Good morning,

What's in this week's Report:

  • Is It Time to Book Profits?
  • North Korea Update
  • Tax Cuts: Will They Happen (And If So, Which Sectors Will Outperform?)
  • Why The Phillips Curve Matters To Your Clients
  • Oil Update
  • Weekly Market Preview
  • Weekly Economic Cheat Sheet

Futures are higher after North Korea tensions eased and the US trade action on China was not as bad as feared.

Sentiment towards the North Korea situation improved over the weekend as multiple administration officials downplayed the chances of military conflict.

The Trump administration announced a "study" into whether there should be an investigation of Chinese trade practices, a move that wasn't as severe as feared.

Economically, Chinese economic data was a universal disappointment.  Industrial Production, Retail Sales and Fixed Asset Investment all slightly missed estimates, although none of the numbers were bad enough to change the expectation of consistent growth in China.

Trending News:

Today there are no economic reports or important earnings so focus will stay on geo-politics.  If North Korea tensions continue to ease, stocks can extend this early bounce – and tech is the key.  The tech sector should lead any substantial rally today.






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This Week

Earnings and economics are in focus this week. Starting with the former, there are important results from HD & TJX tomorrow, TGT and CSCO on Wednesday, and AMAT and GPS on Thursday. The Retail Sales report tomorrow is the highlight of the week economically while the FOMC minutes and ECB minutes (Wednesday and Thursday, respectively) also will potentially move markets. Bottom line, we need better earnings and better data to stabilize this market near term.

Last Week (Needed Context as We Start a New Week)

Escalation of tensions with North Korea, and underwhelming economic data and earnings led to the worst week for stocks in months. The S&P 500 fell 1.43% but is up 9.04% YTD.

Stocks began last week very quietly as the S&P 500 added 0.16% to finish at a new all-time high as global investors continued to buy on lingering enthusiasm about the strong July Jobs Report. But the rally didn't last, as a late-day swoon saw markets close lower on Tuesday as the S&P 500 fell 0.24%. Stocks were higher early Tuesday until North Korea angst began after Trump's "fire and fury" comments. Cautious comments by famed hedge fund manager Jeffrey Gundlach also saw the selling accelerate into the close. Notably, stocks hit new highs before closing below Monday's lows, which in technical analysis is termed a "bearish outside reversal." The pattern is often consistent with a near-term market high, and in this case, that proved true.

Stocks stabilized Wednesday as concerns about North Korea subsided (at least temporarily) and a late-day rally saw the S&P 500 close essentially flat (-0.04%).

Thursday, however, North Korea jumped back to the forefront of geopolitical focus and the escalating tensions paired with soft economic data and underwhelming earnings pushed stocks sharply lower. The S&P fell 1.45% on the day. Specifically, it was the rhetoric regarding Guam between Kim Jong-Un and President Trump that caused the most geopolitical stress on the markets. But under the surface, inflation data (PPI) pretty badly missed estimates while retailers missed already-conservative expectations.

Stocks showed signs of stabilizing Friday morning as notable technical support from June (between 2425 and 2450) began to hold, as the North Korean drama again began to subside. Stocks spent most of the morning in the green before dipping slightly before lunch time. But markets recovered to finish with modest gains.

Your Need to Know

Last week's internals were standard risk off (a trading patter we haven't seen in almost a year). Cyclicals handily underperformed vs. defensives, and on the sector level the declines were pretty standard across cyclical sectors while utilities (XLU) and consumer staples (XLP) relatively outperformed. Yet unless the North Korea situation worsens, that trading pattern is likely temporary.

The bigger event from last week was the outsized declines in two key momentum sectors, super-cap internet (FDN) and semiconductors (SOXX). Both bounced Friday, but both saw continued profit taking, and if they break June lows we'll take that as a negative signal.

Looking elsewhere, banks underperformed thanks to the drop in yields, and with tech and banks both lagging, this is a market that currently lacks sector leadership… which is a problem the longer it goes on. To boot, the S&P 500 traced out a weekly bearish "Outside Reversal," which is a signal that should not be ignored. It doesn't mean the trend is lower, but the overarching point is that market internals are showing warning signs.

