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Trade Wall of Worry

Trade Wall of Worry
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Tuesday, 10 July 2018 08:14 AM Current | Bio | Archive

Strategy: Season’s Greetings

Look at a chart of the S&P 500 (Fig. 1). What do you see? The index obviously has been zigzagging so far this year. If you are bearish, then you are seeing a major market top. If you are bullish, it looks more like a consolidation that is forming a base for the S&P 500 to rocket to new record highs. Joe and I remain in the latter camp.

The S&P 500 has been climbing a trade wall of worry since it bottomed on February 8 at 2581. It retested that low on April 2. Since then, it is up 7.9% through yesterday’s close. We are particularly impressed that the index is up 1.7% over the past two days, despite the imposition on Friday morning of a 25% tariff by the Trump administration on $34 billion of Chinese imports, perhaps with more to come (Fig. 2).

Helping the market to climb the wall of worry are expectations that the Q2-2018 earnings season, which will unfold this month, will be another mega-hit. Trump may or may not Make America Great Again (MAGA). However, there is no disputing that his tax cuts at the end of last year are Making Earnings Great Again (MEGA) this year. Consider the following:

(1) Q2 consensus estimates. As of the 7/5 week, industry analysts were expecting that Q2 earnings for the S&P 500/400/600 jumped 20.3%, 17.0%, and 32.0% y/y (Fig. 3 and Fig. 4). Growth rates are expected to remain high during the last two quarters of the year as a result of the tax cuts at the end of last year.

Joe reports that industry analysts are currently expecting the following Q2 earnings growth rates for the 11 sectors of the S&P 500 from highest to lowest: Energy (141.2%), Materials (33.6), Tech (25.5), Financials (22.0), S&P 500 (20.7), Consumer Discretionary (16.4), Industrials (15.1), Health Care (11.1), Consumer Staples (9.6), Telecom (8.1), Real Estate (2.2), and Utilities (1.2).

(2) Forward revenues and earnings. The strength in earnings growth is mostly attributable to the tax cut at the end of last year. However, notwithstanding all the chatter about a global economic slowdown and the dangers of trade protectionism, the forward revenues of the S&P 500/400/600 continued to rise in record-high territory during the 6/28 week (Fig. 5). The same can be said of S&P 500/400/600 forward earnings (Fig. 6).

(3) 2018 and 2019 consensus estimates. Again, it seems that industry analysts didn’t get the memo about a global economic slowdown. Their S&P 500 revenues estimates for both 2018 and 2019 have been making new highs nearly every week since this year began (Fig. 7). They are currently expecting revenues to increase 7.9% this year and 5.1% next year.

Analysts’ S&P 500 earnings estimates for this year and next jumped dramatically in the weeks immediately after the tax cut, and have continued to inch higher. Industry analysts are expecting earnings to grow 22.3% in 2018 and 9.9% in 2019 (Fig. 8).

The Fed I: Balancing Act

Melissa and I continue to subscribe to the Fed’s official narrative for the course of monetary policy through the end of next year. The members of the FOMC remain committed to gradually normalizing monetary policy. That means they will continue to taper the Fed’s balance sheet, and to raise the federal funds rate by 25bps four more times before the end of next year. That would put the federal funds rate in a range of 2.75%-3.00%. And that is about where Fed officials expect the range to settle for the long term.

We can comfortably say once again that the Fed is likely to stay the course, after carefully reading the minutes of the June 12-13, 2018 FOMC meeting, released on July 5. The minutes stated that “members expected that further gradual increases” in the federal funds rate “would be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation” near 2.0% over the medium term. Participants in the FOMC meeting “generally” shared this view.

FOMC officials should be giving each other high-fives for finally achieving the Fed’s dual mandate. Inflation, as measured by the core PCED, rose to the Fed’s 2.0% y/y target during May after falling below it since the target was first announced January 25, 2012. And the unemployment rate is at historical lows. Meanwhile, US economic growth is chugging along at a good clip, with the latest GDPNow forecast at 3.8% for Q2.

But the officials aren’t celebrating just yet because there are too many significant uncertainties ahead, according to the minutes. Importantly, the minutes characterizes the risks to the economic outlook as “roughly balanced.” So it makes sense that the Fed is continuing an approach to policy that is not too fast or too slow, because “balanced” means that the upside and downside risks to the outlook are equally concerning. Let’s have a look at the minutes’ characterization of risks on both sides of the outlook:

(1) Downside risk from inversion of the yield curve. “A number of participants thought it would be important to continue to monitor the slope of the yield curve, given the historical regularity that an inverted yield curve has indicated an increased risk of recession in the United States,” noted the minutes. The slope of the yield curve reflects the spread between long-term and short-term Treasury yields. When the short end of the yield curve is higher than the long end, that means that investors expect interest rates to decline, which usually happens as a result of recessions.

If officials raise the federal funds rate too fast, the yield curve could invert, signaling a recession as it has in the past. Nonetheless, FOMC participants pointed to many “factors, other than the gradual rise of the federal funds rate, that could contribute to a reduction in the spread between long-term and short-term Treasury yields.” Those include “a reduction in investors’ estimates of the longer-run neutral real interest rate; lower longer-term inflation expectations; or a lower level of term premiums in recent years.”

