Before proceeding, I would advise my readers to understand these two parts for some groundwork:-
- Overall macroeconomic outlook remain strong with a slowdown in the housing market.
- Recessionary indicators are not signalling any trouble yet. Not even a single one.
- Yields hitting 7 year highs is a bullish sign for the U.S markets and I welcome knee jerk corrections to take positions on dips.
- Q3 earnings remain strong with double digit projections. Energy, financials and materials are expected to outperform peers in earnings growth.
- Tech and discretionary losing some momentum with industrials and healthcare taking over leadership.
- Commodity has potential upside with the possibility of metals catching up with oil once inflationary pressure sets in and global growth gets on track. Trade or invest intelligently with stringent risk management.
- Possibility to consider AUD for a long term investment – seeing how poor the AUD has performed this year due to the trade tensions.
There have been questions arising if a 4% GDP growth rate for the U.S is sustainable. Since the subprime, 4% has occurred four times but since the Fed has started to hike interest rates in 2015, this is the first. Looking at the forecasts, many expect growth to moderate but still remain in expansion mode, echoing Jerome Powell’s statement that the economy is doing well and the Fed will continue on its normalization path to attain its r* neutral rate level, which funnily, they have no idea what is the number exactly. Nonetheless, it is an estimation of an ideal figure where monetary policy is neither restrictive nor accommodative. Central bankers believe this value to be 3% but some are suspicious that r* is much lower seeing how the U.S has reached a 49 year low in unemployment, 21 year high in services PMI and a myriad of other promising data which indicates the economy is in full expansion at their ideal inflation rate of 2% at an interest rate of 2.25%. Still, seeing the breakdown of the Phillips Curve that had been occasionally reliable in the past would force the Fed to implement a different approach in seeing monetary policy. Looking at the chart above, Q3 GDP is expected to be in the 3% growth region but the St.Louis Fed remains upbeat with a forecast of 4.4%.
The Fed continues to deliver their promise with subsequent quarter basis points hike while monitoring the 10-year treasury yields to avoid deliberately inverting the yield curve – a grave sin to the markets with inflation only being relatively subdued, for now. The next hike to 2.5% is 76.9% priced in as of today in the December 20th FOMC Meeting, as below. The Fed Rate Monitor below calculates based on the CME Group 30-day Fed Fund Rate futures price, which tends to signal the markets expectations regarding the possibility of changes to US interest rates based on Fed Monetary Policy. The next likely hike would be in March 2019, only at 52% probability for now.
The U.S – China fiasco has had an impact on the U.S trade balance with deficits hitting a 6 month high of USD53.2 billion as declining soybean shipments and a more robust import demand for petroleum, industrial products and cars accelerated deficits. YTD, goods and services deficits increased $31 billion or 8.6% from the same period in 2017. Exports of both goods and services dropped by 0.8% where soybean exports dropped a whopping $1 billion and shipments of crude oil fell by $0.9 billion.
Another milestone is achieved in the labor market as the unemployment rate dropped to 49-year lows at 3.7% in September 2018, beating both previous and market expectations at 3.9% and 3.8% respectively. The momentum continues in the average hourly earnings figures with three consecutive 0.3% MoM growth with YoY growth of 2.8% which will provide a crucial signal for the fed in terms of upcoming inflationary pressures. The wider snapshot of annual wages and salaries growth shows steady numbers at 4.8% over the same month in previous year which tracks the U.S inflation rate. The downside would be the poor NFP figures released yesterday with an increase of only 134 thousand jobs, well below market expectations of 185 thousand and a far cry from the previous month of 270 thousand.
If you were to ask me, I would say the labor market is still doing fine. The dip in NFP tells us that life is a roller coaster and these numbers should be monitored further to warrant any panic reaction. The unemployment and AHE numbers are stellar and decent.
