What’s in this week’s Report:
- Why We’re Buying Cyclical Sectors
7 Dates That Could Make or Break the Market in Q3
- What Does “Reflation” Actually Mean?
- Oil Update: Rolling Over?
- Weekly Market Preview
- Weekly Economic Cheat Sheet
Futures are slightly higher following a quiet weekend thanks to continued momentum from Friday’s rally.
Economic data over night was good, again. Chinese CPI (1.5% vs. (E) 1.6%) and PPI (met estimates at 5.5%) were in-line, while German trade balance beat estimates on stronger exports.
Global bond yields are down slightly despite the good data, and that’s helping global stocks drift higher this morning.
There are no economic reports today and just one Fed speaker, Williams at 11:05 p.m. EST, so given the important events this week are still a few days out (Yellen’s Humphrey-Hawkins Testimony on Wed, CPI & bank earnings on Fri) I’d expect mostly quiet trading today. If bond yields stay flat, then stocks can grind higher today.
S&P 500 Futures
U.S. Dollar (DXY)
Focus will be on both the micro and macroeconomic this week. From a macro standpoint, Friday’s CPI and Yellen’s Humphrey-Hawkins testimony can move bond yields (and by default, stock prices). On the micro-economic front, Q2 earnings season begins with PEP on Tuesday and big bank earnings on Friday (C, JPM, WFC).
Last Week (Needed Context as We Start a New Week)
The S&P 500 was basically flat last week as a continued rise in bond yields, especially in Europe, was offset by strong US economic data (especially the jobs report). The S&P 500 gained 0.06%, and is up 8.32% YTD.
Stocks were higher Monday and Wednesday in quiet, holiday-like trade. The strong ISM Manufacturing PMI helped stocks rally during the half day Monday, and that positive momentum continued on Wednesday during similarly quiet action. On Wednesday, the FOMC minutes were a potential catalyst; however, they proved to be a non-event. As we started trade Thursday, markets were up about 0.5% on the week.
Then, stocks dropped nearly 1% on Thursday thanks to a further rise in global bond yields. Specifically, the German 10-year bund yield breaking through 0.5% caused selling in Europe, which bled over to the US. That rise in yields overshadowed a strong ISM Non-Manufacturing PMI. Stocks closed on the lows in what was a revisiting of a risk-off decline.
The Goldilocks jobs number helped stocks bounce on Friday, and markets drifted higher throughout the session, recouping most of the Thursday losses.
Your Need to Know
Internals were generally positive last week, although trading was quiet due to the July 4th holiday. Banks (BKX up 1.6%) outperformed thanks to higher yields, although tech also managed to rally (Nasdaq up 0.2%). Yet I doubt we will see many more weeks where both sectors can rally together, at least near term.
On the flip side, the 2017 YTD losers continue to underperform: XLE dropped 1.3% on lower oil, and retailers also fell, sinking 2.5%. Lower oil and bad sales, respectively, were the reasons for each decline. And while I continue to look for contrarian opportunities in both sectors, frankly, I haven’t found anything ultra-attractive.
From a sector standpoint, the cyclical vs. defensive battle, which is represented by banks vs. tech broadly, continues. How that resolves itself over the coming weeks will have implications for the broad markets (more on that below).
Stocks enjoyed big gains last week, but the internals weren’t that bullish. Will the rise in global bond yields cause a pullback in stocks? For all the noise in the market, that is the key question facing advisors and investors this summer.
The answer to that question depends on two things. First, whether this rise in yields continues. Second, if the pace of the rise accelerates.
Given that, Friday’s CPI report will be very important, because while US growth-oriented economic data has bounced back lately, inflation numbers are still losing momentum (Friday’s wages in the jobs report being the latest example) and those lackluster inflation numbers are tempering the rise in Treasury yields and keeping it manageable. So, if CPI is hot, we could see the idea of higher rates and better growth send Treasury yields sharply higher. Conversely, if the number is soft, it will reinforce people’s doubts about the staying power of this bond decline/rise in yields.
The key to quickly determining which outcome occurs in the market remains the tech sector. To understand why the tech sector (and especially semiconductors (SOXX) and super-cap internet (FDN)) is so important, we must remember that buying semis and super-cap internet was investors’ way of positioning for 1) Continued slow economic growth, 2) Continued low inflation and 3) Continued low interest rates.
