China Update

Over the past decade cash from China has been deployed into assets such as stock, bonds and real estate around the globe. The Chinese government, concerned by the level of cash leaving the country, has put capital controls into place to slow this flow of cash leaving the country.

From the Wall Street Journal:

China’s seemingly insatiable demand for foreign assets has driven up prices for everything from U.S. Treasury bonds to global companies to luxury real estate. Now, a combination of market forces and capital controls are choking off the flow of Chinese cash. Asset markets around the world will have to adjust.

As Chinese exports boomed starting in the early 2000s and foreign investment flooded into the country, the central bank recycled these inflows into foreign government bonds, mostly Treasurys, to keep the yuan from rising. The buying persisted for over a decade, driving bond prices up and driving yields down globally.

Earnings Heat Up

As we head into the back half of summer, company earnings are heating up while market volatility has declined to an all-time low. We also have an update from the continued fallout in retail after Amazon's purchase of Whole Foods. Let's dive in.

Earnings

An important issue for the market coming into 2017 was the quest for a return to strong growth in company earnings. After 5 quarters of flat or negative earnings growth, the 1st quarter of 2017 saw growth of 14%, a blockbuster number. The next question was whether the 1st quarter number was a fluke or if the strong growth would continue?

With over half the companies in the S&P 500 reporting 2nd quarter numbers, profits are on pace to grow by 11%. It is this growth that has helped to power the stock market to record highs. 72% of companies in the S&P 500 have beaten their earnings estimates compared to the long-term average of 64%. 

Another piece of good news is that revenue growth is up 5% for these companies with 69% beating expectations vs a long-term average of 59%. 

As long as healthy earnings growth continues, the path of least resistance for the market is higher.

Volatility

One of the most important measures of market volatility, the CBOE Volatility Index(VIX), hit an all-time low within the last week. The VIX tends to spike higher when stocks sell-off or when market participants are fearful. With the VIX at record lows there is a debate about whether investors have become too complacent. However, according to Bank America investment managers are holding above-average levels of cash in their portfolios. Also, there is a high level of "short interest" in stocks, that is betting that stocks decline in value. These are not signs of a market with excessive optimism. Typically when the market is close to a near-term top investment managers have very little in cash and short interest is low.  

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Amazon Impact

Since Amazon's announced purchase of Whole Foods on June 16th, many companies from all walks of retail have seen their stocks sell-off. 

Here is a look at how far some strong companies have fallen from their 52 week highs in large part due to concerns of competition with Amazon:

Costco -17%

Kroger -31%

Auto Zone -30%

Ulta Beauty -20%

Target -27%

There is no question that Amazon has disrupted the business model of many retailers. Many department stores as well as specialty retailers have gone up in flames as they were unable to adjust to Amazon.

That said, there is a limit to how many business segments Amazon can dominate before the government becomes concerned with a monopoly status. We aren't there yet, but as the retail shakeout continues there will be some buying opportunities in the space as the baby gets thrown out with the bathwater.   

With the majority of companies in the S&P 500 having reported 2nd quarter earnings, the results have been very good, extending the earnings recovery that began in the 1st quarter. The market response to earnings has been to move higher with low volatility. Whether investors have become too complacent or not will become clearer as we head into the fall. While there will still be values to be found, whether related to the Amazon impact or not, we will continue to closely monitor your portfolios. 

Amazon Upends Grocery Industry

This morning news broke that Amazon.com is buying Whole Foods Market for $13.7 billion. This move will give Amazon a foothold into the brick-and-mortar side of retail that Amazon has significantly altered. The potential impact of this deal could be as large as anything we have seen in decades.

Investors voiced their approval of the deal sending Amazon's stock up 2.44%. Often the acquiring company's stock declines upon deal announcements. However, in this case investors, at least initially, are excited about the opportunity ahead for Amazon given the fact that the size of the grocery market is $800 billion per year. 

