For the first time in a decade, the mood at the World Economic Forum in Davos was of optimism and opportunity. And Trump economic policies have had a lot to do with it.
That optimism has continued to drive markets higher this year: global stocks, global interest rates, global commodities – practically everything.
The S&P 500 is up nearly 7% on the year now — just a little less than a month into the New Year. And we’ve yet to see the real impact of tax incentives hit earnings and investment.
But, with the rising price of oil (now above $65), and improving consumption (on the better outlook), we will likely start seeing the inflation numbers tick up.
Now, what will be the catalyst to cap this very sharp run higher in stocks to start the year? It will probably be the first “hotter than expected” inflation number.
That would start the speculation that the Fed might need to move rates faster, and it might speed-up the exit talks from QE in Europe and Japan.
If the inflation outlook triggers a correction (which would be healthy), that would set the table for hotter earnings and hotter economic growth (coming down the pike) to ultimately drive the remainder of stock returns for the year.
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Last week we talked about the big adjustment we should expect to come in the inflation picture. With oil above $60 and looking like much higher prices are coming, and with corporate tax cuts set to fuel the first material growth in wages we’ve seen in a long time (if not three decades), this chart (inflation expectations) should start moving higher…
And with that, market interest rates should finally make a move. As we discussed last week, we will likely have a 10-year yield with a “3” in front of it before long.
Yields have already popped nearly a quarter point since the beginning of the year. But that’s just (finally) reflecting the December Fed rate hike. What hasn’t been reflected in rates, as it has in stocks, is the different growth and wage pressure outlook this year, thanks to the tax cut. Last year, people could argue it wasn’t going to happen. This year, it’s in motion. And the impact is already showing up. We should expect it to show in the inflation data, sooner rather than later.
With that, today we’re knocking on the door of a big breakout in rates (as you can see in the chart below) — which comes in at 2.65%…
As we’ve discussed, the anchor for the benchmark U.S. 10-year yield (and for global rates), even in the face of a more optimistic global economic growth outlook, has been Japan’s unlimited QE (driven by its policy to peg its 10-year at a yield of zero). On that note, last week, the former head of the central bank in India, Raghuram Rajan (a highly respected former central banker), said he thinks both Europe and Japan will exit emergency policies sooner than people think. That’s a positive statement on the global economy and a warning that global rates should finally start moving.
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The Fed decided to hike interest rates by another quarter point yesterday. That was fully telegraphed and anticipated by markets. That’s the third rate hike this year, and the fifth in the post-crisis rate hiking cycle.
Still, the yield on the 10-year Treasury note (the benchmark market determined interest rate), moved lower today, not higher — and sits unchanged for the year.
We talked earlier in the week about the biggest central bank event of the month. It wasn’t the Fed, but it will be in Japan next week. Japan’s policy on pegging their 10-year yield at zero has been the anchor on global interest rates.
When they signal a change to that policy, that’s when rates will finally move.
With this divergence between what the Fed is doing (setting rates) and what market rates are doing (market-determined), people have become convinced that the interest rate market is foretelling a recession coming — i.e. short term rates have been rising, while longer term rates have been quiet, if not falling. For example, when the Fed made it’s first rate hike in December of 2015, the 30-year government bond yield was 3%. Today, after five rate hikes on the overnight Fed determined interest rate, the 30-year is just 2.72% (lower, not higher than when the Fed started).
This dynamic has created a flattening yield curve. That gets people’s attention, because historically, when the yield curve has inverted (short term rates rise above long term rates), recession has followed every time since 1950, with one exception in the late 60s.
And it turns out, this “flattening of the yield curve” indicator, historically (and ultimate inversion, when it happens), is typically driven by monetary policy (i.e. rate hikes — check). In these cases, the market anticipates the Fed killing growth and eventually leading rate cuts! They find more certainty and stability in owning longer term bonds (leaving short term bonds pushing those rates up and moving into long term bonds, pushing those rates down — inverting the curve).
The question, is that the case this time? Or is this time different. It’s rarely a good idea in markets to think this time is different than the past. But in this case, following trillions of dollars of central bank intervention and a near implosion in the global economy, it’s probably safe to say that this time is certainly different than past recessions. Though the Fed is in a hiking cycle, rates remain well below long term averages. And, as we know, we have unconventional monetary policies at work in other key areas of the world — stoking liquidity, growth and skewing demand for U.S. Treasuries (which suppresses those long term interest rates).
