The Days Ahead: Fed meets and will raise rates.
One-Minute Summary: Stocks reached another record high. We're now up 10.1% for the year and up 15% since the mini correction in February. Small caps have done even better at 16.1% and 19%.
We've seen stocks rotate. That's when stocks that were previously unloved come back in favor. We looked at sectors like Consumer Staples, one of the worst performing sectors, which was down 5% to the end of August but rallied 2.3% so far in September. Tech, the clear winner for most of this year, is down for September.
It’s happening at the stock level, of course. Exxon, the sixth largest company in the S&P 500, was down 4% from January to August. It’s up 6% so far in September. It’s the same story with companies like Caterpillar, Altria, Cigna and some major insurance companies. What this tells us is that prior favorites like Tech and Small Cap are taking a breather or open to profit-taking and lagging companies are having their day. It doesn't change our Small Cap outlook…Tech is different, it’s under some regulatory pressure and much more expensive. Small Caps have a relatively high exposure to REITs, Financials and Specialty Retail…all of which have come under recent, temporary pressure.
The dollar looks like it peaked a month ago. It was up 9% from February but has since weakened against some key currencies…down 4% against the Swiss Franc, 3.5% against the Euro, 2% against the Yen and 3% against sterling. Yes, the dollar has the rate advantage but exchange rates are also driven by confidence, diversification and capital flows. The U.S.’s twin deficits (current account and budget deficit) are heading the wrong way and eventually they’ll show up in the exchange rate.
We don’t think anyone’s winning the trade war. Despite the big numbers from the Administration, the tariffs amount at worst, to $60bn, which is less than 0.3% of U.S. GDP and a drop in the bucket compared to the $220bn of tax cuts coming into the U.S. economy. Because so much of the imports from China are intermediate goods (here’s the list, it’s 195 pages), the costs may show up in higher prices or squeezed margins some months from now. But it won't be big and it won't solve the broader “Made in China 2025” problems.
Also big news: the sector definitions for the S&P 500 will change on September 24. We’ll no longer have a tech sector at 28% of the index. Instead we’ll drop Telecom and have a new Communication Services group. It will bring in some companies which are now Consumer Discretionary, like Comcast and Netflix, and some which are now in Tech, like Google and Facebook and will be around 11% of the S&P 500. Expect some rebalancing trading on Monday.
1. “Tax Cuts will lead to pay increases”. Said some and indeed there was a 2.9% increase in hourly earnings (AHE) in the August payroll numbers. Hooray said some. Not so fast, said others.
There are a few ways to get a pay increase:
1. You're paid more
2. You're paid the same but work less
But we’re not interested in nominal increases. We want to see increases in real purchasing power and wages, otherwise you're just pushing money around the economy, not really increasing broad wealth. And there are a few way you get a real pay increase:
3. You're paid more than the increase in inflation
4. You're paid the same but inflation falls
5. You're paid the same but work less or get more benefits
It’s only #3 that matters and the results are mixed. The tax cut was meant to lead to higher investment, productivity and wages. It was one of those “it pays for itself” programs. As we pointed out at the time, that was a big ask because the tax cuts caused the deficit to increase by 1% of GDP immediately and by another 1% over 10 years.
We've seen companies increase share buy-backs. We've seen some increases in bonuses and time off. But wage increases have been very slow, even as the Fed frets about a sub 4% unemployment rate. Here’s the wage picture in one chart:
The blue bars are what’s reported in the payroll numbers with average hourly earnings up 2.9%. But if we deflate that by the CPI so get a picture of real purchasing power, we see a less impressive 0.23% (black line). And if we separate out the very large cohort of Non-Supervisory Employees from the All Employees category, we see the real hourly wage at $9.24, lower than a year ago.
Now, we bring this up again because of headlines like “U.S. wages grow at fastest pace in nine years” (Financial Times) and “Bumper Wage Growth”. Hey, we’d like nothing more. The U.S. consumer drives 70% of GDP, perhaps more than any other economy in the world. But it’s not showing up in things like retail sales or housing and it’s very likely personal consumption will grow a lot less than the 3.8% it showed in Q2.
2. So, 3% on the 10-Year Treasury. Now what? Probably not much. There are some seasonal aspects to the Treasury market. They have to do with when new auctions come around, corporate cash needs, repatriation and even national holidays in China and Japan. This year, U.S. companies with pension deficits could deduct the cost of funding them using the old 2017 corporate tax rate up until September 15. That meant a CFO could save some 15% on buying Treasuries. We feel that kept the 10-Year Treasury under 3% for most of August. That buying has now stopped.
We've discussed the inverted yield curve. After moving relentlessly from 60bps in January to a low of 19bps in late August, it has now reversed back up to 27bps. Here's the chart:
We're not sure if the move to inversion (i.e. the upper blue line falls to below zero) is a solid indicator of a recession. Sure, looking back over 30 years, there it is…the spread falls to below zero and a recession appears some 14 to 26 months later. So that’s three times in 30 years.
But here’s the thing: being early and right is the same as being wrong. There is no point heading to the long part of the curve in the expectation that all the price weakness will be at the short end.
And as for coming out of equities, well, we’re not timers and markets can have strong and late rallies for quite some time. Here’s the curve shown in stark terms…compare the yellow line to the shape of the curve a month and year ago. It’s only the 2 to 10-Year Treasury spread which is flattening. We'd argue years of QE and low absolute and real rates mean that any inversion will have to look at 3-month bills and long-term bonds. And we’re not close there.
Meanwhile, here’s how we look at the Treasury market:
All we did here was look at several U.S. Treasury prices today and work out how much rates would have to rise in order to lose money on a Treasury trade over 2, 5, 10 and 30 years. The duration measures how much the price of the bond would fall if rates increase 1%.
The best risk/reward right now looks like the 2-Year Treasury (actually it’s about 19 months, maturing in April 2020). It yields 2.38% for a risk/reward of 0.56.
Another way to look at that is that rates would have to rise 1.7% immediately for that investment not to have a positive return. For a 30-Year Treasury, rates would only have to rise 0.16%. To be clear, we’re not ringing any alarm bells here. We're just taking advantage of the recent rise in yields, which makes a short-term Treasury investment look quite attractive and, for the first time in a while, a valid asset class.
3. Any relief on Emerging Markets yet? Some. Performance in 2017, when Emerging Markets were up 45%, seems distant. So far in 2018, we’re down 8% but up 4% from the bottoms just two weeks ago. We've discussed before what’s happened (basically a dollar, interest rate and trade problem) but the question now, of course, is what next? Here are some quick thoughts.
Buying into Emerging Markets is not an exchange rate or trade story. It’s about growth, demography and expanding economies.
Turkey and Argentina are basket cases. They're not in the Emerging Markets asset class to any meaningful weight but their stories grab headlines. We don't believe the financial contagion story for a moment but agree there’s a sentiment problem.
Drawdowns in Emerging Markets are common.
50% of global growth comes from Emerging Markets.
The new NAFTA with Mexico is good for Mexico.
The 22% annual increase in oil prices has hurt Emerging Markets but the supply issues (Iran and Venezuela) are no longer driving up prices.
Seasonal patterns happen in Emerging Markets especially after a bumper year like 2017.
China stocks had their best day in two years on Friday…these things move fast.
So while the short-term can stretch patience, the longer-term strategic case remains.
Bottom Line: Fed meeting. Much will depend on whether the Fed removes the “accommodative” wording. They’ll also review the long-term projections for the Fed Funds rate. It’s currently at 2.3% to 3.5%. If that heads up by 0.5% we may see some pressure on bonds.
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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.
All charts from Factset unless otherwise noted.
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