What’s in this week’s Report:
- Why Economic Data This Week Is So Important
- Weekly Market Preview
- Weekly Economic Cheat Sheet
Futures are modestly higher in quiet, holiday-like trading as global manufacturing PMIs largely met estimates.
Chinese economic data continued to come in better than expected as the Ciaxin Manufacturing PMI rose to 50.4 vs. (E) 49.8. In Europe, the EU June Manufacturing PMI was in line with expectations while the UK number fell short (54.3 vs. (E) 56.3).
The net effect of these June PMIs is that last week’s global reflation trade is taking a break this morning as the PMIs reflect what was already priced into markets. So, we’re seeing modest weakness in the euro (down -.4%) and a bounce in the dollar. Importantly, though, these numbers do not undermine the reflation trade from last week, it’s just that we’ll need stronger numbers in the short term to continue last week’s momentum.
Looking at US markets, today the two big numbers are the June ISM Manufacturing PMI (E: 55.1) and June Auto Sales (E: 16.6M). But, while those are important numbers, today will feel a lot like the trading day after Thanksgiving, given tomorrow’s July 4th holiday. As a reminder, US stock markets close at 1:00 p.m. EST.
So, barring a major surprise from the PMI or auto sales, I’d expect quiet trading today, although today’s data is still important for markets beyond the next 24 hours.
Everyone have a happy and safe 4th of July.
S&P 500 Futures
U.S. Dollar (DXY)
Economic data and Fed speak will be the focus of this holiday-shortened week. The jobs report Friday, PMIs today and Thursday, and Fed minutes Wednesday will be the key market-moving events. And given this is a very popular vacation week and therefore volumes and activity will be subdued, the potential for some significant volatility is there if the data surprises either way.
Last Week (Needed Context as We Start a New Week)
Stocks declined modestly, and volatility returned last week as a coordinated, “not-dovish” message by central banks sent global bond yields surging. The S&P 500 declined 0.61% on the week.
Last week started quietly, as markets were flat despite some tech weakness and underwhelming economic data (Durable Goods specifically). But Tuesday, volatility showed up as the S&P 500 fell 0.8% on a combination of 1) Hawkish comments by ECB President Draghi, 2) Another failed healthcare vote (that further endangers tax cuts) and 3) Cautious comments by Fed Governor Williams, who said stocks were running, “On fumes.”
Yet stocks again showed resilience as markets bounced back Wednesday despite the lack of a catalyst. Dip buying after a decline at the open fed on itself, and the S&P 500 recouped basically all of Tuesday’s losses, rising 0.81%. The whipsaw continued Thursday, as hotter-than-expected German CPI caused the reflation trade to re-engage, and US stocks fell sharply (although they did bounce on key support), and the S&P 500 closed down 0.8%, but well off the lows.
On Friday, stocks rebounded slightly, helped by a benign Core PCE Price Index as the reflation trade took a breather ahead of the holiday weekend.
Your Need to Know
The “reflation rotation” was the major theme from an internals and sector standpoint last week, and evidence of that was visible in the index and sector trade. The Russell 2000 actually outperformed, as it was flat on the week (remember, small caps outperform in a reflationary environment). Meanwhile the Nasdaq plunged 2%, badly underperforming the S&P 500. Again, the tech sector, which is dominated by super-cap tech and internet companies, has taken on almost a consumer staples-like trading posture, as the trends in tech are viewed to be non-cyclical. To boot, “long tech” is a very crowded trade, and we’re seeing tech become the funding source for money that’s rotating into more cyclical sectors.
From a sector standpoint, there also was evidence of the reflation trade. Banks surged 4.4% on higher bond yields while defensive sectors dropped (utilities fell 2.4%, consumer staples fell 1%). Again, the YTD tech sector outperformers fell sharply (semiconductors sank 5% while internet names fell 3.4%). Going forward, the tech sector remains our major focus. The Nasdaq broadly, and FDN and SOXX are momentum indicators we are watching. And while FDN and Nasdaq both held important support levels, they remain dangerously close to tracing out “lower lows” from the mid-June break. Of greater concern is that SOXX hit a new low, which we take as a negative for broad market momentum.
