The Week Ahead:
Watch the dollar. It's the key to Emerging Markets.
We won't recap all the news items this week. There were too many and even the markets, with one finger over the trade button, were caught wrong footed several times. But of note were 1) bank deregulation coming because according to a new official:
“…. we’re not going to burden the banks with literally hundreds of billions of dollars of regulatory costs every year. The banks are going to be able to price product more efficiently and more effectively to consumers.”
…which is pretty rich and 2) Congress said that the Fed must cease all negotiations on regulatory standards and 3) the Administration’s new trade adviser said the Germans are manipulating the Euro for their own gain. Now, if we learned one thing in 36 years of investing, it is that you cannot go around telling markets they are wrong because you disagree with them. The dollar duly sold off.
Of the three, by the way, number 2 is far the most worrying. Every generation learns painfully that an independent central bank safeguards inflation and the economy. If it comes under political pressure, you can bet that markets will fall fast. So far, the Fed has remained quiet but their statement last week warned clearly about inflation risk.
Meanwhile, financials had a good week (all that deregulation) and helped carry the S&P 500 to an all-time high. The stand out for risk assets was Emerging Markets, which are now up 6.6% for the year, nearly three times U.S. stocks. In a busy news week, this caught our eye:
1. Jobs: For an economy that had blowout numbers in consumer and business confidence in the last few months, the 227,000 increase in non-farm payrolls in January left us underwhelmed.
The unemployment rate, the line in the middle, rose and average hourly earnings grew at their slowest rate in almost a year… and on an unchanged workweek. That’s puzzling because minimum wage increases took effect in several states. Vermont increased minimums by 5% and five sizeable states increased by 10% to 25%. Those will hit the data eventually but nothing yet.
We would also point out that the gap between the official unemployment rate (4.8%) and the underemployment rate (9.4%) remains historically wide at 4.6%. It used to run less than 3%. That, and the participation rate, tells us that some parts of the labor market will either a) return as confidence and jobs increase or b) have permanently shifted to part time or c) exited the workforce. The Administration believes A. Anyway, we think this means no rate hike in March.
2. Remember what’s driving the market: We've mentioned before, the reflation trade rests on deregulation, infrastructure spending, tax cuts and fiscal stimulus. There has been some chat on a border tax but precious little on the fiscal side. Time is running out. A fiscal stimulus like infrastructure must be approved, financed, planned and built. Call that 12 months at least. There is a quicker way. In 2001 and 2008, the Bush tax cuts provided tax rebates of $300 to $500 dollars, payable right into bank accounts. If that were happen today, it would cost about $70bn or 0.5% of GDP. Useful enough for growth, except look what happened back then:
Yes, pretty much what you would expect. Savings went up and retail sales increased. But then fell back. It was a classic case of bringing consumption forward a few months and then back to normal. Both were done near the beginning of a recession and, darned if we can find any evidence that they did much good.
3. Emerging Markets: We’ve liked Emerging Markets for a while. The old Emerging Markets story was about massive raw material exports and infrastructure spend. So Brazil sold oil and China sold iron ore and built stuff. We're simplifying. Now it’s about domestic and indigenous growth. For that to work deregulation must take place and currencies have to stabilize. There are growing signs that is exactly what it happening.
China is cracking down on capital outflows and is likely to be the beneficiary of bilateral or regional trade agreements if the U.S. makes good on threats to leave as many trade deals as it can. Asian currencies generally have stabilized so mitigating any U.S. rate increase and Korean and Australian exports showed impressive numbers in the last few weeks.
Those exports are headed somewhere and seem to us consistent with a “Buy EM” trade. Emerging Markets, remember, underperformed the U.S. since 2009 but stayed in line for most of 2016 until the election. They stumbled then but have recently outperformed. We think that's likely to continue.
Market volatility is remarkably low. The VIX is well below 12, although it’s such a flawed index that we rarely pay it much attention until it gets into the 30s. About half of the S&P 500 companies have reported with 52% beating sales (tough to do) and 55% beat earnings (easier). At this rate, the quarter is shaping up to be one of the best in three years.
--Christian Thwaites, Brouwer & Janachowski, LLC
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All charts from Factset unless otherwise noted.