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Week of August 1, 2016
INSIDE THIS EDITION:
U.S. GDP Disappoints…
For What It’s Worth
Weekly Technical Comment
401k Plan Manager
Features Articles & Interviews
The week was relatively quiet for large stocks as the S&P 500 was essentially flat. Smaller stocks performed better and gained nearly 0.6% on the week. Technology and Healthcare paced the best sectors while Non-Cyclical and Energy stocks lagged.
Optimism by Wall Street analysts has been fading. Typically, these analysts are a hopeful lot. Back at the end of 2014, with many major indices near record highs, these analysts had nearly 12.5 buy recommendations for every 1 sell recommendation. Now that the Dow and S&P 500 are once again testing new highs one would expect these analysts to be in a “buy everything” mode. However, they are not. Instead, their buy-to-sell ratio is a subdued 7.8 to 1; the lowest reading since 2010.
Unfortunately, not all is rosy for stocks. It is once again earnings season and over 60% of the companies in the S&P 500 have reported. What we find is disquieting, earnings and sales are down from a year ago. The same thing happened last quarter, a continuation of the earnings recession.
U.S. GDP Disappoints…
Written by: Luke Patterson
CEO & Chief Investment Officer
The second-quarter U.S. gross domestic product data released Friday was a disappointment. U.S. preliminary Q2 gross domestic product grew at 1.2% vs 2.6% expected as inventories fell for the first time since 2011. The Commerce Department also revised the first quarter downward to a 0.8% pace.
Consumer spending was responsible for almost all of the rebound in GDP growth in the second quarter. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased at a 4.2% rate.
Inventory accumulation by businesses fell $8.1 billion in the second quarter, the first drop since the third quarter of 2011, down from a $40.7 billion increase in the first quarter. As a result, inventory investment subtracted 1.16 percentage points from GDP growth in the last quarter. It was the fourth straight quarter that inventories weighed on output.
The most important contributors to weak GDP, and the data components that should get lots of attention, are the indications of sluggish corporate behavior. Companies not only posted disappointing spending on new plant and equipment in the second quarter, there also was a notable increase in stockpiling, which can act as an overhang that can discourage future production.
Instead of directing much of the earnings from strong consumption back into economic activity, companies are sitting idle on bank deposits or using the cash from financial engineering, share repurchases and higher dividend payments.
This is one of the reasons the U.S. stock market has been doing so well, reaching historical records this month. All this points to a healthy appetite for financial risk that stands in stark contrast to companies’ more muted inclination to take business risks.
U.S. Oil Prices Enter Bear Market…
Oil prices have entered a bear market, briefly dipping below $40 a barrel. Crude for September delivery finished down $1.54, or 3.7%, to $40.06 on the New York Mercantile Exchange, marking the ninth time in 11 sessions that prices have closed lower. Prices have dropped 22% in less than two months, ending a rally that took prices above $50 in early June.
Energy companies have had a difficult earnings season this quarter as reports indicate oil price is continuing to be a challenge. In last week’s earnings call from ConocoPhillips, CEO, Ryan Lance, said “we need to be prepared for lower prices and volatility”. He goes on to say “It’s going to take well into 2017 before we see any real increases in prices.”
The rig count is still down nearly 77% from a record in October 2014. Part of the fear is that the market is tracing a similar path to last year, when a rally to $60 prompted a number of producers to pump more oil, and causing the price to move lower.
The charts will indicate that if oil cannot keep its head above $40, then $35-36 looks like the next leg down. Also, the S&P 500 may run into hurdles as it tries to carry that July breakout through into late summer and fall.
For What It’s Worth…
We’re Not Out of the Woods Yet
Written by: Worth Wray
Chief Economist & Global Macro Strategist
If you’ve been paying attention to global markets this year, you are probably still scratching your head as to what fundamentally changed in early February.
What pulled us back from the edge of a global crisis and set the stage for one of the most powerful reflations (ex earnings) in recent memory? What caused corporate credit spreads to collapse, crude oil to bottom, and the S&P 500 to scream higher? And, most importantly, is this a sustainable new trend? Or an epic bear trap?
