Figures provided above are estimate and for illustration purposes only
Independence came and went along with the month of July which brought solid returns in the US stock market and abroad. For the year, the S&P is up almost 12% while international and emerging market stocks are having a fantastic 2017 so far. Certain geo-political events have the potential to destabilize the markets such as North Korea, which successfully test fired an ICBM (intercontinental ballistic missile). North Korea has stated that the US is within reach and many others appear to agree. Not a peaceful thought. The GOP has moved on from healthcare and is now trying to tackle tax reform, although I’m not very confident they’ll be able to get a deal done. Better news for the economy as GDP grew +2.6% quarter over quarter (2.1% year over year) which was an uptick from previous quarters. The estimates for Q3 GDP are strong with the Atlanta Fed’s model forecasting +3.6%. The Fed left rates unchanged but signaled they’ll be reducing their assets on their balance sheet before year end. Details still need to be provided, but all bets are on this happening and a 3rd rate hike is now below a 50% probability. Earnings from Q2 has been very strong and we’re seeing double digit earnings growth across the S&P 500.
The dollar has been falling since it peaked in January while the Euro and Pound have been rallying due to weaker economic data / strong data overseas.
Other Noteworthy News:
- Scaramucci was in and out of the White House faster than anyone could have imagined. The game of survivor continues, which the Post captured perfectly.
- Scott Minerd, Global CIO at Guggenheim had some great thoughts on what’s happening with the US yield curve:
In a manner reminiscent of the Greenspan “conundrum” from the 2004–2006 hiking campaign, today long-term yields are falling while the Federal Reserve (Fed) raises short-term rates. The fed funds rate target range is now 100 basis points higher than it was before the current hiking cycle began, but the 10-year Treasury yield is 13 basis points lower. There are three possible explanations for this yield curve behavior:
Rather than being accommodative, the Fed may actually become more restrictive than it expects. The Fed is projecting longer-run inflation at 2 percent, but if the market perceives that inflation is going to stay around 1.5 percent or lower, then the Fed could actually be ahead of the curve on inflation, and a lot closer to the end of tightening. The growing list of categories experiencing downward price pressure, including commodities, energy, apparel, retailing, owner-occupied rent, etc., makes price acceleration to the Fed’s 2 percent target unlikely anytime soon. If this is the case, the market is discounting the fact that the Fed will have to stop the hiking cycle sooner in order to avoid further downward price pressure.
The fed funds rate may already be nearing the neutral rate. The neutral (or natural) rate—the estimated real short-term rate that is in place when the economy is operating at full potential and with stable inflation—has been declining for the past decade in the United States and now is estimated to be essentially zero in real terms. The decline in the neutral rate results from the declining potential for U.S. growth resulting partly from reduced productivity and declining population growth. With core inflation currently running at approximately 1.5 percent, the Fed is less than two hikes away from the neutral rate in nominal terms. Moving the fed funds rate above the neutral rate, could be excessively restrictive. The market is pricing the probability of the Fed getting close to the neutral rate sooner than expected.
Foreign central banks are distorting the term structure of interest rates. As the Bank of Japan, the European Central Bank, and the Bank of England press on with their quantitative easing (QE) programs, the shortage of high-quality assets could be suppressing all yields, including those on risk assets. Moreover, the Fed has already estimated that the large-scale asset purchases and maturity extension program of QE may have reduced the 10-year Treasury term premium by 80–100 basis points. Only when QE has been reversed will long-term rates have the opportunity to rise.
Whatever the source, until the structural issues around growth and inflation are addressed, the markets are likely to be stuck in a low-rate environment perhaps longer than anticipated. This prolonged period of low rates is leading to distortions in asset prices, which will become more pronounced in time and inevitably lead to destabilizing bubbles that will threaten the economic expansion, ultimately bringing down prices on all risk assets.
- There was some disagreement amongst Fed committee members on the timing of a balance sheet reduction:
FOMC: – Participants expressed a range of views about the appropriate timing of a change in reinvestment policy. Several preferred to announce a start to the process within a couple of months; in support of this approach, it was noted that the Committee’s communications had helped prepare the public for such a step. However, some others emphasized that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation. A few of these participants also suggested that a near-term change to reinvestment policy could be misinterpreted as signifying that the Committee had shifted toward a less gradual approach to overall policy normalization.
- There was also debate over whether our tight labor markets will push inflation to the Fed’s target of 2%
…several participants expressed concern that progress toward the Committee’s 2 percent longer-run inflation objective might have slowed and that the recent softness in inflation might persist. Such persistence might occur in part because upward pressure on inflation from resource utilization may be limited, as the relationship between these two variables appeared to be weaker than in previous decades. However, a couple of other participants raised the concern that a tighter relationship between inflation and resource utilization could reemerge if the unemployment rate ran significantly below its longer-run normal level, which could result in inflation running persistently above the Committee’s 2 percent objective.
