Strategy I: Jazzy Opera. “Summertime” is the aria in the opera Porgy and Bess (1935) composed by George Gershwin. The song became a popular and much-recorded jazz standard, with more than 33,000 covers by groups and solo performers. During these hot summer days, I sometimes like to listen to Ella Fitzgerald sing: “Summertime, and the livin’ is easy. Fish are jumpin’, and the cotton is high. Oh, your daddy’s rich, and your ma is good-lookin’. So hush little baby, don’t you cry.”
For stock investors, the living has been relatively easy since March 2009, when this great bull market started. It would have been far easier if we all fell asleep since then and just woke up occasionally to make sure we were still getting rich. There have been plenty of reasons to wake up crying. But the bull kept singing a lullaby that hushed us all up. Now it seems that we are all getting lulled to sleep by the monotonous advance of stock prices. They just keep heading to new record highs with less and less volatility. Consider the following:
(1) Vix. The S&P 500 VIX fell to a record low 9.36 last Friday. It had spiked to 28.14 early in 2016 on fears of four Fed rate hikes that year. The Brexit scare last summer caused it to spike to 25.76.
(2) High-yield spread. The yield spread between the high-yield corporate bond composite and the US Treasury 10-year bond remains extremely low around 325bps despite the recent weakness in the price of oil. That spread widened dramatically from 253 bps on June 23, 2014 to 844 bps on February 11, 2016, when the price of oil plunged. Not surprisingly, the spread is highly correlated with the VIX. Both suggest that investors are enjoying a summertime siesta.
(3) Sentiment. So does the Investors Intelligence survey, which shows that only 16.7% of investment advisers are bearish. This series is also highly correlated with the VIX. The Bull/Bear Ratio was back above 3.00 last week.
Strategy II: Hot Towns. It certainly is summertime in DC, Baltimore, Wilmington, Philly, and NYC. I was visiting our accounts in those hot cities last week. The heat is making all of us drowsy. That’s especially since the consensus seems to be very much at ease with an economic outlook that’s bullish for stocks. It’s easier to fall asleep when one has few worries. There’s also no noise coming from the VIX to wake us up. However, I found that some accounts are concerned about the lack of volatility and the proliferation of bullish sentiment from a contrarian perspective, but they don’t seem to be losing too much sleep over it.
Almost everyone seems to share my view, which I first mentioned in early 2013, that the risk is a melt-up that might set the stage for a meltdown. A few wondered why I still viewed it as a risk rather than a reality or at least a clear and present danger. Of course, the only trouble with a melt-up is that we must be wide awake to decide when to get out of stocks. I conceded that we might very well be starting a melt-up.
The consensus scenario that seems to be lulling everyone to sleep this summer is as follows: The economy will continue to grow at a leisurely pace, with real GDP rising 2.0% and inflation remaining just below 2.0%. This is certainly not a boom, which therefore reduces the risk of a bust. No boom, no bust (NBx2)! So the economic expansion could last for a long while. Back in 2014, Debbie and I explained why it might last until March 2019. It will be the longest expansion on record if it lasts until July 2019. Everyone has plenty of explanations for why wage inflation hasn’t rebounded and might remain subdued while the unemployment rate is so low and might stay that way. The Fed should continue to raise rates, but monetary normalization will remain very gradual, and the federal funds rate might peak at only 2.00% this cycle.
I am officially dubbing this the “2-by-2-by-2” scenario, with real GDP growing 2.0%, inflation at 2.0%, and the federal funds rate at 2.00%. This is the consensus currently, in my opinion, based on my discussions with some of our accounts, most recently in the Mid-Atlantic states.
So what could go wrong? What might lead to a meltdown (either a nasty correction or a bear market) without a stage-setting melt-up first? Consider the following:
(1) Central bank balance sheets. A few accounts last week raised some concerns about the adverse consequences on the stock and bond markets if the Fed, ECB, and BOJ all were to start to reduce the sizes of their balance sheets from June’s levels of $4.4 trillion, $4.7 trillion, and $4.5 trillion, respectively. While the Fed is set to proceed, Fed officials seem to be signaling that they might slow or postpone rate hikes once they start to reduce their balance sheet. Neither the ECB nor the BOJ seem to be in any rush to halt their ultra-easy policies.
