We’ve talked the past couple of days about economic growth and the likelihood that we’re just beginning to see the positive surprises from Trumponomics materialize in the economic data.
The formula for GDP is consumption + investment + government spending + net exports. So you can see in these components, the direct targeting of economic stimulus in the Trump economic plan to drive growth: tax cuts, deregulation, repatriation, infrastructure and trade negotiations.
Now, consumption makes up about two-thirds of GDP. Let’s look at consumption today, and we’ll step through the other contributors to GDP over the next few days.
First, what is the key long-term driver of economic growth over time? Credit creation. When credit is used to buy productive resources, wealth goes up. And when wealth goes up consumption tends to go up. With that in mind, in the chart below you can see the sharp recovery in consumer credit (in orange) since the depths of the economic crisis (this excludes mortgages). And you can see how closely GDP (the purple line, economic output) tracks creditgrowth.
And we have well recovered and surpassed pre-crisis levels in householdnetworth — sitting at record highs now (up another $2 trillion since we last looked at it) …
A large contributor to the state of consumption is the recovery and stability in housing. We are now back to new highs on the broad housing index …
When we consider this solid backdrop, remember, we’ve yet to have a return of ‘animal spirits’ — a level of trust and confidence in the economy that fuels more aggressive hiring, spending and investing.
And with that, as we discussed yesterday, while we are in the second longest post-War economic expansion, we’ve yet to have the aggressive bounce back in growth that is characteristic of post-recession recoveries.
But we now have the pieces in place to see the return of animal spirits and a big pop in economic growth. And that should continue to fuel for much higher stock prices. And there are stocks that will do multiples of what the broader stock market does.
On Friday, we talked about the building momentum in the economy. We’ve already had huge positive surprises in corporate earnings for the first quarter. And we’re probably just beginning to see the positive surprises on economic data roll in.
Remember, despite the execution success on Trumponomics over the past year (deregulation, repatriation, tax cuts and $400 billion in new government spending approved), the Fed is still expecting growth to come in well below trend (3%), at 2.7%. That’s just 20 basis points higher than they projected prior to the execution of massive tax cuts in late December.
The good news: Positive surprises are fuel for confidence and fuel for stocks.
Remember, we’ve yet to have a return of ‘animal spirits’–a level of trust and confidence in the economy that fuels more aggressive hiring, spending and investing. We should see this reflected in wage growth. Wage growth has been the missing piece of the economic recovery puzzle.
On that note, we’re now near the best wage growth in nine years, and that tax rate cut is still in the early stages of working through the economy.
Don’t underestimate the value of confidence in the outlook (and the return of “animal spirits”) to drive economic growth higher than the number crunchers in Washington can imagine. Remember, these are the same experts that couldn’t project the credit bubble, and didn’t project the sluggish ten years that have followed.
Remember, while we’re in the second longest post-War economic expansion, we’ve yet to have the aggressive bounceback in growth that is characteristic of post-recession recoveries. We now have the pieces in place to finally get it.
So, as we’ve discussed throughout the year, the backdrop continues to get better and better for stocks.
As we head into the long holiday weekend, let’s look at some key charts.
First, just a week ago, the U.S. interest rate market was spooking investors, as 10-year yields were hanging around 3.10%. The fear was, would 3% yields quickly turn into 4% yields, and hit economic activity.
As of today, we’re trading closer to 2.90% again, back below 3%.
But you can see, we run into this big trendline that represents this ascent in rates for 2018, which also reflects the outlook of a hotter economy, thanks to tax cuts (fiscal stimulus).
Bottom line here: The concern in interest rates is speed, not trajectory. The trajectory should continue to be UP, which is a signal that the economy is improving, and finally gaining the tracking to perform at trend, if not better than trend growth. The concern about ‘speed’ should be far less than it was a week ago.
Next, here’s a look at the S&P 500.
You can see in the chart above, we’ve broken the downtrend of this correction cycle. The longer-term trend is UP. And this bull trend started, not coincidentally, at the bottom of the oil price crash in 2016, when global central banks stepped in with measures to stem the slide in confidence.