Bottom Line

Is the North Korea flare up a reason to book profits? That's the major question right now, and despite some relatively ugly price action last week, the facts tell us the answer is "No, not yet" (although there are cautions signs that have nothing to do with North Korea).

I'm not trying to be dismissive of North Korea, but the situation for now remains more bark than bite. So, North Korea appears to be more of a convenient excuse for a market pullback that was likely anyway, due to 1) Very low volumes and liquidity (peak vacation season), 2) High complacency (remember the VIX was at record lows at the start of last week), and 3) Lack of a clear, discernable positive catalyst.

To me, the biggest takeaway from last week was that the pullback was due to more than just North Korea. In what turned out to be good timing, we spoke two Friday's ago about the waning earnings enthusiasm (stocks not rallying after earnings beats) and that anecdotally implied that very strong earnings are now largely priced into stocks. And as we saw last week with disappointing retailer earnings (even against low expectations), the market is reacting to earnings misses. That's important, because rising earnings have been the unsung hero of the 2017 rally, and if earnings growth begins to moderate that leaves this market without a catalyst… especially since economic growth isn't accelerating and inflation is falling.

Bottom line, I do think last week was potentially important as the tide of the 2017 rally may be starting to turn, but I don't think it's because of North Korea. Instead, it may be because of a peak in earnings growth, lackluster economic growth (no rising tide) and a breakdown in momentum sectors (FDN/SOXX).

So, we are now very closely watching 1) Earnings (there are important reports this week), 2) Economic data (again important reports this week) and 3) Momentum sectors (their charts are starting to not look so good). For now, the trend does remain higher, and the resilient market of 2017 must still be respected, especially when we consider the slow news environment and lack of liquidity that can exacerbate price action.

We are holding positions in our "Stagnation" portfolio: FDN, XLV/IHF/IBB, HEDJ/EZU, IEMG, XLU/XLP. We also are holding small allocations to banks (KRE/EUFN) and other cyclicals, although the small position size is an important factor in that decision. In all, our takeaway from last week is that we must be vigilant, as the tide may be starting to turn—but, we are not there yet.

Economic Data (What You Need to Know in Plain English)

Need to Know Econ from Last Week

There was more underwhelming economic data last week, especially on the inflation front, as the prospects for an economic reflation in 2017 continued to dim.

From a Fed standpoint, the disappointing CPI and PPI reports further reduce the chances of a rate hike in December, although importantly the Fed is still expected to begin to reduce its balance sheet in September.

Starting with the headline numbers, CPI and PPI, they were both disappointing. The Producer Price Index declined to -0.1% vs. (E) 0.1% while the core figure was flat vs. (E) 0.2%. Meanwhile, the CPI report was slightly less underwhelming at 0.1% vs. 0.2% on the headline, and the same for the core.

While these aren't horrible numbers, they aren't good either, and the bottom line is that statistical inflation remains stubbornly low, and it is appearing to continue to lose momentum. Again, for context, that's a problem because in this environment, with (supposedly) strong economic growth and low unemployment, inflation should not be going down. Period. And, the longer it goes on, the more it sparks worries that eventual deflation or disinflation will rise, and that's not good for an economy with still-slow growth and extended asset markets.

Bottom line, even before the uptick in North Korea jitters this was a market in need of a positive catalyst to spur further gains. Unfortunately, the economic data (ex-jobs and sentiment surveys) has been consistently underwhelming, so the chances of a rising tide driven by an economic reflation continue to dim. And while a "dovish" number may be good for a mild pop in the S&P 500, soft data and a lower dollar/bond yields aren't going to drive the market to material new highs.

Important Economic Data This Week

This week is busy, with mostly anecdotal data that will give us a better overall picture of the economy and inflation—and the main risk to stocks now is that the data comes in light, and along with low inflation that spurs fears of an economic loss of momentum. If that happens, stocks will take out last week's lows.

The most important report this week will be tomorrow's Retail Sales report. Consumer spending has been lackluster for most of 2017, but around now we see a typical seasonal uptick. That will be welcomed by markets if that appears again this year. If the number is soft, it's going to spur worries about the pace of economic growth (remember, hard economic data hasn't been great all year, it's been the PMI surveys that have been strong).