Kroger, Target, Walmart and Costco were all among the companies that had significant sell-offs on the news. There is a question about whether the depth of the sell-offs were overdone. The grocery industry typically has slim profit margins, and with Amazon now taking aim at the industry competitors are going to have to figure out how to innovate if they don't want to lose market share to Amazon. 

Currently online sales makes up only 2%-3% of the grocery business. That has always been expected to increase but with Amazon now in the business that should accelerate this shift. 

In other news, the U.S. dollar has declined 6.5% from the five-year high it set last December. 

Source: Bloomberg

Source: Bloomberg

The dollar's decline has been beneficial to many of the large U.S. firms that get a majority of their sales from overseas. When the dollar is too strong it leads to lower earnings by the multi-nationals. Other benefactors of a weaker dollar are emerging market economies. Many borrowers in these countries accumulate dollar-denominated debt which becomes cheaper to repay when the dollar weakens vs the particular emerging market currency. 

As long as the dollar doesn't make a strong move in either direction from current levels it shouldn't have a significant impact on the economy.

The recent decline of the dollar has benefited large U.S. multi-nationals and the dollar will continue to be carefully watched. Also, Amazon's purchase of Whole Foods will have a ripple effect across multiple sectors and will offer some investment opportunities. I believe this story will continue to be the focus of the financial media until second quarter earnings reports begin in July.

 

 

Earnings Reports Send Stocks Higher

As the summer approaches the stock market is near it's high powered by strong earnings reports and increased business confidence that has led to higher business spending. Let's dive in.

Earnings Reports

Analysts' earnings expectations for the S&P 500 have consistently been too optimistic during this economic recovery. In fact, going back to 2012 every year has seen earnings come in at less than half of initial forecasts. If this pattern can be reversed we could see added fuel for the stock market in the coming years.

Source: Bloomberg.com

Source: Bloomberg.com

With close to 70% of companies in the S&P 500 having reported their first quarter numbers, we have seen earnings growth in excess of 10% compared to the first quarter of 2016. That reverses a trend over the previous eight quarters of earnings declining on average. While this is a great start to 2017, there obviously is a long way to go for this to become a trend. 

Small Business Update

Small businesses make up 64% of net new private-sector jobs in the United States. So it is good news that small business owners are the most optimistic they have been in the last thirty years about the economic outlook. The results of the presidential election contributed to this as business owners are hopeful for tax reform, regulatory reform, infrastructure spending and a new health care plan that will reverse two decades of policy mistakes by both parties. Of course no one knows what exactly will get passed and become law, but optimism for pro-growth polices appear to already have changed behavior as business capital spending jumped 10% in the first quarter compared to the first quarter of 2016. Capital spending includes expenditures on items like property, plant and equipment. Since the 2008 crisis, many businesses have been very hesitant to increase capital spending and that has been one of the big reasons economic growth (as measured by GDP) has been so sluggish during the recovery. 

Source: NFIB.com

Source: NFIB.com

The Federal Reserve

The Federal Reserve is expected to raise interest rates when they meet again in June. This would be their second increase of 2017 and third increase since last December. We have felt for a long time that the Fed should have been raising rates twice a year going back to 2013. 0% interest rates made sense during the financial crisis, but were kept too low for too long. If the Fed does raise rates in June it would set the table for a third increase during the second half of the year. It will be important for the Fed to not push for a fourth increase in 2017 as the cumulative effect of five increases in thirteen months could have negative ramifications for the economy here and around the globe. 

Second quarter earnings reports, small business behavior and the Fed's June decision will give us more information about what the economy and the markets will have in store in the second half of 2017. In addition to these issues there are always developments in China that will have an investment impact, and we will have see what kind of  progress is made in Washington regarding everything from tax reform to infrastructure. 

 

Optimism Sends Markets Higher

Animal spirits have returned to the markets, at least temporarily, as there have been major shifts since the U.S. presidential election. While there is still not a lot of clarity on the details of President-elect Trump's policies, expectations are that much needed tax-reform, a reduction in excessive regulations and new infrastructure spending will give economic growth a shot in the arm.

