Friday, April 20, 2018

Market Worried About Oil and Rates?

Thomas Franck of CNBC reports, Wall Street doesn't care about your good earnings right now:
Companies have been crushing earnings so far this quarter, but a strange trend is developing: Those that beat expectations are seeing their stock prices fall.

Since the earnings season kicked off last week, shares have returned, on average, a loss of 0.12 percent on the trading day immediately after companies posted their quarterly results, according to data from Bespoke Investment Group. Breaking that number down, the average opening gap following an earnings release is a pop of 0.29 percent, following by an open-to-close decline of 0.38 percent.

Historically, the average opening gap is a 0.1 percent move upward followed by an average full-day gain of 0.04 percent.

The gloomy open-to-close figures come despite the fact that 80 percent of companies that had reported as of Friday morning posted better-than-expected earnings.
You can read the rest of the article here where Franck uses the example of how Goldman Sachs (GS) and Procter & Gamble (PG) sold off despite better-than-expected results this week.

Nothing new to me, I told you last Friday, the market doesn't care about great earnings, it's looking way beyond this earnings season.



It's Friday, it's been another crazy week on Wall Street, there's a lot to cover today so let me get to the point and tell you what I think is spooking markets.

It's the bond market, stupid!: The backup in US long bond yields is what is making everyone so nervous. In particular, every time the 10-year Treasury yield gets close to the all-important 3% level, stocks get slammed hard (click on image):


It's all about oil, stupid!: You might be wondering why are US long bond yields rising, and here too I have an answer, it's mostly due to higher oil prices (click on image):


Higher oil prices have fuelled US inflation expectations higher and that is what is causing the recent sell-off in US long bonds (TLT) (click on images):



Now, I still maintain every time the 10-year Treasury yield approaches 3%, you should be buying US long bonds (TLT).

The rise in oil prices has also helped lift energy shares (XLE), which is something I covered in my blog comment on Monday going over whether it's time to invest in energy.

Admittedly, I've been underweight energy since the beginning of the year and totally missed the latest monster rally in energy, but I remain cautious which is why I have a hard time jumping on energy shares here (I basically think it's a powerful countertrend rally, not sustainable).

My friend Martin Roberge, analyst at Cannacord Genuity, has a different opinion, sending out a note earlier today explaining why he thinks a sector rotation into energy is underway:
The S&P 500 (~0.5%) and S&P/TSX (~1%) are both up this week fueled by strong earnings and commodity prices. Thomson Reuters’ blended S&P 500 earnings growth estimates reached 20% YoY in Q1/18 this week. Even when excluding energy (+69.9%), earnings growth estimates (18.3%) stand above levels reached in recent years. Thus, so far, positive EPS surprises outweigh fears related to trade tensions, geopolitics and rising bond yields. Regarding commodities, crude oil is up ~1% (more below) while copper advanced ~2%, supporting resource stocks this week. Importantly, a sector rotation seems underway considering that energy and materials are markedly outperforming the market since March lows. Undoubtedly, cracks in the tech space and in financials are helping this rotation. Otherwise, the CDN$ gave up early gains and is now down ~1% following the BoC statement where the central bank said it remains “cautious” about future rate hikes.

This week we highlight crude oil. While US President Trump denounced “artificially high” oil prices this morning, we see fundamental improvements justifying current levels. Indeed, the EIA reported Wednesday that crude oil, gasoline and distillate stocks declined 1.1MMbbl, 3.0MMbbl and 3.1MMbbl, respectively. Also, demand for gasoline hit a record level at 9.9MMbbl/d, leading to much higher refinery runs than what seasonal patterns suggest. In a nutshell, as our Chart of the Week illustrates, strong demand and tight supply should allow total petroleum inventories (788.9MMbbl) to cross below their 5-yma (788.6MMbbl) soon. This is an important milestone considering that crude oil traded much higher following similar crosses in 1999, 2002, 2007 and 2011, registering 52.7% returns on average before the next interim price peak (second panel). Also, this time around, OPEC countries seem determined to maintain supply cuts, eyeing the $80/bbl mark. In all, given prospects for higher oil prices and that Canadian oil transportation bottlenecks are expected to clear in H2/18, the ongoing rally in energy stocks does not seem to be another false start (click on chart).