Annual inflation rate slows to 2.7% in August, below market consensus of 2.8% and below previous month of 2.9%. Excluding food and energy, core inflation slowed by 0.2% to 2.2%. PCE increased 0.1% MoM, which is similar to the last two months, under-performing consensus of 0.2%. Prices of goods fell 0.1% while durable goods dropped by 0.3% compared with +0.4%. Cost of services rose by 0.2% while non-durables ended up 0.1% higher. Core PCE on the other hand remains unchanged, below consensus of a 0.1% gain which was downwardly revised from the previous month’s 0.2% gain. The spread between the 10-year Treasury and 10-year TIPS shows that the inflation premium remains range-bound albeit a 7-year high in 10-year yields where there is a possibility that the Fed is underestimating inflation. With wage growth gradually picking up and oil prices expected to rally in a late-market cycle environment, it would be a matter of time before the spread widens if growth sustains.
ISM Manufacturing PMI
ISM Services PMI
Overall, both the manufacturing and services sector remain solid. Manufacturing dipped below 60 to 59.8 from 61.3, below consensus of 60.1 as new orders and inventories rose less. Manufacturers expressed their concerns about tariffs on how it may affect company revenue and current manufacturing locations. Services on the other hand stamped its mark to rise to 61.6, beating consensus of 58 after a 58.5 in the previous month. Companies remain confident about the current and future economic conditions albeit some doubts on global trade.
New orders for durable goods rose 4.5% MoM following a downward revision 1.2% drop in July and handily beating market expectations of a 2% growth. Since the rate hike cycle began, the worst performance would be a double consecutive contraction, for example in early 2016. No issues for now.
Industrial production remains in expansion since the contraction in 2016 by posting a 4.9% August YoY growth, sharpest increase since 2010 following a downward revision 4% gain. Capacity utilization (CU) increased to 78% in August from 77.9% in July. The economy is not overheating yet and CU would be one of the earliest indicator if demand may pick up to deal with capacity constraints. This is when commodity demand will increase and the interplay between production, capacity, raw material supply and demand will trigger inflationary pressure which would cause further tightening of monetary policy which in turn punishes companies with excess misallocation of resources when demand suddenly cools off. This demand in most of the cases would be false signals due to excess money supply in the economy that the companies misinterpret it as real demand. It happens in every market cycle that makes the boom-bust phenomenon so real.
My conclusion here is that there is still more room for capacity to pick-up and may provide further upside to the relatively subdued inflationary pressure seen before this. However, with wage growth picking up alongside oil prices, these will complement the industrial and CU numbers in pushing bond yields higher down the road.
Retail sales had its smallest growth in six-months due to decrease in purchases of motor vehicles, clothing and furniture. It only increased 0.1% August MoM, well below consensus of 0.4% gain following an upwardly revised 0.7% gain in July. Consumer sentiment on the other hand, recorded 100.1, below consensus of 100.8 but remained above the August reading of 96.2. This is the 3rd time that the index topped 100 since January 2004. The Economic Optimism Index remain on the uptrend albeit falling in September to 55.7% from 58% MoM, hitting its lowest level in 3 months.
Overall, consumer sentiment still remains healthy.
Slowdown is still seen in the housing market although housing starts bucked the trend by rising 9.2% MoM, recovering from a 0.3% drop in July and beating consensus of a 5.8% rise. Building permits dropped 5.7% with permits being at its lowest level since since May 2017. Construction spending only managed a 0.1% gain, missing expectations of a 0.4% gain and lower than the previous month of 0.1%. Spending remain tepid with the smallest growth since July 2017. Both new home sales and existing home sales remain on the downtrend while pending home sales is worst among the lot by shrinking 2.3% YoY in August for its 8th consecutive monthly contraction.
I am still holding my shorts in XHB (Homebuilders ETF) and have virtually secured profits, making it impossible to lose money.
SPREADS & RECESSIONARY INDICATORS
The whole curve has shifted upwards since August 2018 yet there is no fear of an inversion.
The “Lucky 13” as I would call it for my recessionary indicators are indicating that the bull market is still intact and any sell-offs or dips are merely corrections in the current overvalued environment. There are no danger signals for now.
