As we discussed last week, the G20 finance ministers and central banks met in China over the weekend. We thought the calls for more fiscal stimulus would come. Monetary policy has been stretched about as far as it can go. What’s been lacking in the global recovery is some easing on the government spending side. Instead, they’ve gotten belt tightening.
That belt tightening in Europe led to another recession, and has contributed to the global economic rut and the continued built of discontent in the European Union — all of which has threatened the global economic recovery. With that, we’ve thought that the Brexit vote may have stoked enough fear that a window may have been opened for governments to finally come in with some spending programs.
That’s exactly what was highlighted in the meetings over the weekend – calls for help from fiscal and infrastructure spending to stimulate growth.
As we know, Japan has already telegraphed a big spending program. The size of the package is now expected to be about 4% of GDP (Japanese GDP), to be approved early August. The BOJ is expected this week to spike the punch bowl again, ahead of the spending package, by changing the size of their QE program and expand the type of assets they are buying (this would equate to a QE3 in Japan).
We suspected that they may outright buy commodities when oil prices were threatening earlier in the year. Remember, it was, in fact, the BOJ’s intervention in USDJPY in February that coincided with the bottom in stocks and oil.
The chart below shows both the Nikkei and the S&P 500 performance following Japan’s QE1 and QE2.
Sources: Billionaire’s Portfolio, Reuters
As you can see in the chart, intervention in Japan has been a key driving force for stocks, not only in Japan but globally (including in U.S. stocks).
Higher stocks and a weaker yen are two huge components of the BOJ’s plan to stimulate inflation. Inflation has remained lifeless. And stocks earlier this year had completely given back the gains of Japan’s QE2. And the yen weakness has been completely reversed. Will the BOJ pull out the bazooka this week?
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Last Friday we talked about some key charts to keep an eye on this week, which included U.S. stocks, German stocks, Japanese stocks, U.S. yields and German yields.
Remember, in a world where stability is king, central bankers have been very sensitive to swings in key financial markets, with the idea that confidence and the perception of stability can become quickly become unhinged by market moves. When that happens, it becomes a big, viable threat to the global economic recovery and outlook.
So those markets we reviewed provide a good check on the market vitals at this stage. And the big disconnect between yields and stocks has been a growing concern.
On that stocks front, we had further gains this week. U.S. stocks printed new record highs again for the week. And German and Japanese stocks, finished higher for the week as well, and remain on the cusp of a big bullish breakout of the trend that describes the correction of the past year for Japanese stocks, and German stocks.
But yields have been lifeless. In the most important bond market in the world right now, the German 10-year yield remains straddling the zero line (a huge level for both fundamental and psychological reasons). And the U.S. 10-year yield has been essentially been anchored by the German bund yield.
When optimism improves, in this environment, stocks go higher and yields go higher, as global capital pulls out of the safety of government bonds in favor of higher return assets (stocks). But it’s not happening, much, at the moment. Though we should acknowledge that both the German and U.S. yields are 20 basis points higher than worst levels of just earlier this month. Still, U.S. stocks are at record highs, and most major stock markets have fully recovered the post Brexit vote declines.
So yields are an important spot to watch next week. The Bank of Japan should announce for more stimulus next week – perhaps a third round of the Abe-led QE campaign, and perhaps in coordination with fiscal stimulus that has been telegraphed by the Abe administration.
As we’ve discussed, contrary to the popular view, QE ultimately has pushed yields up, not down. Because people become more optimistic about the economic outlook.
On a final note, another key market over the past seven months has been oil. We’ve talked a lot about the importance of oil to global economic stability. At $26 oil was threatening another global financial crisis. It’s, of course, doubled since and stocks have tracked the recovery.
Source: Billionaire’s Portfolio, Reuters
But the past two weeks, oil has been moving lower as stocks have been printing new record highs. Oil closes the week still hanging around $45, but this will grow in importance, and send negative signals, if it were to continue lower from here next week — something to keep an eye on.
Have a great weekend!
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The ECB meeting came and went this morning without moving the needle in global markets. And that has left the very important German 10 year yield, as we discussed last Friday, straddling the zero line.
Next up is the Fed, on Wednesday of next week. And shortly following the Fed decision will be the biggie: The Bank of Japan.
As for the Fed, for perspective on how wild the swings in sentiment have been, just 16 days ago, the U.S. 10 year yield was trading at 1.35%, lower than the darkest days of the global financial crisis (much lower), and the darkest days of the European Debt Crisis.