Regarding economic statistics this week, in Canada, the BoC left the overnight rate unchanged at 1.25%. The central bank underscored changes in mortgage rules, depressing home sales and transportation bottlenecks which likely triggered an unexpected drop in exports in Q1/18. The BoC also cited risks tied to trade tensions but overall remains data dependent, which puts today’s inflation and retail sales reports under the spotlight. Headline inflation hit 2.3% in March, boosted by gasoline prices. Meanwhile, the three measures of underlying inflation (CPI-trim, CPI-median and CPI-common) averaged 2% in March, in line with the BoC target. For their part, retail sales increased 0.4% MoM. But Statistics Canada revised past sales estimates down, suggesting sales during the holiday shopping season were far lower than previously thought. In the US, retail sales advanced 0.6% MoM in March, fueled by car sales, to settle at 4.5% YoY. Also, building permits and housing starts rebounded in March, up 2.5% and 1.9% MoM respectively. But higher multifamily housing units mask a marked slowdown in the single-family segment. In Europe, the ZEW Economic Sentiment Index declined to 1.9 (from 13.4), confirming the ongoing growth lull. Ditto for Japan, where exports grew 2.1% and imports fell 0.6% YoY in March, much below expectations. Last, in China, while GDP growth (6.8% YoY in Q1/18) topped expectations and retail sales advanced 10.1% YoY (from 9.7%) in March, industrial production growth moderated to 6% YoY (from 7.2%).

Next week, we will focus on flash PMIs in Europe and the ECB. Given the ongoing growth slowdown in Europe, we expect ECB President Draghi to put the emphasis on downside risks and uncertainty. In the US, we await Q1/18 GDP, new and existing home sales and durable goods orders. In Japan, the BoJ is on deck. The central bank is not expected to dial back on its ultra-loose monetary policies anytime soon. Meanwhile, the Tokyo CPI, retail sales and industrial production should help gauge inflation trends and underlying economic strength.
Next week is a big week. If the ECB surprises the market and cuts its stimulus, I expect the euro to finally start declining versus the US dollar and that might spell the end of the long US dollar (UUP) sell-off (click on image):


And if the US dollar starts picking up steam from these levels, that might put an end to the powerful rally we've seen in commodities (DBC) lately (click on image):


But one commodity trader I know told me that Goldman has been telling clients since the beginning of the year that commodities would be the place to be in 2018 based on this chart  (click on image):

How sustainable is the rise in oil prices?: Now, people will see the charts above and think, "wow, maybe there is a lot more room for commodities to keep gaining here."

However, it's worth noting most of the rally in commodities is driven by higher oil prices so it's also important to take a step back here and THINK of the fundamental ramifications:
  • Higher oil prices lead to higher gas prices and in a debt-laden economy, higher gas prices pretty much wipe out Trump's tax cuts for most Americans, which is why he came out to tweet against OPEC on Friday morning. I found it interesting that Minister Mohammed bin Hamad Al Rumhi of Oman came out shortly after to state oil prices probably won't rise much beyond recent highs near $75 a barrel this year (of course, OPEC is petrified of Trump nor does it want oil prices too high to risk a global recession).
  • More importantly, the Fed has raised rates six times and will continue to raise for the foreseeable future, global PMIs are rolling over, which means a global economic slowdown is ahead, so even if oil prices keep creeping up this summer, it will only add fuel to the fire by tightening financial conditions even more.
  • The yield curve hasn't inverted yet but investors can't ignore it and as AIMCo's CIO Dale MacMaster told me yesterday, the forward yield curve has inverted which is worrisome.
All this to say, those playing the "sector rotation" into energy (XLE) or metals and mining (XME) thinking this is a sustainable rally really need to ask themselves some tough questions as to how sustainable this rally in cyclical energy shares really is.