So the flattening yield curve fears are probably misplaced, especially given big fiscal stimulus is coming. And when Japan moves off of its “zero yield policy,” the U.S. yield curve may steepen more quickly than people think is possible.
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This morning we got a report that smallbusiness optimism hit the second highest level in the 44-year history of the index.
Here’s a look at that history …
optimism
Remember, last year, following the election, this index that measures the outlook from the small business community had the biggest jump since 1980 (as you can see in the chart).
Why were they so excited? For most of them, they had dealt with a decade long crisis in their business, where they had credit lines pulled, demand for their products and services were crushed, healthcare costs were up and their workforce had been slashed. If they survived that storm and were still around, any sign that there could be a radical change coming in the environment was a good sign.
A year ago, with a new administration coming in, half of the smallbusiness owners surveyed, expected the economy to improve. That was the largest agreement of that view in 15 years.
They’ve been right.
Now with an economy that will do close to 3% growth this year, still, about half of small business owners expect the economy to improve further from here.
No surprise, they are more than pleased with the tax cuts coming down the pike. They’ve seen regulatory relief over the past year. And, according the chief economist for the National Federation of Independent Businesses, small business owners see the incoming Fed Chair (Powell) as more favorable toward business (and market determined decisions) than Yellen. And he says, “as long as Congress and the President follow through on tax reform, 2018 is shaping up to be a great year for small business, workers, and the economy.”
This reflects the theme we’ve talked about all year: the importance of fiscal stimulus to bridge the gap between the weak economic recovery that the Fed has manufactured, and a robust sustainable economic recovery necessary to escape the crisis era. This small business survey tends to correlate highly with consumer confidence. Consumer confidence drives consumption. And consumption contributes about two-thirds of GDP. So, by restoring confidence, the stimulative policy actions (and the anticipation of them) has been self-reinforcing.
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We have big central bank meetings this week. Let’s talk about why it matters (or maybe doesn’t).
The Fed, of course, has been leading the way in the move away from global emergency policies.
But they’ve only been able to do so (raising rates and reducing their balance sheet) because major central banks in Europe and Japan have been there to pick up where the Fed left off, subsidizing the global economy (pumping up asset prices and pinning down market interest rates) through massive QE programs.
The QE in Japan and Europe has kept borrowing rates cheap (for consumers, corporates and sovereigns) and kept stocks moving higher (through outright purchases and through backstopping against shock risks, which makes people more confident to take risk).
But now economic conditions are improving in Europe and Japan. And we have fiscal stimulus coming in the U.S., into an economy with solid fundamentals. As we’ve discussed, this sets up for what should be an economic boom period in the U.S. And that will translate into hotter global growth. So the tide has turned.
With that, global interest rates, which have been suppressed by these QE programs, will start moving higher when we get signals from the key players, that an end of QE and zero interest rates is coming. The European Central Bank has already reduced its QE program and set an end date for next September. That makes the Bank of Japan the most important central bank in the world, right now. And that makes the meeting next week at the Bank of Japan the most important central bank event.
Let’s talk a bit more about, why?
Remember, last September, the Bank of Japan revamped it’s massive QE program which gave them the license to do unlimited QE. They announced that they would peg the Japanese 10-year government bond yield at ZERO.
At that time, rates were deeply into negative territory. In that respect, it was actually a removal (a tightening) of monetary stimulus in the near term — the opposite of what the market was hoping for, though few seemed to understand the concept. But the BOJ saw what was coming.
This move gave the BOJ the ability to do unlimited QE, to keep stimulating the economy, even as growth and inflation started moving well in their direction.
Shortly thereafter, the Trump effect sent U.S. yields on a tear higher. That move pulled global interest rates higher too, including Japanese rates. The Japanese 10-year yield above zero, and that triggered the BOJ to become a buyer of as many Japanese Government Bonds as necessary, to push yields back down to zero. As growth and the outlook in Japan and globally have improved, and as the Fed has continued tightening, the upward pressure on rates has continued, which has continued to trigger more and more QE from the BOJ – which only reinforces growth and the outlook.