Last week, ECB President Mario Draghi expressed concern about the risk of a slowdown in bank lending and low annual CPI inflation in the Eurozone. During his 7/20 press conference, Draghi observed that inflation was 1.3% y/y in June, down from 1.4% in May, mainly due to lower energy price inflation. That’s below the ECB’s target of close to, but just below 2.0%. Measures of underlying inflation remain low, he further noted, and do not appear likely to pick up.
Answering a question about inflation expectations, Draghi explained: “[B]asically, inflation is not where we want it to be, and where it should be. We are still confident that it will gradually get there, but it isn’t there yet.” Reiterating his prepared introductory statement, he continued: “Therefore a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term.”
Draghi added: “But let me just make clear one thing: after a long time, we are finally experiencing a robust recovery, where we only have to wait for wages and prices to move towards our objective. Now, the last thing that the Governing Council may want is actually an unwanted tightening of the financing conditions that either slows down this process or may even jeopardise it.” Reading from the introductory statement again, Draghi repeated: “If the outlook becomes less favourable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.” Citing the Bank Lending Survey for Q2, however, Draghi observed that bank lending rates are currently at supportive levels, credit standards have further eased, and loan growth continues to be supported by demand.
Also last week, despite a recent slowdown in the pace of monthly purchases, the BOJ maintained its annual purchase target of “more or less the current pace” of 80 trillion yen in Japanese Government Bonds (JGBs). The bank also maintained its “QQE with YCC” policy, targeting 10-year JGB yields at around zero percent, with the short-term rate held at -0.1%. No change was made to the inflation target of 2.0%. However, the BOJ lowered its median CPI inflation forecasts last made during April as follow: to 1.1% from 1.4% for 2017, to 1.5% from 1.7% for 2018, and to 2.3% from 2.4% for 2019. Excluding the effects of the consumption tax hike, the bank expects CPI inflation to reach just under 2.0% around 2019. While the forecasted growth rates for Japan’s economy were somewhat higher than the previous ones, risks “to both economic activity and prices are skewed to the downside,” according to the BOJ’s “Outlook for Economic Activity and Prices (July 2017).”
(2) Inflation. While the major central banks are struggling to push inflation up to their 2.0% targets, I did run into one person in NYC last week who believes that both growth and inflation soon will make comebacks in the US because he is convinced that the Millennials are on the verge of getting married, having kids, and buying houses. I was skeptical, but remain open-minded about that possibility. I told him when I see it in the data, I’ll believe it.
My friend and I agreed that there are three possible scenarios. There’s the consensus sleepy, but bullish, 2-by-2-by-2 scenario. There’s my sleep-depriving melt-up scenario. There’s his sleep-jarring inflation scenario, which would force the Fed to tighten monetary policy at a more normal rate and might trigger a meltdown. My subjective probabilities on these three currently are 40%, 40%, 20%. I’m thinking about raising the odds of a melt-up above 50%, but the summer heat is slowing me down.
(3) The swamp. It’s certainly the dog days of summer in Washington, DC. President Donald Trump has called on members of Congress not to flee the city to go on their summer vacations but to stay and work until health care reform has been accomplished. It was mighty hot there last week when I stayed overnight at the Watergate Hotel, just for the fun of it. Even hotter is the political fighting between the Republicans and Democrats and infighting among the Republicans. However, the bull market couldn’t care less. There’s always the possibility of a selloff if the latest round of gridlock is so bad that another debt-ceiling deadlock could force yet another government shutdown. Then again, this bull market seems so charged up that a shutdown might be welcomed: If we can’t drain the swamp, then let’s shut it down.
Banks: Hits & Misses. High expectations and low interest rates and volatility are putting a damper on S&P 500 Financials’ Q2 earnings season. While most EPS results beat expectations, they failed to light a fire under the sector’s stock index. While it is up 29.7% y/y through Friday’s close, making it the second-best-performing S&P 500 sector over that period, over the last week the sector fell 0.3%, making it the third-worst-performing sector (Fig. 12).
