Sunday, August 5, 2018

This Week's Message: General Conditions Remains Strong, But We're Seeing Some Cracks Here and There

For this week's message we're sharing the general conditions summary of our weekly analysis, which includes my view of the possibilities going forward: 

General conditions:
Disappointing auto sales and Japan falling into our neutral range on the Citi Economic Surprise Index (U.S., Eurozone, China, and E.M. aggregate remain in the red [under-performing economists' expectations on a rolling 3-month basis]) brought our economic subindex down 4 points this week. The financial stress subindex came in unchanged at a high 72.73 (which is good, meaning financial stress in the system is presently at a low level), while improving risk metrics (vix curve and put/call ratio) added 4.35 to the financial markets subindex. The overall PWA Index score for this week is 44.05, down marginally (-1.19) from last week. 

A PWA Index score of 44.05 is solid relative to history; however it's a markedly lower score than the one occurring on January 15th of this year (+81). 

While the macro analysis still points to low recession odds in the foreseeable future, among other things, the rotation I'm seeing from cyclical stocks to defensives has my attention. 

The staples/discretionary ratio has turned strongly in favor of staples. Whether this is a harbinger of tough times to come, or traders simply hedging against the potential for more trade skirmishes would be the question. Given what are still robust general conditions, the latter would be a legitimate hypothesis; suggesting that an end of the trade warmongering would see the rotation flip back in the opposite direction. The longer this goes on, however, the more damage it'll do to general conditions.

Consequently, we could ultimately get to the point where momentum has completely shifted, leaving a contraction imminent; at which time an end to the trade nonsense would not turn the tide, as that train will have already left the station. 

To add insult to potential injury, at this juncture we have to assume that the economy during the next recession will not be assisted by the typical fiscal stimulus that government generally brings to bear. I.e., the Administration has chosen to cut taxes and increase spending -- measures generally saved for times of financial stress -- amid a notably strong economic expansion. Worse yet, if the economy were to begin contracting sooner than later, the Fed is nowhere near in position to apply a great deal of monetary stimulus, as rates are still hovering near historic lows and the Fed's balance sheet remains bulged with the treasury and mortgage backed securities it mopped up while battling the 2008 crisis.

Bottom line: Conditions remain supportive of economic growth and higher stock prices going forward, although there are some cracks beginning to form. While recessions, their inevitability notwithstanding, are never welcome, a protracted trade war could bring one on at a frighteningly inopportune moment. Therefore, commonsense, and incredibly high political risk, suggests cooler heads will prevail in time.

Of course we remain open to all possibilities...

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