So, we’ve had a healthy 12% correction in stocks, we’ve held the 200-day moving average, we’ve maintained the longer-term trend, and we’ve broken out of the downtrend of the correction. Small cap stocks have already returned to new record highs. And we have an economy on pace to grow at 3% this year or better, with corporate earnings expected to grow at 20% for the year. So, the second half of the year should be very good for stocks.
We have a lot of geopolitical noise surrounding markets.
Let’s step through them:
1) Yesterday, we discussed the Trump trade threats with China:
How is it playing out?
We have an economy that is leading the global economic recovery. China wants and needs to be part of it. Trump’s bark, with the credibility to bite, is creating movement. It’s creating compliance. That’s becoming a very positive catalyst for global economy and for geopolitical stability (the exact opposite of what the experts have predicted these tactics would produce).
2) We’ve talked about the shock-risk developing in Europe. A coalition government forming in Italy, with an “Italy first” approach to the social and economic agenda, has created some flight of Italian bond market capital toward safety. This has people skittish about another blowup threat of the euro zone.
How is it playing out?
The last time Italy was on default/blow up watch, the 10 year yields were 7% (unsustainable levels). At those levels, the ECB had to intervene.
This recent move in the Italian bond markets leaves yields at just 2.4% …
This looks like Grexit, Brexit and the Trump election. It creates leverage for the third largest economy in the European Union (excluding Britain). In this case, we may see it result in a loosening of fiscal constraints in the European Union – and an EU wide fiscal stimulus plan to follow the lead of the U.S.
3) The North Korean nuclear threat …
How is it playing out?
Eight months ago, North Korea launched a missile over Japan. Markets barely budged, and the world continued to turn. Now, we’ve quickly gone from an imminent threat to potential denuclearization. And now a meeting has been cancelled. With that, on the continuum of this relationship, I’d say it’s closer to its best point, rather than its worst.
Bottom line, these risks should do little to stop the momentum of the economy and the stock market.
There has been a lot of attention over the past couple of days on China and trade relations.
China has moved down tariffs on auto and auto parts imports. And a source today said the government has “encouraged” China’s largest oil refiner to buy more U.S. crude oil. Based on the reports, China is now taking about 8 times the daily volume of U.S. crude imports, compared to averages a few months ago.
These are concessions! This is a distinct power shift. Not long ago, the world was afraid to rattle the cage of China. They (global trading partners) tiptoed around touchy matters like Chinese currency manipulation prior to the global financial crisis a decade ago, and even more so after the crisis.
But now, you can see the leverage that has been created by Trump. This is exactly what we talked about the day after the election.
Here’s an excerpt from my November 9, 2016 ProPerspectives note, back when the experts were predicting Draconian outcomes for poking the China giant: “As we’ve seen with Grexit and Brexit, the votes came with dire warnings, but have resulted in creating leverage. Trump’s complaints about China are right. And a threat of slapping a tariff on Chinese goods creates leverage from which to negotiate.”
Now, we have an economy that is leading the global economic recovery. China wants and needs to be part of it. And we have a President that has a loud bark, and the credibility to bite. And that is creating movement. Let’s revisit, also from one of my 2016 notes, why this China negotiation is so important …
TUESDAY, SEPTEMBER 27, 2016
China’s biggest and most effective tool is and always has been its currency. China ascended to the second largest economy in the world over the past two decades by massively devaluing its currency, and then pegging it at ultra-cheap levels.
Take a look at this chart …
In this chart, the rising line represents a weaker Chinese yuan and a stronger U.S. dollar. You can see from the early 1980s to the mid-1990s, the value of the yuan declined dramatically, an 82% decline against the dollar. China trashed its currency for economic advantage—and it worked, big time. And it worked because the rest of the world stood by and let it happen.
For the next decade, the Chinese pegged its currency against the dollar at 8.29 yuan per dollar (a dollar buys 8.29 yuan).
