Today’s Report is attached as a PDF.
What’s in Today’s Report:
- Was last week the start of a pullback in stocks?
- Weekly Economic Cheat Sheet
Futures are slightly higher following a quiet weekend as the yen is steady and global flash PMIs didn’t contain any major surprises.
April Manufacturing PMIs slightly missed estimates in China (50.1 vs. (E) 50.4) but importantly remained above 50. In Europe, the number beat estimates (EMU PMI 51.7 vs. (E) 51.5) and overall April PMIs aren’t changing anyone’s opinion on global growth.
Japan was the big laggard o/n as the Nikkei dropped 3%, but that market was closed Friday so this move is just catch up, not more weakness. The yen is up small vs. the dollar this morning.
Trading should be generally quiet today as the UK, Hong Kong and Chinese markets are closed. In the US, focus will be on ISM Manufacturing Index (E: 51.5) and two Fed speakers: Lockhart (8:50 a.m. ET) and Williams (5:30 p.m. ET).
Finally, focus will remain on the yen. It’s up small vs. the dollar this morning but if those gains accelerate, it’ll weigh on stocks again like it did Thursday/Friday.
|S&P 500 Futures||1937.00||22.50||1.18%|
|U.S. Dollar (DXY)||97.325||0.721||0.75%|
|Near Term Stock Market Outlook:
SPHB: 25% SPLV: 75%
|Stocks dropped last week on peripheral China concerns and a surging Japanese yen, but those two events served to remind investors that the outlook for stocks had become a bit too rosy, and valuation justifications a bit too stretched. Even with last week’s pullback, we still think stocks are priced for a very optimistic outlook, and the risk/reward remains unappealing at these levels.|
|Tactical Allocation Ideas:
· What’s Outperforming: Small Caps (IWM), Banks (KRE), European Financials (EUFN), Industrials (XLI), European Corporate Bond Funds (will benefit from the ECB buying), Inflation-linked sectors/assets (global miners, commodities, TIPS).
· What’s Cheap (we think there’s medium-term opportunity here): Defensive/Large Cap/High Dividend Payers/Inverse Emerging Markets, Short Duration TIPS ETF (VTIP), Utilities (XLU), Consumer Staples (XLP), Vanguard Mega Cap ETF (IOO), Inverse Emerging Market ETF (EUM).
The Week Ahead (Macro and Micro Catalysts This Week)
For all intents and purposes earnings season is largely over, and focus this week will be on economic data. The jobs report Friday is the most important piece of data out this week, but the manufacturing PMIs out today and composite PMIs out Wednesday will be potential market movers as well.
From a macro catalyst standpoint, the key as we start this week is the yen. If it keeps rallying that will continue to be a general headwind on stocks.
Last Week (Needed Context as We Start a New Week)
Stocks had their worst week in almost two months as a surging Japanese yen, lackluster data, China concerns and a non-ultra-dovish Fed weighed on stocks. The S&P 500 dropped 1.26% and now is up just 1.05% YTD.
Trading Monday-Wednesday last week was downright boring as stocks declined modestly Monday in quiet trade, and were flat Tuesday despite a soft Durable Goods report as traders positioned ahead of the Fed. Wednesday brought the Fed meeting, but it was neither hawkish nor dovish, and markets didn’t really react except for a small, algo-driven rally into the closing bell that saw averages finish the day modestly higher.
Volatility reappeared Thursday as stocks were initially lower following the Bank of Japan’s decision not to ease policy further. In the afternoon stocks broke lower as the yen continued to surge vs. the dollar, and two negative China catalysts emerged (more on that later). Those catalysts, combined with a market that was overextended, resulted in a near-1% drop in stocks during the last two hours of Thursday trade.
That selling continued Friday as the yen rally continued, and the yen hit a new 52-week highs vs. the dollar, and inflation data generally came in hotter than expected. Stocks drifted lower for most of the day before bouncing slightly to close off the worst levels of the day.
The big underperformance of tech was the notable event in markets last week. Nasdaq dropped 2.6%, doubling up the drop in the S&P 500. A lot of that had to do with AAPL, but tech earnings overall have been underwhelming. The one exception has been internet stocks (AAPL/FB/LNKD, etc.), which have been very strong, and if you’re looking to buy something in tech, look there. Defensive sectors handily outperformed last week and reversed the trend of lagging cyclical sectors, and we continue to think there’s some tactical opportunity there if the outlook remains generally challenged.