So we have the BOJ to thank, in a pretty large part, for the sustained improvement in the global economy over the past year.
As for global rates: As long as this policy at the BOJ appears to have no end, we should expect U.S. yields to remain low, despite what the Fed is doing. But when the BOJ signals it may be time to think about the exit doors, global rates will probably take off. We’ll probably see a 10-year yield in the mid three percent area, rather than the low twos. That will likely mean mortgage rates back well above 5%, car loans several percentage points higher, credit card rates higher, etc.
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We had a jobs report this past Friday. The unemployment rate is at 4.1%. We’re adding about 172k jobs a month on average, over the past twelve months. These are great looking numbers (and have been for quite some time). Yet employees, broadly speaking, still haven’t been able to command higher wages. Wage growth continues to be on the soft side.
With little leverage in the job market, consumers tend not to chase prices in goods and services higher — and they tend not to take much risk. This tells you something about the health of the job market (beneath the headline numbers) and about the robustness of the economy. And this lack of wage growth plays into the weak inflation surprise that has perplexed the Fed. And the weak growth that has perplexed all policy makers (post-crisis). That’s why fiscal stimulus is needed!
And this could all change with the impending corporate tax cut. The biggest winners in a corporate tax cut are workers. The Tax Foundation thinks a cut in the corporate tax rate would double the current annual change in wages.
As I’ve said, I think we’re in the cusp of an economic boom period — one that we’ve desperately needed, following a decade of global deleveraging. And today is the first time I’ve heard the talking heads in the financial media discuss this possibility — that we may be entering an economic boom.
Now, we’ve talked quite a bit about the run in the big tech giants through the post-crisis era — driven by a formula of favor from the Obama administration, which included regulatory advantages and outright government funding (in the case of Tesla). And we’ve talked about the risk that this run could be coming to an end, courtesy of tighter regulation.
Uber has already run into bans in key markets. We’ve had the repeal of “net neutrality” which may ultimate lead big platforms like Google, Twitter, Facebook and Uber, to transparency of their practices and accountability for the actions of its users (that would be a game changer). And we now know that Trump is considering that Amazon might be a monopoly and harmful to the economy.
With this in mind, and with fiscal stimulus in store for next year, 2018 may be the year of the bounce back in the industries that have been crushed by the “winner takes all” platform that these internet giants have benefited from over the past decade.
That’s probably not great for the FAANG stocks, but very good for beaten down survivors in retail, energy, media (to name a few).
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With all that’s going on in the world, the biggest news of the day has been Bitcoin.
People love to watch bubbles build. And then the emotion of “fear of missing out” kicks in. And this appears to be one.
Bitcoin traded above $16,000 this morning. In one “market” it traded above $18,000 (which simply means some poor soul was shown a price 11% above the real market and paid it).
As we’ve discussed, there is no way to value bitcoin. There is no intrinsic value. To this point, it has been bought by people purely on the expectation that someone will pay them more for it, at some point. So it’s speculation on human psychology.
Let’s take a look at what some of the most sophisticated and successful investors of our time think about it…
Billionaire Carl Icahn, the legendary activist investor that has the longest and best track record in the world (yes, better than Warren Buffett): “I don’t understand it… If you read history books about all of these bubbles…this is what this is.”
Billionaire Warren Buffett, the best value investor of all-time: “Stay away from it. It’s a mirage… the idea that it has some huge intrinsic value is a joke. It’s a way of transmitting money.”
Billionaire Jamie Dimon, head of one of the biggest global money center banks in the world: “It’s not a real thing. It’s a fraud.”
Billionaire Ray Dalio, founder of one of the biggest hedge funds in the world: “Bitcoin is a bubble… It’s speculative people, thinking they can sell it at a higher price…and so, it’s a bubble.”
Billionaire investor Leon Cooperman: “I have no money in bitcoin. There’s euphoria in bitcoin.”
Billionaire distressed debt and special situations investor, Marc Lasry: “I should have bought bitcoin when it was $300. I don’t understand it. It might make sense to try to participate in it, but I can’t give you any analysis as to why it makes sense or not. I think it’s real, as it coming into the mainstream.”
Billionaire hedge funder Ken Griffin: “It’s not the future of currency. I wouldn’t call it a fraud either. Bitcoin has many of the elements of the Tulip bulb mania.”