Expectations on the next rate hike had been moved out, at that point, as far as 2018 in the minds of market participants – and the market began to even price in slim chances of a cut.
And as we said in our July 5 note, “the last time yields made record lows around those levels, what turned it? It was intervention – or at least the threat of intervention. It was the ECB stepping in and saying they would do ‘whatever it takes’ to save the euro.”
Not surprisingly, global yields bounced just days after the reaching new record lows, earlier this month, on news that Japan was planning on rolling out a big fiscal stimulus package (i.e. intervention).
As we said, despite all of the criticisms surrounding policymakers meddling in markets, intervention (in one shape or form) has determined many historic turning points in markets – something to keep in mind.
The market is now pricing in a little less than a coin flips chance of a hike this year from the Fed. That’s up from a 13% chance just 16 days ago.
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U.S. stocks traded to new record highs this morning.
Yesterday we talked about the trajectory of earnings surprises for the second quarter, and the big positive surprises that are being reported in the earnings of banks and financials. Morgan Stanley joined the bunch today with much better than expected numbers (beating on earnings and revenue).
But, as we said yesterday, financial stocks, broadly, still remain in the red for the year, lagging all other sectors in the S&P 500.
Here’s a look at the sector performance year to date.
If you missed the boat on the rebound in energy stocks earlier in the year, this lag in bank stocks could be the next big run.
What could be the catalyst? An improving economy and global market stability would certainly be helpful. The outlook, on that front, will most likely be driven by more intervention.
As we’ve said, next week we think the Bank of Japan will take the opportunity, in response to the Brexit uncertainty, to unleash the powerful combination of fresh fiscal stimulus and (more) monetary stimulus. And Europe would be smart to follow that lead.
The ECB meets tomorrow, but should do nothing. But Draghi may/should use his press conference platform wisely, to pressure European politicians to pursue fiscal stimulus to ward off the threats of a Brexit contagion.
And G20 finance ministers and central bankers meet this weekend in China, to set the table for the G20 Summit of global leaders later this year.
What’s a main topic due to be discussed by G20 finance ministers and central bankers? Fiscal stimulus!
Though waning, that contagion risk in Europe (i.e. threat of a European Monetary Union member leaving the EU and euro), and the crippling effect it would have to the global financial system, is what continues to weigh on bank stocks, including Germany’s biggest, Deutsche Bank.
We’ve already seen a very positive response in global markets to a telegraphed spending package in Japan. The same in Europe would go a long way toward ending the global shock risk associated with Brexit, and provide optimism about recoveries in Europe and Japan (which would be a big boon for the global economy).
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We’ve talked about the reasons markets and economies are set-up nicely for positive surprises. Surprises create changes in outlooks. And “change” is the primary catalyst that moves/reprices markets.
On that note, today we want to focus on earnings.
Last earnings season, 72% of the companies in the S&P 500 beat expectations. Still, companies dialed down expectations coming into the second quarter. Of course, then Wall Street lowers its bar. And companies are now beating estimate again.
Like it or not, that’s how Wall Street works and has always worked. FACTSET says on average (the five-year average) 67% of companies in the S&P 500 beat their analyst expectations. And they beat by an average of 4%.
That begs the question: Why aren’t analysts adjusting up their expectations on average, by 4%, given the history? As we know, better than expected earnings are fuel for stocks.
Now, in the current earnings cycle, over the past week, we’ve had 35 companies report in the S&P 500, as of the close of last week. And the positive surprises are, again, running close to 70%.
The biggest surprise has been in bank earnings. We’ve heard all of the warnings over the flattening yield curve. Historically, a flattening yield curve, is a drag on bank earnings (banks earn less on the spread between what they pay on deposits or borrowing and what they earn by lending).
But as we know, overtime, banks have become very different animals. In the 80s this spread or the “net interest margin” was king. For big banks, interest income was about 90% on their income. In the recent era, it’s about 75%. These days, what’s tipping the balance is non-interest income. And the banks seem to be finding ways to improve that number, whether it’s through costs cuts, or better trading profits.
Overall, the health of the banks is as good as it’s been in a long time. Last quarter loan balances grew at the fastest 12-month rate since 2008, the share of unprofitable banks fell to an 18-year low, and the number of ‘problem banks’ continued to decline.