Here’s the performance derby for the S&P 500 and its 11 sectors over the past week through Friday’s close: Utilities (2.6%), Tech (1.1%), Health Care (1.1), Consumer Discretionary (1.0), Telecom Services (1.0), Real Estate (0.8), Consumer Staples (0.6), S&P 500 (0.5), Materials (0.0), Financials (-0.3), Energy (-0.5), and Industrials (-1.0) (Table 1).
Despite the disappointment, forward earnings expectations for Financials remain optimistic. Analysts expect the sector’s revenues to grow 3.7% over the next 12 months, and earnings to increase by 12.3%. As a result, Financials boasts the third-highest forward earnings growth of the 11 S&P 500 sectors.
At 13.9, the industry’s forward P/E has rebounded from its recessionary lows, which will make further expansion tougher to come by. However, the sector’s stocks should climb along with earnings, bolstered by higher dividend payments, stock buybacks, and a friendlier political environment. Here’s a quick look at some of the highlights of the Q2 earnings Financials have reported so far:
(1) Flattening spreads. Hopes were high that interest rates on long-term bonds would have risen by now, giving a boost to banks’ net interest margins. However, the 10-year Treasury yield is lower today than it was in December, while short-term interest rates have continued to climb. As a result, the spread between the fed funds rate and the 10-year Treasury, which ran up to 213 bps on December 14, 2016, fell back to a low of 98 bps during June 26 of this year. The spread widened slightly in recent weeks to 111 bps.
Bank of America’s Q2 net interest income may have risen by 8.6% y/y to $11.0 billion, but it fell by $72 million from Q1. The bank warned in May that the sale of a business and the interest-rate environment would weigh on results, the 7/18 WSJ reported. Banks earnings have room to improve dramatically if long-term interest rates rise. Their best chance may come this fall if the Fed goes through with reversing quantitative easing. Wall Street remains optimistic about the S&P 500 Diversified Banks industry, penciling in forward revenue growth of 4.0% and forward earnings growth of 12.2%.
(2) Unprofitable VIX. Record-low volatility in the stock market and a sharp drop in the price of oil combined to hurt trading results for most financial players. As we mentioned above, the CBOE Volatility Index hit its lowest level since 1993 on Friday, July 14, in part because the stock market in the past year has gone only in one direction: up. The three major stock indexes in the US, Europe, and Asia have yet to pull back by 5% or more this year. “Never in at least the past 30 years have all three indexes—the S&P 500, MSCI Europe and MSCI Asia-Pacific ex-Japan—gone a calendar year without falling at some point by at least 5%,” a 7/19 WSJ article reported.
The markets took their biggest bite out of Goldman Sachs’ results; Q2 revenue in its fixed-income, currency, and commodities trading business fell 40% y/y. The declines were less dramatic at other shops, but the area was a drag nonetheless. FICC revenue fell 6% at Citigroup, 14% at Bank of America, and 4% at Morgan Stanley. Goldman still beat analysts’ estimates for the quarter, but leaned on profits from its private equity division to do so.
Wall Street’s analysts are forecasting 6.2% forward revenue growth and 14.4% forward earnings growth for the S&P 500 Investment Banking & Brokerage industry.
(3) Languishing loans. There has been some concern about slowing loan growth given that we’re in the eighth year of an economic expansion. The y/y increase in C&I loans at banks was 1.4% in mid-July, slower than the 12% increases enjoyed just two years ago. At BAC, Q2 loan growth was only 1.5% y/y, but at JPMorgan and PNC loans grew a bit faster, at 4.1%. The Pittsburgh-based bank said it expects loans to rise by a mid-single-digit rate for the full year.
Wall Street analysts are projecting some of the strongest results in the Financials sector to come from Regional Banks. Revenues is expected to grow 6.3% over the next 12 months for the S&P 500 Regional Banks industry, and earnings should jump 14.3%.
Posts by Dr. Edward Yardeni
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