Uncertainty Can Be Bullish

Uncertainty Can Be Bullish
Tuesday, July 5, 2016
See the pdf and the collection of the individual charts linked below.(1) Trennert, Straszheim, Rothman, Laffer, Greenberg, and me. (2) Laffer curves election outcome toward Trump landslide. (3) Reagan, like Trump, also was despised by Republican establishment. (4) Talking about a melt-up on a down elevator. (5) Is the Brexit panic over already? If so, why? (6) Melt-up in bonds and interest-rate-sensitive stocks. (7) Brexit uncertainty begets certainty about central bankers’ reaction. (8) Carney is promising rate cuts this summer. (9) ECB can’t find enough bonds to buy and can’t get inflation going. (10) BOJ has the same no-show problem with inflation as ECB. (11) Yellen will have some things to talk about at Jackson Hole in late August.

Scuttlebutt: Laffer’s Curve. Last week, I spoke at an investment conference hosted by one of our accounts in Ohio. Among the other speakers were Jason Trennert (the chief investment strategist at Strategas), Don Straszheim (the “China guy” at ISI), Michael Rothman (a top-rated energy industry analyst), and Art Laffer (the “father” of supply-side economics).

Of course, Laffer will forever be associated with his Laffer Curve, which he sketched on a napkin at a meeting with Ford administration officials Dick Cheney and Donald Rumsfeld in 1974. It is typically represented as a graph that starts at a 0% tax rate with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. Laffer argued that if the tax rate is too high, it will weigh on economic growth and depress tax revenues. He long has advocated low tax rates as the best supply-side means to stimulate growth. He generally has disparaged demand-side fiscal policies aimed at stimulating the economy.

Laffer was the dinner speaker at the conference a week ago. He predicted that Donald Trump will win the White House in a landslide. He noted that when Ronald Reagan ran for President, he also was spurned by his own Republican party establishment because he was an outsider in many ways, like Trump. Art noted that in recent elections, Republicans have captured majorities in Congress and state legislatures and represent the majority of governors as well.

Art is convinced that Trump will lower tax rates for individuals and for corporations. Promoting his supply-side paradigm, he said, “If you take money away from rich people to give to poor people, you’ll get fewer rich people and more poor ones.” He acknowledged that he isn’t happy with Trump’s anti-trade rhetoric, but believes that Trump really doesn’t mean it. He reckons that if Trump wins, he will appoint at least one conservative judge, who will swing the Supreme Court more toward Republican orthodoxy.

Jason thinks that stock prices can continue to rise. His mantra has been “TINA: There is no alternative” to stocks. Don thinks that China’s economy is actually growing at only a 4% rate, not 6%-7% as officially proclaimed by the government. Mike expects that the plunge in the oil rig count will cause US production to plummet soon and that oil prices could go higher. He is very worried about the stability of Saudi Arabia and says that some of the wealthier Saudis are moving their families abroad.

Back in NYC last Thursday, I had lunch with the president of a major bank in the Rainbow Grill at the top of Rockefeller Center. He is very concerned about the flattening of the yield curve. However, his bank has a large portfolio of bonds that have appreciated nicely and boosted the bank’s profits. He wasn’t happy to hear my forecast that the yield curve could stay this flat for a long time. He told me that in his bank’s wealth management department their European accounts are buying US bonds because the yield is higher here than over there.

After lunch, I took an elevator down with two gentlemen who started talking about the stock market, agreeing that it had to go down. I butted into their conversation and said that it could actually melt up because the 10-year Treasury bond yield was down below 1.50%. The older gentleman said that Brexit surely must be bearish. I said that the two-day Brexit panic attack was probably already over because the Fed is likely to keep interest rates lower for longer. When the doors opened on the ground floor, I shook his hand and introduced myself. He did likewise, saying that he is Hank Greenberg. But I guessed that when I got on at the 65th floor.

Brexit: Uncertainty & Certainty. The two-day Brexit panic selloff in global stock markets–following the UK vote to exit the EU on Thursday, June 23–was widely attributed to the resulting uncertainty about the future not only of the UK but also the entire European Union, as well as the Eurozone. So why did stock markets recover so smartly from Tuesday through Friday of last week?

Here is the performance derby of the major MSCI stock market indexes (in local currencies) during the two-day panic and their subsequent relief rallies during the last four days of last week: EMU (-10.8%, 6.9%), Japan (-6.0, 2.3), UK (-5.6, 10.0), All Country World (-5.6, 5.1), US (-5.4, 5.1), and Emerging Markets (-3.3, 3.6).

Here is the performance derby ytd of these MSCI indexes (in local currencies): UK (5.4%), US MSCI (2.7), Emerging Markets (2.6), All Country World (-1.1), EMU (-10.4), and Japan (-19.8). The major European markets are all still down for the year with the exception of the UK, which is up so far (Fig. 1 and Fig. 2).

The rebound in the S&P 500 has been extraordinary (Fig. 3). It was down 2.1% ytd at the end of last Monday. Now it is up 2.9% ytd and only 1.3% below its record high of last year. The rebounds in the cyclical sectors of the S&P 500 have been just as impressive, while the Consumer Staples, Telecom Services, and Utilities sectors went vertical late last week to all-time record highs (Fig. 4 and Fig. 5). These three interest-rate-sensitive sectors now sport forward P/Es of 20.6, 14.1, and 17.9, respectively. The forward P/E of the S&P 500 is back up to 16.6 from the recent low of 15.8 last Monday (Fig. 6). Our 30%-probability Melt-Up scenario may be underway, led by the interest-rate-sensitive sectors.