As regular FWIW readers may remember, I offered a hypothesis in mid-March – arguing that major central banks had begun to quietly intervene in foreign exchange markets (“Did Central Bankers Just Save the World?” & “You Can’t Blame Them for Trying”) – and I laid out a vision for 2016 as long as policy elites were able to keep the trade-weighted US dollar in a “goldilocks” trading range.
Five months later three things are pretty clear: (1) central banks are actively intervening to stave off a global shakeout, but (2) major governments are failing to turn this short-lived stability into something more durable, and (3) global markets are growing dangerously complacent even as Fed officials continue to signal as many as two rate hikes in 2016.
At this point, I still have more questions than answers… namely, what happens next?
Is the worst behind us? Or still yet to come?
Will the Fed hike interest rates again? Or are they effectively done?
Have central bankers finally managed to overcome the global business cycle? Or are they in the process of losing control yet again?
Time will tell, but – while my colleagues and I on the STA Committee recommit ourselves every day to keeping an open mind – we continue to see more risk on the downside than reward on the upside.
Yes, beaten-up assets like emerging markets and energy stocks have staged quite a price reversal in recent months. But I’m still not convinced it’s the beginning of a lasting trend.
In my mind, the risk of a global shock is rising once again as (1) oil prices fall back into the $30s and (2) modestly improving US economic growth strengthens the case for a rising dollar.
Of course, last week’s initial estimate for Q2 GDP growth puts a minor dent in that argument – as markets dismiss the odds of a Fed hike in the next twelve months – but a closer look at the underlying data tells a different story.
As you can see in the chart above, inventories and fixed investment exerted a serious drag on real GDP growth in the second quarter, but the American consumer has not been this strong in more than eighteen months.
I’m not saying the slowdown is over, or that 2016 and 2017 recession risks are necessarily receding, but if the Q2 estimate gets revised upward in the coming weeks, or if we start to see more signs of a seasonal growth pick-up already underway in Q3, markets could start to pay attention to Fed officials like William Dudley, John Williams, and Robert Kaplan who keep warning that “September is very much on the table.”
To be clear, I don’t actually expect the Fed to hike interest rates before the November 8 presidential election. I’m not even convinced they will hike again in this cycle. But even on its own, the probable revival of market expectations has enormous implications in light of global conditions.
As you can see in the chart below, the world economy may already be nearing another breaking point as foreign central bank assets held at the Federal Reserve continue to fall on a year-over-year basis.
It may not sound like a big deal, but – as my friends at GaveKal Research keep reminding me – every time that red line has fallen below zero in the last fifty years, it has coincided with a major global event.
Here’s an older chart from last summer if you want to understand the significance of this indicator.
Hard to ignore, isn’t it?
I can’t pretend to know exactly why foreign assets at the Fed are falling this time around, but my suspicion is that oil producing countries (who officially flipped from current account surplus into current account deficit in 2015) are liquidating their US dollar assets to manage government budget shortfalls and, in the case of Saudi Arabia, to defend its US dollar peg.
To that point, it’s worth pointing out that the Kingdom’s foreign exchange reserves continue to fall at an alarming rate…
… and the fact that WTI crude oil just fell below $40 per barrel certainty doesn’t help.
Considering the budget impacts on already stressed governments – not to mention energy firms around the world who continue to default in droves – the next leg down in oil prices could be far more disruptive than it was in 2015 and it may not take much to trigger a major event like a 1998-style strategic sovereign default (Russia, anyone?) or even a Saudi devaluation.
Of course, that’s just one risk.
We also have to worry about European bank stress, another desperate round of easing from the Bank of Japan or the European Central Bank, a Chinese RMB shock, or even outright conflict in the South China Sea or in Eastern Europe.
As I’ve said for the last few years, anything that leads to a significant upswing in the US dollar – whether it’s a global flight to safety or simply global policy divergence – holds the power to unleash a truly global crisis.
To be fair, such events are incredibly difficult to forecast. Oil prices could bounce again (particularly in the event of OPEC instability). Europe could somehow backstop its banks. The US economy could stay relatively weak. Fed policy could tilt dovish. And the trade-weighted dollar could retest its recent lows.
My point is that we’re not out of the woods yet and, with so many plausible risks already on the table, a pick-up in US growth would only raise the odds of a global disruption.