With the massive devaluation of the 1980s into the early 1990s, and then the peg through 2005, the Chinese economy exploded in size. It enabled China to corner the world’s export market, and suck jobs and foreign currency out of the developed world. This is precisely what Donald Trumpis alluding to when he says ‘China is stealing from us.’
China’s economy went from $350 billion to $3.5 trillion through 2005, making it the third largest economy in the world.
This next chart is U.S. GDP during the same period. You can see the incredible ground gained by the Chinese on the U.S. through this period of mass currency manipulation.
And because they’ve undercut the world on price, they’ve become the world’s Wal-Mart (sellers to everyone) and have accumulated a mountain for foreign currency as a result. China is the holder of the largest foreign currency reserves in the world, at more than $3 trillion dollars (mostly U.S. dollars). What do they do with those dollars? They buy U.S. Treasurys, keeping rates low, so that U.S. consumers can borrow cheap and buy more of their goods—adding to their mountain of currency reserves, adding to their wealth and depleting the U.S. of wealth (and the cycle continues).
This is the recipe for big trade imbalances — lopsided economies too dependent upon either exports or imports. And it’s the recipe for more cycles of booms and busts … and with greater frequency.”
Again, China has to be dealt with. And we’re starting to see signs of progress on that front. Good news.
Yesterday we talked the set up for a turn in the dollar (lower) and in commodities (higher). The broad commodities index hit a fresh three-year high yesterday, and hit another one today – led by natural gas and copper.
This is where we will likely see the next big boom: commodities.
Throughout the post-financial crisis period, we’ve had a disconnect between what has happened in global asset prices (like the recovery in stocks and real estate) and commodities.
Stocks have soared back to record highs. Real estate has fully recovered in most spots, if not set new records. But commodities have been dead. That’s because inflation has been dead.
And that has created this massive dislocation in valuation between commodities and stocks.
You can see in this chart below from Goehring and Rozenzwajg.
The only two times commodities have been this cheap relative to stocks was at the depths of the Great Depression in the early 30s and at the end of the Bretton Woods currency system in the early 70s. Commodities went on a tear both times.
The last time commodities were this cheap, relative to stocks, a broad basket of commodities returned 50% annualized for the next four years – up seven-fold over 10 years. With the economy heating up, and inflation finally nearing the Fed’s target, it’s time for commodities prices to finally catch up.
Last week, rising market interest rates in the U.S. were becoming a concern. But as we discussed on Friday, we ended the week with a big bearish reversal signal in the 10-year yield. This week, the market focus seems to be shifting toward a lower dollar and higher commodities.
Friday’s bearish signal in rates seems to have foreshadowed the news coming into today’s session, that Italy is putting forward an agreement for a coalition government that would break compliance from EU rules (an “Italy first” approach to an economic and social agenda).
That has created some flight to safety in the bond market. You can see in this chart below, money moving out of Italian bonds (yields go up) and into German bonds (yields go down).
And that means money goes into U.S. Treasuries too. So you can see U.S. yields (the purple line in the chart below) backing off of the highs of last week, and with room to move back toward 3% (or below) if this dynamic in Italy continues to elevate the risk environment.
Now, with the rate picture softening, the dollar may be on the path of softening too. That would be a welcome site for emerging market currencies. We discussed last week how the push higher in U.S. yields was putting pressure on emerging market currencies. And the combination of weaker currencies and higher dollar-denominated oil prices was a recipe for economic strain.
Today, Larry Kudlow, the Chief Economic Advisor to the White House, carefully crafted a response on the dollar, as to not say they favored it “stronger.” That’s probably enough, given the rising risks in emerging markets, to get the dollar moving lower (to alleviate some of the pain of buying dollar-denominated oil for some of the EM countries).
And it may be the signal for commodities to start moving again. Because most commodities are priced in dollar, commodities prices tend to be inversely correlated to the dollar.
Today we had a fresh three-year high in the benchmark commodities index (the CRB Index).
