The Days Ahead: More earnings and a Fed meeting.
Stocks ended the week well. The S&P 500 is now up 7.4% this year, Emerging Markets up 10% and European markets up 8%. U.S. Treasuries have held to the 2.6% level and there was a well received Seven-Year auction mid-week. The fears of a bond market correction, which we never believed, took a back seat.
1. How’s the dollar doing?
Not well. You would think that as Treasury Secretary, you would tread lightly and carry a soft stick, especially when you’re specifically responsible for international affairs and the dollar. Note, the Fed is not, despite what some confused senators think. But no, on Tuesday, Treasury Secretary Mnuchin said a weak dollar was good for the country.
“Fine,” said the markets, “we can go for that. We've already sold the dollar down 13% in the last year, so, ya know, whatever, we’ll take it down 2%.” Remember it takes a heck of a lot of volume to move a currency. U.S. stocks trade around $150bn a day. The FX market trades around 40 times more at $5.6 trillion, so that's a lot of heft behind the move. But then the President said, no, Mnuchin is confused and a strong dollar is great. Cue a dollar rally. Mnuchin thought for a while, agreed with his boss, and said a strong dollar was great too. This is what it looked like hour by hour.
Now Mnuchin was a Goldman Sachs trader and successful hedge fund manager. So he must have known what effect his words would have.
And man, did it work. ECB President Draghi was asked about currency wars on Thursday and responded that they’ll not get involved in any devaluations. Over at the BoJ, Governor Kuroda said that currencies should not move much (it’s handy when they’re all on the same mountaintop…they can hold dueling pressers). But he also said that inflation was now near target. Why’s that important? Because the Bank of Japan has targeted a government 10-Year Treasury Rate of 0% in order to boost inflation. If inflation is now close to target, they can back off easing and the yen can appreciate.
Well, all this is interesting in the short term but what’s the long-term trend? After the financial crisis, the dollar strengthened. Part of that was a flight to quality. Some was the lingering Euro crisis. In the past FX traders could have used the Deutschemark and Gilder to gain exposure to a strong currency. Now they have to use the whole Euro, which has countries in it that investors were keen to avoid back in 2009 to 2012.
But the Euro area is now recovering strongly and global reserve managers are probably reducing their overweight positions in dollar reserves. The story is the same for Japan and the yen and China’s Renminbi, which appreciated 6% in the last six months. All three countries have a current account surplus of between 2% to 8% of GDP or $850bn. The U.S. runs a deficit of 1.5% of GDP or $150bn.
That means in a period of more stable, synchronized growth, where it's no longer just a U.S. story, the dollar will weaken. It’s a mug’s game to try to predict how much and when. But all the forces are in place and we can now add an administration that, at best, will practice benign neglect.
And what’s the effect on inflation? Well, here's a chart showing the U.S. dollar with a one-year lead and two measures of inflation.
It does seem that when the dollar is weak, inflation ticks up and vice versa, but with quite a lag. This could happen again, although there are many forces, which drive towards a low inflation rate. In the short term, we’d say this is good for U.S. investors in international and Emerging Markets and for U.S. exporters.
2. Well, the 3s were nice but….
You maybe have heard about the two successive quarters of 3% growth we had last year. Forecasts were for another 3% but the first estimate came in at 2.6%. The 2017 number is around 2.3%, which is in line with the post-financial crash era.
We're not too concerned. The data are subject to much revision. This is, after all, accounting for a $19.7 trillion economy less than three weeks after close of business. But the major contributor was a run-down in inventories, a notoriously volatile component and a big jump in imports. The big questions now are: will consumption turn up in Q1 and will investment in equipment, which was up a massive 11%, continue? We think yes, primarily because the benefits of the tax reform are front end loaded.
3. SPY, CAT and NFLX.
Three quick hits on corporate news this week. First, SPY,or the State Street ETF that tracks the S&P 500 hit $300bn. Well done State Street for creating an investment product that took the world 25 years ago. We don't use it because it’s favored in short and hedging positions by traders. The daily volume is $30bn so the annual turnover is, er, a lot. The Vanguard ETF (VOO), trades around $730m a day. It also outperforms SPY.
Netflix, meanwhile, added another 8.3m users, 75% of those overseas. The international side is really taking off and that will only improve with a weak dollar. Spare a thought for the humble DVD rental business (remember how you started?). It’s twice as profitable as streaming, is only 3% of revenues but makes 16% of profits. It’s now making money but still on a sky-high PE of 210x. So the themes of “winner takes all”, the network effect and monopoly positions, which underpin the success of the FANGS, seems alive and thriving with Netflix. Its stock rose 11%.
Of far more importance to the U.S. is Caterpillar (CAT). It’s the 50th largest company by market cap, has big overseas sales and employees nearly 117,000 people. Its sales were up 35%, with Asia and Latin America up 22% and 40%. They mostly serve three industries: construction, resources, energy, and transportation, specifically marine and rail. Profits were up but the company had to take a $2.4bn write down its deferred tax liabilities (that’s the tax reform at work but no worries, it's a GAAP convention and no money changed hands). CAT is a great lead indicator of economic growth. You don't buy a CAT earth mover , if you're not pretty confident about the future. As they say on their website, “$1 spent on road, highways and bridge improvements returns $5.20 to the economy” so they're first in line for any infrastructure build out.
Bottom Line: Big industrial earnings next week. Stocks are still well bid across the world.
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