The Week Ahead:
A big earnings weak. Political news may surprise.
The Dow Jones Industrials finally hit 20,000 last week. Slow hand clap all round. It’s a deeply flawed index with 30 not terribly representative stocks with a weird methodology. Goldman Sachs, with a market value of $94bn, for example, carries eight times the weighting of GE, a $265bn company, merely because Goldman’s share price is $236 and GE’s $30. Anyway, we’ve got there and now we can stop fussing about it.
More important was the record on the S&P 500, which was up 1.1% on the week and 2.5% year to date. The S&P 600 small cap index, which readers remember is something we have liked for a while, was up nearly 2% and flat year to date. But it had risen much faster in the post-election period. Meanwhile the 10-Year Treasury peaked mid-week but rallied by Friday to reach 2.42%.
There hasn't been too much to move Treasuries out of a narrow range for the last week. The “reflation” trade is mostly on. That’s the one where animal spirits are on the rise, lower taxes help companies and people, and we’re building infrastructure. So good for financials, materials, commodities and TIPS.
The deflation trade, however, lurks right behind. That means low housing demand, spare capacity here and overseas, rock-bottom rates in Europe and Japan, a strong dollar and low inflation expectations.
That’s good for bonds, staples, REITs and Treasuries. We're going to need more data to see which side we land. On balance, we’ll go with “reflation” but with some risks to the downside.
1. Those animal spirits: were nowhere in sight in the Q4 GDP numbers that came out on Friday. Full year growth was the slowest in five years and the fourth quarter was up 1.9%, below Q3. The key constraint was foreign trade, which pulled 1.7% off growth.
There was a large contribution from an inventory rebuild but that has been weak for most of the prior six quarters so due for a rebound. Personal consumption, which is 68% of the economy, was weak, especially in housing. Durable goods orders were up strongly so perhaps we can look though the Q4 numbers and see a positive trend into the New Year.
2. We have to talk: the political headlines dominated much of the news. We won’t go over all of them here except to say that the market has been taking much of it in its stride. Talk about breaching trade agreements, foreign relations and unspecified changes to healthcare would have seriously rattled markets a year ago. This time it’s a case of barking and moving caravans.
The performance of the Mexican peso and stock market was really impressive last week. This may be a case of markets bottoming out on bad news, and that certainly seems to be case here. Mexico represents about 4% of the Emerging Markets index, which is up 6% this year. We think that i) Emerging Markets’ debt problem is overblown and servicing costs manageable ii) if “reflation” is on, then materials and commodities work well and iii) if U.S. trade becomes a problem, then China will play a strong regional role.
3. If you missed our conference call: we discussed whether the end of the bond bull market was over. The answer is “No”. The quick version was that to have a fully fledged bond bear market you need four things to happen: 1) fast rising inflation 2) full employment 3) wage pressure and 4) increasing supply. We'll argue that all four are not flashing red or even on a worsening trajectory. Yields may back up to 2.7% but if growth stumbles along at 2.5%, which is more than we've had for nearly two years, it’s tough to see yields heading north fast. Anyway, do take a listen if you want the full version.
The chart below shows just how much U.S. yields are above comparable sovereigns. Any further increase will put even more pressure on the dollar, which will suck in imports very quickly.
4. Earnings: we're about a third of the way through earnings. What was notable last week was some M&A activity, good news from Caterpillar in China, and revenue beats from Microsoft and Intel. About 65% of companies have beaten earnings and 52% have beaten revenues. The latter number is far more important. Earnings can be managed. Sales, mostly, can not.
This week we have the Fed meeting and a jobs report on Friday. The market is floating on hope right now. Nothing wrong with that, but it certainly pays to spread the risk around.
-- Christian Thwaites
Brouwer & Janachowski, LLC
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