MorningWord 7/11/16: Such Great Heights… Depths

by Dan July 11, 2016 10:19 am • Commentary

Fears of a recession in the U.S. following the late June Brexit vote in the U.K was one of the main reasons for the 5% drop in the S&P 500 (SPX) and the new lows made in the 10 year U.S. Treasury yield (and the flattest spread between 2yr/10yrs). Now that the SPX has recovered to make new all time highs, the 10 year yield remains near its lows. The SPX and the 10 yr are signaling very different economic expectations.

Get used to seeing this chart, and the explanations as to why US Treasury yields long race to the bottom and US stock’s relentless push higher don’t mean what you think they should:

I most certainly do not have the answer. I can’t tell you that it’s in any way natural. But Brexit (for now is in the rearview) and we’re about to enter corporate earnings season, and that’s a whole ‘nother story, especially given how low expectations are heading in. The peeps over at Bloomberg took a shot at why this earnings recession isn’t foretelling an imminent economic recession: Weakling Earnings Recession Is Why Nobody Pulled Cord on S&P 500. Simply put, it was different this time, the earnings recession over the last few quarters in the U.S. has been largely concentrated within a couple sectors:

Unlike the last recession where the earnings slump was spread across almost every industry, the one going on now is centered on the commodity space. Twelve-month income from energy producers have plunged by $189 billion since 2014, compared with $187 billion in lost profit for the whole S&P 500 universe. Should the industry be excluded, profit would’ve actually risen by 0.2 percent.

There are always outliers, sectors to be excluded from calculations that tell the right story. But remember what the driver for the sharp decline in energy and materials stocks was. The Fed’s unprecedented crisis monetary policy of QE and ZIRP started in Q4 2008. The central bank expanded their balance sheet from below $1 trillion to nearly $5 trillion. One massive result, a dramatic decline in the dollar, and the launch of an epic credit fueled commodity super-cycle.  But the end of QE and ZIRP (starting a path of divergent monetary policy with that of almost every other nation in the world) beginning in 2014 caused an all out collapse in industrial commodities, creating an all new set of similar risks to the global economy that years of easy monetary policy was expected to solve. Since, we’ve seen multiple bouts of risk asset volatility not witnessed since the financial crisis.

It’s been my view that the increasingly uncertain global economy and fragile state of financial markets make investing new capital in U.S. stocks far from attractive (despite those who espouse T.I.N.A, of which I am not a believer). As the SPX makes new highs today, and global equities shake off fears of Brexit induced financial calamity (Nikkei was up nearly 4% last night, and the FTSE in London is back in Bull Market territory, up 20% from its February lows), I am clearly wrong with that assessment right now.

And a breakout and at least a consolidation above the prior highs would be the main thing that would have me change my view on equities and what is the path of least resistance.

But with new highs come greater risks of being wrong on committing new money to equities. So it’s good to keep in mind what those warning signs would look like. Tom Lee, founder and head strategist for Fundstrat Global Advisors, who sports one of the highest year end targets on the SPX, in a note to clients on July 5th titled “Brexit biggest risk, but still… “stocks are the new bonds“, succinctly detailed what he sees as the headwinds to his (correct) bullish thesis:

• Brexit becomes EU contagion: Clearly greatest concern for investors at the moment.

• Policy uncertainty: A broader issue for markets is the inability to track policy risk which has grown in frequency in past few years.

• China: China is navigating an extremely challenging balance of slowing credit growth/expansion while transitioning growth from an investment-oriented to consumption oriented model. The structural changes over the past decade have resulted in China and its EM neighbors increasingly operating as an ecosystem, with the US less affected by “shocks” in China.

• Commodity producers: Commodity producers are seeing increasing financial stress, stemming from falling volumes and prices, currency weakening and diminished confidence by capital markets.

• Deflation: Falling inflation and the pernicious effects of deflation weigh on markets– particularly since debt burdens become very difficult to manage in a falling pricing environment.

• Credit cycle: Default expectations have risen in 2016, stemming concerns about falling commodity prices and reduced market liquidity. Investors have pulled nearly $80 billion from high-yield mutual funds over the past 18 months.

• Central bank policy divergence: Lastly, investors worry about policy errors from Central Banks. The Fed might resume tightening while other major countries are easing. Hence, the fear of a continued surge in USD and therefore more headwinds to US corporates.

If you replace “Euro Banking Crisis” with “Brexit” this is basically a list of the stated reasons behind the epic sell-offs we’ve already seen in global risk assets last August/September & January/February .

As we head into Q2 reporting season in the next week, I suspect that any weak Q2 reports will be given a mulligan. If large cap U.S. companies are able to meet or guide higher for the back half of the year, then we could very well see a new range in the SPX established above the prior highs.

For the most part the risks listed above all come from overseas. But as I stated earlier, even though the most recent U.S. profit recession came from overseas, its origins trace back to our FOMC policy changes. Our stocks have climbed a wall of global worry to new highs. And in many ways our flight to safety status has been because of our continued first mover position in central bank action.

Mohamed El-Erian, Chief Economic Adviser to Allianz, recently stated in a piece titled; 3 Things to Know About Record-Low U.S. Yields for Bloomberg View:

The beneficial impact of lower yields on the economy will be limited, and could even be offset by financial considerations

which also could mean any breakout in U.S. stocks could have legs (think blow-off move):

changes in yields will impose even more pressure on the banking system by darkening the prospects for earnings and profit. This is particularly worrisome for European banks whose recovery process has lagged that of their U.S. counterparts, and for whom the credit quality of loan portfolios will be affected by the economic slowdown.

The lower yields will also amplify worries about excessive risk taking by non-banks. As they try to meet unchanged — and increasingly unrealistic — objectives, investors are likely to stretch even further for financial returns, increasing the risk of financial instability down the road.

It’s the last bit that suggests that walls of worry will be climbed. A disregard for normalizing monetary policy can and will lead to asset bubbles that can go on longer than most rational people think. But they ultimately place us on at even more risk down the road if things are allowed to inflate way past the point of doing any good for the overall economy.