Stocks and Bonds

U.S. stocks have rallied, led by small-caps, financials and industrials all gaining over 10%. 

Bond prices have plummeted sending interest rates swiftly higher, with the yield on the 10-year U.S. Treasury rising from 1.74% before the election to 2.49% today.  

Many financial pundits have been predicting a rise in interest rates every year for the past five or six years. Up until now that has not been the case with interest rates hitting an all time low this summer.

As a result of low rates, stocks like consumer staples, utilities, telecoms, as well as corporate bonds and government bonds have outperformed since 2010 as investors chased higher dividends and interest income. Short-term rate increases in interest rates during this time provided buying opportunities for these investments. Since the election these investments have been sold off by the market and if interest rates continue higher the low-rate/low-growth playbook that was so profitable for so many years could continue to be under pressure.

Oil

Oil has surged to $51/barrel aided by OPEC members agreeing to to cut oil production for the first time since 2008. U.S. oil hit a low of $26/barrel in February 2016 before rallying. Since March, oil has traded in a range between $43 - $52

While the OPEC agreement is a good sign for oil prices going forward, there are doubts about whether the countries involved will stick to the agreement. Also, with the recovery in oil prices U.S. production is expected to pick up, offsetting some of OPEC's cuts. Many analysts believe a range of $50 - $60 would be beneficial for the U.S. economy moving forward.

Economic Surveys

The NFIB, which surveys small businesses on a monthly basis, reported in November that small businesses are the most optimistic about their new hiring plans than they have been in over ten years.
From the Wall Street Journal:

The National Federation of Independent Business monthly employment survey for November will show that owners of small firms are preparing for a better future. “A seasonally adjusted net 15 percent plan to create new jobs, up 5 points from October and the strongest reading in the recovery,” NFIB Chief Economist William Dunkelberg tells us.

Consumer confidence reached a nine-year high in November with The Conference Board's measure jumping to 107.1, up from 100.8 in October, far outpacing economists expectations of 101.8. Consumers tend to spend more when they are upbeat so this report is positive for holiday retail sales.

It remains to be seen how markets will perform moving forward. In December the Federal Reserve will meet and are expected to raise interest rates a quarter point. What the Fed says about their plans for 2017 will be closely watched. Coming up December 4th Italy is holding a referendum, which if voted down will lead to the resignation of their Prime Minister. Following in the footsteps of Brexit and the U.S. Presidential Election, we expect the No vote to win.
It is expected if No wins there could be a vote in Italy next year to determine if Italy will leave the Eurozone. 

We are in the process of making necessary adjustments to our portfolios and will continue to track all developments both here in the U.S. and abroad.

  

 

Brexit Upends Global Markets

The U.K. vote to leave the European Union shocked financial markets, here are our thoughts:

1) The U.S. stock market is taking things in stride relative to declines globally with the U.S. market falling back to where it was just one week ago. Some of the largest declines have taken place in European stocks(-10.50%), European banks (-15%), the British Pound (-8%) and Japanese stocks (-7.7%). Fortunately these were areas of the market we have been avoiding. On the flip side Gold, U.S. Treasuries and the U.S. Dollar have all been benefactors of the vote to leave with strong gains today.

2) Britain's vote to leave was not that surprising if you looked at how close the polls were going into the vote, however global markets had strongly rallied for five straight days on the assumption the Remain vote would win. Bookmakers in the U.K. put odds at almost 80% that Remain would win going into the vote. Moving forward the U.K. will not begin to exit the EU until October and even then the process will take several years.

3)  What will be interesting to watch going forward will be to see what impact, if any, this vote will have on politicians in Italy, Spain, France etc. It is possible there will be a push for similar referendums. The leading candidate in the race for Prime Minister in the Netherlands today said he will be calling for a referendum to leave the EU if he wins. The Netherlands have had five straight years of GDP growth under 1%.

On a related note, growth has continued to be abysmal in Europe. European Central Bank President Mario Draghi has repeatedly voiced frustrations that while the ECB has implemented program after program to try and boost the economy politicians have not passed pro-growth reforms. Draghi specifically has mentioned reforms in areas like labor laws, tax policy and pensions.  