Here is the performance derby for the 10 S&P 500 sectors for the two-day panic and the four-day relief rally: Financials (-8.0%, 5.9%), Materials (-7.6, 4.1), IT (-6.5, 5.0), Industrials (-6.2, 5.9), Energy (-6.0, 6.1), Consumer Discretionary (-5.4, 5.3), Health Care (-4.2, 5.5), Consumer Staples (-2.2, 3.7), Telecom Services (-0.3, 3.5), and Utilities (1.4%, 2.8%).

The vote certainly has increased uncertainty about the UK. Will Scotland now vote to leave the UK? Who will replace Prime Minister David Cameron? Boris Johnson dropped out of the race last week. The two leading challengers for the leadership spot both have said that they are in no rush to trigger Article 50 of the EU treaty to begin divorce proceedings, which could take years in any event. On the Continent, will there be Frexit, Itexit, or Nexit referendums? What will be the economic fallout for the UK, the EU, and the rest of the world? Is populism a serious threat to Globalization, which has been bullish for stocks and bonds?

All this uncertainty seems to have increased the certainty that the BOE, ECB, and the BOJ will provide still more monetary stimulus. Even the Fed is more likely to postpone normalizing monetary policy, with one-and-done still possible this year but none-and-done now looking more likely after the Brexit vote.

That certainly would explain why the US 10-year Treasury bond yield has dropped to a record low in recent days (Fig. 7). The yield curve, as measured by the spread between the 10-year and two-year yields, is the flattest it has been since November 28, 2007 (Fig. 8). Now consider the following central-bank-related certainties:

(1) Carney says BOE will cuts rates this summer. In a televised address last Thursday, BOE Governor Mark Carney said, “It now seems plausible that uncertainty could remain elevated for some time. … [T]he economic outlook has deteriorated and some monetary policy easing will likely be needed over the summer.”

He said the bank won’t hesitate to act to safeguard the economy and the resilience of the financial system. The BOE also will continue its liquidity auctions for banks on a weekly, rather than monthly, basis and consider a “host of other measures.” The pound slumped as investors increased bets on a rate cut by August (Fig. 9). Of course, the 10.3% plunge in the pound since June 23 is very stimulative and is why UK stocks are up for the year.

(2) ECB is running out of bonds to buy. A 6/30 Bloomberg article reported: “The European Central Bank is considering loosening the rules for its bond purchases to ensure enough debt is available to buy in the aftermath of the Brexit vote … Policy makers are concerned that the pool of securities eligible for quantitative easing has shrunk after investors piled into the region’s safest assets and pushed down yields on some sovereign debt too far to meet current criteria … Some Governing Council members now favor changing the allocation of bond purchases away from the size of a nation’s economy toward one more in line with outstanding debt …”

Meanwhile, the ECB still has an inflation problem: The annual rate of inflation in the 19 countries that use the euro rose to 0.1% in June from below zero, according to the flash estimate, still far short of the official 2% target (Fig. 10).

(3) Inflation continues to elude BOJ. The Bank of Japan also has an inflation problem. Data released Friday showed that the central bank’s 2% inflation goal has become increasingly elusive. Core consumer prices, which exclude fresh food, fell 0.4% from a year earlier in May (Fig. 11). It was the biggest drop since April 2013, when the BOJ under Gov. Haruhiko Kuroda kicked off a large program of monetary easing.

According to another release Friday, household spending fell for the third month in a row in May. Meanwhile, a BOJ business survey showed sentiment at big manufacturers was unchanged, but Japanese bank sentiment hit its lowest point in three and a half years.

(4) Fed studying Brexit’s impact. In a 3/29 speech titled “The Outlook, Uncertainty, and Monetary Policy,” Fed Chair Janet Yellen said that “global developments pose ongoing risks.” She mentioned China and the price of oil. She did not mention the Brexit vote. She did note this uncertainty and risk in a 6/6 speech: “One development that could shift investor sentiment is the upcoming referendum in the United Kingdom. A U.K. vote to exit the European Union could have significant economic repercussions.” She has yet to comment on the result.

However, Fed Vice Chairman Stanley Fischer told CNBC on Friday: “As we consider the effects of Brexit, we have to put that effect on the U.S. together with what else is going on in the U.S. economy. And probably the other things … going on [are] more important for the U.S. outlook … than Brexit all by itself.” Asked about the fact that markets aren’t predicting any more Fed interest rate increases this year, Mr. Fischer said, “We’ll have to wait and see how things turn out.” He implied that the Fed will know more by its July 26-27 meeting about the implications of the Brexit vote for the US economy, and said those effects will be weighed against positive incoming US economic data.

He can take some comfort from the strength in the US M-PMI last month, though it wasn’t confirmed by the regional business surveys conducted by five Fed districts (Fig. 12). In any event, given her dovish leanings, Yellen is likely to welcome the uncertainty created by Brexit as an opportunity to postpone the next rate hike. She may wait until her speech at Jackson Hole on August 26 to share her thoughts with us.