Earnings in world’s largest economy is still expected to grow by double digits at around 19.2%. For Q3 2018, 25 S&P500 companies have issued positive EPS guidance while 75 of them have issued negative EPS guidance. Based on forward 12-month EPS, it indicates the direction of the S&P500, consolidating the fact that earnings drive equity markets performance. In the chart below, when earnings are expected to grow, actual results tend to outperform the estimates due to companies reporting positive earnings surprises. With an average value of 4.6% where actual exceeds estimates, we can safely predict that Q3 2018 earnings may beat the 20% mark but still remain below 25% EPS growth. The downward revisions led the decrease of estimated EPS growth from 20.4% to 19.2%. All sectors are expected expected to report YoY earnings growth led by Energy, Financials and Materials sector. All sectors are also expected to report YoY growth in revenues with Energy, Communication Services and Real Estate leading the pack. Revenue growth for the S&P500 is predicted to be at 7.3%.
In terms of earnings guidance, 75% of companies (out of 99 pre-announcements) have issued negative guidance which is the highest sine Q1 2016. In terms of earnings growth, higher oil prices driving oil companies revenue while all 5 industries in the financial sector are expected to deliver double digit growth, led by the insurance industry. All 4 industries in the materials sector are also expected to deliver double digit earnings growth. Moving into Q1 2019, analysts expect a steep drop in earnings growth to only 7.2% and revenue growth down to 6.4%.
Analysts are projecting a 10% upside in the S&P500 in the next 12 months with the Materials sector gaining 16.3% while Healthcare and Utilities may be the smallest contributor at 5.9% and 5.1% each. In terms of stock ratings, 52.6% of stocks has buy recommendations, 41.7% are hold while only a minor 5.7% are sell ratings. Energy sector (60%) has the most buy ratings while consumer staples has the lowest percentage of buy ratings at 42%.
SEASONS & CYCLES
The BEST 6 MONTHS of the year begins in Q4 and we can see from the table above that seasonally, all sectors have higher probability of bullishness that will inevitably drive the S&P500 higher.
We can see from the last 20-years that October has a 70% probability of delivering a 2.2% gain with the best return of 10.8% in 2011 and worst return of 16.8% during the subprime crisis. It outperforms other months in terms of best and worst returns.
For the last 3 months, we can see the 2018 top performers, tech and discretionary starting to lose steam and handing the leadership over to industrials and healthcare. Staples which looked promising 2 months back,is starting to stagnate and remaining range-bound on concerns of rate hikes and lesser attention to the implications of the trade war. Real estate has taken a tumble on weaker housing macros and also concerns over a less accommodative monetary policy on top of surging bond yields. Financials, Materials and Utilities remain directionless. Energy sector is being powered by bullish sentiment in oil but still remain range-bound and should follow oil in the event of a breakout. Earnings may propel this sector but maybe held back by a seasonal correction in oil for Q4. If earnings growth remain intact and no new hoo-hah arises in the trade tensions, the broader market should rally but I expect real estate to remain weak through November. Dips in the current market environment would be a good opportunity to take a momentum long entry.
Oil remains the strongest performer this year with a 30% gain in the ETFs. Precious metal lags due to the slowdown in China and tariffs imposed in global trade. I expect the whole commodity complex to recover and rally before the next recession so I’m betting on metals to catch up and hence would say the AUD would be a good buy moving forward, being one of the worst currency performer this year alongside the NZD. The most important factor to look out for now is inflation.
The dollar index has gained 2% YTD and is the strongest performer against the basket of emerging market currencies, 21.7% gain against the Real and 14.5% gain against the Rubble. Commodity currencies such as the AUD and NZD remains the YTD laggards and I am personally fond of accumulating the weakest currencies provided they are supported by strong country fundamentals and a solid macroeconomic footing such as the AUD. My favourite currency pair, the USD/JPY shows sign of bullishness in the US equity markets and the carry trade should continue, underlying the strength of the U.S economy. This solidifies my view that I should remain bullish in the U.S.
Over and out,