We take a deeper dive into the inverted yield curve, as well as the other issues driving recent market volatility.
It was another extremely volatile week for both the stock and bond markets. Stocks rallied Thursday and Friday after large declines on Wednesday.
Some of the issues that have fueled the recent volatility have been:
1) The rapid decline in interest rates.
2) Very poor economic data out of countries like Germany and China.
3) Uncertainty around President Trump's recent tariff announcements.
All of these developments will need to be closely monitored as all three have the potential to create challenges for markets and the economy. I will have a video out next week going into more detail.
That being said, there was a lot of reporting this week that the U.S. is likely heading into a recession. We still believe it is highly unlikely the U.S. will enter a recession in the near-term.
While the U.S. economy is slowing it is still doing well led by a very strong U.S. consumer. And the consumer should be strong with a very robust jobs market and good wage growth.
Also, small business owner confidence increased in July and is not far from all-time highs. A few lines from the report from the NFIB:
“While many are talking about a slowing economy and possible signs of a recession, the 3rd largest economy in the world continues to defy expectations, generating output, creating value, and expanding the economy,” said NFIB President and CEO Juanita D. Duggan. “Small business owners want to grow their operations, and the only thing stopping them is finding qualified workers.”
“Contrary to the narrative about impending economic doom, the small business sector remains exceptional. This month’s index is a confirmation that small business owners remain very optimistic about the economy but are being hamstrung by not finding the workers they need,” said NFIB Chief Economist William Dunkelberg.
With the U.S. consumer doing well and small businesses feeling optimistic the U.S. economy is on firm footing. However, the U.S. is not an island and there has been an impact to the U.S. from negative interest rates around the globe and very weak global growth. Also, the concerns surrounding President Trump’s recent tariff announcements is going to be a drag on growth. We will have more on all of this next week.
The S&P 500 was flat this week as the index sits just 1.2% off of its all-time high set last September. The market has had an incredible rally to start 2019 after its steepest decline since the Great Recession in the 4th quarter. Not every index is approaching a new high; the Russell 2000, which tracks small cap stocks, is still off over 10%. However, it had further ground to makeup than the S&P 500 as it declined 28% during the 4th quarter.
As we have discussed before, the turnaround in the stock market was triggered by the Federal Reserve pivoting from a path of quarterly interest rate hikes to holding tight at current levels. This change of course was the right decision and further evidence of that are recent figures that show inflation continues to drift lower. In fact, in the last five or six years concerns about deflation have been more prevalent than concerns about inflation.
This week brought good economic news on several fronts:
1) The jobs market continues to be robust, with the latest release of claims for unemployment benefits. From CNBC:
The number of Americans filing applications for unemployment benefits fell to more than a 49-1/2-year low last week, pointing to sustained strength in the economy.
Initial claims for state unemployment benefits dropped 5,000 to a seasonally adjusted 192,000 for the week ended April 13, the lowest level since September 1969, the Labor Department said on Thursday.
2) U.S. retail sales increased 1.6% last month, making this the biggest rise since October 2017, and beating expectations for an increase of 1.1%. The consumer continues to be alive and well.
3) Earnings reports for the 1st quarter have been much better than expected so far, beating expectations by 5.7%. Earnings estimates were brought down by analysts in the wake of the market sell-off and global slowdown, but if companies continue to outpace expectations by close to 6% that could be a good sign for the rest of 2019.
While the U.S. economy continues to see strong growth, Europe and Japan are flirting with recession as several issues weight on growth, including the lack of pro-growth reforms.
The following chart shows the decline in two measures of economic activity in the Eurozone:
In 2018, economic growth in China was its weakest since 1990. However, there are now signs that this economic slowdown may have bottomed. China is such an important part of global growth so a reacceleration in business activity would be a welcomed development.
After a painful decline in credit growth during 2018, we have seen a dramatic turnaround to begin 2019. Further stimulus efforts by the Chinese government also is a boost to growth, though they have to be careful here as they already have high debt levels, thanks in part to previous stimulus efforts.
With the Federal Reserve on the sidelines for the time being, attention has turned to earnings growth and the state of the Chinese economy. In spite of weakness in Europe and Japan, the recent data has given good reasons to be optimistic that the market can take out the September highs. I will leave it on that note, have a good weekend.
The stock market rally to begin 2019 has certainly been a welcome sight after the steep declines the market suffered in the 4th quarter of 2018.
Let’s take a look at some of the factors impacting financial markets.