Sluggish economic growth was not the primary reason for Brexit. However it did play a factor and the longer politicians in other European countries go without implementing pro-growth reforms the more probable it becomes that the status quo in those countries will be upended.   

4) Odds of a Federal Reserve rate hike in 2016 plummeted from 42% to 18% this morning after the Brexit vote. The awful May jobs report had taken a summer rate hike off the table. For now the odds of a hike at any time in 2016 are low. It will take much stronger U.S. economic data in the 2nd half of 2016 for a hike to occur.

The volatility that has come with Brexit is in the process of producing some attractive investment opportunities. Caution is still warranted though, as a key question to be answered will be what degree of impact this vote will have on business confidence, as one of the drawbacks of sluggish economic growth is that it leaves very little margin for shocks to the system. The U.S. economy has been able to overcome global hurdles over the past 5 -6 years and continue to plod forward with 2% GDP growth. We will be watching the data as we enter the 2nd half of 2016. 

S&P 500 Back Into Familiar Territory

This Spring has had no shortage of market-moving stories. Notable among them, The U.S. Dollar Index, which measures the U.S. Dollar vs a basket of other currencies, declined from 100 in early February to 93 in early May. This weakening of the dollar fueled gains in stocks, oil and commodities. We will have more on this in a future post. Speaking of oil, it has made a strong comeback off its February low of $27/barrel climbing to $49/barrel today. There are still significant supply hurdles that will have to be overcome for oil to avoid revisiting the $30's.

On to other topics...

The S&P

The S&P 500 is back in a trading range it has seen twice before over the past year. 

So what has kept the the S&P from breaking out of this trading range to the upside? Last August it was the Chinese currency devaluation that triggered a market sell-off and then in the first week of 2016 the Chinese devalued their currency again beginning another market fall below the trading range. Over the past few months the Chinese have taken back tight control over their currency so another devaluation in the coming months is less likely, though can't be ruled out. 

Another key point- declining revenue and earnings over the previous four quarters have also kept the S&P from breaking out. Some analysts project that the 7% earnings decline seen in the first quarter was the low point and that companies will have a much stronger second half of the year. This has been projected for several years but has failed to materialize. That being said, there are CEOs who are optimistic. 

The Fed

The market focus over the next few weeks will once again be on the issue of whether the Federal Reserve will raise interest rates at their June meeting. Just in the past week market participants have placed the odds of a Fed rate increase from 4% to a 32% chance today. This shift began after Fed meeting minutes were released last Wednesday that showed Fed officials were much more open to a June interest rate increase than the market had previously anticipated. In addition to the Fed minutes numerous Fed officials have been talking about the need for 2-3 rate hikes this year. The Fed has put themselves in another position in which they need to follow through and increase rates at the June meeting to try and restore some of the credibility they have lost with the many flip-flops we have seen from them in the past few years. 

The Fed claims to be data dependent, though it certainly has become much more market dependent under Janet Yellen. Looking at the data, first-quarter GDP was very weak at a .5% annual pace, first-quarter retail sales were poor and the April jobs report fell short of expectations. However, U.S. economic data has improved recently with a strong April retail sales number, good industrial numbers and April new home sales which rose to the highest level since 2008.

To reiterate our position, the 0% interest rates put in place during the 2008 financial crisis were for emergency measures and the Fed made a mistake waiting until December 2015 to begin the process of increasing rates. The economy was strong enough in 2013 & 2014 to begin slowly increasing rates from 0% to 1%, still a very low rate but off the emergency level. The Fed didn't do that and now has found themselves with a more challenging job.

