2017 Q2 Market Analysis
Share prices continued their skyward arc in tandem with warnings of frothy valuations and reckonings to come.
The Federal Reserve Bank raised its estimate for 1Q growth to a respectable clip, though other institutions, such as the International Monetary Fund and Bank of America, revised their forecasts downward for annualized growth, citing gridlock in Washington and concerns of the Trump agenda.
An invigorated Europe, fueled in part by the results of France’s presidential elections, provided global investors with an under-bought market even as it overshadowed the dollar.
Oil and other commodities slumped, Amazon loomed even larger amid the ashes of America’s brick-and-mortar retail sector and the pace of new loan creation continued to dwindle.
Nevertheless, we see no reason why the post-2008 global recovery should not continue at its steady, if languid pace. Uninspired is not recessionary, after all, and barring a geopolitical crisis we are holding fast to our existing course: confident but vigilant.
U.S. Markets: Still Buoyant
Equity valuations had a Shiller PE ratio of 30x in June, the highest level on record and matched only by those that prevailed on the eve of the tech bubble's collapse. The S&P 500 hasn't had more than a 5% pullback since July 2016, according to Michael Batnick, Director of Research at Ritholtz Wealth Management, the longest such streak since 1996 and the bane of day-traders. If equity markets are due for a pullback, however, it may be shallow in scope. Writing for The Fat Pitch, analyst Urban Carmel noted that, since 1991, similarly meteoric S&P performances resulted in an average annual gain of 2.3% and 5.9%, respectively and an average 12% for the previous year. Conversely, The Daily Coin argued that valuations have passed their 2007 peak - prime bubble territory and one of the key milestones Warren Buffett cited when warning about the prospect of a tech-boom bust.
Meanwhile, the Wall Street Journal reported in June that the pace of share buybacks has slowed this year despite record market highs, a trend that may signal apprehension among corporate executives. It noted that S&P companies repurchased $133 billion of their own shares in Q1, down 18% on a year-on-year basis. The article coincided with a Goldman Sachs report that disparaged “hope-driven" share rallies and forecasted the S&P would end the year 6% in the red. Bank of America warned of unstable "internal inconsistencies” between booming stock markets and weak economic data while Bloomberg reported that option contracts that reward stock index declines outnumber those that favor gains by a rate of more than 2-to-1, the most since January 2016. Goldman also cast doubt on the US dollar’s recovery, citing stronger-than-expected and increasingly synchronized growth in overseas markets while revising upward its forecast for sterling and the euro.
Crude oil prices slipped below levels sustained before recent OPEC production cuts thanks in part to robust output from Libya. With future production cuts unlikely and with the number of drilled-but-uncompleted wells at their highest level in at least three years, according to Bloomberg, the outlook for oil prices is bleak. Other commodities took a beating as the promise of President Trump’s vision for an ambitious infrastructure bill has yet to materialize. Iron ore prices gave back half their gains on the year, for example, while bids for lumber and copper declined dramatically.
Even as BofA announced that central banks continue their stimulative debt-repurchase plan - to the tune of $3.6 trillion this year on an annualized basis - JP Morgan worried that remarks from the Fed about its plan to gradually reduce its debt portfolio was too limited. The Fed’s proposed target of depleting its portfolio by $600 billion per quarter from late 2018 - about the same time frame it took to build up its debt in the first place - would be “like watching paint dry.” Treasury rates swung back and forth in June on countervailing dovish and hawkish comments from Fed presidents Charles Evans and William C. Dudley. Evans said he anticipated downside risks to the inflation outlook and suggested the current environment demands gradual rate hikes with slow balance sheet reductions. He counseled the Fed to delay the next round of credit-tightening until December so officials would have ample time to consider the market environment before making good on their commitment to three rate hikes by the end of the year.
American corporate bonds are close to their most expensive valuations ever, according to Morgan Stanley, after taking into account their vast quantity, abundance of low ratings and high exposure to shifting interest rates. Thus handicapped, the risk premiums on US corporate debt were at the start of June a mere 0.21 percentage points away from their all-time narrowest levels. Already, according to Bloomberg, tight credit spreads and uncertainty about the Trump agenda have money managers bracing for low returns on their corporate bond portfolios this year. In addition, the default rate for high-yield bonds continued to decline, according to Moody’s, to 3.3% in May on a year-on-year basis and is expected to fall further to close 2017 at 2.5%.