From an earnings standpoint the season is mostly over, and obviously on the headline the results were better than expected (as usual). Banks and the aforementioned internet stocks were the standouts while some consumer staples and healthcare names were underwhelming. Bigger picture, earnings season is not going to be a catalyst to drive stocks higher from here (and 2016 EPS expectations remain around $120 share).
On the charts, the S&P 500 appears to have once again failed at 2,100. The low from last week, 2,053 now is important support to watch this week.
Your Need to Know
The identifiable “reasons” for the declines last week were twofold: First, caution on whether the Chinese recovery is sustainable (the Reuters article on Chinese margin lending concerns and the Carl Icahn negative AAPL/China/broad market comments were the negative catalysts there). Second, the surging yen after the Bank of Japan chose not to do more stimulus.
In truth, neither of those events were real macro negatives (they could be if they continue), and the real reason stocks dropped was because the move from 2,000-2,100 in the S&P 500 was driven by positioning and hopes of a perma-dovish Fed. And as we and others have been saying, neither of those reasons are particularly sustainable.
So, those two events simply reminded people that while the macro environment is better than it was in February, it’s still not without risks, and the growing optimism and valuation justification for 2,100 in the S&P 500 was ahead of itself.
Additionally, the optimism surrounding a $123 2016 EPS number faded and drifted lower towards $120-$121, and even at these levels the market is trading at 17X $121 EPS—so again, not a lot of room for error.
Going forward, risks remain including: more currency volatility (the yen will be a near-term driver of stocks and the stronger it gets, the worse for stocks); a roll over in economic data (data needs to get better ex-employment), continued rollback of extraordinary Chinese stimulus and recalibrating Fed rate hike expectations (a July hike is not out of the question).
So, we continue to remain cautious on stocks and could easily see the S&P 500 trade back towards 2,000 or even 1,950 should one of the above mentioned risks materialize, and as a result we would not buy this dip in the S&P 500 yet. From a tactical standpoint we continue to prefer broad European exposure over the US, TIPS in the fixed income market, and generally defensive sectors (consumer staples/utilities, which have come in lately and aren’t as stretched from a valuation standpoint as they were before).
Bottom line, barring an uptick in economic growth (which we are not seeing) we do not see what positive catalysts loom to boost the S&P 500 through 2,100 and towards 2,200. As a result, the risk/reward remains unfavorable.
Economic Data (What You Need to Know in Plain English)
Need to Know Econ from Last Week
There were more whiffs of stagflation in the data last week as growth generally underwhelmed while inflation surprised to the upside. The mix of soft data and firmer inflation didn’t cause the late-week swoon in stocks, but it didn’t really help the outlook going forward.
The key event from a market standpoint last week was the Bank of Japan meeting (and I’m proud that we were one of the few publications saying that the BOJ might be the biggest potential market mover). The BOJ chose not to ease policy, as you know, and that ignited a massive rally in the yen and decline in the dollar that reverberated throughout global markets Thursday and Friday. Going forward, there is still the expectation the BOJ will ease policy this summer, but the question now is how much damage will be wrought upon the Japanese economy in the meantime.
Staying with central banks, the Fed meeting last week was a relative non-event. The key takeaway was that the Fed signaled that US economic data, not geopolitical influences, now are the primary driver of whether the FOMC will hike rates in June or July. And while the Treasury market did not react to that change (it’s still acting as though a December hike is the only hike possible in 2016), Fed fund futures increased the probability of a June or July hike to near 50%, and we continue to think there is a real risk of a bond market adjustment (i.e. bond selloff) if US economic data stays better or firms over the next two months.
Beyond the central bank decisions, inflation data was in focus and it was hotter than expected. In the Q1 GDP report the Core PCE Price Index rose at a 2.1% annual pace for Q1 2016, above the Fed 2.0% target. Then on Friday the quarterly Employment Cost Index rose 0.6%, as expected, but that was a bit misleading. The ECI combines benefits and wages, and wages actually rose faster than the headline, up 2% yoy and 0.7% in Q1, which is the highest quarterly increase since the recovery, and more evidence that wages are trending steadily higher.
Bottom line, inflation isn’t high enough to make the Fed more hawkish yet, but it certainly seems to be heading in that direction—and rising inflation remains a risk to stocks due to a still-very-dovish bond market.
Finally, looking at last week’s GDP report, it confirmed anemic growth in Q1 2016. Q1 GDP rose just 0.5% vs. (E) 0.7%, consumer spending was sluggish growing at 1.9% while Non-Residential Fixed Investment (think major business spending on equipment, machines, expansion, etc.) dropped 5.9%, the worst quarterly decline since the financial crisis. Bottom line, economic data needs to get better to help support equity prices, because another quarter of sub-2% growth is not priced into stocks at these levels.