More directly, the leadership sectors for 2017 (tech, semis, FDN, utilities) all are breaking down, but we’re not seeing enough strength in cyclicals to take on the leadership load. And, the longer this goes on, the more vulnerable the market will be to a pullback.
It is the peak of summer vacation season, but there are potentially important shifts occurring in the markets that could substantially change sector performance for the balance of 2017, and also cause the first pullback in stocks since February 2016. Specifically, over the past three weeks, global central banks (Fed, BOE, ECB, Chinese Central Bank, even the Bank of Canada) have voiced a consistent desire to eventually reduce monetary accommodation, and they’ve simultaneously voiced confidence in the global economy and global inflation trends despite underwhelming data.
This is in polar opposite to what we’ve all become accustomed to from central banks, as for the past eight years any hint of deflation or slowing growth was met by a coordinated, dovish response from global central banks. Now, the opposite has occurred.
Given this change, the reflation trade that powered stocks higher in late ’16 tried to reassert itself in June. Global bond yields rose, and safe-haven sectors lagged. But, the broad markets didn’t rally like they did in late ’16, and the reason is economic growth. In late ’16, economic growth was accelerating, but now, it is not.
So, here is the practical takeaway. With central banks no longer reacting perma-dovishly, the reflation trade will assert itself on a sector level (and that has implications for sector performance as the year-to-date outperformers could seriously lag in 2H ’17, and vice-versa).
Until economic data starts to get better and show actual acceleration, this reflation trade won’t be enough to power stocks higher. If anything, it will increase downward pressure on markets as bank outperformance won’t be enough, by itself, to offset the decline in tech and defensive sectors.
This set up is exactly why this week has become very important. If the ISM PMIs and jobs report are better than expected, we could see a broad reflation trade reassert itself, and that means markets rally. Conversely, if the data underwhelms then the increase of a pullback in stocks will rise, materially.
From an exposure/allocation standpoint, we continue to hold current positions and allocations, as we think it’s very important to get confirmation of which reflation we’re going to see… one on the sector level, or one in the broad market.
Most of our current tactical holdings (healthcare via XLV/IHF/IBB, Europe via HEDJ and EZU, cybersecurity via HACK, emerging markets via IEMG) are pretty well insulated from any material negative from this potential rotation. The exception is FDN, which will continue to underperform if this rotation continues. We are watching that position carefully, and are prepared to exit if this sector rotation looks like it’s taking hold.
Finally, late last week we bought EUFN, as we think higher yields in Europe along with better growth will help European financials outperform (more on this in the Special Reports and Editorial section below). With regards to US banks, we want more clarity on the economic data and from the Fed (via Fed minutes) before allocating more capital to KRE or KBE.
Bottom line, we are on the cusp of a potentially significant turn in markets, and despite the fact that it’s peak summer vacation time, the economic data this week could go a long way to telling us how to be positioned for the second half of 2017.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
As mentioned, the most important economic event of last week was the advancement of the coordinated, confident message from global central banks as they now are looking past temporary weakness in inflation and economic data. Unfortunately, looking at the economic data last week, it didn’t confirm a reflation is underway, and going forward economic data (both inflation and growth) need to get better to support a rally in stocks.
The big number from last week was the Core PCE Price Index, and it met low expectations. Headline PCE Price Index dipped to -1.1% in May, while Core PCE Price Index (the Fed’s preferred measure of inflation) rose to 0.1%, and 1.4% yoy. That’s a long way from the stated 2.0% goal, and down sharply from the 1.7% in April. But, the market largely ignored the numbers because the Fed has clearly stated that low inflation stats are not a problem at this point, and they will not dissuade the Fed from continuing to tighten monetary policy in the coming months.
Turning to the rest of last week’s data, it was similarly underwhelming. Durable Goods was the only other notable number, and it missed estimates. The key, “New Orders for Non-Defense Capital Good Ex-Aircraft” number fell to -0.2% vs. (E) 0.5%, and April data was revised lower. So, at least through May, business spending and investment isn’t going to spur an economic acceleration in Q2.
