the Trump rally and its aftermath (so far)

the Trump rally

From the surprise election of Donald Trump as president through late December 2016, the S&P 500 rose by 7.3%.  What was, to my mind, much more impressive, though less remarked on, was the 14% gain of the US$ vs the ¥ over that period and its 7% rise against the €.

the aftermath

Since the beginning of 2017, the S&P 500 has tacked on another +4.9%.  However, as the charts on my Keeping Score page show, Trump-related sectors (Materials, Industrials, Financials, Energy) have lagged badly.  The dollar has reversed course as well, losing about half its late-2016 gains against both the yen and euro.

How so?

Where to from here?

the S&P

The happy picture of late 2016 was that having one party control both Congress and the administration, and with a maverick president unwilling to tolerate government dysfunction, gridlock in Washington would end.  Tax reform and infrastructure spending would top the agenda.

The reality so far, however, is that discord within the Republican Party plus the President’s surprisingly limited grasp of the relevant economic and political issues have resulted in continuing inaction.  The latest pothole is Mr. Trump’s refusal to release his tax returns–that would reveal what he personally has to gain from the tax changes he is proposing.

On the other hand, disappointment about the potential for US profit advances generated by constructive fiscal policy has been offset by surprisingly strong growth indications from Continental Europe and, to a lesser extent, from China.

This is why equity investors in the US have shifted their interest away from Trump stocks and toward multinationals, world-leading tech stocks and beneficiaries of demographic change.

the dollar

The case for dollar strength has been based on the idea that new fiscal stimulus emanating from Washington would allow the Fed to raise interest rates at a faster clip this year than previously anticipated.  Washington’s continuing ineptness, however, is giving fixed income and currency investors second thoughts.  Hence, the dollar’s reversal of form.

tactics

Absent a reversal of form in Washington that permits substantial corporate tax reform, it’s hard for me to argue that the S&P is going up.  Yes, we probably get some support from a slower interest rate increase program by the Fed, as well as from continuing grass-roots political action that threatens recalcitrant legislators with replacement in the next election.  The dollar probably slides a bit, as well–a plus for the 50% or so of S&P earnings sourced abroad.  But sideways is both the most likely and the best I think ws can hope for.  Secular growth themes probably continue to predominate, with beneficiaries of fiscal stimulation lagging.

Having written that, I still think shale oil is interesting   …and the contrarian in me says that at some point there will be a valuation case for things like shipping and basic materials.  On the latter, I don’t think there’s any need to do more than nibble right now, though.

 

 

Shaping a Portfolio for 2017: interest rates and currency

To a great degree, changes in interest rates and changes in currency substitute for each other in an overall macroeconomic sense.  A rise in the world value of the US$ is equivalent to an increase in interest rates, in that both act to slow down overall US growth.  A decline in rates or in the dollar acts as stimulus.

What is 2017 likely to bring?

interest rates

Ignoring the mid-year lows, one-month T-bills began 2016 at a 0.17% yield and are now at 0.39%.  The 10-year bond opened the year yielding 2.24% and is closing at 2.46%.  Over the same period, the Federal Reserve has raised the overnight money rate by 0.25%.

My guess is that the Fed will raise the overnight lending rate by at least 0.50% and possibly by 0.75% in 2017.  The latter would likely translate into a rise in the 10-year to something just below 3%, the former to a yield of 2.75% or so.

currency

I think the chances of the larger rate rise are greater if the dollar remains around today’s level.  As I’ve written recently, I think the US stock market is already trading as if long-dated Treasury bonds were yielding 4%–where I think the endpoint of restoring rates to normal will be.  That’s something that probably won’t occur until 2018.

In addition, the US stock market has typically gone sideways during past times of Fed tightening.  What would be unusual this time around would be if Congress follows through on a large, growth-stimulating, public works spending program.  This would, I think, minimize any negative effect rising rates would have on stocks.

effects on the S&P 500

If the past is prologue, the main effect of rising rates and rising currency will be on the relative performance of sectors.

The more interest rates rise, the more attractive bonds will become vs.stocks whose main appeal is their stream of dividend income.  So income stocks would be negatively affected.