Important Economic Data This Week
There are just a few key events to watch this week, but they are important ones, as we will get a lot more insight into the current state of the global and US economy. And as we said earlier, the data needs to be good to help support stocks.
First and foremost, it’s jobs week, so we get the ADP report Wednesday, claims Thursday and the employment report Friday. Everyone expects another strong number (it would be a big shock if the number came in soft), and the keys for the Fed will be the inflation data (the year-over-year wage data). As has been the case, the risk for stocks is for a “Too Hot” number to cause the Fed to become more hawkish, but that’s going to require a massive blowout jobs number given weakness in other economic data points.
Already we’ve seen the final manufacturing PMIs from China and Europe (China’s was underwhelming but not terrible), and we get the US data later today. In the US, the soft manufacturing PMIs in April have come as a negative surprise after a rebound in March, so a reading that is better than the flash estimate will be welcomed.
On Wednesday we get the global composite April PMIs and the US Non-Manufacturing PMI, and the key here is for improvement over March to demonstrate that while manufacturing remains in flux, the service sector of the US economic continues to rebound. If the manufacturing PMI and Non-Manufacturing PMI are both weak numbers, some people will start to get nervous again about the US economy.
Those are the three keys to watch this week from a data standpoint (Manufacturing PMI, Jobs Report, Non-Manufacturing PMI) and given the recent dip in stocks these data points need to show improvement and stabilization, otherwise downward pressure on stocks will increase regardless of whether it makes the Fed slightly more dovish in 2016.
Commodities, Currencies & Bonds
|Commodities||Bearish||Commodities continued to rally last week, this time driven by the yen-inspired collapse of the dollar. Both oil and gold surged late in the week as dollar weakness pushed commodities higher. But, much like the stock market, the move seems to have extended beyond the fundamental rally, and while commodities can keep rallying if the dollar drops further, we think the market is extended short term, and fundamentals unfortunately are not this bullish, yet.|
Starting in Commodities, energy continued to surge and gold finally broke out of a multi-month trading range. The commodity ETF, DBC, finished the week up 3.70%, and at a fresh 2016 high. Beginning with the metals, gold was the big mover on the week as the BOJ rattled markets, which ultimately led to the dollar breaking support and fueling the gold rally.
The volatility that resonated from the surging yen led to a flight-to-safety across asset classes that helped drive a material upside break in gold, which finished the week up 4.96%. Bottom line, gold has finally broken out from the sideways price action and last week’s move is fundamentally supported by the breakdown in the dollar. The charts turned bullish with the violation of trend resistance and new closing high. Looking ahead, the next upside target is $1,310.
Looking to the industrial metals, copper continued to underperform, but rallied a modest 0.75%. For now, we remain cautious on copper because of its repeated failure to rally through resistance at $2.30.
Turning to the energy space, the momentous rally continued for a fourth-consecutive week with WTI futures notching a gain of 5.12%. Looking ahead, we could see some profit taking this week, but that would just be a pullback in an otherwise upward trending market. On the charts, uptrend support lies below $44.50, and that is a key technical level to watch. Next week we will be looking for an uptick in the pace of US production declines in the weekly EIA report, as the recent moderation in output declines is not as favorable for the bulls.
|US Dollar||Neutral||The Dollar Index dropped sharply last week due to a surge in the yen following inaction by the BOJ. The Dollar Index dropped to a multi-month low, and if the yen continues to surge the dollar will decline further in the short term—although it’s important to note that from a fundamental standpoint, this dollar decline is not justified, and we are likely near a fundamental floor in the dollar.|
Looking at the Currency Markets, it was a turbulent week in currency markets as the BOJ decision spurred a huge rally in the yen that sent the dollar to multi-month lows. The Dollar Index fell 2.17% on the week. The yen rallied 4.88% against the dollar, leading the USD/JPY to close at the lowest level since September 2014. Though the BOJ is expected to ease more this summer, the yen rally has momentum and the near-term path of least resistance is lower for the USD/JPY. The next downside target is toward 104, and then there is a support band between 101 and 102.
The yen rally is important for two reasons. First, the recent surge has presented a substantial headwind for Japanese stocks that could very well have a “contagion effect” on other equity markets. Second, because the yen is the second-highest weighted currency in the Dollar Index (just under 15%), continued yen strength will weigh on the dollar and create more volatility that is not good for stocks.
