view that investors should still 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. North Korea is of course a problem that continues to flare and never seems to go away but I just can’t see the worst case scenario happening as it’s not even in North Korea’s interest.
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. It was July 1st that the GST officially began but will definitely take time for most businesses to adjust. This won’t go smoothly but the benefits I believe are tremendous. 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.
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. Temer continues to fight tooth and nail and seems to have the support needed to work thru these allegations.
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. 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 am making a change in recommendation however with my positive view on European stocks. I recommend selling half your position. A rise in European interest rates in response to a change in ECB policy is a major risk to stock prices and European stocks won’t be immune.
The action in gold and silver continues to be frustrating as they vacillate between the benefits of a weak dollar, very low real rates and central bankers that are losing credibility on one hand and the fears of some that higher rates and the tightening of monetary policy will be a headwind for something that yields nothing on the other. I remain bullish as I see where all this is going. Central bankers will tighten us right into the next recession and will quickly halt and then reverse the process. That is when gold and silver really explodes 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. 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. We’ve seen possibly a trend change in agriculture prices, particularly wheat, corn and soybeans. Over the past few weeks prices have spiked, especially in wheat due to dry weather but also there is a historically low level of acreage dedicated to wheat. The CRB food price index is on the cusp of breaking out to a multi year high. Now it’s too early to say if we are seeing the beginning of the next bull market after 6 years of a bear but 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.
I keep repeating this but will again. 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. The OPEC deal has failed in stemming the pressure on prices and that is in large part due to Libya and Nigeria, two members that DON’T have to adhere to the limits because of previous country specific problems. They’ve ramped up production at the same time US shale just won’t stop. 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 two weeks ago. I am holding on to COP and HP as two individual companies. Both pay good dividends. I added a new recommendation, Williams (WMB), the large natural gas pipeline, gathering, processing and storage company two weeks ago. 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. We did get one piece of negative news in the nuclear space a few weeks ago when the new president of South Korea said he wants to stop using nuclear power but that could take decades to unfold.
Updated 7/10/17 – As stated above, the bond world changed a few weeks ago when Mario Draghi seemed to be laying the groundwork for another round of tapering at the September meeting. The next ECB gathering is on July 20th and expect the wording and body language to continue to change. ECB QE is officially expected to end on December 31st. That of course is not going to happen but as we get closer, they have to begin to pivot. European bond yields spiked in response to the Draghi comments. The German 10 yr yield in particularly more than doubled over a two week time frame from .25% to near .60%, the highest since early 2016. This in turn caused a global rout in bonds. Long term yields even jumped in Japan and the US 10 yr is now approaching 2.40%. Yields are of course still very low but there is an obvious monetary policy regime change that is upon us.
With respect to the Fed, they seem intent on tightening again in September whether via another rate hike or QT. I’ll go with the latter with another rate hike maybe in December. 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.
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. Today it’s above 1% and at the highest level since early January. 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. I repeat 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.
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish and have been as I believe European sovereigns are a train wreck that maybe is on the cusp of happening. 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. Junk bonds in Europe yield less than 3%. Imagine that. 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.
I’m including an etf that traders can use to play the short sovereign bond trade, short BNDX. It’s the Vanguard Total International Bond ETF.
Updated 7/10/17 – 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 as Libya, Nigeria and US shale have offset this. Oil at current levels then is really tricky from a trading standpoint as the market now questions OPEC’s resolve. 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 $50 I’m a seller.
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 you can see my arguments above. Gold and silver remains in this vortex between rising rates/tightening of monetary policy on one side and the weaker dollar, negative real rates and the creeping loss of central bank creditability on the other.
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 have spiked over the past few weeks and a trend change might be upon us. I like DBA and added CORN, the etf to my buy list four weeks ago. I am today adding SOYB, the soybean etf. China has recently ramped up their imports of soybeans. The global demand for food is on a one way trajectory higher. The CRB food stuff index is just off the highest level since last year. Not many are paying attention.
Updated 7/10/17 – 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. Mario Draghi changed the bond/FX world with his laying groundwork for policy change in September. 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.
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.
Two weeks ago I added the Canadian dollar (FXC) to my buy list. The main catalyst was the hawkish comments from both Governor Poloz and one of its other members who believe that a rate hike is in order. This past Friday saw a much better than expected June jobs report that most likely clinched a rate hike on July 12th. The Canadian dollar rallied this week to the highest level since September 2016.