I still maintain that going forward, US long bonds (TLT) will offer the best risk-adjusted returns. The rise in oil prices and the rise in long bond yields only makes me more certain that a slowdown is ahead and I'd be jumping on US long bonds at this level, especially if the 10-year Treasury yield surpasses 3% which it might (but I still have my doubts).

To recap, I'm preparing for a second half global 'synchronized' economic downturn, and as such I'm recommending investors to trim risk in their portfolio by investing at least 50% in US long bonds (TLT) and overweighting consumer staples (XLP) and interest-rate sensitive sectors like utilities (XLU), telecoms (IYZ) and REITs (IYR) and underweighting cyclical sectors like energy (XLE), financials (XLF), metals and mining (XME), industrials (XLI) and emerging market shares (EEM).

I also think too many investors still don't understand the inflation disconnect and they're being sucked into a market phishing for inflation phools.

What else? It's critically important to understand inflation is a lagging indicator. An astute investor and reader of my blog sent me a comment from Kessler Investment Advisors explaining how inflation is the caboose of the economy:
Inflation has once again become a hot topic of discussion. Core CPI has returned to 2%, oil is near $70 a barrel, and copper is well over $3 per pound. What is easily forgotten, yet not hard to show, is that inflation is the last of the lagging indicators. In fact, headline CPI is best correlated to the economy (coincident indicators) with a 21 month lag!

The chart below shows that inflation tends to reach its peak well after the recession has begun. In our most recent recession, from 12/2007 – 06/2009, CPI peaked in July of 2008, Copper peaked on 7/2/2008 and Oil peaked on 7/3/2008. This was in the middle of recession, a full year after interest rates had peaked and nine months after the stock market peaked.


While counterintuitive, it would not be unusual for inflation to continue climbing as we get closer to a recession as interest rates continue to fall. Interest rates are much more interested in the outlook for future inflation than what it has measured in the last 12 months. The lagging inflation surge of 2008 did affect interest rates negatively, but only temporarily (3 months), and within a much bigger primary trend of falling interest rates (see below).

Got that? Stop worrying about cyclical swings in inflation due to higher oil prices and a lower US dollar (which increases import prices) and remember, structural deflationary headwinds still persist.

Lastly, take the time to read Hoisington Investment Management's latest Quarterly Economic Review which John Mauldin posted on his website here. I agree with Lacy Hunt's analysis and his conclusion:
Important to the long-term investor is the pernicious impact of exploding debt levels. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.
But I don't want to sound all doom & gloom as it is Friday and there are some market strategists and analysts who think the world is just fine, growth will continue, and the rally in energy and commodities is sustainable.

Below, Alpine Macro's Chen Zhao discusses China's Q1 GDP. Chen raises many great points here that made me think maybe I'm reading China all wrong. Listen carefully, well worth it, he almost makes me rethink my bearish stance on commodities, Chinese (FXI) and emerging market shares (EEM).

Second, Pension Partners' Charlie Bilello tells Michelle Caruso-Cabrera that the rally in crude could be giving a signal to the Federal Reserve and bond market. I follow Charlie on Twitter and StockTwits, he posts great stuff on markets.

Third, Guy LeBas, Janney Montgomery Scott chief fixed income strategist, provides his outlook on interest rates and explains why oil is a short-term driver of rates. I couldn't agree more.

Lastly, Minneapolis Federal Reserve President Neel Kashkari discusses the US economy with CNBC’s Steve Liesman and explains why the flattening yield curve shows a ‘sign of caution’. As I recently told you, don't ignore the yield curve, it's pointing to a slowdown ahead.

Hope you enjoyed reading this comment. Please remember to donate to this blog via PayPal on the top right-hand side, under my picture. I thank all of you who take the time to donate, it's greatly appreciated.



No comments:

Post a Comment