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Hike but no spike

The Days Ahead: Fed meets Wednesday. Yes, they will raise rates. Bonds won't move much. New dot plots will be important

One-Minute Summary.  After flirting with crossing below its 50 and 200-day moving average (better known by its Wagnerian title, The Death Cross), the S&P 500 had a solid week and is up 4% for the year. The Small Cap world of the S&P 600 and Russell 2000 reached all-time highs and are up around 10% this year. Bonds hung in the 2.90% to 2.95% range. Pretty much unchanged for the last month.

Europe is still worried about the Italian politics, debt and bond world. Italian banks were down over 6% and even the news of a merger of Unicredit with SocGen was not enough to stop a 2.5% drop in the share price. The trade news was not good. One would expect the markets to freak out at the retaliations, a very grumpy G-7 meeting and rate pressure. But the trade war has not changed the generally good narrative. Why? Well 1) the devil is in the details on trade and until we know what they are, it’s tough to put a number on growth and 2) perhaps markets are in the “take it serously, but not literally” world.

Something very definite came in last week from Commerce Department on Chinese steel flanges. You know, the things that look like this. If it goes ahead, U.S. customs will charge importers around $50m. But imports would quickly take up the slack so the final cost to consumers will be negligible in a $20 trillion economy.

Meanwhile, the U.S. ISM numbers were good. Job openings were up. The trade deficit narrowed. The FANG basket of tech stocks has outperformed the S&P 500 every month this year except April and have done it again in June. This won't continue but there’s a trend in place.

1.     Markets are jumpy (Part 3): This week was the turn of the Brazilian stock market.

The basic story was that the government imposed fuel price controls following the trucking strike, which has been going on for weeks. The central bank stepped in with some aggressive currency swaps to try to prop up the Real. But inflation is on the rise (hence the price controls) and there’s an election in October. Throw in trade problems, the Emerging Markets (EM) debt problems, and one wonders why it took so long for the market to wake up.

We think the EM story is solid but the recent weakness is because:

  1. Core yields have risen in developed markets and EM’s track the increases. We think these will moderate.
  2. The dollar has strengthened which hurts EM’s debt management. We expect the US dollar to soften over time.
  3. Crude has been on the rise which hurts more EM economies than it helps. We think that’s about to end.
  4. Trade tensions are high. They will remain so but we don't expect them to affect intra-EM and EU trade.

So, it’s been a test of resilience for sure but Emerging Markets remain an excellent asset class for solid growth.

2.     There’s an awful lot of debt. Yes, but not in the usual places. If we’re looking for the next bear market, one place you can pretty well know is that’s it’s not going to be in the same place as the last time. So, as we said last week, don't go looking at the MBS world. In fact, don't even go looking at consumers. The new snappily-titled Z.1 report came out this week. It was called the Flow of Funds report, which describes exactly what it is. But, hey, I’m not a branding expert and someone came up with Z.1. And who can blame them? It’s a ton of information that gives us plenty of blog subjects if the markets aren't really doing anything or we need a break from tweets and headlines like this.

Here’s what caught our eye:

The blue line is household debt. That’s all the mortgages, credit card, auto loans, and home equity lines thrown in together. You can see the peak of 120% of GDP a few years ago. Since then, households have taken the message of running down debt very much to heart. It even fell more last quarter. So it seems consumers are a) not following through on the confidence they say they have and b) not using the tax cuts to borrow more.

The other line is non-financial corporate debt (we need to exclude banks who need debt for capital and loan growth). It’s at an all-time high. Now we know one of the themes of the last few years was for companies to borrow at low rates to offset cash held offshore and pay for share buy-backs. And we know that we should probably adjust the number for cash and cash equivalents held by companies (remember Apple’s $100bn cash pile).

But still, that’s a fair amount of borrowing and we think it’s one of the main reasons why stocks have been tepid in recent weeks. Yes, the tax cuts have helped a lot. Estimates for S&P 500 earnings in 2018 made in early December were $146, up 11%. By January, they were $158, up 19%. The difference was entirely due to the lower tax rate. So in a high-leveraged world, companies with lots of pricing power (think software, personal products, pharma) do well. Companies with less pricing power and leverage (think energy, transportation, autos) will not. And there are a lot more companies in that second group than the first.

So what? We're keeping a close watch on the leveraged companies. We’re out of some of them (like REITs) and expect more sideways market action until the story is clearer.

Bottom Line: Yield curve is flattening again. This time in the 5s and 30s. Europe will struggle with the trade news. Volatile but sideways stocks.  

Light blogging only next week. Heavy travel. Back in two.

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 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
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