Before proceeding, I would advise my readers to understand these two parts for some groundwork:-
The U.S economy advanced an annualized 4.1% in Q2 2018, which is the highest reading since Q3 2014 and in-line with market expectations. This was supported by higher personal consumption expenditure (2.69% pts), fixed investment (0.94% pts), government spending (0.37% pts) and exports (9.3%) at the expense of slowing business spending.
The unemployment rate touched 4%, which is the lowest since April 2000 after setting an 18-year low record the previous month. This 0.2% increment came about as the civilian labour force grew MoM and the participation rate edged up by 0.2%.
Inflation rate grew by 0.1% to 2.9% which matches the peak during February 2012 in the last 6 years with December 2011 being the last time inflation stood at 3%. This came about from rising oil and gasoline prices aided by a 0.2% gain in the food index.
Fed Fund Rate stands at 2% albeit reaffirmation from Jerome Powell that the Fed will keep to its TWO more rate hike promise this year with normalizing taking place by end of 2019 with FOUR quarter bps hike next year amid intensifying risks around trade policy as mentioned in the FOMC’s meeting minutes during June 12th-13th.
NFP increased by 213k which handily beat market expectations of 195k following a downward revision from the previous month of 244k. Majority of the gains came from manufacturing, healthcare and business services at the expense of retail trade.
Claims for unemployment benefits rose by 9k to 217k, hitting above market expectations of 215k but remains below median for the last 4 months.
Average hourly earnings rose by 0.2% which slightly underperformed market expectations of 0.3%. This increase remains within the average for the last 2 years. Experts are not seeing enough wage growth to stimulate demand inflation to warrant further rate hikes beyond 2019.
Overall, this depicts a solid job market although showing signs of an economic top.
CPI has been steadily increasing in the recent years and hit an all-time high of 250.86 index points in June 2018 under a 68-year historical average of 110.74 index points. On the other hand, PPI gained 0.3% MoM in June, beating consensus of 0.2% while YoY, PPI grew by 3.4%, largest by far since November 2011 with largest gains from services (0.4%) and healthcare (0.2%). The PPI/CPI spread (YoY comparison) shows a narrowing spread as CPI slightly picks up against a decreasing PPI. With inflation strengthening, it is likely demand-related which can be confirmed with consumer confidence data and personal consumption expenditure. However, with PPI recently picking up and no latest CPI data, it remains to be seen if producers managed to pass on their cost to consumers to protect their margins.
The TIPS spread shows that inflation expectations remain robust which coincides with the recovery of commodity prices. The breakeven rate was 2.02% at the beginning of 2018 but has since increased by 11 bps recently.
Overall, inflation has hit the Fed’s expectations but if the 10-year yields start breaking new highs since the subprime and commodity starts picking up steam, this would prompt the Fed to further taper to contain inflation to avoid getting behind the curve.
The ISM PMI increased to 60.2, beating consensus of 58.4 from June. This is the highest reading in the last 4 months and is showing an uptrend due to a pickup in production and inventories. On the other hand, Markit PMI showed expansion at 55.5, beating consensus of 55.4. This solid trend is supported by stronger growth in manufacturing amid robustness in new orders, production volumes and employment.
Transportation equipment led a mediocre 1% rise in durable goods order which missed expectations of a 3% rise.
Capacity utilization is reaching post-subprime highs while production is picking up as well. What happens from here is that as capacity constraints hit, companies will either cool-off or spend more to expand hence demand will pick up at the expense of available supply. This usually leads to a spike in commodity prices and typical of economy tops where companies will mis-allocate resources to high performing sections and when demand cools-off, companies will then be caught off guard with excess capacity.
Overall, businesses remain solid with expansion on the manufacturing front. Production hit all-time high with relatively lesser capacity which could indicate better productivity.
Retail sales increased by 0.5% MoM matching expectations with the major gainer being motor vehicles and part dealers which was one of the 8 retail categories from a total of 13 that showed MoM increases.