Stock market declines were ignited on October 3rd when Fed Chair Jerome Powell said that more hikes were on the way and that rates were “a long way from neutral.” Market declines accelerated on December 19th after Powell’s hawkish statement that the Fed’s plan to reduce their balance sheet was on autopilot.
In early January we saw the start of an almost 180 degree turn by Fed Chair Powell from his stance in the 4th quarter. This has been the primary driver of the strong rally stocks have had to begin 2019.
As we said in December, it was time for the Fed to take a pause on their plan to hike interest rates and let the economy work through the cumulative impact of nine interest rate increases.
Now that the Fed has moved to the sidelines, at least for the time being, we will see what the impact on the economy will be as we progress through 2019.
The driving force behind the U.S. economy is consumer spending. By almost every measure the consumer is doing very well. In February consumer confidence bounced back to very strong levels. This bodes well for future consumer spending.
For over 40 years Gallup has polled Americans about their finances. Their February report had more good news on the consumer front:
Americans’ optimism about their personal finances has climbed to levels not seen in more than 16 years, with 69% now saying they expect to be financially better off “at this time next year.”
The 69% saying they expect to be better off is only two percentage points below the all-time high of 71%, recorded in March 1998 at a time when the nation’s economic boom was producing strong economic growth combined with the lowest inflation and unemployment rates in decades.
For our final look at the U.S. consumer, the Labor Department’s February Employment Report showed employee wages grew 3.4% year-over-year. This is the fastest pace of wage growth in ten years. Strong wage growth had been missing for most of the economic recovery, but has greatly improved over the last year.
With the Federal Reserve on hold for now with regards to interest rate hikes and with the U.S. consumer very optimistic, economic growth in 2019 should be strong once again in the U.S., a far cry from the many calls for recession we heard in the 4th quarter of 2018.
That said, we are certainly later in the business cycle and the picture for the global economy is much more concerning. Our next post will look at the global economic slowdown and the impact the trade war is having on China’s economy. Have a great weekend.
The roller coaster ride in the stock market continued this week, albeit with smaller moves than we saw last week. Let's jump in and look at a few of the factors the market is grappling with.
Stock Market Volatility
We have seen stock market volatility spike higher in recent weeks. This spike began when Federal Reserve Chair, Jerome Powell, indicated during an interview that interest rates remained a long way from neutral, a point where interest rates are neither restrictive or accommodative of economic growth. This comment moved investors to sell bonds, and saw interest rates jump higher as we detailed last week.
While there are genuine concerns that the Fed could raise rates too far, too fast, it is not a surprise to see higher market volatility as interest rates go higher. We believe the stock market can handle higher interest rates, however, sharp moves higher in rates like we have seen a few times in 2018 will lead to higher volatility. A key point to remember is that October is historically the most volatile month of the year for stocks.
This earnings season has been very good so far with strong earnings reports from the likes of Proctor & Gamble, United Healthcare, Netflix, PayPal, CSX and many more. Third quarter earnings growth for companies in the S&P 500 are coming in at 22% so far. This outstanding growth has exceeded virtually every forecast analysts had coming into the year. This also comes on the heels of 25% growth in the first half of this year.
Not all news has been great on the earnings front. Any company involved in housing or autos has struggled due to several factors, including rising interest rates. The housing market in particular has cooled, as higher interest rates mean higher mortgage payments for consumers looking to buy a new home or refinance. Existing home sales fell for the 6th straight month to 3-year low. We will be watching for signs of housing to firm.
From a technical perspective, the S&P 500 closed yesterday right on its 200-day moving average.This moving average has been key support for the stock market going back to the strong run that began after the election in November 2016. Some investors who are trend-followers like to buy when the market is above the 200 DMA and sell when the market drops below the 200 DMA.
The slowdown in the Chinese economy continues, with 3rd quarter GDP growth slowing to 6.5%. This was the lowest rate of growth in China since 2009. The Chinese stock market has also seen a significant decline of 25% so far in 2018. That being said, expect the Chinese government to step up with measures to support the economy and the stock market. There are plenty of levers the government can pull in the short-run.
The trade dispute currently taking place between the U.S. and China continues with no signs of a resolution in the short-term. One concern some have voiced is that China could dump U.S. Treasuries on the market causing interest rates in the U.S. to soar, thus slowing the U.S. economy. China currently owns over $1 trillion of U.S. Treasuries. Click below for a detailed analysis of the situation which explains while it is highly unlikely China will go down this path as it would likely hurt China far more than the U.S.
