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The Lift then the Drop

The Days Ahead: Inflation and a short week for the bond market

One-Minute Summary: U.S. equities fell for the second week. This hasn't happened since last June and we would note that too was a quarter-end trade. We expect some recalibrations of portfolios.

Small caps came under some pressure. They’re down 6% over the last month but still well up on the year. We also saw corrections in the Consumer Discretionary, Tech and Communication Services sectors. We’d put that entirely down to the new sectors that came into being a few weeks ago (we wrote about it here), where tech companies moved around and probably threw off sector allocations for managed and index funds.

The market has faced some pressing issues recently. Trade talks, some hawkish Fed talk, Italian bond yields, QE tapering in Europe, oil. Take your pick. Caution is called for while we go through the next few months.

 1.     Jobs, less than expected but more than enough. The number was less than expected at 134,000. There are two surveys in the monthly employment numbers and the differences are important when bad weather strikes.

One, the household survey (basically people answering a phone survey), which is taken the 12th of the month and counts anyone employed full time, even if they didn't work because of bad weather. Two, the establishment survey (businesses answering a questionnaire), which asks about average weekly hours and will record fewer hours if employees can't get to work. So, in the first, weather has no real impact on full time workers but does on part-time and in the second, the amount of work can change and throw off the trends.  

 And that was the case with the September numbers. Florence hit between September 10 and 13, and so the official numbers would not have caught part timers who could not work because of the storm. Similarly, while the average hourly workweek did not change, it fell for high labor intensity industries like wholesaling and construction. Overtime hours also fell which you would expect if you can't get to work. All in all, the low headline number probably underestimates the strength of the labor market.

 Putting this all together and we get this chart:

Unemployment fell to a near 50-year low, annual wage growth fell a little on a base effect (it rose this time last year) and the broader measure of unemployment rose and is not close to its multi-year lows.

The headline numbers are strong and won't dissuade the Fed from moving rates up again in December. We don't totally buy into the increase in earnings because a) it’s all employees and so is skewed by high-end earners and b) it's not inflation adjusted so doesn't really tell us if purchasing power is increasing (it's not).

 2.     The Bond Market corrected. Last week we wrote about how the Fed seemed to be all on the same page. Steady growth, slowly tightening and inflation behaving. This week we saw a speech from Chair Powell that revived the whole Phillip’s curve debate which suggests they are more worried about the low unemployment rate leading to increased wages. Hey, he even put in a nice equation:


Which looks impressive until we dig in and see that a) slack is notoriously difficult to measure b) Cinflaiton (sic) is the tendency for inflation to linger, so also tough to measure and c) Other, is, well, “unspecified factors”. Clear? No, nor us.

We're not there yet with increase wages and, to us, that relationship seems so very 1970s.

But along with good numbers from the Manufacturing and Service Industry surveys (the latter at a record high), the 10-Year Treasury yield spiked from 3.08% to 3.23% for about a 1% capital decline. Some of this may be technical…weird stuff happens at quarter end...what with window dressing and rebalancing.  The 2-Year Treasury only moved up 8bps and for the issue that we’ve been buying recently, the price fell $0.05 from $99.13.

It seems one of two things must happen as rate hikes continue.

Either, the yield curve inverts, and that can be any part not just the popular 2s/10s, and the economy weakens.

Or, the curve shifts upwards as growth and inflation take off.

The market shifts between the two and last week the latter had the upper hand. The employment and ISM numbers supported the second version. The disappointing trade number (the deficit with China was at a record level…we’ll leave it at that), supports the first.

We'd also keep an eye on this. This shows the spread for U.S. Investment Grade Corporate bonds over Treasuries:

It’s fallen in recent weeks. Now, call us cautious but it does not seem that U.S. corporate debt became less risky recently. It’s 90% industrial and financial companies and 50% of the index is BBB rated: one notch above junk. One thing we know about this cycle, is that companies have rushed to load up on debt at low rates. Normally, around 7% to 15% of companies are downgraded at the end of a cycle. Assume it will be at the top end of the range this time, then we’re looking at 15% of BBB bonds will be junk. And then ETFs and Funds will be forced sellers at the bottom. That’s not a good place to be and keeps us firmly overweighting short term Treasuries.

Bottom Line: There is a collection of exacerbating factors driving capital markets right now. Most of these are known but sometimes the market stops, weighs them all up, takes some profits and rethinks it all. Nothing major happened but some traders are getting out of positions that didn't work last quarter. We'd continue to buy insurance for our long equity positions. China was closed all week so there may be some catch-up on Monday.

Please check out our 119 Years of the Dow chart  

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 --Christian Thwaites, Brouwer & Janachowski, LLC

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All charts from Factset unless otherwise noted.

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