Here’s an excerpt from one of my Forbes Billionaire’s Portfolio notes back in June, on the building momentum for commodities: “The technology sector minted billionaires over the past decade. It’s in commodities that I think we’ll see the new billionaires minted over the next decade. The only two times commodities have been this cheap relative to stocks was at the depths of the Great Depression in the early 30s and at the end of the Bretton Woods currency system in the early 70s. Commodities went on a tear both times.”
We’ve talked this week about the pressure that rising U.S. market interest rates are putting on emerging markets.
The fear surrounding the big 3% marker for U.S. 10-year yields is that 3% may quickly become 4%. And a 4% yield, much less a quick adjustment in this key benchmark interest rate, would cause some problems.
Not only does it create capital flight out of areas of the world where rates are low, and monetary policy is heading the opposite direction of the Fed, but a quick move to a 4% yield on the 10-year would certainly cloud the U.S. economic growth picture, as higher mortgage and consumer borrowing rates would start chipping away at economic activity.
With that said, we may have a reprieve with the action today in the bond market.
As we head into the weekend, today we get a softening in the rates market. And that came with a big technical reversal pattern (an outside day).
You can see in the chart above, the engulfing range of the day. This technical phenomenon, when closing near the lows, is a very good predictor of tops and bottoms in markets, especially with long sustained trends.
I suspect we may have seen some global central bank buyers of our Treasurys today (which puts downward pressure on yields) to take a bite out of the momentum. We will see if this quiets the rate market next week, for a drift back down to 3%. That would calm some of the nerves in global currencies, and global markets in general.
We talked yesterday about the building pressure in emerging markets, driven by weakening currencies and rising dollar-denominated oil prices.
With that bubbling up as a potential shock risk, gold hasn’t exactly been telling the story of elevated risks.
You can see in this chart above, since the tax cuts were passed in late 2017, rates have been rising (the purple line). This is a hotter economy, pick-up in inflation story. And, as it should, gold stepped higher with rates all along–until the last few weeks. You can see the divergence in the chart above.
I suspect we’ll see gold snap back to reflect some increasing market risks, and especially to reflect a world where central banks are beginning to finally see inflation pressures build. The gold bugs loved gold when inflation was dead. And now that it’s building, they are surprisingly very quiet.
We’ve talked about the stock market’s discomfort with the 3% mark in rates. People have been concerned about whether the U.S. economy can withstand higher rates–the impact on credit demand and servicing. That fear seems to be subsiding.
But often the risk to global market stability is found where few are looking. That risk, now, seems to be bubbling up in emerging market currencies. We have a major divergence in global monetary policies (i.e. the Fed has been normalizing interest rates while the rest of the world remains anchored in emergency level interest rates). That widening gap in rates, creates capital flight out of low rate environments and in to the U.S.
That puts upward pressure on the dollar and downward pressure on these foreign currencies. And the worst hit in these cases tend to be emerging markets, where foreign direct investment in these countries isn’t very loyal (i.e. it comes in without much commitment and leaves without much deliberation).
You can see in this chart of the Brazilian real, it has been ugly …
Oil has become the potential breaking point here. At $40-oil maybe these countries hang in there until the global economic recovery heats up to the point where they can begin raising rates without crushing growth (and with a closing rate gap, their currencies begin attracting capital again). But at $70-oil, their weak currencies make their dollar-denominated energy requirements very, very expensive. They’ve had nearly a double in oil over the past ten months, and a 15% drop in their currency since January (in the case of Brazil).
Something to watch, as a lynchpin in this EM currency drama, is the Hong Kong dollar. Hong Kong has maintained a trading band on its currency since 2005 that is now sitting on the top of the band, requiring a fight by the central bank to maintain it. If they find that spending their currency reserves on defending their trading band is a losing proposition, and they let the currency float, then we could have another shock event for global markets, as these EM currencies adjust and their foreign-currency-denominated debt becomes a default risk. This all may force the rest of the global economy to start following the Fed’s lead on interest rates earlier then they would like to (to begin closing that rate gap, and avoid a shock event).