Greece

Every few years around this time market volatility has picked up and all of us have been subjected to hearing endless media conjecture about Greece and the question of will they or won't they be bailed out. The market won't be fretting over a Greece bail out this year because it has been taken off the table. From the WSJ:

"Eurozone finance ministers and the International Monetary Fund patched together a deal in the early hours of Wednesday that clears the way for fresh loans for Greece and sets out how the country could get debt relief in the future.
The ministers, who held an 11-hour meeting in Brussels, said Greece had done what was necessary to unlock the next slice of financial aid, concluding a review of its bailout that was delayed for months. The new payouts will save Greece from defaulting on big debt redemptions to the IMF and European Central Bank in July."

What happened here is the politicians in the EU didn't want to have this battle with Greece right now, so they gave Greece $11 billion so Greece wouldn't default on previous bailout loans. Greece is in a hole they will not be getting out of and this move is another classic illustration of kicking the can down the road.

Going forward all eyes will be on the Fed and their June decision. Based on the Fed minutes, unless the economic data in the coming weeks is just dreadful, they have put themselves in a situation where a rate increase is needed for multiple reasons, their credibility being the most important. Regardless of what the Fed decides to do, we will be paying attention.

Financial Stocks Lead Market Decline

It has been another rousing week here at Sentara Capital with the financial headlines changing by the hour. 

Behind the scenes during more volatile times in the markets we are monitoring client portfolios to insure that losses are contained. If there are individual positions that are suffering steeper losses than we anticipated then we will make adjustments. We have been very pleased with the results so far this year, but it is an ongoing process. Market declines are not all created equal, the playbooks change, the investment mix that worked well before won't necessarily work well the next time. Market conditions change over time and that is why it is imperative for us to continue to closely follow them. It gives us the ability to create a new playbook instead of relying on a previous playbook.

Chinese markets were closed for the Lunar New Year holiday this week but that didn't mean global markets were in for a calm week. Japanese stocks led the way lower, with their worst week since 2008, down 11%. The Bank of Japan surprised investors on January 29th by announcing negative interest rates, meaning banks would have to pay the central bank to keep excess reserves at the central bank. Since that time investors have sold bank stocks concerned that negative interest rates would lead to a very challenging environment for the sector.

Also weighing on the market this week was Deutsche Bank, Europe's largest bank, which continued to see its share price fall, down almost 40% in just six weeks. This company has been on our radar screen since last summer when their CEO abruptly quit after just one month on the job. Since then the stock has been collapsing, the company reported operating losses for calendar year 2015 and is facing regulatory hurdles. Add to this concerns that the company has over $70 trillion of derivatives exposure and it is not difficult to see why Deutsche Bank has led the banking sector in Europe down 30% year-to-date. 

Big U.S. banks have declined 20% and have led our markets lower, taking the mantle from energy companies which were the primary drivers of lower prices early in the year. Today Jamie Dimon, CEO of JP Morgan, bought $26 million of JP Morgan stock, which lifted shares of JP Morgan and other bank stocks. There is no question that the balance sheets of U.S. banks are very strong, but the market is clearly concerned about the impact lower interest rates, European bank problems, and slower Chinese growth will have on U.S. banks. 

A few noteworthy items:

Gold: The precious metal has rallied to $1,239/oz, up over 8% in the last week alone. Gold has been in a bear market since 2011 so this recent rally is the first real strength the metal has seen in some time. We will be watching to see if this strength can be sustained.

The Fed:  Coming into the year the Fed signaled their intent to raise interest rates four times in 2016; however the market is now pricing in a less than 25% chance of even one interest rate increase in 2016. 

Meanwhile bond rates have had a steep decline since the start of the year on worries of weak global growth and deflationary concerns. The yield on the 10-year U.S. Treasury has fallen from 2.28% on January 1st to 1.70% today. It is worth nothing that the drop in bond rates accelerated when the Bank of Japan surprised investors on January 29th by announcing negative interest rates. For more on negative interest rates I suggest you click here.

The U.S. Consumer: The Commerce Department reported Retail Sales grew .2% in January, a 3.4% increase over last year. This was a strong showing by the U.S. consumer and a much needed bright spot to the economic data that has been released so far. Any fears that the U.S. is in a recession right now can be put to rest with this report.  

