What's in this week's Report:
- What the Fed Decision Means for Markets (Not Dovish)
- Political Update: Impeachment vs. Taxes
- Weekly Market Preview
- Weekly Economic Cheat Sheet
- Oil Outlook: Can It Keep Falling?
Futures and global markets are modestly higher following a quiet weekend of no economic or political surprises.
No political surprises is the "reason" for the bounce this morning as markets continue to unwind the political based dip from late last week.
Economic data was positive as Chinese home prices rose 0.8% in May vs. (E) 0.7% while Japanese exports slightly missed estimates and imports beat expectations.
Today there are no economic reports but there are two Fed speakers: Dudley (8:00 a.m.) and Evans (7:00 p.m.). The former is more important as he's part of Fed leadership and he could give more color on the Fed's feelings towards inflation (i.e. is the Fed really not that concerned? Watch for a potentially dovish reaction to his comments).
S&P 500 Futures
U.S. Dollar (DXY)
This week focus will be on economic data (specifically the Friday flash PMIs), politics (the special House of Representatives election on Tuesday), and the bank sector (round 1 of the stress tests come Thursday and this could be a positive catalyst).
There are multiple other events this week (especially internationally) but those three are the biggest potential market movers.
Last Week (Needed Context as We Start a New Week)
Stocks were basically flat last week, as political drama, soft economic data and a slightly hawkish Fed weighed on risk assets. The S&P 500 edged higher by 0.06% on the week, and is up 8.68% year to date.
Positioning ahead of the Fed dominated trading early last week, as the S&P 500 notched a small gain through Tuesday on mild short covering into the Fed.
Wednesday was the busiest day of the week from a news standpoint, as a plunge in oil due to weekly inventory data, a very soft set of economic data (between Retail Sales and CPI), and a not-as-dovish-as-expected Fed decision led the S&P to forfeit gains and close down 0.10%. The declines continued Thursday as the S&P dipped 0.22%, as politics again reared its head as a market influence again. News that President Trump was being investigated for obstruction of justice paired with the digestion of the slightly hawkish Fed pressured equities, but the selling was very orderly and losses were modest.
On Friday morning, stocks came for sale at the open, thanks to soft data (New Home Sales, Consumer Sentiment) and markets were lower for most of Friday, although once again we saw resilience in the markets as stocks drifted higher during the afternoon despite any positive catalysts.
Your Need to Know
Internals continued to deteriorate, as 2017 leadership sectors (tech specifically) continued to trade poorly last week. The Nasdaq fell 0.9% while semiconductors declined 2.1% and super-cap internet (FDN) dipped 0.6%. None of those names broke 2017 uptrends last week, so this should still be considered a normal pullback in an otherwise upward trending market. The bottom line is a test of critical uptrends across tech appears to be coming soon, and whether that test holds or fails will have implications for the broad market.
Outside of tech, defensive sectors again outperformed last week as utilities and healthcare both outperformed the S&P 500 while industrials also traded well (XLI up more than 1%) on continued GE tailwinds and better global growth numbers.
Banks were pretty resilient throughout the week, but the less-dovish-than-expected FOMC meeting failed to spur a real rally in Treasury yields, and banks gave back early gains late last week. BKX finished down 0.05%, and failed to hold a break out above 94.00. So, despite an effort to rally, banks are still having a hard time generating any real momentum.
From a single-stock standpoint, the big news was the AMZN/WFM merger Friday. That had the expected effect of hammering the grocers (KR, SVU) and pressuring AMZN competitors (WMT, TGT). But, while it's an incredibly interesting move from a business standpoint, it didn't have any bigger market implications.
Bottom line, the failure of tech leadership, which started two weeks ago, continued last week. And while it's premature to declare a trend change, right now the market is left without a strong leadership sectors. We need either tech or banks to start trading better if we're going to see another breakout in stocks near term.
Peripheral risks to the rally continued to build last week with an uptick in political drama; a less-dovish-than-expected Fed, and more underwhelming economic data. Despite these slowly building headwinds, stocks remain impressively resilient, and for now, the trend higher remains intact.
The markets' resilience was best demonstrated Friday, where more soft economic data (in particular soft University of Michigan Consumer Sentiment reading, which dropped to the lowest level since November) pressured stocks. But for no explicit reason, buyers stepped in and helped the major averages slowly and methodically lift and finish the day basically unchanged.
It was a notable microcosm of 2017, where fundamentals have consistently deteriorated, but on an absolute level are not bad enough yet to warrant a trend break, especially given the expectation for earnings growth for stocks (this, more than anything else, is the lynchpin under this market, and it will make the Q2 earnings season in July very important). If expectations for earnings growth start to slow, as BlackRock's Larry Fink warned they may, then a serious trap door will open under this rally.
