Weekly Special: All anyone is talking about, except for the 'stable genius' of course

08-10-2018

[Editor’s note: With summer vacation in full swing, Linda Duessel this week weighs in on three issues that could shape the markets in the months to come.]

Don’t sweat the yield curve

With the yield curve continuing to barrel toward inversion—the gap between 2-year to 10-year Treasuries now sits around 20-25 basis points, half its level of just a few months ago—it’s possible the two will invert by year-end. This flattening isn’t just occurring in the U.S. Canada’s yield curve has been following a similar trajectory, and the gap is even narrower in Japan and near post-crisis lows in the U.K.

Historically, inversions are considered to be reliable signals of an upcoming recession, indicating a growing risk of a downturn in several advanced economies. But the yield curve is not the crystal ball it’s often made out to be. For one thing, outside of the U.S., it has a weak relationship with GDP growth. Moreover, because yield curves are influenced by factors beyond pure expectations about the economic outlook, inversions are considerably worse at “predicting” recessions. What’s more, a flattening or inversion doesn’t give much indication about the timing of a potential downturn.

In fact, some Fed research says the shorter-dated forward curve is a more reliable indicator of recession risk and it actually has been steepening. With the economy firm, credit spreads tight and the futures yield curve steepening on the short end, a flattening of the 2-10 curve could potentially prove dovish. According to June’s meeting minutes and Fed Chair Jerome Powell’s recent testimony before Congress, Fed policymakers have discussed at length the flattening of the curve, viewing it less as predictor of a pending slowdown than as a sign they are moving nearer to their neutral rate, which could be interpreted as a sign the Fed’s closer to the end of its rate movements.

Dollar strength: Asian crisis redux?

After a record-making January plunge—its worst January since 1987—the U.S. dollar has rebounded strongly, registering its best first half to a calendar year since 2015. Among the reasons: a rate-hiking, quantitative-tapering-bound Fed, as well as economic outperformance relative to much of the developed world and many emerging-market (EM) countries.

Dollar strength has been very negative for Asia and evokes memories of 1997-98, when debt pegged to the U.S. currency exploded as the dollar rose sharply relative to Asian currencies. The risk is that if U.S. companies begin to repatriate cash, there could be a squeeze on dollar deposits in Asian banks, which are the footings for local lending. This is precisely what is happening now that tax reform has forced U.S. companies holding profits overseas to pay tax on those earnings, whether they are repatriated or not.

The problem for Asian EMs is their local banks must replace those dollars and can only do so through swap agreements with the Fed. But their swap line levels currently seem insufficient to hold the dollar down, creating a dollar squeeze, the Institutional Strategist says. If the U.S. trade balance begins to improve, it could set off a dollar spike, triggering a risk-off market and eventually a potentially interesting buying opportunity as the panic peaks. The U.S. will then have to decide what the mix of trade policy, dollar policy and Fed policy will be. With essentially one free trader left in the upper echelons of the Trump administration (Treasury Secretary Steven Mnuchin), the odds are a global currency realignment is coming.

If you want to worry, worry about Europe

The weakening of hard data in the euro area has continued, with Q2 GDP on the Continent now tracking at an annual rate of 0.75-1%, which if it holds would represent the weakest quarter for growth in more than five years. Uncertainties over Italy’s new government and German Chancellor Angela Merkel’s hold on power, not to mention mounting trade frictions with the U.S., have added to market turmoil. But Brexit is by far the biggest headache.

Handelsblatt, a German media company, recently reported that 47% of German companies have postponed investment spending; an additional 33% have stopped investment totally. The reason: complacency about Brexit has suddenly shifted to panic. Continental Europe has for some time been expecting a “soft” Brexit would occur, but this looks far less likely now in no small part due to the way the European Union (EU) is negotiating—it’s basically saying “No!” to everything the U.K. proposes. Companies, especially large companies which operate just-in-time supply chains, need time to adjust to new trading conditions, and time is running out.

Consider BMW, which sells two times the number of cars in the U.K. than it does in the U.S., and three times the cars it sells in China. The U.K. is a crucial export market for its suppliers, making the negotiating behavior of the EU even more dangerous for the EU economy as well as the U.K. Large EU companies won’t wait for a typical EU deal to be done at 11:59 p.m. on March 29, 2019. They need guidance now and it appears they will not get it from either side. Recent price action in the euro and British pound suggests an economic slowdown is unfolding on the Continent precisely for this reason.

What else

Trade a market tailwind? The forward P/E multiple for the S&P 500 remains nearly 5% below its peak from prior to Donald Trump’s inauguration and this winter’s market tumble. Although bears argue a growing trade war demands a much less effusive ratio, FBN Securities believes all sides in the dispute will come to a workable solution, allowing companies to take advantage of the best economy in over a decade, further buttressed by transparent and certain monetary policy. This could drive up multiples even as earnings remain robust.

Most FAANGS unfazed by China dust-up With the exception of Apple, technology giants Facebook, Amazon, Netflix and Google (Alphabet) are less exposed to China than other tech firms. That’s because they’re mainly focused on software services, making them less integrated with China than hardware producers, which typically have production facilities there. Second, most FAANGs have relatively little sales exposure to that country because large Chinese competitors provide the same type of services and products in that market.

Bullish buybacks While initial public offerings jumped 48% the first six months of this year, yielding $28.6 billion in proceeds, that’s dwarfed by share repurchases, which totaled $189.1 billion in Q1 alone and $575.3 billion in the 12-months ending March 31. This has caused shares outstanding to continue to decrease, adding to a bullish outlook over the next 12 to 18 months.

Don’t be such a ‘drag’ Many continue to view the economy as being on a fiscal policy “sugar high’’ that’s sure to fade in 2020. Strategas Research has heard it all before. In 2010, 2012, 2013, 2015 and 2017, observers spent an entire year warning of a fiscal drag that never occurred. Strategas believes the latest drag argument ignores any supply-side impact from the tax cuts. It also reminds us that the S&P has not declined in the 12 months following a midterm election since 1946, in part because presidents push fiscal policy ahead of their re-elections.

Connect with Linda on LinkedIn