That has worked beautifully throughout 2017, but in June, the tech sector faltered. That forecasted the now-uncertain outlook for investors. If we are seeing a switch to 1) Better economic growth, 2) Higher inflation and 3) More Fed rate hikes, then we need to rotate out of tech and into more cyclical sectors like banks, small caps, industrials and inverse bond ETFs… and that’s the battle we saw playing out in June.
In the very short term, though, if bond yields accelerate higher it will likely cause a pullback, because tech is simply too crowded a long position. From a weighting standpoint, outperformance in banks and cyclicals will not offset the selling pressure generated by investors reducing tech exposure.
However, longer term, that pullback will be a buying opportunity if economic data is really accelerating, because the path to a truly sustainable rally in stocks is through better growth, higher inflation, and (because of a stronger economy) higher interest rates. Longer term, that’s what we should all be hoping for, even if it does cause some near-term pain.
As a result, this week I will be allocating a small amount of capital to our cyclical/higher-rate basket, i.e., banks (KRE/KBE), small caps (IWM), inverse bond funds (TBF/TBT) and industrials (XLI). And, I will reduce my position in FDN to fund the switch. Now, to be clear, this is just a small first step. If the CPI report is soft, this rotation will be a near-term mistake… but I think at this point, with the 10-year Treasury yield having broken its recent downtrend, it’s worth starting to position for a more cyclical-based rally in stocks. If data goes our way, I will continue to add to cyclicals in the coming weeks.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
Reflation on? Not just yet, but last week’s data did imply that the US economy may be starting to gain more positive momentum, which will be much to the Fed’s relief after looking past recent soft economic data. Specifically, every major economic data point released last week beat expectations, and some handily so.
Before getting to those numbers, it’s important to address the biggest market-moving event last week: The ECB meeting minutes. Anticipation of those minutes, which were mildly hawkish, caused the German bund yield to break to a multi-year high above 0.5%, and that caused an acceleration in the decline in bonds/rise in yields that ultimately resulted in the 1% decline in stocks last Thursday.
The importance of the ECB minutes (and largely all the data from last week) was that it confirmed central banks do expect better growth and inflation, and that expectation is leading them to get less dovish, which is sending global bond yields higher.
The bottom line for the ECB and the Fed remains 1) The ECB is expected to begin to taper QE in January 2018, and end it completely in mid-2018, while the Fed is expected to begin to reduce the balance sheet in September, and hike rates again in December. The events of this week reinforced those expectations, which are largely priced into stocks and bonds at this point.
Turning to the economic data, it was good last week. The jobs report was the highlight, and it was strong. Job adds in June were 222k, solidly above the 170k estimate. However, wages were a slight disappointment, up just 0.2% and 2.5% yoy, which stopped the strong jobs report from being “Too Hot.”
Looking at the other two key numbers last week, the June ISM Manufacturing PMI and ISM Non-Manufacturing PMI, they also were strong. The Manufacturing PMI surged to the best level since August 2014, rising to 57.8 vs. (E) 55.1 while the Non-Manufacturing (or service sector) PMI rose to 57.4 vs. (E) 56.5. Details of both reports were also strong, as New Orders rose, suggesting continued momentum into the summer.
To a point, the data can be taken with a grain of salt, because there’s no question the jobs market remained strong in June (the weekly claims told us that) while the PMIs are still just “soft data” in so much as it’s survey data, and not hard economic data. Still, these numbers were good, and it does reinforce that we are seeing an emerging reflation in the economy, and an emerging reflation trade in markets.
Important Economic Data This Week
Normally after the jobs report the following week is pretty quiet on the economic front. Yet that’s not so this week, as we get three very important economic numbers Friday.
June CPI is the highlight of the week, and it will be an important number for markets given the recent rise in yields. Since the Fed and other global central banks expressed surprising confidence in their respective economies in June, economic data has largely reinforced that expectation.
However, now it’s inflation’s turn. If inflation metrics show a further loss of momentum, that will undercut central bank’s expectation of future inflation, and could cause at least a mild reversal in the recent reflation trade (so bond yields down, banks/small caps/cyclicals down, defensives/tech up). Conversely, if CPI is strong, it will further prove central banks were right to look past the soft data, and the reflation trade will likely accelerate. So, this will be an important number regarding sector trade, and near-term performance in the broad market.
Also on Friday we get June Retail Sales and June Industrial Production. As previously mentioned, there is still a gap between soft, survey-based data (the PMIs) and hard, actual economic numbers. Given the strength in the PMIs, expectations for better actual economic data via Retail Sales and Industrial Production now is somewhat expected.