Now, these are all Wall Streeters. And they haven’t participated. But this all started as another disruptive technology venture. So what do billionaire tech investors think about it…
Billionaire Jerry Yang, founder of Yahoo: “Bitcoin as a digital currency is not quite there yet. I personally am a believer that digital currency can play a role in our society, but for now it seems to be driven by the hype of investing and getting a return, as opposed to transactions.”
Mark Cuban: He first called it a “bubble.” He now is invested in a cryptocurrency hedge fund but calls it a “Hail Mary.”
Michael Novagratz, former Wall Streeter and hedge fund manager. He once was a billionaire and may be again at this point, thanks to bitcoin: “The whole market cap of all of the cryptocurrencies is $300 billion. That’s nothing. This is global. I have a sense this can go a lot further.” He equates it to an alternative to, or replacement for, the value of holding gold – which is an $8 trillion market… “over the medium term, this thing is going to go a lot higher.” But he acknowledges it shouldn’t be more than 1% to 3% of an average persons net worth.
Now with all of this in mind, billionaire Thomas Peterffy, one of the richest men in the country and founder of the largest electronic broker in the U.S., Interactive Brokers, has warned against creating exchange traded contracts on bitcoin. He says a large move in the price could destabilize the clearing organizations (the big futures exchanges) which could destabilize the real economy.
With that, futures launch on Bitcoin on Sunday at the Chicago Mercantile Exchange. This is about to get very interesting.
It’s hard to predict the catalyst that might prick a market bubble. And there always tends to be an interconnectedness across the economy to bubbles, that aren’t clear before it’s pricked (i.e. some sort of domino effect).
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With the potential government shutdown looming, let’s look at some perspective on government debt.
As we discussed early in the week, the policy execution pendulum for the Trump administration has swung over the past four months, from winless to potentially two big wins by the year end.
As I’ve said, with a massive corporate tax cut coming and big incentives for companies to build, invest and bring money back home (from overseas), we should be entering an economic boom period — one we have desperately needed, post-recession, but haven’t gotten.
Still, there are people that hate the tax cut idea. They think the economy is fine shape. And that debt is the problem. The Joint Committee on Taxation is the go to study for those that oppose the tax cuts. The study shows not a lot of growth, and disputes the case that the tax cuts will pay for themselves through growth.
What the headlines that cite this study don’t say, is that the study has huge assumptions that drive their conclusions. Among them, that creating incentives to repatriate $3 trillion in offshore corporate money will only contribute about a fifth of the taxable value of that amount of money. And they assume that the Fed will hike rates at a pace to precisely nullify any gains in economic activity (which wouldn’t be smart, unless they want to go revisit another decade of QE).
Now, with this study in mind, people are fearing the debt implications, on what is already a large debt load. And they fear that global investors might start dumping our Treasuries, as a result.
This has been a misguided fear throughout much of the post-financial crisis environment. Conversely, international investors have flocked into our Treasuries (lending us money), as the safest parking place for their capital. Why?
For perspective on the debt load and the fiscal stimulus decision, as we discussed earlier this week: “The national debt is a big number. But so is the size of our economy – about $19 trillion. Sovereign debt isn’t about the absolute number. It’s about the size of debt relative to the size of the economy. With that, it’s about our ability to service that debt at sustainable interest rates. The choice of austerity in this environment, where the economy is fragile and growth has been sluggish for the better part of ten years, would send the U.S. economy back into recession (as it did in Europe). And the outlook for re-emerging would be grim. That would make our debt/gdp far inferior to current levels — and our ability to service the debt, far inferior.”
Add to this, the increase in sovereign debt relative to GDP, has been a global phenomenon, following the financial crisis. Much of it has to do with the contraction in growth and the subsequent sluggish growth throughout the recovery (i.e. the GDP side of the ratio hasn’t been carrying it’s weight).
You can see in the chart above, the increasing debt situation isn’t specific to the U.S.
The euro zone tried the path of austerity back in 2011, and quickly found themselves back in recession, only re-emerging by promising to backstop the failing countries in the monetary union, and launching a massive QE program.
What about the government shutdown threats? Would it derail stocks? Stocks went up about 2% the last time the government shutdown in 2013. Before that was 1995-96 (stocks were flat) – and 1990 (stocks were flat).
