This past week we saw technology stocks soar in one-way trading, reminiscent of the 1998-2000 Tech Bubble. Throwing caution into the wind would be an understatement. Amazon passed $2020 per share vs. $753 in January 2017. Apple crossed above $228 (thanks Warren!) vs. $112 in January 2017. Microsoft broke above $112 vs. $60 in January 2017. In other words, after 7 years of bull market through January 2017, the giants of tech doubled again in the past 18 months. In the 18-months prior to the March 2000 Tech Bubble top, the Nasdaq Composite rose not 100% but 200%! Optimists could say that we have not reached Tech Bubble proportions. However the rally in tech stocks from early 2017 came from an already high base. Besides, it is unlikely that the current price action will play out to the same degree as the Tech Bubble. But with emotionless machines driving the market, anything is possible.
It was another light week for macro news. The week began with a tweet from Trump announcing that a new trade deal with Mexico had been reached, banal news which received credit for the rally in risk assets earlier in the week. Then trade war once again became reason for mini-profit-taking. Thursday, Trump was said to be ready to move ahead with a plan to impose new tariffs on China as soon as next week. While Chinese stocks look attractive, the negative reaction of the market kills all Chinese company stocks, and to a lesser extent, industrial and materials multinational companies (with significant exports to China). It is still a mystery why the trade war does not impact more broadly U.S. companies.
As for macroeconomic data, we learned that the Conference Board measure of consumer confidence surged to 133.4 in August from 127.9. It was the highest reading since…the backside of the Tech Bubble in November 2000! Interestingly, the European Commission Consumer Confidence index has ticked down each month in 2018 (-1.9 in August), matching the general uptrend in the S&P 500 and general downtrend in the EuroStoxx Index this year. We are not suggesting that confidence is the best timing tool, but extreme optimism tends to coincide more closely to a major market top and not a low point in asset prices. Pending home sales continue to be weak, contracting -0.7% in July vs a consensus estimate for +0.3% (more on housing below). The Fed’s preferred measure of inflation, the Personal Consumption Expenditures index (PCE), inched up to +2.3% y/y. The September Fed rate hike is pretty much assured at this point. The Fed Funds rate is rising under Jay Powell (see chart below). Quantitative tightening does not bother markets for now. Our bet is that the Fed Funds rate will not make it to 3% before markets fall out of bed. It is still an open debate where the “neutral rate” of Fed Funds is (the neutral rate is considered the rate at which monetary policy is no longer simulative for the economy, yet not a brake on economic growth – a nebulous estimation).
Finally, we note that second quarter GDP in the U.S. was revised higher to 4.2% on an annualized quarterly basis. The previous estimate was 4.1%. Not quite yet at Trump’s hoped for 6% GDP growth, but the strongest rate of growth since 2014. GDP is a rear-view mirror stat. We’ll see at the beginning of September is the PMIs confirm the strong growth into year-end.
Weakness Within The Economic Expansion
While headline GDP looks robust in the U.S., several areas of the economy are fragile. There is clearly not yet reason to sound the recession alarm based on economic date, even if a nine-year old expansion is already long by historical standards. In this Commentary, we note the macro-economic data that needs to be monitored. Economic weakness always creeps up from some sector of the economy. Here is what could put overall economic growth at risk.
The housing market drove the last economic expansion, but also became the source of its demise with the subprime contagion. While the stock market and GDP numbers say that everything is rosy, the housing market is not doing very well.
Pending home sales are contracting on a y/y basis.
Likewise existing home sales are contracting annually.
The University of Michigan Buying Conditions for Houses index has fallen to the weakest level of the expansion. People no longer need/want to buy homes at this stage.
To put the fall in home prices and the rise in stock prices on a relative basis, the chart below shows that the ratio is back to Tech Bubble highs.
Another big ticket item showing weakness is sales is automobiles.
Indeed, the consumer is showing a much reduced appetite for consumption in general. With the age of the economic expansion, and the fact that buyers with the ability to buy have, by now, purchased their big ticket items, the word “saturation” comes to mind.
We can see the diverging retail sale strength from auto sale weakness. The first step in an economic slowdown is reduced spending on big ticket items.
That evil four letter word, D-E-B-T, is also making a comeback. Rising debt levels at the end of an economic expansion (no worries about paying off credit card debt, etc) are also often a sign of risk to the expansion.
Credit card delinquencies outside of the 100 largest banks have surged to 6.2% in Q2, exceeding the peak of the Financial Crisis.
And it’s not just consumers hooked on debt. Outstanding debt of U.S. Non-Financial Corporations relative to GDP is at another new high. With low interest rates, it’s natural that companies leverage up. When the adults (central bank policy makers) also act like children, pandemonium reigns! Now the real risk is servicing interest rate payments on higher debt loads as interest rates rise. It may not go over well.
Perhaps the most ominous statistic is inflation. Markets believe that the Federal Reserve is willing to experiment with higher than 2% inflation. But at the same time, Powell is much more vigilant than Yellen and Bernanke on getting rates normalized. As shown above in the Fed Funds rate chart, the Fed is indeed tightening rate with inflation.
The Consumer Price Index (CPI) year-on-year change is up to +2.9%, a level last seen in 2011.
Producer prices are also at cycle highs.
Finally, as mentioned in the intro, the PCE measure is also at seven-year highs. We don’t think that the Fed, in the end, will let the inflation genie out of the bottle. If Yellen sat on her hands throughout her term as Fed chair, she could point to the absence of inflation. Powell can no longer cite inflation for Fed inaction.
In sum, we see the potential risks to the economy at this stage in housing/big-ticket consumer purchases, the frothy levels of consumer credit and corporation debt, and rising inflation that will force the Fed’s hand to keep a hawkish bias. We’ll need at least one trigger for the weakness to spill over into the entire economy and financial markets (and trade wars is not the trigger). We remain sanguine on the U.S. economy at the moment, although very much less so in U.S. equities.
Weekly Trade Recommendation
This week we put on a long position in gold (GLD). Sentiment has soured to such a point that we expect that the sharp selling between August 13-16 marked a selling capitulation. Gold just hit its lowest level since January 2017.
Looking at Commitments of Traders data (COT), gross shorts surged in August, which is typically a sign that the short side has gotten too crowded. In fact, money managers (proxy for speculators) have never been more bearish on the gold outlook since the CFTC started to publish its COT statistics in 2006.
The summer sell-off in gold had been chiefly driven by an accelerating appreciation in the dollar, which has backed off since mid-August. The risk to our gold trade here is that the dollar index has entered a new uptrend, as shown below. Gold may rally with the dollar, but it more often an exception. The 10-year correlation coefficient between the dollar index and Gold is -0.585.
Additional reasons for our gold trade include inflation and risk-hedging. As shown above, inflation is rising and precious metals are the inflation hedge par excellence as an economy tops out and begins to move towards recession (and we should not be far from this stage of the economic cycle by now). Gold is also a safe-haven asset. While we don’t think the trade war will spill-over into prolonged geopolitical strife, any market anticipation of this should drive money into safe-havens such as gold.