The decline in stocks here in the U.S. have brought valuations back to very reasonable levels and certain sectors have become cheap for the first time in a long time. That being said, the market is at a key technical level which means a level where buyers have been coming in to keep the market from further declines. Over the next few weeks it will be important to see if this key technical level can hold as more developments unfold concerning the Europeans banks and the Chinese economy.

As always we will be closely watching and taking care of your portfolios.    

Rough Start to a New Year

Stocks sold off today putting a cap on what has been an ugly first two weeks of 2016 for global financial markets. Let's take a look at what has driven the markets lower:

1) Oil- Crude prices fell to a twelve-year low of $29 a barrel. This is a decline of over 20% in January alone. There is no question that excess supply has been a significant factor in the decline in oil prices over the past eighteen months, but there still are very few signs that supply has been reduced in a meaningful way anywhere around the globe. Also, there continues to be no increase in demand and that is not good news for the global economy that already has it's hands full with adjusting to a slowing Chinese economy. Which takes us to point #2.

2) China- Last August China took financial markets by surprise when they devalued their currency, leading to stock market declines of more than 10% in many regions. After that decision authorities in China made a point to say there would be no reason for further devaluation. Fast forward to the first week in January and the People's Bank of China again devalued their currency, the yuan. This action has investors around the globe asking the question, is Chinese economic growth much weaker than Chinese authorities have acknowledged? The Chinese have projected 7% GDP growth for 2016. However some economists feel that growth will fall well short of 7% and that authorities in China will continue to devalue their currency to try and spur exports and increase growth.

So why would this cause so much pain for stocks in the U.S.? For the past four - five years the fast pace of economic growth in China has really helped the global economy overcome weak growth in Japan, Europe, Latin America, etc. If, and at this point it is still an if, China is dramatically slowing that will have a negative impact on the global economy and many U.S. companies. Also, as a result of the devaluation Chinese goods will become cheaper for U.S. importers. But when combined with plummeting commodity and oil prices, this will put significant deflationary pressures on the U.S. economy, which is a challenge our sluggish economy does not need.

On a side note, the Chinese stock market, The Shanghai Composite, is down over 18% so far in January. As we have said before action here should not be overplayed as the market does not have the same connection to the Chinese economy as Western markets have to their economies.

3) U.S. Retail Sales-  The Commerce Department reported that Retail Sales grew just 2.1% in 2015, down from 3.9% in 2014 and from an average of 5.1% from 2010 - 2014. Even though the U.S. economy has seen average GDP growth of only 2% during this recovery, the U.S. consumer has been the bright spot up until now. The question is will this prove to be a temporary blip or is this the start of a slowdown? When taking a deeper look at the report there are pockets of strength and this is just one of many snapshots of the U.S. economy.

4) Federal Reserve- The Federal Reserve raised interest rates by .25% in December, ending the unprecedented run of seven years of 0%. While a .25% increase is a very small number, it isn't the size of the increase that has had an impact on the markets it is the psychology. Financial markets are now adjusting to the fact that after seven years of 0% interest rates and $4 trillion added to the Fed's balance sheet, the Fed is now in a tightening cycle. There is no way to measure how much impact the Fed rate increase has had on the volatility of the past few weeks but it is healthy for markets to adjust to higher interest rates.   

We entered the year with a cautious stance and nothing has changed our position. The Federal Reserve projected four interest rate increases this year and we believed we would see no more than two. A March increase is probably off the table due to the current state of markets and especially the deflationary pressures that are increasing. We are entering the heart of earnings season and this will give us a very good look at not only the current state of the U.S. economy but also the impact the Chinese economic slowdown is having on U.S. companies. Stay tuned.    

The Fed Kicks the Can on Interest Rates

Last week the Federal Reserve punted on the opportunity to begin raising interest rates. The dovish tone of the Fed's accompanying statement also took the market by surprise.

We break down the Fed's reasons for leaving rates unchanged and the reaction from financial markets. We also take a look at a Federal Reserve Bank President who disagreed with the decision to leave rates at zero.