It was a different story internationally. Inflation and economic data in Europe (and China via their June May manufacturing PMI) did beat estimates, and that helped fuel a legitimate reflation trade in Europe that saw European and British bond yields surge higher. Specifically, German CPI, EU HICP and consumer confidence all beat expectations, and the idea that European growth is starting to accelerate is taking hold. Last week, that hit European stocks short term, but it’s a longer-term positive for the region and its ETFs.
Important Economic Data This Week
Due to the July Fourth holiday tomorrow, this week is a bit disjointed, but here is the rundown. First, it’s jobs week, so we get the official jobs report Friday, and ADP and claims on Thursday. But given the Fed’s hawkishness, the set up for this report is a bit different, and over the medium term, the market needs a strong number.
Beyond the jobs report, the next most important event this week is the Fed minutes, which come Wednesday. The market is digesting this new found hawkishness from the Fed, and the minutes will give us more color into the current Fed discussion—and the implications on bond yields could be substantial.
Finally, from a domestic and global standpoint, we get the final June manufacturing and composite PMIs. The global numbers manufacturing PMIs are already out, while the US manufacturing PMI comes later this morning.
Then on Wednesday we get the global composite PMIs, and on Thursday the US Non-Manufacturing PMI. The importance of these numbers is obvious. With global central banks expressing more confidence in economic resilience, the data needs to confirm that confidence. Bottom line, this week’s data will help determine whether this reflation trade stays on the sector level, or whether it broadens out to help push the entire market higher.
Commodities, Currencies & Bonds
In Commodities, there were several notable developments in the space last week, as crude oil futures turned higher after a multi-week sell-off while copper broke out of a tight trading range… both of which are encouraging developments for the reflation trade. Meanwhile, gold finished the week lower after a “flash crash” took futures to six-week lows on Monday. The commodity ETF, DBC, rose 4.56% on the week.
In the energy space, WTI crude oil futures had a weekly gain of 7.32% after falling for five weeks prior. The catalyst for the rally was the weekly EIA report, which showed a substantial drop in Lower 48 oil production of -55K b/d. The two bearish influences on the oil market this year have been declining confidence in the efficacy of OPEC policy, and rising US oil production. So, with the trend of rising US oil output pulling back (even though it was largely due to adverse weather in the gulf) the market became a little “less bearish” and rallied into the end of the week.
Bottom line, for now OPEC outlook remains a constant, and that’s bearish for the market as their policies are not having the desired effect on prices. If last week’s significant pullback in output turns out to be a one off, the oil market will continue to trade heavily (more likely). If output has topped for the year (less likely) then oil could very well form a bottom in the low-to-mid $40s this summer.
Turning to the metals, gold futures fell 1.30% on the week. Looking ahead, gold remains in a corrective pullback, but the 2017 trend remains bullish. We need to see either a pick-up in inflation (bullish gold), or a continued rebound in interest rates (bearish gold) for gold to break materially away from the mid $1200s. Copper rallied 3.10% to new Q2 highs last week, which was encouraging. For most of the year, copper has underperformed, and that was a concern to us. Now that copper is in “rally mode” again, one headwind is being removed for stocks, and the argument for the reflation/Trump trade has becoming incrementally stronger.
Looking at Currencies and Bonds, global economic reflation was the theme last week, as global bond yields and currencies surged while the dollar fell to fresh 2017 lows. The Dollar Index declined 1.6%.
The move in global bond yields was easily the biggest story for markets last week. The 10-year Treasury yield surged 14 basis points on the week, and closed right on the March downtrend at 2.28%. The No. 1 question as we start this week is whether the economic data will get the 10-year yield to punch through that downtrend. If so, that will mean likely changes for tactical allocations.
But notably, the 10-year yield didn’t surge because of US data, it surged because of European and UK data, and central bank speak. The 10-year German bund yield rose 13 basis points, and 10-year Gilt (UK bonds) yields rose a shocking 23 basis points. So, it was a global increase in yields last week, as markets digested the coordinated “not-dovish” central bank speak. This week the key will be whether economic data can extend these rallies, and potentially change the market set up.