The more the US$ rises, the weaker the US$ growth of foreign operations of US multinationals will be.  Import-competing businesses would be hurt as well.  Purely domestic firms would be relatively unaffected.  My guess, however, is that the bulk of the dollar rise on a more functional national government has already occurred.

 

 

Brexit, sterling and InterContinental Hotels Group (LN:IHG)

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession.  Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG.  The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked.  But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note    that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency.  This is an unexpected boon for British-based multinationals.

As Richard Solomons, the CEO of IHG, put it in yesterday’s report to shareholders:

“Note that whilst the UK comprises around 5% of our group revenues,

approximately 50% of our gross central overhead and

40% of Europe regional overhead are in sterling.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit.  Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been.  But overheads will be down by much more.  In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive.  This means that it can act as a way for British residents to preserve the purchasing power of their savings.

 

Brexit, sterling and the case for London stocks

the UK stock market

I started to learn about the UK stock market in 1986, a scarily long time ago, when I took over management of a failing global fund.  I realized pretty quickly, though, that despite similarity with the US in language and accounting standards, London stocks trade on complex signals that are far different in kind from those I was familiar with in New York.  I ultimately decided that the large effort required to become proficient would pay too small a reward to justify making it.  So I remain more or less an innocent (read:  the dumb money) in that market to this day.

12% cheaper

Nevertheless, the large drop (about 12%) in the value of the pound against the dollar suggests to me that there will ultimately be a big post-Leave-vote equity investing opportunity in the UK.  If the government follows through on its plans to cut the corporate tax rate from the current 20% to 15% (something the EU would have opposed) and lowers interest rates as well, the potential would be substantially larger.

Two reasons:

Mexico

–Weak currencies most often mean strong stock markets.  The most striking example I can think of is Mexico in the 1980s.  Over that period, the peso lost 98% of its value against the US$.  Still, Mexican stocks were, in US$ terms, just about the best-performing in the world–outdoing the US stock market by a mile.

Three causes:  supportive economic policies by the Mexican government; currency decline gave Mexican exporters a powerful price advantage; and the currency collapse created substantial inflation, which prompted local investors to strongly prefer equities as a way of preserving the real value of their savings.

Yes, Mexico is an extreme, but stocks in the UK are now 12% cheaper in US dollars than they were a couple of weeks ago.  And the government appears to be preparing to implement significant economic stimulus.  So earnings prospects for many firms are substantially better.

currency markets lead the way

–currency fall typically comes in advance of stock market rise.  The lag may be months.  This is partly because the currency markets always seem to act far ahead of stocks and bonds.  It’s also because equity investors, particularly in Europe, want to see some evidence of earnings improvement–either actual results or management confirmation that the numbers are looking surprisingly good–before they are willing to act.

timing

The big question, I think, is not whether London stocks, especially multinationals or exporters, will do well.  It’s when the fallout from the Brexit vote will have fully played itself out in financial markets.  Given that European investors typically take the month of August off, and that the start of this annual vacation period is only a few weeks away, my guess is that this won’t be until close to Labor Day.

the January 2016 Employment Situation

Earlier this morning the Bureau of Labor Statistics of the Labor Department released its monthly Employment Situation report for January.

job growth

The ES indicates that the economy added a net 151,000 new jobs during the month.  That’s roughly the number needed on average to absorb new job entrants, and it’s around the figure being reported each month last summer.  However, it falls short of the mammoth job addition figures achieved over the prior four months.  And it’s around 40,000 less than the consensus of Wall Street economists.

Revisions of prior months’ data didn’t move the needle much, either.  The ES numbers for November were revised up from +252,000 new jobs to +280,000; those for December were revised down from +292,000 to +262,000.  That’s a net of -2,000.

wages

Wage growth might be a different story. Over the past year, average hourly wages grew by 2.5%, which is a little better than inflation but not terrific.  And it’s not really consistent with a low unemployment rate of around 5%.  For January, however, average hourly earnings rose by $.12 to $25.39.  Of course this is only one data point, but if sustained would amount to +5.7% annual growth.  This could be (stress on the could) an early indicator of rising wage inflation (the only kind that really counts in advanced economies).

market reaction

S&P futures immediately dropped from a slight positive to a small negative.  The dollar spiked up against the euro.  My guess is that these are just knee-jerk reactions.  If we want to make more of them than that, however, Wall Street’s read would seem to be that the US is finally starting to see strong real wage growth.  While that’s good for the economy, it also would mean less worry at the Fed about continuing to raise interest rates.  In early going, it would seem the latter is what traders have latched onto.