Still, the S&P 500 bank index is down 5% year-to-date, underperforming the broader index by more than 10 percentage points. Financials are the only sector in the S&P 500 in the red year-to-date. If you think the worst blow to global economic sentiment might be behind us, the banks should offer some of the best upside in stocks.
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We left off last week taking a look at some key charts to watch. U.S. stocks closed just off of record highs, after printing five consecutive new record highs during the week. The last time that happened, in 1998, the S&P 500 went on to climb 50% over the next two years.
While U.S. stocks have technically broken out, both Japanese and German stocks look poised to follow. Japanese stocks were closed overnight for holiday, but open tonight positioned to break the year’s downtrend. And German stocks are quickly approaching the breakout of a declining trend too.
As we’ve discussed, stock performance in this environment is huge for preserving and/or building confidence. And the U.S. stock market is the global barometer for sentiment.
With that, if we look at the VIX (where uncertainty is most clearly expressed by market participants), that measure is looking tame — only three weeks following the big Brexit vote. And given the events in Turkey over the weekend, and the escalating global terrorism, the VIX (or the fear in markets) appears to be driven mainly, at this stage, by the prospects for financial crisis. Which is now pricing in little concern.
Sources: Billionaire’s Portfolio, Reuters
Lower fear and uncertainty doesn’t bode well for the gold rebound. You can see in the chart below, gold trades into the top of this declining trend channel. If Japanese and German stocks break out of the downtrend (i.e. bullish), gold will stay IN the downtrend (i.e. bearish).
Sources: Billionaire’s Portfolio, Reuters
The European Central Bank meets this week. Given that the UK’s central bank took a pass on more action last week, and given the ECB has already upped the ante on monetary stimulus earlier this year, we should expect Draghi and company to stand pat. But remember, the positive that may come from the Brexit vote is that it may finally get the politicians off of their hands on fiscal stimulus. It’s already brewing in Japan.
With Draghi taking the stage on Thursday for his post-meeting press conference, it would not be surprising for him to focus on the need for fiscal stimulus in Europe. Europe’s biggest threat is the anti-EU sentiment. Big spending packages in Europe could be the antidote.
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Over the past week, we’ve talked about the rational reasons to be long stocks. Today we want to walk through a few charts as we end the week.
Stocks
Stocks have set a new record high every day for the entire week. The last time that happened was in 1998. And following that period, stocks went up 50% over the next two years.
Last Friday we talked about the powerful influence of higher stocks. Central banks are well aware. As we’ve said, they want stocks higher, they need stocks higher. It’s the most effective resource they’ve had for restoring and building confidence, and promoting stability, in a low growth, vulnerable world working out of a debt crisis.
With that, we close the week near fresh record highs in U.S. This is 8% off of the bottom just three weeks ago.
Sources: Billionaire’s Portfolio, Reuters
As we came into the week, the post-Brexit laggards had been Japanese and German stocks, and yields in the government bond market.
First, as we’ve discussed this week, the week kicked off with good news out of Japan. They’ve telegraphed a big fiscal stimulus package. And with the BOJ set to meet at the end of the month, and growth and inflation in Japan recently downgraded, Japan is in the position to unleash the powerful combination of both fiscal and (more) monetary stimulus.
With that, Japanese stocks have been on a tear for the week, now 11% off of the Brexit lows. The Nikkei has now fully recovered the sharp post-Brexit declines, and looks like a technical breakout of the correction off of last year’s highs is in the making (i.e. going higher).
Sources: Billionaire’s Portfolio, Reuters
And as we’ve said, we think Europe will be next to roll out much needed fiscal stimulus.
With that, German stocks aggressively rebounded this week too, led by bank stocks, which had been trading like big bank failures were in the pipeline (namely, Deutsche Bank). But for the German, European and global economy, Deutsche Bank is too big to fail. German stocks also look like a bullish technical break is coming.
Sources: Billionaire’s Portfolio, Reuters
Yields
With all of this said, early in the week we discussed the big divergence between record high stocks and record low government bond yields (particularly in the U.S.). And yields are now bouncing…
Germany sold negative yielding 10 year government bonds this week. And now, as we end the week, the German 10 year yield has gone from -20 basis points back into positive territory. This is a big deal and a key area to watch – the zero line.
Sources: Billionaire’s Portfolio, Reuters
The U.S. 10 year traded just under 1.70% going into Brexit. After the UK vote it hit a record low at 1.32%, and goes out this week at 1.59%.