Finally, Fed Chair Yellen gives the second of her Humphrey-Hawkins testimonies this week, and she will address the Senate Banking Committee on Wednesday and the House Financial Services Committee Thursday. The tone of her comments will obviously be closely watched, but with several years on the job, Yellen seems to have learned not to give anything away in these testimonies. Yet if her tone echoes the confidence in the economy and inflation that we saw in the June FOMC meeting, it will be at least a mild reinforcement of the reflation trade across assets (i.e. higher yields).
Commodities, Currencies & Bonds
In Commodities, volatility surged last week despite thinner-than-average holiday trade. Crude oil whipsawed higher before reversing lower on a spike in US oil production while gold continued its recent downtrend after the June Jobs report. The commodity ETF, DBC, fell 1.38% on the week.
Gold came into focus Friday as the strong headlines to the jobs data spurred some hawkish money flows, including a stronger dollar. Gold finished the week down 2.38%, and at a four-month low. On the charts, gold made a “lower low,” as futures violated a key support level from early May. That development changes our near- and medium-term technical outlook to bearish. Fundamentally, the earnings data in the jobs report, a proxy for wage inflation, was soft. That further supports the case for higher real interest rates (especially with the recent jump in Treasury yields) which is bearish for non-yielding safe havens such as gold.
Elsewhere in the metals space, there was a churn in the copper market, but futures did move lower on the week by 2.14%. Still, an uptrend has formed in recent weeks for the industrial metal, and that is encouraging for risk assets medium term.
In the energy space, crude oil futures moved sharply higher as a short-covering rally from the previous week extended into last week ahead of the July 4th holiday. That rally continued on the bullish headline supply draws in oil and gasoline reported by the EIA, but once the spike in US production to almost two-year highs was digested, the market came back for sale in a big way and futures finished the week down 4.32%. Looking ahead, the continued trend of rising US oil output (specifically in the lower 48) remains the single-biggest headwind for the energy market, as it negatively affects the OPEC/NOPEC production-cut deal. Bottom line, until US production reverses (clearly no sign of that yet) or overseas producers cut output further to balance global supply-demand dynamics (for which chances are slim), oil prices will remain lower for longer.
Looking at Currencies and Bonds, yields continued their recent surge higher last week, driven by hawkish ECB minutes and better-than-expected economic data. The German 10-year bund yield rose above 0.5% for the first time since early 2016, while the 10-year Treasury closed well above resistance at 2.28%, signaling a likely trend change in bonds (going forward, bonds prices down/bond yields up).
In the currency space, the Dollar Index bounced modestly, rising 0.36% on better-than-expected economic data. The dollar remains largely at the mercy of the euro, which saw some mild profit taking last week and dipped 0.3% despite the higher yields and hawkish minutes.
Bigger picture, if US economic data can indeed accelerate and continue the momentum from last week, then we should see at least a modest dollar rally. Over the past three weeks, the dollar has gotten hit very hard on a slightly hawkish recalibration of expectations from the ECB. But with ECB policy now pretty well known, markets should start to re-focus on general fundamentals, and the simple truth is that if US economic data remains firm, the Fed will be leading global central banks in tightening policy… and that will be dollar positive.
Elsewhere in the currency space, the pound fell last week on lackluster economic data, as metrics there broadly underwhelmed, and caused some modest profit taking. The yen also weakened vs. the dollar, falling to a two-month low, thanks to similarly lackluster economic data. A continuation of the decline in the yen will be positive for DXJ (the currency hedged, long Japan ETF).
Looking forward, the US economic data this week will be key to determining whether we’ve seen a near-term low in the greenback. A strong CPI report will likely send the Dollar Index back through 96.00… and likely for good this time.
Special Reports and Editorial
7 Dates That Could Make or Break the Market in Q3
The first half of 2017 was defined by historically low volatility, and one of the quietest macro calendars we’ve had in years. However, with several parts of the market and economy in flux heading into the second half of the year, we’re likely going to see an uptick in volatility, and I think we got a preview of that during June.
So, we’ve identified four key events and seven key dates associated with those events that we believe could either 1) Lead to an acceleration of the rally, or 2) Cause a reversal and substantial pullback in stocks.
We haven’t included the regular monthly economic data (Jobs reports, PMIs, Core PCE Price Index) because that’s always important, every month. Instead, the list below is comprised of events that are not typically on a quarterly calendar, and we want you to be aware of 1) What they are, 2) Why they are important, and 3) How they can move markets.