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As we continue to creep toward the December 13th Fed meeting, the Fed funds futures are pricing in a 90% chance the Fed will hike by another quarter point.
And now we have a big tax cut package coming. Stocks are up big for the year. Industrial metals are up big for the year. But the benchmark 10 year treasury remains flat.
This has been great news for borrowers. It’s kept the housing market on it’s hot trajectory. It’s kept auto demand going. But the flattening yield curve sends a cautionary message to markets. For those that have been nervous about valuations and the “what could go wrong” scenarios, they lean on the yield curve to support their view, assuming it may be indicating an ultimate inversion (and therefore, recession).
But if we look across the behavior in yields in Europe and the policy actions in Japan, it looks more like a global bpmd market that is being anchored by Japan’s explicit policy to keep the the Japanese 10 year yield at zero.
But in this environment, things can change with the utterance of a few words. And this dislocation in the interest rate market can change quickly — yields can move very aggressively. We’ve already seen this whipsaw, this year…
Yields bounced off of the bottom nearly a quarter of a point in five days.
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It looks like we’ll get tax cuts approved before year end! And that will give us two of the four pillars of Trumponomics underway in the first year of the new administration.
What a difference four months makes.
Remember, we entered the year with prospects of a big corporate tax cut, a huge infrastructure spend, deregulation and incentives to bring trillions of U.S. corporate money home.
By this summer, the ability to execute on these policies, given the political gridlock and mudslinging, was beginning to look questionable.
The game changer was the hurricanes.
In my note on August 29th, I said: “I think it’s fair to say the optimism toward the President, the administration and Washington policy making has been waning with the lack of policy execution. And from the optics of it all, sentiment couldn’t go much lower. But in markets, turning points (bottoms and tops) in the prevailing trend are often triggered by a catalyst (big trend changes, by some sort of intervention).
With that, the hurricane will likely have little negative impact on overall growth, but it may do something positive for policy making (maybe a turning point).
Given the mess of the political landscape, and an economy that remains vulnerable and in need of fiscal stimulus and structural reform, the crisis in Texas might serve as a needed catalyst: 1) to offer an opportunity for Trump to show leadership in a time of crisis, an opportunity to earn support and approval, and 2) to engage support for rebuilding, not just in Texas but throughout the U.S. (i.e. the much needed economic catalyst of infrastructure spend)…
National crises tend to be unifying. And in the face of national crisis, the barriers to get government spending going get broken down.
So, as we discussed last week, it may be the hurricanes that become the excuse for lawmakers to stamp more spending projects which can ultimately become that big infrastructure spend. And the easing of social tensions and political gridlock on policy making would all be highly positive for the global economic outlook.”
Of course that was followed by the big hurricane in Florida, and then in Puerto Rico. All told, the damages are north of $250 billion.
Congress has approved, to this point, about $60 billion in aid for hurricanes and wildfires (as far as I can track). And that number will likely go much higher — well into nine figure territory (probably more like a quarter of a trillion dollars). For Katrina, the ultimate federal aid disbursed was $120 billion.
On that momentum the first tranche of aid passed back in September, Trump went right to tax cuts. Three months later, and tax cuts are coming.
So, quickly, the policy execution pendulum has swung. This should pop growth nicely next year (and in Q4), which we desperately need to break out of the post-crisis rut of weak demand, slow growth and low inflation.
What about the $20 trillion debt load the media loves to talk about? It’s a big number. So is the size of our economy – about $19 trillion. Sovereign debt isn’t about the absolute number. It’s about the size of debt relative to the size of the economy. With that, it’s about our ability to service that debt at sustainable interest rates. The choice of austerity in this environment, where the economy is fragile and growth has been sluggish for the better part of ten years, would send the U.S. economy back into recession (as it did in Europe). And the outlook for re-emerging would be grim. That would make our debt/gdp far inferior to current levels — and our ability to service the debt, far inferior.
On the other hand, with fiscal stimulus underway, don’t underestimate the value of confidence in the outlook (“animal spirits) to drive economic growth higher than the number crunchers in Washington can imagine (the same one’s that couldn’t project the credit bubble, and didn’t project the sluggish 10 years that have followed).
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