There’s certainly risk is extrapolating from one data point, especially one that has given false positive signals in the recent past.  Traders are likely judging that there’s little chance of the stock market running away to the upside, though, so there’s less risk to making the negative bet than would seem on the surface.

My reaction is that this is giving long term investors a chance to pick through the rubble to find cheap stocks with good long term prospects.

What Janet Yellen did/didn’t say yesterday

Yesterday the Fed announced that its Open Market Committee had decided to postpone, yet again, beginning to raise interest rates from their current intensive-care lows.

In her press conference following the decision, Jane Yellen cited several reasons :  the recent rise in the dollar, a plateauing of consumer spending in the US and worries that the authorities in China might be bungling their way through the necessary change in that economy from export-led growth to one that’s led by domestic demand.  (Ms. Yellen pointed to recent ructions in the Shanghai and Shenzhen stock markets as evidence for the last.  Personally, I don’t think this is correct.  I see those markets’ rise and fall as what almost inevitably happens when a country allows margin borrowing for the first time.)

Whatever the motivations, the fact remains that the Fed sees the current situation in the US as too risky to warrant even a miniscule rise in short-term interest rates.  …and this is despite six years of economic growth and increasing employment since the economy bottomed in 2009.

What isn’t being said here?

Two things, I think:

–after Japan’s financial collapse in 1989-90, that country twice tightened economic policy prematurely–once by raising interest rates, a second by raising taxes.  The result of these miscues was a quarter-century of deflation and economic stagnation.  The Japan example suggests that in a slow growth environment with no inflation the risks of policy tightening are much larger than most people in the US suspect.

–governments have two main tools to influence GDP growth:  monetary (changes in the price or availability of credit) and fiscal policy (changes in spending and/or taxes).  Fiscal acts slowly but lays the general foundation for growth and indicates a broad direction for expansion.  Monetary acts relatively quickly and is most useful for mid-course corrections, slowing or accelerating the pace.  A dysfunctional Washington has meant that, other than the bitterly contested bank bailout plan in 2009, fiscal policy has done virtually nothing useful to stimulate growth over the past half-decade (arguably, it’s a mild deterrent).  Nor is it likely that Congress, now winding up to shut the government down, will change its stripes.  This implies that the Fed has no backstop if it makes a policy mistake.

 

Nothing about either is particularly new news.  But the Fed decision calls attention the major structural difficulties the US economy faces.  This is not a recipe for having stocks go up.

HSBC says the dollar is peaking

HSBC (Hong Kong Shanghai Bank Corp) has begun to seek publicity for a research report arguing that the US dollar has peaked.  I’ve seen mention of it both in the FT and on Bloomberg (the link above).

HSBC is generally pretty good at economics, and has been ahead of the curve on major moves like this before.  So I think its argument is worth considering.  It also fits in with the way I’ve been thinking over the past few weeks.

The HSBC argument:

–the EU is starting to show economic strength as the US is beginning to slow a bit

–on purchasing power measures, the US$ is more overvalued than everything except the Swiss franc

–the Fed is reaching the end of its tolerance for dollar strength

–sentiment is universally bullish for the dollar (i.e., where are new buyers going to come from?)

–the dollar typically weakens after the first Fed Funds rate hike.

 

Risks to the view are mainly geopolitical:

–Greece exits the euro

–emerging markets crisis

–perceived failure of Abenomics

–US legislation forcing American companies to repatriate foreign cash holdings.

 

my take

I don;t know David Bloom, HSBC’s chief currency strategist and the report’s author, personally.  But I see his work as another piece of evidence that the pro-dollar consensus is beginning to crack and that at least a mild reversal of form is likely sooner rather than later.