- Jeffrey Gundlach says the bond wipeout is just beginning
In an email to Bloomberg, Gundlach said that 10Y yields are on course to move “toward 3%” this year. There has “been no justification for the divergent policies in the U.S. versus Europe given economic fundamentals,” he said – a point he has made previously. A 10-year yield at 3 percent would put Treasuries in “definitive” bear market territory, Gundlach added. The 10Y traded as high as 2.39% on Thursday, just 3 bps below the key retracement of 2.42%, coinciding with the May high. The yield is also just shy of the 100 DMA, whose breach could lead to more systematic and CTA selling. (…)
- Forget an IPO, Coin Offerings are new road to startup riches. Initial Coin Offerings (ICO’s), are exploding in value. This year, companies have raised more than $1 Billion through this new, unregulated fundraising method that is based in the world of cryptocurrencies.
- Fannie Mae raises the debt-to-income ratio from 45% to 50%. This has a profound impact on the amount borrowers can afford when they’re looking to buy a new home. In my opinion, having a max 50% D/I ratio when being considering affordability for a home is laughable. As a father of 3 in a 5 person household, if my mortgage was 50% of my income, there’s no way I could afford to survive. Hedgeye Risk Management summarized the move here:
Fannie Mae recently announced that it would be raising the ceiling on the back end debt-to-income (DTI) ratio from 45% to 50% on July 29, 2017. Since mortgage applicants with material student loan debt are most often rejected because their back-end DTI ratio exceeds allowable levels, this could provide a boost in home purchases by American’s with a high relative level of student loan debt.
The Federal Reserve has reported that exceeding the DTI threshold was the number one reason that mortgage applicants were denied for a loan in recent years. According to the 2015 survey, 23% of applicants saw their mortgage applications denied (conventional and nonconventional loans) because their debt-to-income ratio was above the mandated limit.
We analyzed the impact that raising the DTI to 50% would have on housing affordability and student loan capacity in our recent 3Q Housing Themes presentation. Specficially, we found that increasing the back end DTI ratio from 45% to 50% would enable a potential homebuyer to afford either a 15% more expensive house or carry a 123% high student loan burden. While a 5% DTI bump may not sound like much, enabling a borrower to shoulder more than 2x the level of student loan debt is a very material easing of the underwriting pendulum.
In a separate analysis, the Urban Institute – who does good work in housing policy research -found a similar magnitude of impact, estimating the change will allow for an annual increase of +95K in new mortgage approvals.
Someone uncovered the notes/speech from a Ben Graham lecture from 1963 which was interesting: http://jasonzweig.com/wp-content/uploads/2015/03/BG-speech-SF-1963.pdf
Charts, Charts & More Charts
US PCE inflation retreated to below 1.50% after briefly touching 2% earlier in the year. Most of that increase was due to the rebound in oil/gas prices. Now that oil has been rangebound, I don’t expect 2% inflation, barring something unexpected.
Hard and soft data (surveys vs actual data) is starting to diverge again. Will actual data catch up or are people getting ahead of themselves again?
The Fed is still waiting on wage inflation, but so far, a tight labor market isn’t yelling fueling it. In the past when unemployment was low (as well as jobless claims), wages would rise causing inflation and the Fed would have to respond by raising rates. So far, this hasn’t yet happened and many people have tried to explain the phenomenon.
PE backed companies are issuing a lot of bonds these days. Some of them are issuing bonds to pay special dividends which saddle the company with debt.
The debt maturity wall keeps getting pushed off. If markets stay accommodative, these can continue to be pushed out into the future. A lot of people worried about the debt walls in 2011/2013, but a lot of companies were able to refinance and kick the can. This creates zombie companies that ultimately die if/when they go to refi and markets have shifted.
It should be no surprise that with the stock market pushing higher (taking valuations with it), the equity/EBITDA ratios are moving higher as well.
And with all of the dry powder in buyout funds, it’s conceivable valuations continue to move up.
There’s been a lot of people worrying about subprime auto loans and comparing them to subprime mortgages from the financial crisis. While they are troubling and can have problems, it doesn’t appear to be nearly as big an issue as we saw in 2008 financial crisis. Still something to keep our eyes on though.
The S&P 500 has become more concentrated which is something I highlighted in a previous post, “Perhaps the Biggest Bubble Ever?”
Hedgeye Risk Management’s US GDP forecasts show the US accelerating and GDP surpassing 3.5% by mid 2018.
Credit Suisse projects the Treasury will run out of cash by mid-October. Another debt ceiling debate is on tap while they’re trying to address tax reform.
Because of the debt ceiling and cash running low, the short-term rate markets continue to price in the risk of a US technical default. Such a “tail-risk” event would take place in October if Congress fails to raise the debt ceiling. First time we’ve seen an inverted yield curve in many years.
There are a number of drilled, but uncompleted wells in various shale formations in the US. It’s not a stretch to think that any increase in the price of oil will cause the oil co’s to tap and increase production to take advantage of pricing.
Where is the construction boom going strong? Seattle leads the charge for the 2nd time in a row followed by Los Angeles and Chicago. Not sure if the Austin figure is accurate since I tend to see more cranes when looking out across downtown.
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