So while the U.S. showdown with China, fear of rising interest rates and the slowdown in housing and autos are clearly worth watching, it is also the case that we are in the midst of the best stretch of economic growth in the U.S. since the late 90's. Pro-growth economic policies have led to an incredible increase in company earnings, the strongest small-business sentiment in 35 years and a surge in capital investment.
As October winds down, volatility could remain elevated in the run-up to the mid-terms as markets work through the issues detailed above. Last week we raised an extra 5%-7% of cash in our portfolios, giving us more dry powder if the market volatility continues.
It was an ugly day in the markets with the Dow Jones Industrial Average down 832 points, or 3.15%, with the S&P 500 down 3.29% and the tech-heavy Nasdaq plummeting 4.08%. Days like today certainly are not a lot of fun but are a reality even during bull markets.
Last week interest rates shot up with the 10-year U.S. Treasury bond yield jumping from 3.05% to 3.24%, the highest yield on the 10-year since 2011. The S&P 500 is now down five straight days since this move occurred.
Let's not forget that in January of this year we saw the 10-year U.S. Treasury bond yield jump from 2.48% to 2.85%, which at the time was the highest yield since 2013. Stocks proceeded to fall over 11% into early February. It was a bloodbath, with five or six days of declines similar to what we saw today. However, over time the stock market digested that move higher in yields and went on to erase those losses and hit new highs.
Unfortunately, I do not have a crystal ball, well I do but it just shows me colors- not helpful here. Back to being serious, I do not have a crystal ball, but the decline seen over the last week is very similar to many stock market corrections in the past. And while the corrections are not enjoyable they play a pivotal part in a longer-term bull market.
I will have more to say later this week on the bigger picture, but for now know I am watching the markets and your portfolios very closely.
For Tesla Chief Executive Elon Musk, outside-the-norm has always been the norm. Even by those standards yesterday Mr. Musk sent shock waves throughout the business community with message he sent from his Twitter account announcing he was considering taking the company private at $420 a share. Mr. Musk also indicated that funding had been secured.
The timing of the message, during market trading hours, was highly unusual for a message of this magnitude. Also, there was no explanation for how Mr. Musk arrived at the $420 per share figure. Mr. Musk would need to raise an estimated $60-$70 billion in debt and/or equity to take Tesla private. That is an enormous task for a company that is still rapidly burning through cash. The SEC will certainly take a close look at Mr. Musk's tweets.
Time will tell what the outcome ultimately will be, but there is no question this is one of the wildest financial stories I have seen. Tesla's stock has never traded on fundamentals, and headlines around Mr. Musk have often been surreal.
For more analysis on this story, head over for a take from MarketWatch.
Last week a significant milestone was reached as Apple became the first company to reach a valuation of $1 trillion. From the WSJ:
Apple’s rise has been propelled by the sustained success of the iPhone developed under late co-founder Steve Jobs, a product visionary who helped revive the company from a death spiral in the late 1990s. His successor, Tim Cook, has turned Apple into a cash-generating giant by pushing its existing products to prominence in China and cultivating its rapidly growing services business—moves that have helped stave off concerns about the absence of a new, blockbuster device.
With a market capitalization of $1 trillion, Apple is larger than the GDP of most countries, including Sweden, Saudi Arabia, Turkey and The Netherlands. It is a remarkable achievement, especially when you consider that the company had to reinvent itself multiple times just to stay in business. Their superior innovation, technology and marketing helped them become the first trillion dollar company.
As we near the halfway point of 2018 several themes are emerging. Let's take a look.
After years of virtually no capital expenditures, businesses have significantly accelerated investment into things new buildings, equipment, vehicles and software. One of the biggest reasons for increased investment is due to the tax cuts that took place January 1st, 2018. During 1st quarter earnings reports, company after company have cited the tax cuts when asked what was driving increased investment.
"U.S. companies could plow more of the money saved from sweeping tax cuts into business investment later this year, perhaps even surpassing a jump in first-quarter capital expenditure that was the highest in almost seven years, strategists and analysts said.
Higher spending on technology, equipment and facilities could ease worries that S&P 500 companies have reached a peak in the profit growth investors are counting on to extend the nine-year bull market in equities.
With data in from 94 percent of S&P 500 companies, first-quarter capital expenditures total $159 billion, up more than 21 percent from a year ago and on track to be the highest year-over-year growth since the third quarter of 2011, according to S&P Dow Jones Indices data."