Beyond retail sales, we also get a first look at August economic data via the Empire and Philly manufacturing indices. Both numbers haven't been highly correlated to the national PMIs lately, but it's still our most-recent economic data and it could move markets, especially if we see any weakening in the data. Empire comes tomorrow and Philly comes Thursday.

Turning to central banks, we get the Fed minutes from the July meeting on Wednesday, and the ECB minutes from the July meeting on Thursday. The Fed minutes are important because we will be looking for clues as to how eager or committed the Fed is to September balance sheet reduction. With the ECB, the key will be seeing how committed or eager the ECB is to announce tapering of QE in September. As is usually the case, there shouldn't be any big surprises in these minutes, but they could slightly shift expectations for those two events (balance sheet reduction/announcement of tapering), and as such also move Treasury yields and Bund yields.

Finally, July Industrial Production and Housing Starts also come this week (Thursday and Wednesday, respectively). Again, these are an opportunity for the hard data to rise and meet strong soft data surveys, and in doing so reassure investors that the economy's accelerating.

Bottom line, none of the numbers this week are "major," but in aggregate they will give us a lot more insight into the pace of economic growth and the outlook for the Fed and ECB. And, this market needs some economic reassurance to help bolster sentiment after last week. Better data and steady Fed/ECB are a needed boost markets this week.

Commodities, Currencies & Bonds

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In Commodities, the segment was as volatile as the rest of the global markets last week, with oil chopping sideways in a broad range before finishing lower on Friday while gold screamed towards the $1300 mark on a geopolitical fear bid. Meanwhile, the risk-off money flows weighed on copper while a bullish inventory report in natural gas helped futures finish the week near the highs. The commodity ETF, DBC, declined 0.27% on the week.

Beginning with oil, the $50 mark in WTI remained elusive last week as concerns about OPEC and a continued rise in US production are keeping sentiment in favor of the bears. WTI finished the week down 4.58%. Specifically, with OPEC, the fact that compliance was down and production was up in July was seen as a material bearish development. Looking ahead, if there is not a substantial shift in behavior out of the cartel, then they will continue to "shoot themselves in the foot" as their policy efforts are thwarted by their own cheating habits.

In the US, lower 48 production growth did slow to just 15K b/d, which is well below the 26K b/d average weekly gain so far in 2017. It was just one report, however, and unless data continues to show a pause in US output growth in the weeks ahead, last week's report will be shrugged off. Bottom line, the two biggest influences on the energy market right now, OPEC and US production, both remain bearish for the time being… and that will help the bears defend the $50/barrel zone.

In the metals, it was a classic scenario of risk-off trade late last week as copper underperformed with stocks and gold rallied with safe havens. Copper futures still rallied 0.90% on the week but gold outperformed with a rally of 2.43%. Looking ahead, any North Korea headlines will continue to influence more risk-off trading (copper lower, gold higher).

Longer term, we continue to like the strong uptrend in copper, which is sitting just off two-year highs while the outlook for gold is less clear. For now, the benefit of the doubt remains with the gold bears, but if futures are able to punch through the $1300 resistance level that will reverse, and the outlook will shift to bullish for the medium term.

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Looking at Currencies and Bonds, North Korea and more soft inflation data were the major influences on the currency and bond markets last week, and both caused declines in the dollar and yields (although the latter was impacted more than the former). The Dollar Index fell 0.49% while the 10-year Treasury yield closed down 7 basis points and below support at 2.22%.

The North Korea drama caused a risk-off move in the currency and bond markets in the middle of last week, and that resulted in two consequences. First, the Japanese yen surged more than 2% on safe-haven demand from investors. Second, it caused 10-year Treasury yields to drop to support at 2.22%.

Looking at those two events, the rally in the yen vs. the dollar will likely prove temporary if North Korea tension cool, but the drop in the 10-year yield is more material. That's because the soft CPI report on Friday pushed the 10-year yield below support at 2.22% (it closed at 2.19%). If this week's economic data is underwhelming or the Fed or ECB is dovish, then a test of the recent lows of 2.10% in the 10 year isn't out of the question.

Looking more broadly, the fledgling dollar rally we saw last week was undercut by the soft PPI and CPI reports, and until we can get some traction in inflation data, the dollar will remain under pressure, regardless of what else is going on in the world.

