Larry Kudlow was appointed by President Trump as Director of the National Economic Council, replacing the widely respected Gary Cohn. Kudlow, a former Federal Reserve and Wall Street economist and most recently a television host on financial news network CNBC, has raised some eyebrows with his comments regarding his support for a strong dollar. The dollar has been in a downward trend against a basket of major currencies since the beginning of 2017, although it has strengthened modestly over the past month or so. Weakness may have been more related to economic repair or the regaining of lost ground for the rest of the world versus the US. We view that as positive for the global economy and not necessarily a bad thing for the US. Corporate US fundamentals – most notably earnings growth – are robust and should support securities prices going forward. But, a stronger dollar could place downward pressure on earnings and serve as a headwind.
Every cycle is a bit unique, but usually small- and mid-size companies underperform in the late stages of market cycles and ultimately contract more than their large-cap counterparts as markets correct. There is much concern that this cycle is in an advanced state and a consolidation or correction phase is upon us. What we find interesting is that small cap US stocks are rebounding and approaching all-time highs. We view this as an important development if the trend continues, especially with the heightened volatility of late. We also note that it appears that small- and mid-cap stocks have contracted less over the past week or so than large-caps on days when the major indices are negative. If these key segments of the stock market can surpass levels reached earlier in the year, that would mark obvious positive milestones and could lead the overall market higher still. Fundamentals dominate our analysis, but these technical factors are worthy of our attention as well.
Here is something on which the Partners at WCM do not agree. We have a diversity of views as to the merits of punitive tariffs and the possibility of a trade conflict if not a full-on trade war. There is an extraordinary amount of complexity in the system, and as a consequence no clear, straight line of causality. Raising steel and aluminum tariffs could help to revitalize US industry and jobs, or it could raise input costs for infrastructure companies, auto and plane manufacturers, commercial builders, etc. Those tariffs could spark domestic activity, or it could kill jobs and mute the stimulative effects of the recently legislated tax cuts. Our disagreement is fine. That reflects the realities of the country and the economy, and therefore the markets in which we operate. Economists, analysts, academics, business leaders, pundits, policymakers, politicians, and the press all have hot takes on what this does and could mean, but nobody knows, including us.
Equities in the Eurozone have had difficulty keeping pace with their global peers. There have been many encouraging signs on the economic front within the common currency zone, stock market valuation measures remain attractive compared to peers, and the interest rate outlook remains stable, yet regional shares continue to lag. One reason may be that consensus earnings expectations were inflated and are now being adjusted lower. (Chart courtesy of and copyright Bloomberg Finance LP 2018)
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We have been looking at the charts, very much the heart of our process, and are a bit puzzled by Europe. Many of the fundamentals that we have discussed in our blogs, monthly and portfolio updates have been pointing to favorable market conditions for equities and a lid on rates thanks to ECB policy. But the charts – oh the charts. If we take currency out of the equation the market’s performance has been, to be kind, lackluster. Our question – what is holding it back?
Stock markets around the world have been gyrating in response to higher interest rates – particularly in the United States. Long-term US Government bond yields have increased significantly over the course of the past year and a half. Yields on the 10 and 30 year US Treasuries have recently reached levels that some market participants believe may become headwinds for equities. While recent advances have been steep, interest rates are still well below what would be considered “normal levels” which would imply more volatility in corporate securities markets across the globe.
US stocks have regained their footing relative to US fixed income and have resumed their capital market leadership. Stock prices in the US have rebounded from their February 8th low while upward trending interest rates have been an obvious headwind for bonds. The higher interest rate environment, while widely anticipated by some for several years, may be a formidable challenge for equities both here and abroad. In our view, as long as interest rates rise at a moderate pace, equities should continue to advance and the global economic expansion should remain intact.
We would point out, however, that we are in the early stages of the recovery and the market may yet shake investors’ confidence in coming sessions.
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We decided to sit this one out. The way the market just whipped around over the last few weeks with little provocation, our concern was about informationless volatility, and we did not want to jump into the fray with comments much less action without any additional insight. In our view, there was very little if any new information that came into the market to trigger the bout of vol. A lot of observers and pundits were pointing to data about jobs (or was it wage growth, or perhaps it was GDP?) that signaled the potential for inflation, and with it the specter of a Fed getting the knives out to cut back the easy money. But, at least from our perch, these new data points were not only knowable, they were known, and they were not new. Perhaps rate watchers and equity market participants were hoping if they clenched their eyes very tightly the hallmarks of an expanding economy might go away on their own.
In terms of purchasing power, there has not been real wage growth for at least a couple decades for the cherished middle class, much less their undercompensated neighbors further down the economic ladder. Even at sub-5% unemployment, the quality of jobs may be poor in terms of wages and ability to exploit workers’ educations, skills and capabilities, and many of those workers would take more hours if only they were available. Compounding that, a significant and growing portion of the workforce is self-employed, and not by choice. Many jobs that used to be salaried and permanent, including knowledge economy jobs that were supposed to be the future of employment, have become temporary 1099 gigs if they have not been shipped overseas entirely. When looking at the fundamental reality on the ground, we could not find a rational explanation for why markets choked on encouraging but fairly benign data. An overheating economy appears still far off in the future and the Fed’s path to higher rates is inexorable, yes, but also slow and deliberate.
So what happened?
The last few trading sessions in stock markets around the globe have been painful. The sell-off on Friday February 2nd was the steepest in nearly two years, only to be followed by a deeper fall Monday. The prompt for the market rout appears to be a strong jobs report in the US that included signs of increasing wage inflation. Benchmark interest rates, in turn, rose with the yield on the 10-year U.S. treasury climbing to 2.84% on Friday only to fall to 2.7% on Monday evening. The perception that interest rates may rise faster than the market expects unnerved equity investors. In our view, the US stock market is consolidating strong gains posted over the past year and its longer term trends are still upward-sloping. With economic conditions showing continued improvement and corporate earnings accelerating, equities should resume their upward trajectory after this bout of selling pressure recedes. For now, we view the stock market as experiencing a healthy, albeit harrowing, correction.
The yield on the 10 Year US Treasury bond reached 2.72% today and has climbed over 65 basis points since early September 2017. This is not wholly unexpected given the strengthening of the US and world economies that has been building over the past several quarters. What we find interesting is that global government bond spreads (the difference between yields in the US and international markets) are staying persistently high, especially in the face of a weakening US dollar. The chart below shows spreads in the US versus comparable yields in the Eurozone, the United Kingdom and Japan going back two decades. US Treasury – Japanese Government Bond (JGBs) spreads have been historically wider, notably in the 2000s, while US Treasury spreads versus the UK (Gilts) and European equivalents are near all-time highs and significantly above 1.0% which served as an upper boundary.
It appears “something has to give” – either the US dollar strengthens, rates in the US recede or yields in Europe rise, thus closing the gap with US Treasury yields. We have our doubts that European economies can absorb materially higher rates even with welcomed improving economic trends.