Consumer sentiment stood at 97.9 for July 2018, above the preliminary reading of 97.1 and coinciding with a 6-month low. However, YTD the sentiment still looks solid.
The economic optimism index rose to a 5-month high, rising to 56.4 from 53.9 in June 2018. All THREE components: Six-month economic outlook, personal financial outlook and confidence in Federal Economic Policies outlook rose in the range of 1.1% to 9.5%.
Overall, consumer sentiment remains solid and this should drive further consumption moving forward.
Overall, the housing market is experiencing a slowdown in pending and existing home sales. Nonetheless, new home sales have picked up YoY which reduced the monthly supply of houses YTD. The most important indicator would be the building permits which is showing strength. Construction spending remains flat while home prices are still on an uptrend. No major issues observed in the housing market for now.
SPREADS & RECESSIONARY INDICATORS
- Very reliable indicator. So far it has not dropped by 0.02%. Job market looks solid.
- Inflation expectations are picking up again while the capacity utilization VS total business inventories to sales ratio spread looks healthy.
- The latest yield curve is relatively flatter than ever, but it has slightly steepened since two weeks back. The spread between the 5-10 and 10-30 are both at 12 bps as of close of last week.
- The financial sector was performing poorly with the flattening of the curve but have ever since “resuscitated” from the current earnings season, being one of the top performers in the last 1 month with a gain of 6.71%.
- The spread looks healthy for now.
- The Fed Fund Rate vs 10 year Treasury Yield spread is a key mainstay as the FFR is akin to a remote control that the Fed uses to manipulate the economy.
- The 10-year yields are climbing again and closed at 2.96% last week, which is primed to challenge the 3.1% high while the FFR stays within the 1.75 – 2.00% range. For now, there is still more room for rate hikes but Jerome Powell and co will have to be careful on how soon they would want to normalize rates. Markets will tend to race towards the top as the spread narrows when the bond traders feel that the 10-year yields would not have further room to climb as corporate earnings and balance sheets start to deteriorate at the expense of rising inflation. At this point of time, investors will start demanding a higher premium for holding instruments hence widening the credit spreads. As the Fed starts getting more hawkish on their stance, the curve inverts this tightens liquidity as it would not be profitable for banks to lend out money – they would simply lose from the spread. This situation can be frightening as there will soon be a flight to safety, causing further liquidity problems.
- Looking at current times, yield spreads are decreasing, indicating some doubt over the next 1 year amid a handsome looking US economy. Among all the macro indicators, treasury yield spreads are the one causing the divergence. Nonetheless this does not strike as a surprise as having a 6-year high on inflation, 18-year low on unemployment and 11-year low on bond yields are indicative of an economic top.
- The top chart shows different corporate-grade bonds of similar maturities while below shows the spread comparison between junk bonds and higher quality investment grade bonds. The junk spread indicated by the red line is still staying below the critical 5% level while the investment grade debt securities has risen slightly in this year’s vexatious performance but still remain below the end of 2015 yields. Earnings have been decent where with 53% of the S&P500 companies reported, 83% reported a positive EPS surprise and 77% have reported a positive sales surprise. The lowest class among all investment grade bonds – the “BBB” rating is still below the dreaded 2% yield level albeit spreads overall are rising in tandem with market volatility this year. These bonds are faced with various risks such as interest rates, inflation, default risk, liquidity and prepayment risk hence the premium demanded by investors vary based on macroeconomic situations.
- Spreads are starting to tighten again as trade tensions quieten. This is good for the financial markets.
- Thus, looking at the lowermost graph, spreads remain relatively tight, near the pre-subprime lows before widening up to the financial crisis. Current times are showing almost similar pattern with spreads widening after forming a lower low just like in the 2005 – 2007 period.
- In current times, the market index is healthy at a -64% correlation. This spread correlation could be used as the first warning sign before the other macro spreads kick in with their danger signals.