Overall, until there is an uptick in economic and inflation data, yields and the dollar will continue to grind lower. And, we view that as an anecdotal negative for broad markets generally, as it undermines the possibility of an economic reflation. In a growing economy, we should not be seeing Treasury yields and the dollar plumbing new lows for the year. This can't end well.

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Special Reports and Editorial

North Korea Update

Undoubtedly some of you are getting calls from nervous clients about North Korea, and while I don't view this as a major market issue, I do want to briefly cover the situation so you can handle any client calls. Ignoring the rhetoric and bluster on both sides for a moment, two important things happened with regards to North Korea this week.

First, in what was a major positive, the UN passed very harsh sanctions on North Korea with a unanimous vote. That second part is key, because both China and Russia supported the sanctions, implying the international community is at least on the same page regarding North Korea's nuclear program.

Second, in what was a negative that resulted in the recent escalation of tensions, North Korea has apparently learned how to miniaturize a nuclear warhead and place it on an intercontinental ballistic missile. If true, that means they could theoretically strike Japan or the western US with a nuclear missile.

Those two events, one positive, one negative, are why this situation has escalated so quickly.

Going forward, despite the threats from North Korea, the events of the past weeks need to be viewed as a positive. If China and Russia stay on board, then the chances of resolution (peaceful resolution) go up significantly. So, while things seem bad now, in reality, the chances of a lasting solution have gone up since this time last week.

However, if you have clients who are worried about this and want to hedge up a bit, basically the "North Korea Defensive Playbook" would be as follows: 1) Buy Treasuries (belly and longer dated, so TLT or IEF), 2) Buy defense stocks (TRN, LLL, LMT, NOC) and 3) Buy the yen via FXY and sell Japanese stocks (if you own any DXJ or EWJ). Now, to be clear, I don't think you should do this, but this is the playbook if any clients are asking what to do in case of a conflict.

I was also asked last week what event would tell me the probability of military conflict between the US and North Korea has risen substantially, and my answer was this: US personnel evacuations from South Korea. If the US begins to pull citizens out of South Korea (and I doubt they can do this quietly in today's age) that will be a sign that a military conflict is a real possibility—and I would likely raise cash in that occurrence.

Additionally, there are two more ETFs for the "North Korea Playbook." The first is another safe-haven currency—the Swiss franc. It will rally if a conflict becomes more probable. The ETF for the franc is FXF. The second is the defense and aerospace ETF, ITA. There are other defense company ETFs, but none are as liquid or have as much trading volume as ITA. So, that's an alternative way to get defensive exposure.

Tax Cut Update: Bullish/Bearish Scenarios and Sector Winners

About the only piece of the Republican agenda that has any chance left of actually coming to fruition is corporate tax cuts. And while it likely will be a scaled-down version compared to what was initially envisioned by investors in early 2017, it still represents a $5-$10/share EPS boost in 2018… if moderate cuts are enacted.

So, given this is about the last potential bullish catalyst looming from Washington right now, I want to take a moment and provide accurate context of 1) What's Expected and 2) What Will Make It A Bullish or Bearish Catalyst, and 3) Which Sectors Will Benefit the Most from Tax Cuts. This is particularly important now, as Congress will return from vacation after Labor Day, and the tax cut headlines will start flying.

What's Happened: In truth, not much. The White House issued a "Tax Outline" back in late-July, but it contained no specific details on the plan other than to note that the idea of border adjustments is dead (this is a positive for retailers, but not much else). Additionally, the White House produced a "timeline" of sorts: Tax legislation clears the House in October, clears the Senate in November, and then goes to President Trump's desk. But using 2017 as a guide, that timeline is optimistic at best, and at worst it's ridiculous.

What Expected: A Corporate Tax Cut to Around 28% By the End of Q1 2018, Plus Foreign Profit Repatriation. This is still expected, and to a point, priced into stocks at these levels. A move here would likely be a mild positive, especially if the repatriation succeeds in bringing a lot of foreign profits back on shore (those would likely be returned to shareholders via dividends or buybacks).