I say that, because while the trend in stocks is still higher, there are growing signs market leadership is starting to crack.
I recently listed multiple momentum indicators we were watching to tell us when momentum turns. Those indicators were investor sentiment (which was and remains overly cautious, so no signs of a top there), the NYSE Advance/Decline line (which remains in an uptrend) and two select tech sector ETFs: FDN and SOXX.
Those two sector ETFs traded poorly over the past 10 days (down 2.1% and 0.6%, respectively last week) and if we get a break of those respective uptrends, that will be the first sign that momentum is starting to break down. So, we are watching those two ETFs very carefully, along with the A/D line (which also is close to testing support that dates back to the 2016 low).
The trend remains higher, so we will continue to hold broad equity allocations despite the stiffening headwind. For now, these headwinds aren't enough to turn the trend. However, we still caution against adding capital broadly to US stocks, as the risk/reward here is not favorable. Again, we'd prefer to go internationally, or focus new capital on tactical allocations (Europe via HEDJ or EZU, healthcare via IBB, XLV, or IHF, emerging markets via IEMG). Finally, industrials are starting to look attractive to us given their exposure to the rising global economy, and we're going to be flushing out that idea a bit more this week.
Bottom line, the market resilience must be respected, but headwinds continue to build. So, monitoring the macro horizon for signs of a break remains critically important to avoiding any potential nasty pullbacks… and that's what we are particularly focused on going forward.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
The Fed hiked rates and gave a not-as-dovish-as-expected statement while economic data (especially on inflation) generally disappointed. In sum, it was a week of underwhelming growth and a slightly more hawkish-than-expected Fed, although in a testament to how resilient stocks have been in 2017 neither the data nor the Fed caused stocks to decline.
Starting with the Fed, there were two distinct takeaways: First, the Fed is staying the course on hiking interest rates, despite underwhelming inflation. That is a hawkish shift from market expectations, as while the Fed acknowledged lower inflation, it doesn't think it's enough to change policy. Second, the Fed revealed details of how it plans to reduce its balance sheet (a hawkish exercise), and the surprise came when Fed Chair Yellen said balance sheet reduction (i.e. not reinvesting bond principal payments from years of QE) could start "relatively soon," which likely means September.
Bottom line, the Fed wasn't hawkish enough to cause a material change in markets, but it's not as dovish as expected, either… and we think that's an important distinction going forward (could be bad for stocks and bonds, so stocks lower/yields higher). From a practical standpoint, market expectations now are for balance sheet reduction to begin in September, and for another rate hike in December.
Looking at the actual economic data last week, it was on balance underwhelming. The positives were the June Empire and Philly Manufacturing Indices. The former exploded to a three-year high while the latter dipped but remained solidly in positive territory at 27.6. Unfortunately, those positive sentiment indicators were undermined by actual May economic data. The gap between sentiment surveys and hard data remains wide, and a risk to the rally.
First, CPI again missed, as the headline declined to -0.1% vs. (E) 0.0%, and more importantly, if we annualize the last three months gains in core CPI it equals 0.0% for the coming year. That is a far cry from the Fed's 2% inflation target.
Second, May Industrial Production was a disappointment. The manufacturing sub index dropped to -0.4% vs. (E) 0.2%, and while that decline was driven mostly by a drop in auto manufacturing, and is coming off a strong 1.1% April increase, it's still not a number that's indicative of an economy in reflation mode.
It was the same with May Retail Sales. The "control" index (which is the best measure of discretionary consumer spending) was flat in May, although there were positive revisions to April (from 0.2% to 0.6%).
Bottom line, the data is "ok" in an absolute sense, but we've definitively lost upside momentum, and we need that to restart if the broad economy is going to power this rally higher.
Important Economic Data This Week
The key event this week will be Friday's global flash manufacturing PMIs. Specifically, we need to see if the national number can move higher and provide some needed strong data for the markets. Internationally, there shouldn't be any surprises, and the PMIs should broadly confirm the global rally is indeed underway.
Outside of the flash PMIs on Friday, there isn't much on the calendar other than some housing data. Last week's housing starts data was pretty ugly, frankly, as single family starts dropped 4% while single family permits declined 1.9% (permits lead starts by a few months). So, there will be a bit more focus on the housing data this week. Existing Home Sales comes Tuesday while New Home Sales is released Friday. Bottom line, we need strong data to help contradict the worrisome economic signals in the bond market, and the sooner we get that the better.
