Updated 7/25/17 – Again, Janet Yellen rode to the rescue of markets with her perceived dovish commentary at her semi- annual testimony in front of Congress two weeks ago. By implying that they might be towards the latter stage of this rate hike cycle because of their econometrically driven version of a “neutral rate” is rather low, both stocks and bonds got all excited. Lost in that testimony was the part of the sentence that followed which said that the “neutral rate” will trend higher in coming years. Either way, we must focus on when and what impact QT or quantitative tightening will have on markets. The FOMC meeting on July 26th might shed light on a September start and if so, the market rubber will then meet the road. I say this because we can’t deny how ebullient markets have been in light of QE, whether in the US or the byproduct effect from its form in Japan and Europe. Thus, I expect QT will have an opposite effect. While maybe not symmetrical, I’m expecting no free lunch.
The selloff in the tech highfliers on June 9th has mostly been negated (Apple still is below the previous day level) both on the Yellen comments but on strong subscriber numbers out of Netflix. This coming week will put most of the others to the earnings test and there is no question the bar is high. What we’ve seen so far in this earnings season is the typical beat rate but the stock market response has been very mixed. Those that beat have seen a slight rally (other than NFLX which rallied huge), those that meet, miss or have tempered guidance have gotten hit hard. Examples are the bank stocks, GS, BLK, GE, HOG, MXIM, CSX, UNP, UAL and IBM to name a few.
With very high valuations (has been the case for the past few years but hasn’t mattered), the question is whether investors start to become more discriminating because central banks are just not the same type of friend anymore. Central banks certainly are afraid to move at anything more than a snail’s pace with the comments from the BoJ and the ECB this past week clearly evidence of this but a change in policy is still afoot. Kamikaze Kuroda just won’t give up on his 2% inflation pipe dream (even though they are doing less QE with the focus now on ‘yield curve control’) and Mario Draghi is deathly afraid of the bond market impact of tapering at the same time he is not close enough to his 2% inflation obsession. We still expect a further tapering to come by January 2018 the latest. Draghi certainly confused the markets this past week with the jump further in the euro (and sharp selloff in European stocks) while European sovereign bond yields fell.
Two things are clear. Firstly, central banks are trying to remove or back off somewhat from their extreme accommodation but secondly, have been and will continue to do so in such a ‘gradual’ fashion and coincident with transparency that they hope will cushion the impact and ease the markets thru the process. This then begs the question over whether the end result will be any different. This is the analogy I gave last week on my feelings with this: “I’m still not convinced advanced notice will really matter as the impact is still tightening. I’ll give this analogy. While I’m not that strong, if I give you a week’s notice that I’m going to punch you in the face and then hug you after, will the punch feel any less painful when it actually comes?”
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.
I do my best to always understand the other side of the market to what my viewpoint is and it seems that the positive opinion on stocks has been predicated on a further rebound in earnings and hoped for tax reform. I’m confident that the latter will happen by year end but uncertain on the extent of the tax cuts. As to earnings, looking at the broad picture (rather than just S&P 500 companies) gives a more mixed than the headlines. Half of the expected Q2 earnings bounce is energy driven and current oil price will likely lead to earnings downgrades in the 2nd half. And, labor costs are rising and profit margins are falling and I’m thus not confident in a high quality (that does not include lower tax rates and stock buybacks) improvement in corporate earnings.
Bottom line, I have to acknowledge the teflon behavior of this stock market. It trades great no question and has sharply surpassed my expectations. That said, I remain of the belief that the underlying fundamentals are really fragile. Economic growth will likely be below 2% for a 2nd straight year, corporate earnings looking at the National Account’s data within GDP are now falling, and most importantly, central banks are now looking for reasons to tighten after years of finding every which way to ease. We can’t ignore that the tremendous multiple expansion seen in this bull market can be mostly attributed to QE, ZIRP and NIRP.
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), India (INDA), and South Korea (EWY). 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. An early read is that the implementation has gone without any major disruptions. 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.
I remain bullish on Brazil. 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. 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. Temer continues to fight tooth and nail and seems to have the support needed to work thru the bribery allegations.
I’ve been bullish on European stocks and that has worked out but two weeks ago I recommended selling half your position. Luckily I did because markets took it on the chin last week in response to the stronger euro. France remains intriguing because of the positive economic changes that President Macron could implement. I also like European banks that would benefit from further European tapering and the eventual end to negative interest rates. Keep in mind, bullishness on European stocks is a more crowded trade and a key reason why I took some chips off the table.
Gold and silver stocks rebounded as the US dollar continues to trade terribly and on the heels of Yellen’s dovish testimony. I’m hoping we are on the cusp of the next leg higher because it seems that the fundamentals are coming together with a weak dollar, low real rates, central banks that will remove accommodation at a snail’s pace and importantly, the hits to their reputation will only intensify.
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 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. 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. The 2017/2018 harvest may result in the first fall in ending stocks for corn since 2010 and 2011.
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. 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. I added a new recommendation, 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%.
I have my eye again on the industrial metals, not because I’m seeing any notable increase on the demand side but I believe the supply side continues to be reined in, especially in China. I’m not making any moves yet 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. 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 7/25/17 – I believe the bond world changed last month when Mario Draghi verbally laid the groundwork for another round of tapering, whether by year end or in early 2018. Over fear of a bond market tantrum in response, the ECB has tried to walk back from it but the toothpaste is out of the tube. 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.
Mario Draghi was completely noncommittal last week in his press conference but the pressure is growing to come up with a plan as the current QE program expires in December. He continues to obsess about not meeting his 2% inflation target at the same time the European economy is doing just fine without it being achieved. Either way, expect more tapering news in September.
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 (see analogy above) 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 1.05% and near 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.
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 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.
As for US treasuries, they will be caught in the push and pull of lower yields due to weak growth 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.
Two weeks ago I included a way to short sovereign bonds by being short BNDX. It’s the Vanguard Total International Bond ETF.
Updated 7/25/17 – 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 BUT I’m considering getting back in. 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 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 prices were awoken from their recent stupor by Janet Yellen’s dovish Congressional testimony and as the US dollar can’t get out of its own way.
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 six weeks ago. Two weeks ago I added SOYB, the soybean etf. China has recently ramped up their imports of soybeans. The global demand for food is on a one way trip higher. The CRB food stuff index is just off the highest level since last year. Not many are paying attention.
Updated 7/25/17 – The US dollar continues to trade like crap and Janet Yellen’s dovishness and expected ECB tapering soon are no help. We’ve had 4 rate hikes from the Fed and they are getting closer to embarking on quantitative tightening and even this can’t help the US dollar. 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 expect the US dollar to trade much lower from here against a broad basket.
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. The recent Chinese economic data has been stable, however manipulated and artificially driven by credit stimulus.
Last month I added the Canadian dollar (FXC) to my buy list. We got the anticipated rate hike from the Bank of Canada who seem willing to look past the current modest pace of inflation. They hiked rates by 25 bps to .75% and thus took back one of the two emergency cuts they implemented in response to the oil price collapse. The Canadian dollar rallied this week to the highest level since September 2016 at around $1.25. Stay long.