Bullish If: Corporate Rate Below 25%, Foreign Tax Repatriation. Senior advisor Gary Cohn has called for a corporate tax rate of 23%, but frankly that seems unlikely given the current state of Washington. However, if the rate were to drop below 25% (and be accompanied by foreign profit repatriation) that would be a modest positive for stocks, as soon as that became a likely outcome.

Bearish If: No Corporate Tax Cuts or Foreign Profit Repatriation. Given the lack of progress on the Republican agenda so far in 2017, expecting nothing to get done here certainly has merit. But again, the idea that Republicans would enter an election year (2018) without achieving any of their agenda seems unlikely, if for no other reason than it'll seriously jeopardize job security. Overall, a corporate tax cut below 25% will be positive for the entire market, although some sectors will benefit more than others.

Tax Cut Sector Winners: Healthcare (XLV/IHF/IBB), retail (XLY/RTH), oil and gas (XLE/XOP) have average corporate tax rates well above 30% (so even a drop to 28% will be positive for these sectors). So, they should see the most upside if/when corporate tax cuts become reality in Q1 2018. Conversely, they may see modest selling if tax cuts fail (although I won't view that failure as a bearish game changer).

Foreign Profit Repatriation Winners: Super-cap tech (so QQQ and FDN), as well as multi-national consumer stocks (XLP) and pharmaceuticals (XPH seems to be the most liquid pharma pure-play ETF—it traded about 220k shares yesterday).

To be clear, I'm not saying to pull the trigger on these names now, but as tax cuts appear more likely these will be the sectors that should see the most benefit from either a drop in the rate to or below 28%, or a foreign profit repatriation holiday.

Why the Phillips Curve Matters to You

The Phillips curve is a term you're likely seeing and hearing more recently than at any time previously in your career (regardless of how long it is). The reason the Phillips curve is being discussed so much is simple: There's a growing school of thought that thinks the Phillips curve is broken, and if that's the case, then the Fed and other central banks may be largely powerless to spur inflation (which is a potential negative for the broad markets).

Before we get into this debate, first let's get a bit of background on the Phillips curve. Basically, the Phillips curve is just a graph of this simple idea—Low unemployment creates higher inflation.

From a common-sense standpoint, it is logical. Less available workers and robust business activity (so low supply and high demand for workers) will cause salaries (the "price" of a worker) to rise, and that in turn will flow through to the entire economy. So, the Phillips curve says low unemployment will spur inflation. And, this idea has been the cornerstone of Fed policy for decades.

But, there's a small problem: It doesn't appear to be working in today's economy, as historically low unemployment is failing to spur inflation.

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Now, this may seem like a theoretical, academic conversation, but it has real, near-term market consequences. For instance, the entire mid-July rally in stocks came because the Fed began to note low inflation more than low unemployment. That caused the decline in Treasury yields and exacerbated the drop in the dollar.

However, that may have changed with Friday's jobs report. The unemployment rate hit 4.3%, a fresh low for this expansion and a multi-year low. So, while there is a debate about the Phillips curve still being accurate, the bottom line is that the Fed still follows it. At some point, if unemployment continues to drop, the Fed will have to continue with its rate increases.

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So, the 4.3% unemployment rate was the reason the jobs report didn't spur a "Goldilocks" rally in stocks.

And, going forward, whether unemployment continues to decline will have an important impact on returns, regardless of inflation. Here's why: If unemployment grinds towards 4% or below, the Fed will have to get hawkish or either 1) Abandon decades of monetary policy that has largely worked, or 2) Risk a significant rise in inflation down the road (according to the Phillips curve) that would require a sharp, painful increase in interest rates—a move that almost certainly would put the US economy into recession.

The practical investment takeaways are this: If unemployment grinds lower, regardless of inflation, "reflation" ETFs such as KRE, XLI, IWM, TBF and TBT will likely outperform, just like they did from late-June to mid-July.

However, if inflation remains low and unemployment doesn't grind lower, then "stagnation" ETFs will outperform (FDN, EZU, HEDJ, XLV, IHF, IBB, XLU, XLP, IEMG).

You see, this abstract, macro-economic concept of the Phillips curve matters from a practical investment standpoint.

The next data point in this saga comes Friday via CPI. At some point, low unemployment will cause inflation, and if inflation shows more signs of stabilizing (like it did in the jobs report), expect banks (KRE/KBE) to potentially break out.

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