Sunday, July 22, 2018

This Week's Message: The Setup's Fine, but less so than at the beginning of the year...

Long-term technical trends and macro conditions at this juncture have 2018’s market action looking more like a consolidation within an ongoing bull market than it does the saw tooth pattern that often precedes a looming bear market. The still generally strong macro setup explains how – as evidenced by a flat NYSE Composite Index on the year – equities have been able to buck the extreme headwind of rising protectionism.

The present bullish setup notwithstanding, we would be remiss if we didn’t mention that our PWA Index, which scored a record high 81.3 during the second week of January – and, thus, foretold of Q1 turning out to be an exceedingly good corporate earnings season – has since trended notably lower to what now reads a still solid 47.6 (above zero says odds favor continued expansion for the foreseeable future). 

While “still solid” would be the operative words with regard to our present macro score (60% of our indicators read positive, 12% negative and 28% neutral), we remain mindful that conditions are not what they were when the year began (on January 15th – when our index hit 81.3 – 84% of our indicators read positive, 3% negative and 13% neutral).

With Q2 earnings reporting season now underway, and with protectionism at a modern-history high, we fully expect forward outlooks to be tempered by the unavoidable and alas palpable uncertainty that the existing, and threatened, tariff schemes can’t help but incite. In fact, two bellwethers – GE and Alcoa – last week both cautioned that tariffs will become major drags on their financial results going forward. General Motors predicts that if the Administration moves forward with yet another wave of tariffs, the U.S. auto industry will likely shrink in size; specifically stated, “less investment, fewer jobs and lower wages.” This has been the virtual (of course Nucor Corp. [steel] isn’t complaining) across the board warning coming from automakers, trade groups, and the vast majority of other U.S. industries.

All that said, we expect this week’s Q2 U.S. GDP report to come in at the high-end of expectations, and, thus, there’ll be the attendant “we-told-you-sos” and “see-we-know-what-we’re-doings” coming from White House officials – which, by the way, would be deserved self-pats on the back, given the justifiable optimism spawned over tax cuts and deregulation! 

Our warning herein being that while such celebratory (possibly 4%+) growth, were it completely unhindered, would be difficult enough for an advanced economy to sustain over the long run, add in a global trade war and we can say with confidence that, ultimately – should the TW become a protracted affair – we’ll see the GDP number decline precipitously off of whatever Q2 delivers. It’s also fair to say that Q2’s results will reflect a pulling forward of activity, as companies rushed to get business done at the more favorable terms that existed before the unfortunate imposition of tariffs coming and going; a phenomenon that by itself sets us up for a marked letdown in future quarters.

The summary paragraph from the communiqué that followed this weekend’s Group of 20 Nations (G20) Finance Ministers & Central Bank Governors Meeting in Buenos Aires essentially mirrored our macro analysis. It began:

“Global economic growth remains robust and unemployment is at a decade low. However, growth has been less synchronized recently, and downside risks over the short and intermediate term have increased.”
It went on to place “heightened trade and geopolitical tensions” at the top of the list of financial vulnerabilities.

While the above may read as though we’re feeling deflated versus how we felt coming into the year, honestly, we can’t be counted among those in the bear camp just yet. In fact, with long-term up trends still very much intact within the cyclical sectors, and with our macro score still a long ways from signaling a contraction, we remain longer-term bullish, despite the concerns we outlined above. Which means that when trade headwinds abate, which remains our base case – we maintain that the political risk is too great to allow for such a global affront to last – as long as general conditions hold up, we’ll see the present bull market move its way into its next phase -- which will be characterized by solid economic growth, strong corporate earnings, increasing inflation and higher interest rates; a phase that, from current levels, can last for an extended period going forward.

But what about the flat yield curve?

Readers who are more tutored in economics than most may be wondering about what has been a flattening treasury yield curve of late. Our view is that it reflects more of a reactionary (due to trade concerns) flight to quality (the long-end of the yield curve) against a Fed in tightening mode (raising short-term interest rates) than it does economic stress/weakness building in the greater economy. That said, every modern-day recession has been preceded by an inverted yield curve (the 2-year treasury yield rising above the 10-year’s), which is indeed in the cards as long as the threat of trade war persists. 

While if and when inversion occurs we’ll be paying very close attention to other factors that tend to exist when the phenomenon foretold of recessions past, know that even when the recessionary ducks were lining up the ensuing contractions began on average 2 years later. Thus, per the following, anxious traders who bet on a bear market immediately upon inversion got utterly hammered:
“A trading strategy that shorts the S&P 500 when the 10-2 spread crosses below zero and goes long when the spread rises back above zero triggered 34 signals over the past 30 years. Following the 17 short signals would have resulted in a loss of 58.7 percent. That suggests the cross was not the optimal time to sell the market.” Bloomberg
In closing, of course nothing's guaranteed when we’re talking markets and economies, thoughtful investors and advisers must forever keep their minds open to all possibilities. At PWA, our assessment of prevailing general conditions dictates our investment decisions. Therefore, should our base case not come to pass – that is, should conditions (inverted yield curve or not) deteriorate sooner than later to the point where odds favor recession over continued expansion – we will not hesitate to shift accordingly (play defense with our sector and asset class weightings) within client portfolios.

Have a nice week!

No comments:

Post a Comment