We’re not aggressively betting on a crisis, but my colleagues and I on the STA Investment Committee continue to run conservative portfolios with an underweight to equities, and a focus on yield-oriented assets (like corporate bonds and preferred stocks) and defensive assets (like cash, gold, managed futures, and long-dated US Treasuries) while we wait for quality assets to go on sale.
-Worth Wray, Chief Economist & Global Macro Strategist
Weekly Technical Comment
Written by: Luke Patterson
CEO & Chief Investment Officer
Dollar Drops on Weak GDP Report…
A combination of factors are pushing the U.S. Dollar sharply lower. One was Friday’s report of GDP growing only 1.2% in the second quarter. That pushed Treasury yields lower and bond prices higher and weakened the dollar. The chart shows the PowerShares Dollar Index ETF (UUP) gapping lower and putting it well below its 200-day moving average. Most other major currencies are rallying against the dollar, including commodity currencies like the Aussie and Canadian Dollars.
Falling Dollar Boosts Commodities…
One of the immediate side-effects of a falling dollar is higher commodities. The chart below shows the Bloomberg Commodity Index ($BCOM) rebounding off a rising trendline drawn under its January/April lows. The commodity selloff this month has reflected weakness in the price of oil and energy shares which have been weighing on the stock market. The rebound may take some pressure off both. Industrial and precious metals (along with shares tied to them) are rebounding after a minor pullback. Dollar weakness may also be giving a boost to large multinational stocks in the U.S. that depend heavily on foreign business. A weaker dollar is also helping boost emerging markets.
Emerging Markets IShares Reach 12-Month High…
Emerging markets are rising faster than most developed markets. The chart below shows the MSCI Emerging Markets iShares (EEM) trading at the highest level in a year after having broken through a “neckline” drawn over its October/April highs. Commodity currencies in Brazil, Russia, and South Africa have been rallying along with EM Asian currencies. That’s a sign that global investors are willing to assume more risk in the search for higher yields.
EAFE IShares Looking Stronger…
Although it’s encouraging to see emerging markets breaking out to the upside, it would be even better to see developed markets joining the global rally as well. And they’re getting close. The chart shows the MSCI EAFE iShares (EFA) nearing a test of a “neckline” drawn over their October/June peaks. Needless to say, an upside breakout would give a boost to the global rally. EAFE includes stocks in Europe Australasia and the Far East.
Sector Relative Rotation Model
The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.
The chart below (updated through August 1, 2016) indicates relative strength (relative to the S&P 500 Index). Healthcare and Small Cap stocks are leading relative to the S&P 500. Financials and Consumer Discretion stocks have lagged. Consumer Staples, Materials, Industrials, Utilities and Energy indicate weakening, and Technology indicates improvement in the model. Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline.
Note: There are four quadrants on the chart:
Featured Articles & Interviews
• Thursday, July 21st, Grant Williams
Michael Smith and Worth Wray Interviewed Grant Williams. Worth, Mike and Grant spoke about the current Global Economic Environment, US Stocks, Monetary Policy and Gold. Grant is the author of the popular investment letter Things That Make You Go Hmmm… and co-founder of Real Vision Television. He has 30 years of experience in finance on the Asian, Australian, European and US markets and has held senior positions at several international investment houses. Grant is also a senior advisor to Vulpes Investment Management in Singapore.
• Tuesday, July 12th, Holly Wade
Michael Smith and Luke Patterson spoke with Holly Wade with the NFIB. Holly Wade is the director of research and policy analysis for NFIB, where she provides analysis on public policy issues and economic trends affecting small business. She also produces the monthly Small Business Economic Trends survey with NFIB’s chief economist. She is a member of the National Association of Business Economics, National Economists Club, and the Department of Commerce’s Industry Trade Advisory Committee on Small and Minority Business.
• Friday, June 24th Brexit Video
Worth Wray, Chief Economist and Global Macro Strategist for STA Wealth explains Britain’s vote to exit the European Union. It is a historic decision sure to reshape the nation’s place in the world.
If you have any questions, please feel free to email me at firstname.lastname@example.org.
STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Worth Wray, Chief Economist & Global Macro Strategist
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
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