Elsewhere, the euro broke out through near-term resistance as did the pound, as they rallied 2.07% and 1.51%, respectively. Commodity currencies were mixed with the Aussie falling 1.036% thanks to a soft inflation report that increased expectations for a rate cut from the RBA while the loonie continued to march higher, adding 0.92% in sympathy with oil gains.
We are currently testing a major support zone in the Dollar Index near the 93 level, and every currency in the basket besides the buck is trending higher, which suggests that key level may well may be violated.
|Treasuries||Bearish||Treasuries rallied modestly last week thanks mostly to lower stock prices, as buying Friday helped push Treasuries higher. Beyond that short-term effect, the inflation outlook rose last week and the Fed is, for now, no longer ultra-dovish—so the fundamentals for Treasuries got worse last week. Near term, if the pullback in stocks continues Treasuries will be buoyant. If growth and inflation continue to trend higher, then Treasuries are overvalued at current levels.|
Turning to Bonds, the 10 year rallied last week to close with a yield of 1.819% while the 30 year closed at 2.666%. Bonds finished the week higher and remain stubbornly resilient as volatility in other assets classes in the back half of the week spurred a flight to safety into Treasuries. On a relative basis, yields on US government debt still are appealing to international bond investors.
Bottom line, inflation statistics continue to firm, and the bond market is not pricing in any chance of a summer rate hike even though Fed funds futures jumped to show a 50% chance of a July hike. So, once again we are looking at a seemingly overbought Treasury market, and the chances of a sharp correction lower on strong data and/or a hawkish shift in Fed tone is rising.
Special Reports and Editorials
Why the Rising Yen is Becoming a Headwind for Stocks
The yen rose further last week to hit a new 52-week high vs. the dollar Thursday, and like two weeks ago that weighed on global stocks last Friday.
A surging yen is negative for two reasons: First, a rising yen is a signal that the market is losing more confidence in the BOJ’s ability to help stimulate growth in Japan and it also undermines confidence in global central banks’ ability to help get global growth back to normal (i.e. all these years of stimulus may not work in the end). Second, the rising yen is an economic headwind on an already-soft Japanese economy, and since Japan’s economy is the third largest in the world, if that rolls over it isn’t particularly positive for the larger global economy.
The Bottom Line on the FOMC Meeting
The bottom line from last week’s FOMC meeting is this: The Fed let the market know that the international periphery had stopped being a dovish influence on the Fed (and rightly so), so in that regard the meeting was hawkish. At the same time, the Fed redirected the market back to US economic data as the key to future hikes, with the implication that if data gets better and inflation firms, they’ll hike rates in June/July. And, if the data does not get better, they will not hike rates in June or July.
Given that, we do not view the Fed meeting as a positive catalyst for stocks. Yes, we are aware it’s been spun as dovish when in fact it wasn’t, and that spin can cause further chasing—and we’d be surprised if stocks don’t take a look at the 2,111 high near term. But, with the Fed back now out of the role of “global Fed” and back to “US Fed,” the outlook for stocks going forward just got more challenging.
First, the weaker dollar tailwind is likely done, and while the BOJ easing further might help, the only way we should see the dollar trade to new lows is if US economic data rolls over, and that’s not good for stocks.
Second, rising yields is now a legitimate risk to stocks (not today, but it will be in the future). I say that because if the US economic data gets better and inflation firms, the Fed will hike rates in June or July, and given markets are still only pricing in one hike this year, interest rates simply must move higher (and likely sharply so).
Third, it puts a big onus for a material move higher in stocks on economic growth. So, if US economic data doesn’t recover (and just as a reminder, so far it’s not recovering) then do you really want to own stocks at 17X earnings in a US economy at stall speed? Slowing economic growth and perma-0.5% Fed funds is not the key to 2,200 and beyond in the S&P 500.
From a tactical standpoint, last week’s Fed announcement doesn’t mean this relief rally in stocks is over, as it can still squeeze higher. But I think the major takeaway is that a dovish Fed/lower dollar tailwind has been removed, and that must be replaced by real growth—and if growth accelerates that means higher interest rates.
Bottom line, the Fed’s statement in the context of recent economic data reinforces our preference for broad European exposure (HEDJ) over US stock exposure, and in the fixed income market we would be surprised if yields at least don’t stabilize or start to creep higher. VTIPS are attractive following this meeting, as we think there is a further-elevated risk of bonds yields trending higher over the coming weeks/months, assuming economic data doesn’t get worse.
Finally, the Fed is still cautious and it is still trying to stimulate inflation—so again, getting long some inflation hedges here makes sense for longer-term portfolios.
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