Looking at currencies, the euro and pound were the big outperformers, as you’d guess given last week’s events. The euro rose almost 2% vs. the dollar and hit a fresh 52-week high above 1.14 while the pound rose 1% and traded above 1.30. Elsewhere in the currency markets, the yen weakened as economic data there slightly underwhelmed while the commodity currencies rose to multi-month highs vs. the dollar. Better Chinese economic data and higher commodities (oil, metals) helped push the commodity currencies higher.
Bottom line, the hawkish turn by the ECB and BOE caught markets off guard, and the dollar got hammered. However, longer term, the outlook for the dollar remains dependent on economic data. If the data rebounds, like the Fed expects, then the dollar is a bargain here, because the Fed will be much more aggressive tightening policy than any other major central bank. Until economic data decidedly turns for the worse, we’re not abandoning our longer-term, positive dollar stance.
Special Reports and Editorial
EUFN: How to Play Rising Yields in Europe
Last week’s stress test results for US banks were better than expected, as all US banks had their capital return plans approved for the first time in stress test history (since 2011). From a specific name standpoint, COF was the only modest disappointment, as it only received “conditional” approval and must resubmit numbers at a later date. Conversely, from research I’ve read, BBT, C, WFC and BK all were upside surprises.
Banks have rallied nicely into these stress tests results, and it feels like banks are trying to reassert market leadership. But while the stress test results were positive, they are already mostly priced in. So, for banks to really reassert themselves as market leaders we need the 10-year yield to break its downtrend (so resistance at 2.28%) and the economic data to pick up, and we’ll wait till that happens to get more aggressively long US banks.
Turning to Europe, after taking a one-day break, yields are once again rising. And with rising yields and consistently better economic growth, the set up for European bank stocks is starting to look similar to the set up for US bank stocks last July (when they started to massively outperform).
European bank stocks are not without risks (we’ve had two banks closed in Spain and Italy this month), but for those with appropriate risk appetite, EUFN (the MSCI European Financial ETF) is the best “pure play” on European banks. If yields in Europe keep rising, this ETF should handily outperform European and US averages (and, likely, US banks). We bought a small position last week ahead of the HICP report.
This All Could Be Coming to a Head
The market dynamic appears to be trying to change, but it needs help from yields and economic data. That reality makes the next 10 trading days very important.
Through June, markets have been dominated by tech and defensive outperformance as economic data and pro-growth policies implied a continued slow-growth economy and very gradual interest rate increases. As a result, defensive sectors (of which super-cap internet stocks that comprise FDN can be counted) and yield plays outperformed.
However, in early June tech broke down badly, and that has been followed by hawkish comments from Yellen, Draghi and Carney. The market is trying to embrace a more upbeat, cyclical outlook on the markets and the economy. The offshoot of that would be renewed outperformance by cyclical sectors (banks, industrials, small caps, retailers) at the expense of defensives. But, the actual economic data hasn’t validated bankers’ opinions, so the rotation can’t occur… at least not yet.
However, if the economic data in over the next five days beats expectations and validates central bankers’ expectations, then this rotation can occur, and cyclicals can potentially lead the market higher. Conversely, if this data remains lackluster, then we’ve got to start worrying about a stagnant economy in a rate-hike cycle—and that will be a headwind on stocks. Bottom line, we should have some pretty important resolution on the attempted rotation we saw in June over the next week or so.
If A Yield Curve Inverts In China, Does It Signal A Looming Recession?
In last week’s “Credit Impulse” section, I explained how China remains the largest macro threat to the rally as it begins to deflate its massive credit bubble, a credit bubble that has funded asset bubbles across geographies (Australian property, California property, Treasuries, stocks, etc.).
At this point, it’s just a risk, as there are no concrete signs that the Chinese economy is in trouble, although the Chinese bond market is signaling some caution.
