The Week Ahead: Expect the market to stay sidelined.
For all the talk about high-frequency algos running up volatility, some weeks are plain quiet. The S&P 500 can’t seem to break out of the very narrow (less than 0.85%) range that we’ve seen since July. The Ten-Year Treasury traded between 1.70% and 1.74%. That means for the Treasury note maturing in August 2026, prices ranged from $97.05 to $97.26.
We think markets are positioned for three things: 1) a political outcome 2) a small Fed hike in December and 3) some talk about fiscal stimulus. The last one is the most difficult to pin down. It’s there in both U.S. Presidential candidates’ policies. A little more defined in one than the other. But even in Europe there is vague talk about the need for “growth friendly” policies. Here’s what caught our eye.
1. Inflation: We’ve been sanguine about inflation. Wage inflation is extremely weak and food and energy costs are flat or declining. Last week inflation came in at 0.3% for the month and 1.5% for the year. But it’s up from 0% a year ago and there are some worrying trends in the details. We’ve talked about healthcare inflation before. Well, here it is again:
The nice blue bars show core inflation at a steady rate of around 2% for most of this year. The lines show prescription drug prices, health insurance and hospital services…all running at over 6%. Together, these are only 5% or so of the index. But they have a bigger weighting in the Producer Price Index, especially in the form of employee health insurance. So those costs are coming through either in prices, higher co-pays for employees or lower margins. Now inflation is not about to take off. But we expect some rises in the next few months. That’s why we hold TIPS.
2. Low Rates: the ECB confirmed no policy change. It’s worth restating: 0% if you want to borrow and negative (0.4%) if you want to deposit. They also recommitted to €80bn per month of bond purchases. The chart shows just how low spreads on European corporate borrowers have closed since the ECB increased the program in January.
And also just how low interest rates have fallen. Investment grade companies can borrow at less than 2%. The equivalent number in the U.S. is around 4%. We don’t think there’s much upside in Europe’s credit markets. Growth is still feeble and most, but especially the Germans, will ignore the siren call of fiscal policy (which would otherwise be good for equities) .
3. Earnings: over a quarter of companies have reported. The average decline is (0.3%) but last month the expectation was for (2.0%). The market trades at 16.5 times earnings, so cheaper than it was in the summer.
One big question is how much longer will the energy sector be a drag on earnings? We’ll know more next week when Exxon and Chevron report. Both account for around 3% of the S&P 500 and even more of the earnings. Exxon has reported seven straight quarters of earnings declines. That will soon change. Meanwhile, the small cap market is fairing better. Earnings there will be up around 0.3%, which doesn’t sound great until you note the dispersion between energy, down 190%, and Financials, up 22%.
Bottom Line: The most frequent question clients ask is “Isn’t the market overvalued?” No. It’s not cheap but if it can stay calm and bring in a no-surprise earnings quarter, then valuations are reasonable. But, as always, expect distractions along the way.
“It’s miserable, miserable” Hedge Fund managers woes
–Christian Thwaites, Brouwer & Janachowski, LLC
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