Commodities, Currencies & Bonds
In Commodities, volatility spiked in the segment last week as inventory data spurred a sharp pullback in oil and the refined products while the hawkishly received Fed weighed on metals. Natural gas outperformed thanks to a smaller-than-expected supply build, but it still only closed flat on the week. The benchmark commodity ETF, DBC, fell 1.40% on the week. Oil futures were the most volatile commodity last week, as choppy, sideways price action gave way to a substantial 4% sell-off on Wednesday after the EIA reported an unexpected and sizeable build in gasoline stockpiles. Meanwhile, the draw in oil supplies was not as much as estimated. WTI futures fell 2.16%, the fourth weekly decline in a row.
US production remains one of the biggest headwinds on oil prices right now, as lower 48 output rebounded to a new 2017 high according to Wednesday's EIA release. Also in that data print, gasoline demand appears to be softer than many analysts had anticipated going into the summer. Lastly, doubts regarding OPEC compliance are still very high right now, and the risk of the global production deal falling apart continue to increase as market share is actively forfeited to US producers. Bottom line, we remain in a lower-for-longer oil price environment.
Elsewhere in energy, a late-week rally in natural gas thanks to a smaller-than-expected inventory build helped futures finish the week essentially unchanged. Natural gas has been trending lower since early May, as weather reports have been mild. However, if temperatures heat up, support will likely form near the $3 mark, and the long-term uptrend could continue.
In the metals, it was a stronger dollar and hawkish money flows that weighed on both gold and copper futures, which fell 1.07% and 2.81%, respectively last week. The fundamentals of the gold market took a slightly bearish turn last week as inflation underwhelmed. Soft inflation influences real interest rates to rise, which is not a good time to own gold as investors are attracted to yield-bearish safe havens like Treasuries. For now, the trend remains bullish for gold, but if inflation remains subdued and interest rates hold steady, critical support at $1219 will be tested.
Looking at Currencies and Bonds, the biggest takeaway from last week was that the near-term downtrend in bond yields remains very much intact. The 10-year yield hit a new 2017 low of 2.10%, and closed down 4 basis points on the week. So, the discrepancy between stocks and bond yields continues to grow, and we will keep reminding everyone that historically, that is a caution sign on markets.
Bigger picture, looking at the currency and bond markets as a whole, it's notable that markets traded much more off economic data (the low CPI, specifically) than off a more-hawkish-than-expected Fed. The Dollar Index dipped 0.16%.
Market-based evidence is starting to mount that the Fed has, at least temporarily, lost control of markets. Throughout 2017 and again last week, markets did the opposite of what the Fed is trying to accomplish (i.e. higher rates). That raises the chances of the Fed having to provide a surprise to get the markets back in line (again, more on that later this week).
Looking internationally, Britain was in focus as the pound rallied modestly (up 0.3%) thanks to a stronger-than-expected inflation reading, and a surprisingly close 5-3 BOE rate decision (three BOE members voted for a rate hike). But despite that vote, expectations for a rate hike haven't risen materially, and we don't see last week's event as a bullish catalyst for the pound.
Looking elsewhere, the euro drifted slightly lower thanks to follow through from last week's slightly dovish ECB meeting, and some slightly disappointing economic data.
Bottom line, the era of forever-low global rates and global QE may be starting to end. For now, the downtrends in the dollar and bond yields remain intact, with key resistance sitting at 99.50-100.00 and 2.30%, respectively. Until those levels are broken (and it's going to take better economic data to do that) the trend in both will remain lower, and that remains a big non-confirmation on the stock rally.
Special Reports and Editorial
Political Update: Stay Focused on Taxes, No Impeachment
First, I want to remind everyone that any political coverage I give in this report is solely from the perspective of the markets, they don't reflect my preference or lack of preference for any specific politician or party. My personal opinions are not important. What is important is giving you analysis that cuts through the steadily rising amount of sensationalist noise in the financial media (on both sides), and keeping you focused on what's really moving markets.
That said, given the latest revelations on President Trump, I wanted to take a moment and push back on some of the sensationalism.
Specifically, I want to explain clearly that any talk of impeachment is not realistic. The reason is simple: Impeachment is a political, not a legal process. The House of Representatives must start the impeachment process, and since it's controlled by Republicans, short of having incredibly damning evidence against the president, that simply won't happen.
In all likelihood, even if Robert Mueller's commission finds that President Trump likely obstructed justice during the Russia investigation, the evidence would have to be unequivocally conclusive in order to cause the Republicans to impeach. That means we would have to have the equivalent of video or audio of Trump telling someone to break the law.
Obstruction of justice, unlike perjury, is an opinion derived from conclusions; it's not a hard and fast fact (i.e. you told the truth under oath, or you did not).
So, to be clear, impeachment of President Trump is very unlikely over the next 1.5 years, again because of political reasons, not legal ones (and to be fair to Republicans, Democrats wouldn't impeach a president either without undeniable evidence).