First, it’s well known that inverted yield curves predict recessions. Here in the US, the inverted yield curve predicted the ’81, ’91, and ’00 recession, and the ’08 financial crisis (remember the yield curve inverted in ’05, and stayed that way until the Fed started cutting rates in late ’07).
So, it is noteworthy that the Chinese government bond yield curve is essentially flat, and in some cases, has inverted. For instance, as of yesterday the 3-year government bond was yielding 3.558%, higher than the 5 year at 3.524%. And, the 7 year was yielding 3.626%, higher than the 10 year, which yielded 3.56%. So, while not a total inversion, it is safe to say it’s flat.
Now, before we go running for the hills and sell stocks, we have to realize this is China, not US Treasuries. As such, liquidity distorts this picture somewhat. For instance, 10-year Chinese bonds are by far the most liquid, so they will move more than other issues. Still, this is not the type of yield curve that implies an economy that is healthy. Again, this matters, because the last time we got a Chinese economic scare it caused the S&P 500 to collapse 10% in a few days… not once, but twice in a six-month period.
Bottom line, I’m not saying get defensive, but I am saying that from a macro standpoint 2H ’17 is shaping up to be bumpier than 1H ’17, and I want everyone to be prepared. We will be watching China closely for you.
When Will the Bond Decline Matter?
For three months, we and other macro analysts have been warning that the bond market, via falling yields and a flattening yield curve, was sending a worrisome signal about future economic growth and inflation. And, that falling bond yields would act as a headwind on stocks.
Over that three months, the S&P 500 has moved steadily higher.
Now, given that, it might seem like falling bonds yields don’t matter to stocks. However, decades of experience in this business combined with listening to experienced analysts and traders tells me that bond yields always matter to stocks… it’s just a question of “when” they matter.
Regarding when, most of us are working on a medium/longer-term time frame (i.e. quarters and years), so getting the bigger market signals right is more important than outperforming over a few weeks. To that point, if bond yields do not reverse in the coming weeks/months, then I am quite sure that over the medium/longer term the stock market is in for a potentially significant pullback. Avoiding that pullback will be the key to multi-year outperformance.
So, the really important question is: “When will low bond yields matter?”
I believe the answer is: When investors realize bond yields are warning about slowing future growth, not lower inflation.
Right now, bulls are saying the drop in Treasury yields is just due to declining inflation—not because of potential slower economic growth.
Specifically, they’re pointing to statistical measures of inflation such as the CPI, PCE and the Price Deflator in GDP. Those measures of inflation are falling, which usually means deflation (which is bad for stocks).
But, the bulls aren’t as concerned about falling statistical inflation because, in their view, inflation has changed. Specifically, there is a growing school of thought that in a technology-dominated world, the old inflation statistics (CPI/PCE/Price Deflator) no longer capture true inflation in the economy.
For instance, those inflation statistics are currently being driven down by 1) Lower oil, 2) The Amazon effect, where retail margins are relentless slashed, and 3) General technology making most everyday items cheaper and more efficient. However, those price declines aren’t bad for the economy, and they don’t reflect the lack of consumer demand that usually accompanies falling prices. Technology and margin compression is making these prices fall, not an unwillingness of consumers to spend.
Meanwhile, asset and other forms of inflation are rising quickly. Over the past few years, home prices are up; rents are up, car prices are up, airfares are up, health insurance is up, tuition is up, the stock market is up and the bond market is up. So, the prices of all the things we “need” are up, but the prices of discretionary items (HD TVs, laptops, tablets, dishwashers, appliances) are down. Since CPI measures consumer goods heavily, inflation statistics are subdued.
Based on this logic, many investors aren’t sweating the decline in bond yields, because they believe, for now, that it’s just reflecting the decline in statistical inflation and not a future slowing of actual economic growth.
The key will be to recognize when investors begin to believe low bond yields reflect lower growth prospects. That will be the time to get seriously defensive in asset allocations. Yet as last Monday showed, with the market ignoring the soft Durable Goods report, we’re not there yet. But if this data doesn’t turn around, we will get there. Unfortunately, we don’t believe it’s different this time.
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