Bank regulators, including senior Fed officials, have signaled they would support a roll-back of the Volcker Rule, stress tests and other constraints on Wall Street after the Trump administration issued a long list of proposals for financial deregulation. Fed officials said they were open to a rethink of the trading restrictions and reducing the burden of the annual exams that evaluate banks’ ability to weather severe economic shocks.
U.S. Economy: Reality bites
The Labor Department unveiled a robust employment report of 222,000 new jobs added in June, though wages continued to disappoint. The news followed the Fed’s decision to raise its Q2 growth estimate to 3.0%, up from its previous 2.7% forecast, based on strong manufacturing and consumer spending data. The ISM Manufacturing Index rose in June to 57.8 compared with May’s 54.9 figure - its fastest pace in nearly three years – all while spending rose 0.1% in May, according to the Commerce Department. The ISM data, however, was at odds with the IHS Market US Manufacturing PMI report, which concluded that factory production weakened in June “with few signs of growth picking up any time soon.” At the same time, Gallup reported in its monthly household savings report that consumers “pulled back significantly” in June, with daily reports of spending averaging $82, down from the $95 and $93 recorded in April and May respectively. In addition, the University of Michigan said its index of consumer sentiment slipped to 95.1 in June from May’s 97.1 - the lowest level since last November - as consumers expressed growing doubts about future growth prospects. The survey peaked in March with its strongest reading since the end of 2000 before registering modest declines.
The IMF cut its forecast for annual US growth to 2.1% in 2017, down from the previous estimate of 2.3%. The Fund said it could no longer assume the Trump administration will be able to deliver on his promises of tax cuts and infrastructure renewal. Bank of America followed suit, slashing its 2017 GDP forecast to 2.1% from 2.5%.
The bell continued to toll for the retail sector as sales declined 0.3% in May, the steepest drop since January 2016. Restaurants, department stores, and appliance and electronics retailers led the declines while online orders - read “Amazon,” which dominates e-commerce - reported steady growth. The June purchase of Whole Foods by Amazon triggered a selling frenzy among shares in rival grocers like Kroger - down 19% in a single trading day - as well as related sectors such as pharmacies, drug distributors, and even real estate.
The value of new loans continued to slow across the board, particularly the all-important Commercial and Industrial space. After growing at 7.0% on a year-to-year basis at the start of the year, C&I loans declined to 3% at the end of March and 2.6% at the end of April, according to the Fed. The report revealed that the annual rate of increase in the C&I sector has declined to 1.6%, its lowest since 2011.
The number of new buildings dropped by 5.5% in May - completing the first trimester of declines since January 2009 - badly missing expectations of a 4.1% increase. Building permits also tumbled by 4.9%, in contrast to an anticipated increase of 1.7%. Additionally, Bloomberg reported that in the 10 most expensive U.S. metropolitan areas median home values have increased by 63% since 2000, after adjusting for inflation, while in the 10 cheapest metros, median values rose by just 3.6%.
International: More Europe
The European Central Bank cut its European Union inflation forecasts - from 1.7%-1.5% this year and 1.6%- 1.3% in 2018 - while enhancing GDP expectations from 1.8%-1.9% and 1.7%-1.8% during the same periods. The recalibration was interpreted by some analysts as proof that the ECB has failed to stimulate inflation.
Nevertheless, Europe continued to lure foreign investors. The Vanguard FTSE Europe exchange-traded fund absorbed $871 million in just five trading days in mid- June, part of a surge of investment in European equity markets on the heels of a deal between Greece and its creditors and French President Emmanuel Macron’s successful majority in parliament. In June, hedge funds increased their euro positions to “net long” for the first time in more than three years, according to the Commodity Futures Trading Commission.
On a sober note, the world’s economic recovery may encounter headwinds owing to an arcane debt-related instrument. According to UBS, the “global credit impulse” - the second derivative of credit growth and arguably the biggest driver behind economic growth worldwide - has abruptly stalled due to a “sudden collapse” in the ability of Chinese banks to keep up with “the recent extraordinary pace of credit acceleration”. Commenting on the report, ZeroHedge concluded that “absent a new and even more gargantuan credit expansion by Beijing - which is not likely to happen at a time when every single day China warns about cutting back on shadow banking and loan growth - the so-called recovery is now assured of fading.”
Speaking of China, the Financial Times reports that regulatory agencies have cracked down on Chinese corporations that have invested massively in highly leveraged mergers and acquisitions overseas. Largely as a result, Chinese foreign M&A activity came to a screeching halt earlier this year. On the other hand, Bloomberg reported that the Chinese government is prepared to increase its holdings of U.S. Treasuries as officials judge the assets are becoming more attractive than other sovereign debt as the yuan stabilizes.
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