Now, all this might change if the House changes hands in 2018, and frankly that's more than possible. On average, the president's party loses about 30 seats in the House in the first midterms, and the Republicans enjoy a 45-seat majority. So, if the average holds, it'll be close. Then if the Democrats take control and this is still an issue, impeachment is a real risk… but that's a problem for another day.
In the near term, the key is to stay focused on tax reform. Expectations are pretty low at this point, but the market does expect corporate tax cuts in 2018, and the ongoing Russia saga does continue to reduce the chances of that expectation being met. The biggest risk to stocks continues to be if the market begins to factor in no tax reform in 2018. If that happens, it'll be good for at least a mild pullback. Taxes, not Russia, remain the number one risk to this rally.
The Fed increased the Fed Funds rate 25 basis points, as expected, last Wednesday. The decision was not the dovish hike the market was expecting, although it wasn't exactly a hawkish decision, either (even considering Yellen's balance sheet surprise). Looking at the statement, the Fed wasn't as dovish in its language as the consensus expected. The economic growth language remained good, and actually improved a bit from the May statement.
The inflation language, as expected, was downgraded, but the Fed refrained from changing the characterization of risks, and left them "roughly balanced." That's Fed speak for "any meeting is live for a rate hike."
However, the Fed did note the undershooting of inflation recently, and explicitly said they are monitoring inflation, meaning if it continues to underperform they will react with easier policy. For now, the best way to characterize the statement is "steady as she goes" with regard to the Fed's current outlook.
The "wildcard to watch" in this Fed meeting was the topic of the balance sheet, and it provided the only real surprise this time. Importantly, the Fed gave guidance on all three major balance sheet related questions: When will it reduce the balance sheet? How will it reduce the balance sheet? What holdings will it reduce?
What will it reduce: The Fed revealed that it will simultaneously reduce holdings of both Treasuries and Mortgage Backed Securities (MBS), which was generally expected.
How will it reduce its balance sheet: The Fed will implement a rising monthly "cap" on principal reinvestments. What that means, practically, is the Fed will not reinvest the first $6 billion of Treasury principal and the first $4 billion of MBS principal, making it a total of $10 billion that it won't reinvest each month, at least initially. That cap will rise by $10B every three months, so one year from the start date (which will likely be September), the Fed will no longer be reinvesting $50B worth of bond principal payments per month. That number and this escalation is not surprising, and was close to in line with most forecasts (i.e. this wasn't "hawkish.")
When will the Fed start Reducing the balance sheet: This was the surprise, as Fed Chair Yellen said balance sheet reduction could start "relatively soon." That is sooner than expected, as the consensus was the Fed would hike rates again in September, and start to reduce the balance sheet in December. Now, that may be flipped.
Since reduction of the balance sheet is like the Fed hiking rates, this was taken as mildly hawkish, and the dollar bounced along with bond yields. However, this surprise is not a hawkish gamechanger, and won't alter anyone's outlook on Fed policy going forward. Bottom line, for all the noise and production yesterday, the Fed outlook remains broadly the same: One more rate hike and balance sheet reduction in 2017, unless inflation metrics get much worse.
EIA Analysis and Oil Update
Last week's EIA release was, on balance, mixed between headlines and details. But a rebound in US oil output and a rise in gasoline stocks spurred a bearish reaction. WTI futures fell to close at a new low for 2017.
Starting with the headlines, despite the API calling for a build of +2.8M bbls, commercial crude oil stocks declined -1.7M barrels... but that was less than forecast by analysts (-2.6M), and traders responded bearishly. The gasoline build of +2.1M bbls vs. (E) -700K was more in line with the API's +1.8M, but clearly an even larger build. That spurred a big pullback in RBOB gasoline futures. Gasoline futures have been leading the space lower so far in the early summer, as summer driving demand has underwhelmed and stockpiles are still higher than they were in March.
Looking at the oil production figures, the trend higher resumed in the lower 48 last week as output rose +25K b/d, the 18th rise in 19 weeks. That more than offset the prior week's dip of -20K b/d. Lower 48 production now has risen 599K bbls so far this year, offsetting half of OPEC's agreed production scheduled to last through Q1'18.
Bottom line, the outlook for the energy market remains decidedly bearish for several fundamental reasons. Beginning with OPEC, their agreement with non-OPEC members remains in a fragile state as none of the participants are particularly happy about the arrangement, and their active forfeiture of market share to US shale producers. And, every barrel of market share the global producers give up increases the odds of "cheating," or the deal crumbling all together.
In the US, the trend of rising production remains strong (output hit new 2017 highs recently), and that is very bearish due to the aforementioned reasons. Furthermore, gasoline demand has been soft so far, and oil production is expected to continue to rise steadily this summer. On balance, fundamentals as well as technicals continue to suggest lower price action for longer
than initially expected. The next area of notable support lies between $43.05 and $43.65 in WTI.
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