Everything we do at CapitalisthHQ.comis based around efficiency—giving you only the critical information in the shortest amount of time, so in that vein this list is organized by potential impact on markets (i.e. the first events listed have the most potential to move markets).
Q3 Market Event #1: Q2 Earnings Season. Date: 7/17. What It Is: Second quarter earnings season. Specifically, big banks (C, WFC, BAC, etc.) start to report earnings as early as 7/14, but the real volume of reports won’t kick in till 7/17, and that’s when things could get interesting.
Why It’s Important: As we’ve said before, the unsung hero of the 2017 rally is earnings expectations. Markets are expecting nearly 10% yoy earnings growth for the S&P 500 from 2017 to 2018. That means that conservatively, we’re looking at $137 or $138/share for 2018 S&P 500 EPS, and that doesn’t include a boost for any corporate tax cuts. Those rising earnings make the valuation math work for investors, as it keeps the S&P 500 at 18X 2018 earnings, the historical top for valuation levels. Without that earnings growth, the valuation math on this market won’t make sense, and we’ll get a pullback.
How It Could Move Markets: If earnings growth looks to be slowing in Q2, that could cause that 2018 expected S&P 500 EPS to decline, to say $135ish. If that occurs, this market is too expensive, and we could easily see a 3%-5% pullback.
Q3 Market Event #2: Government Funding Expires. Date 9/30.
What It Is: Markets have taken increasing levels of government incompetence in stride so far in 2017, but that’s only because the market still expects corporate tax cuts in 2018, and because all the noise and distraction hasn’t had any negative effect on the economy. That could change in the next few months.
Why It’s Important: First, the government must raise the debt ceiling by the fall, otherwise we’ll have another default scare. Second, the government must pass a budget to keep funding the government. If they don’t, we’ll have another shutdown scare.
How It Could Move Markets. If the drama in Washington threatens to have real, concrete implications on the markets and economy, then stocks will get hit, potentially hard.
Q3 Market Event #3: Fed Tightening. Date(s): 7/26, late August, 9/20.
What Is It: Easily the biggest issue for markets as we exit 1H ’17 is that the Fed is more hawkish than we are used to, and how that materializes over the next three months will move markets. There is a Fed meeting on July 26, and while no one expects a rate hike at that time, if bond yields remain low and financial conditions continue to ease, the Fed could try and send a message. Then, in late August, the Fed’s annual Jackson Hole conference takes place. The Fed could again try and deliver a hawkish message to markets. Finally, the September meeting on 9/20 is where the Fed is expected to begin to reduce its balance sheet.
Why It Matters: No one knows how markets will react if the Fed gets more hawkish. Bonds have been stubbornly buoyant, but that could change, and then the question is whether the rise in interest rates is gradual, or whether we get another “Taper Tantrum.” Conversely, if economic data stays uninspiring in Q3, we could have a scenario where yields are rising but economic growth is not.
How It Could Move Markets: If yields rise too quickly or economic data remains lackluster but the Fed stays on a tightening path, that could hit stocks. Conversely, if economic growth accelerates and the rise in rates is gradual, that could power a reflationary rally, led by banks, small caps and cyclicals.
Q3 Market Event #4: Washington Policy—Healthcare & Tax Cuts. Dates: 7/28, 9/5.
What Is It: Things are coming to a head on healthcare and taxes, and over the next few months we’ll see whether the expectation for corporate tax cuts in 2018 is still reasonable. Specifically, the healthcare issue will be resolved one way or the other by July 28, as a bill will either pass the Senate, or it will be dead. Regarding taxes, the Trump administration has promised a specific tax plan by the time Congress returns from the August recess on Sept. 5. If there isn’t something concrete by then, tax reform in Q1 ’18 (which is expected by markets) will become very difficult to achieve.
Why It Matters: Markets still expect corporate tax cuts in Q1 2018, and if that expectation proves false, then investors will re-assess owning stocks at these valuations, as there won’t be a visible, positive earnings catalyst on the horizon.
How It Could Move Markets: If there is no concrete, real tax plan (and I’m talking about agreement on border adjustments, interest deductibility, etc.) then that changes the market’s valuation paradigm. Conversely, if we do get progress on this issue that will be bullish for highly taxed sectors such as retail, energy, healthcare, etc.