- We can see from the top chart that as financial conditions get tighter where all 3 lines are positive, it must stay above 0 for at least 3 months before a recession hits. In current times, we can see that credit conditions are still relatively loose but further rate hikes could jeopardize this scenario. We can also see leverage and the ANFCI increasing currently which indicates that although general conditions remain loose, it is still relatively tightening. In addition, tightening standards are painting a picture where consumer loans, credit cards and auto loans are tighter than usual as compared to looser standards for corporate loans. This analysis is in line with the current yield curve scenario where spreads are tightening which squeezes the profit margins for banks. As a financial institution, I would rather lend my money to those who invest the funds into growth or investment scenarios with adequate collateral which pose a lower risk of defaulting as compared with consumers who indulge in depreciative spending in credit cards, personal or auto loans. I cannot afford a higher default risk when my margin is already squeezed as my profits would stem from the ability of my clients to pay up the capital alongside the interests. However, it could also be due to increasing demand in consumer loans or high debt service ratio of households that make lending them money less attractive.
- I look at the net positions, extreme conviction sentiment and the range of the USD/JPY price before analyzing if the smart money is attempting to unwind or add to their carry positions. Currently the large specs and leveraged funds are net long in a symmetrical triangle consolidation pattern.
- 59% of traders are net long while 49% are net short with no clear-cut conviction.
- Based on the COT Report, open interest dropped as commercials added 11,932 longs and covered 546 short positions. The non-commercials on the other hand are net short and increased their bearish exposure by closing twice as much as their shorts. These indicates strong bearish sentiment, and this may indicate an upside breakout if the central banks deliver as expected.
- Tech and consumer discretionary has been top YTD performers.
- Financials & Industrials have picked up considerably in the recent months.
- Sector rotation can be seen with defensives such as staples, real estate and utilities coming back from the dead. Smart money is gradually rotating into defensives.
- Eyes will be on consumer staples as it recently broke above the 200 DMA after being the worst 1-year performer. Current market cycle is suggestive of staples being the next best performer after energy.
SEASONS & CYCLES ANALYSIS
- The S&P500 is in the worst quarter of the year with August and September being the most bearish months of the year. Summer time trading lulls triggers unconvincing volumes in the market. The next 2 months is the best time for a market correction to tone valuations down slightly.
- October begins the best 6 months of the year.
- With inflation and interest rates rising, bonds falling and commodities strengthening, we are near the peak of the liquidity cycle with US being near or at full recovery.
- Looking ahead, capacity constraints should hit (signs are showing in capacity utilization) while inflation strengthens. Earnings growth may top with industrial
- PMI’s flatlining. Bond yields should widen and trigger a stock price collapse. This will be in a period where liquidity will begin to decrease.
- In a nutshell, we are close to an economic top. Let’s look at our sector rotation model below to confirm this.
- Energy has moved up in recent times due to rising oil prices while staples have only recently risen above its 200 DMA.
TECHNICAL ANALYSIS (S&P500 ETF)
Key Levels & Fibonacci Retracements
- Prices have recently hit a key Fibo level of 161.8% at 283.43.
- Major support is at 280, 274 (horizontal and 100% Fibo) and 268-270 (horizontal and 61.8% Fibo).
- Major resistance is at YTD high of 286.60.
Divergence seen as volumes are decreasing while double top is being formed. Seasonal divergence.
- Double top pattern is forming on both weekly and monthly.
- Shooting star weekly candlestick reversal pattern with relatively higher volume. Presence of sellers.
- Weakening momentum based on MACD analysis.
The US economy is still healthy, and the bull run should be intact for at least another year although there should not be any surprises if the market corrects to normalize valuations. This is an economic period where commodities and equities should move in tandem and it remains a matter of time where inflation will pick up to persuade the Fed to raise rates above 3% to combat inflation. The smart money would also eventually rotate into defensives from cyclicals which should coincide with the economic top. Bond spreads should be closely monitored along with the job market to identify the market top among other recessionary spreads.
Over and out,
Ramone Mikgail Kok
U.S Macro Trader