When all was said and done 1st quarter earnings grew at a blistering 26.5% pace. After earnings growth had flat-lined in 2015 & 2016 financial analysts are forecasting growth of almost 20% in 2018. This would be an impressive number on the heels of 14% growth in 2017. Tax cuts, deregulation and consumer confidence in the economy have all played a role in the earnings surge.
Not only were 1st quarter results impressive, but we saw the highest spread between companies rasising their earnings forecast and companies lowering their earnings forecast since 2003.
Small Business Optimism
Given that small businesses are so critical to the U.S economy, the fact that optimism from business owners hit the highest level in 35 years should be very beneficial to the economy during the 2nd half of 2018.
“Main Street optimism is on a stratospheric trajectory thanks to recent tax cuts and regulatory changes. For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” said NFIB President and CEO Juanita Duggan.
Investors could not have asked for a better start to the year for company earnings than what they have gotten. With small business optimism hitting records and a long overdue surge in business investment, the table is set for continued strength in the U.S. economy.
Next, we will look ahead to some of the challenges the market could face in the 2nd half. We will tackle the ongoing tariff negotiations currently taking place between China and the United States as well as the decision by the Federal Reserve to hike interest rates once or twice by the end of the year. We will also take a look at which investments have been the leaders and which have been the laggards in the first half of 2018.
Market volatility has persisted as wide intraday swings in stock prices have continued to be the norm following the stock market correction in early February.
There has been a tug-of-war for the market's attention between higher interest rates and strong earnings growth. On one side the interest rate on a 10-year U.S. Treasury Bond topped 3% this week for the first time since early 2014. Coming into 2018 the 10-year rate was 2.40%. Remember that when interest rates go up that means that bond prices are declining. The Barclays Aggregate Bond Index, which is viewed as the S&P 500 of the bond market, is down 2.67% year-to-date and Long-Term U.S. Treasuries have declined 7.07% year-to-date. It has been several years since we owned Long-Term Treasuries as the risk of interest rates going higher outweighs the reward of earning a slightly higher yield.
Also taking it on the chin this year:
Consumer Staples -10.20%
What these investments have in common is that all three doubled in price between 2011 and 2016, outperforming the S&P 500 as investors searched for high-paying dividend stocks with bond rates and money market rates extremely low.
The valuation of these "bond-proxies" are still not cheap and if interest rates continue to go higher there will likely be more pain ahead for this group.
The high yield for the 10-year U.S. Treasury in 2014 was 3.03%. Earlier this week that level was tested again and rates subsequently backed down to under 3%. The issue for some investors isn't necessarily higher interest rates, but the concern is the potential for interest rates to quickly move higher making it more difficult for the market to adjust.
As we approach the halfway point for first quarter earnings reports, revenue and earnings growth continue to be sensational. Earnings are on pace to grow 21.1% with revenue increasing 7.6%. It was not too long ago that some analysts said that low single digits growth was the best that could be expected and that the days of faster growth across the board were gone.
As of January 1st, 2018 the projected growth rate for first quarter earnings was 12.2%. Actual results are going to be nearly double those projections.
A theme from 2011-2016 was that analysts were overly optimistic each year in their forecasts for earnings growth (and economic growth as well) and as the year progressed would have to cut their forecasts. 2017 earnings growth came in slightly below the initial forecast and so far in 2018 analysts have significantly raised their forecasts.
Let's briefly touch on a few more issues.
The Cass Freight Index gives valuable insight into the level of economic activity by tracking freight expenditures and freight volumes. This chart does a good job of illustrating the dramatic turnaround that has taken place in the U.S. economy since the beginning of 2017.
This index is a leading indicator of economic activity so the March reading is a positive for future economic growth.
The U.S. consumer continues to feel very good about the economic outlook. When consumers are more confident in the economy they tend to spend more.
Part of the reason for the consumer's positive outlook is that their take home pay is increasing at the highest rate in over ten years thanks to the recent tax cut. March saw an increase of 7.5%, up from the 2%-3% range previously seen.
As first quarter earnings season continues to unfold we will closely track not only the earnings themselves, but also companies outlook for the rest of 2018. We will also monitor interest rates with particular attention around the 2014 high yield of 3.03%. Keep in mind that strong economic data does not guarantee more upside for the stock market. That said, 20% earnings growth on the back of double-digit earnings growth in 2017 provides a strong foundation for stocks.