There are real, potentially significant market-moving events in the third quarter that could easily cause a “melt up” in stocks, and turn 2017 into a banner year… or cause a nasty pullback. Because just based on the calendar, we’re due for a pullback (there’s been no real pullback since Feb. ’16). While it’d be nice if we got a continuation of the calm, levitating market we saw in the first half, given these looming events (and considering many of them are Washington oriented) it’s unlikely.
What Does “Reflation” Actually Mean?
One of the reasons I started this service is because I hated the overuse of jargon by analysts and commentators. Frankly, markets and economics are not particularly complicated topics. There are a lot of variables involved, so getting the future right is difficult. However, understanding market dynamics and economic conditions actually is mostly common sense, because markets and economies are just the sum of collective actions by people. And, since people generally act in their own best interests, it’s easy to understand markets and economics once you get past the jargon.
To that point, I’ve found myself using the terms “reflation” and “cyclical” entirely too much lately. That’s jargon I want to make sure that everyone knows exactly what I mean when I say, “reflation trade” or “cyclical outperformance.”
So, what is reflation? Reflation is simply the idea that economic growth is going to accelerate in the future. To understand why we use the term reflation, think of the economy as a soccer ball. The ball is full of air when we have consistent 3% GDP growth. But, fallout from the financial crisis has put GDP growth around 2% for nearly a decade. So, the soccer ball (i.e. the economy) is deflated.
However, if we see economic acceleration back to consistent 3% growth, the ball (i.e. the economy) has been “reflated.” So, any economic news that implies better growth is termed “reflation.”
And, since reflation is just the expectation of an accelerating economy, people (i.e. investors and the market) react to that expectation. That reaction, typically, is comprised of: 1) Selling bonds (so higher rates) because in an accelerating economy central banks hike rates and inflation rises, both of which are negative for bonds. 2) They allocate investment capital to sectors of the economy that are more reactive to better economic growth.
These sectors are called cyclicals, because they rise and fall with economic growth (like a cycle). Banks (better economy=more demand for money), industrials (better economy=capital investment in projects), small caps (better economy=rising tide for products and more availability of capital), and consumer discretionary (better economy=more spending money) all are cyclical sectors.
Companies in those sectors usually make more money when the economy is getting better, and the anticipation of that attracts capital at the expense of bonds and “non-cyclical” sectors such as utilities, consumer staples, healthcare, and, increasingly, super-cap tech. Businesses in those sectors don’t have better years when the economy is accelerating, so capital leaves for better earnings growth.
Up until June, the non-cyclicals outperformed because there was no evidence of higher rates or better growth. But in June central banks sent a shot of confidence into the markets, and since then, in anticipation of that economic acceleration, cyclical sectors have outperformed. And given last week’s strong jobs report, that’s likely a trend that will continue, especially given the trend change in bonds. As such, we will have to react accordingly in tactical sector allocations.
The Fed minutes were largely a non-event, and while we can parse and dissect whether “some,” or “many” or “most” Fed officials were dismissive of inflation or cautious on decreasing the balance sheet, the bottom line from a market standpoint is this: The current expectation of a September reduction in the balance sheet followed by a December rate hike remains.
From a market reaction standpoint, there was a very slightly hawkish response as the dollar rallied, but that was more because markets somewhat expected a slightly dovish walk back of the June statement and press conference, but that did not happen.
So, from a Fed standpoint, we are starting the second half of 2017 like how we ended the first half. On balance, the Fed is more confident in the economy and inflation than they have been in some time, and as a result, the Fed is now marginally less dovish than they have been in years. If this set-up continues, it remains positive for banks, interest rates and cyclical sectors.
Oil’s Big Drop
For a holiday week with relatively light volumes, commodities saw some material movement. On Wednesday, crude oil futures fell more than 4%, which resulted in effectively all of the gains since the previous Friday being retraced. There were a few catalysts worth citing, most notably that Russia would be opposed to deeper production cuts if proposed by OPEC. There has been chatter about deeper cuts (the current total deal is -1.8M bbls, -1.2M of which OPEC has pledged) in recent months, but if Russia does not participate it would be hard to see a “deeper deal” going into effect.
Additionally, Reuters data showed a 450K bbl rise in OPEC exports from May to June, and due to Nigerian and Libyan output increases (both are exempt from the production deal), OPEC production hit a new 2017 high last month. Bottom line, the global outlook for oil prices remains bearish medium term, as expectations of the market balancing continue to get pushed back later and later beyond fall 2017 thanks to stubbornly high production levels.
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