During the meeting, Fed staff presented an alternative “indicator of the likelihood of recession.” It’s based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead, derived from futures market prices. The staff noted that this measure would be less sensitive to the factors noted above than the traditional yield curve. (For more, see the 6/28 Fed note titled “(Don’t Fear) The Yield Curve” and our discussion of it in the next section.)

Missing in the list of explanations for the flattening of the yield curve is that the bond market has been globalized in recent years. So the US Treasury bond yield may reflect the fact that comparable yields in Germany and Japan are near zero.

(2) Downside risk of trade uncertainty slowing investment. The section in the minutes titled “Participants’ Views on Current Conditions and the Economic Outlook” stated that although district contacts were generally upbeat, they “expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity.”

More specifically: “Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy. Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Participants don’t seem to be too concerned about the direct economic effects of Trump’s tariffs. But they are worried about the “negative effects” that trade policy uncertainty could have on “business sentiment and investment spending.”

(3) Downside risk of spillover from Europe and EMEs. Fed officials are concerned that economic weakness abroad could spill over back home. Many participants saw “potential downside risks to economic growth and inflation associated with political and economic developments in Europe and some EMEs.” In Europe, the Italian economic and political situation was noted as an area of particular vulnerability.

(4) Upside risk from tax cuts. Last year’s tax cuts received a brief mention in the “Staff Review of the Economic Situation” section of the June minutes. The minutes stated that “the lower tax withholding resulting from the tax cuts enacted late last year still appeared likely to provide some additional impetus to spending in coming months.” While some participants aren’t sure that fiscal policy is on a sustainable path, “a few” see fiscal policy changes as an “upside risk.”

On a separate but related note, the Fed’s 6/13 Summary of Economic Projections shows the median forecast for the federal funds rate moving up to 3.40% by the end of 2020, then back down to 2.90% over the longer run. Fed forecasters seem to be anticipating the need to cool off shorter-term growth, probably related to fiscal stimulus, which is expected to subside over the longer run.

(5) Upside risk of overheating economy. Some participants are worried about letting the economy run “beyond potential” for too long. As a result, inflation could overheat or bubbles could emerge in asset prices and the credit markets. Some worry that either of these scenarios could lead to a downturn. The question is whether the economy is currently running “beyond potential.” A “number of participants” noted that it was “premature” to conclude that the FOMC had achieved the 2.0% inflation objective.

Participants also suggested “that there may be less tightness in the labor market than implied by the unemployment rate alone, because there was further scope for a strong labor market to continue to draw individuals into the workforce.” As a result, a number of participants anticipate “wage inflation to pick up further.” The minutes don’t name names, but we know that Fed Chairman Jerome Powell believes that there is room for labor market participation and compensation to improve, as we discussed last week.

The basic message of the minutes is that there are a lot of moving parts to monetary policy right now. So slow and steady is the pace.

The Fed II: Don’t Fear the Yield Curve

The FOMC minutes mentions staff research on the yield curve as an indicator of recessions. That research is explained in a 6/28 FEDS Notes titled “(Don't Fear) The Yield Curve” by two Fed economists. In brief, they question why a “long-term spread” between the 10-year and 2-year Treasury notes should have much power in predicting imminent recessions. As an alternative, they’ve devised a 0- to 6-quarter “near-term forward spread.”

Here is their main point: “This [near-term] spread can be interpreted as a measure of the market's expectations for the direction of conventional near-term monetary policy. When negative, it indicates the market expects monetary policy to ease, reflecting market expectations that policy will respond to the likelihood or onset of a recession. By that token, the current level of the near-term spread does not indicate an elevated likelihood of recession in the year ahead, and neither its recent trend nor survey-based forecasts of short-term rates point to a major change over the next several quarters.”

The authors of the note stress that the long-term spread reflects the near-term spread, which they argue makes more sense as an indicator of a recession that is expected to occur within the next few quarters. In any case, they also note that an inversion of either yield spread does not mean that the spread causes recessions. In their words:

“This does not mean that inversions of the near-term spread cause recessions. Rather, the near-term spread merely reflects something that market analysts already track closely—investors' expectations for monetary policy over the next several quarters and, by extension, the economic conditions driving those expectations.”

And here is their complete conclusion:

“The narrow lesson to take away from this exercise is that the current near-term forward spread, which arguably serves as a proxy for market expectations of Federal Reserve policy, indicates the market is putting fairly low odds on a rate cut over the next four quarters. Unlike far-term yield spreads, the near-term forward spread has not been trending down in recent years, and survey-based measures of longer-term expectations for short term interest rates show no sign of an expected inversion. More generally, our findings do not support the practice of appealing to the long-term spread for a different signal about the prospects for year-ahead economic performance. A more subtle suggestion from our analysis is that the predictability of recessions by the near-term spread would appear to be a case of ‘reverse causality.’ That is, the near-term spread may only predict recessions because it impounds expectations that market participants have already formed.”

So let’s all give a big sigh of relief!

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
Look at a chart of the S&P 500. What do you see? If you are bearish, then you are seeing a major market top. If you are bullish, it looks more like a consolidation that is forming a base for the S&P 500 to rocket to new record highs.
trade, worry, market, index
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2018-14-10
Tuesday, 10 July 2018 08:14 AM
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