Sources: Billionaire’s Portfolio, Reuters
Remember, we talked earlier in the week about the divergence between record high stocks and record low yields. And we looked back at the performance of stocks following the sharp bounce in yields from the 2012 new record lows. In this environment, yields bounce when sentiment improves. Improved sentiment is good for stocks. In 2012, yields bounced from 1.38% to, ultimately, 3%, and stocks finished up 16% in 2012, and added another 32% in 2013.
Have a great weekend!
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Since the Brexit news in late June we’ve discussed a couple of huge implications that we’ve thought will ultimately find Brexit to be a net positive to the global economy (in fact, a big net positive).
First, central banks have had the pedal to the medal throughout the post-Lehman environment, successfully averting a total disaster and manufacturing a semblance of global economic recovery. The missing piece of the policy puzzle has been fiscal stimulus.
In a debt crisis, it’s hard to convince politicians to stick their necks out and approve spending packages when overindebtedness has taken the world to the brink of total collapse. But they’ve discovered, without growth, the debt problem doesn’t get better, it only becomes more threatening. And fiscal stimulus (to accompany the zero interest rate world) is one of the few viable solutions to end the low and stagnant growth rut the global economy has been mired in for the better part of seven years.
So with the widespread uncertainty surrounding the Brexit vote, politicians now have the ammunition/ the excuse to green light fiscal stimulus.
What’s the second “net positive?”
The Brexit fallout may finally give Japan the courage (and also the excuse) to crush the yen.
We discussed this two weeks ago, when Japanese stocks will still sitting near the “Brexit fallout” lows, and yen was strong — yet other markets (including UK stocks, U.S. stocks, oil) had already bounced and recovered.
We said: “We think they can, and will, ultimately destroy the value of the yen — mass devaluation.
Unlike the U.S., which is constrained by “flight to safety” global capital flows and a world reserve currency, Japan has the ingredients to make QE work, to promote demand, and to promote growth. Japan has the largest government debt problem in the world. They have an undervalued currency. They have a stagnating economy with big demographic challenges. They have are in a deflationary vortex.
They have the perfect attributes for a mass scale currency printing campaign. Not only can it work for their domestic economies, but it serves as the liquidity engine and stability preserver for the global economy.
In normal times, the rest of the world wouldn’t stand for a country outright devaluing their way to prosperity. But in a world where every country is in economic malaise, everyone can benefit – everyone needs it to work. It can be the solution for returning the global economy to sustainable growth. We wouldn’t be surprised to see USDJPY return to the levels of the mid-80s (versus the dollar)in the not too distant future. That would be 250+. Currently, 103 yen buys a dollar.”
On cue, this week, due to fallout from Brexit, Japan announced they will be rolling out a large spending package, after Abe’s party secured a super majority in the upper house over the weekend. The package is said to be about $200 billion dollars in fiscal stimulus this year alone, or about 4% of Japan’s GDP! This is huge news. Japanese stocks are already jumping sharply on the news and the yen has been weakening sharply.
And the Japanese government has also just dramatically downgraded both its growth and inflation projections for this year and next. That’s more ammunition for more action.
In Japan, bad news is good news for global markets, because it forces the BOJ and the Abe administration to do more. As we’ve said, we think the grand solution will be a massive devaluation of the yen.
The BOJ meets at the end of the month, and the table has been set for the most powerful response yet – a combination of fiscal and more, bolder monetary stimulus. Japan has no choice but to keep the pedal to the metal. And they have the right formula to use their currency as a tool to solve a lot of problems – both for their domestic economy and the global economy.
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Earlier this week we talked about the disconnect between yields and stocks.
The move lower in German yields, given the contagion risk in Europe that people have feared from Brexit, as we’ve discussed, has also dragged down U.S. yields. With that, the U.S. 10 year yield, post-Brexit, has traded to new record lows.
So we have record highs in U.S. stocks, and record lows in U.S. yields.
For people looking for the next reason to be worried, this is where they are hanging their hats. But is the uneasiness associated with this divergence warranted?
Let’s take a look at the chart…
Sources: Billionaire’s Portfolio, Reuters
Now, you can see from the chart, we recently breached the record lows of 2012 in U.S. yields (the green line).
For a little back-story: Back in 2012, Europe was on the verge of a sovereign debt defaults that would have blown up the euro and the European Union. The ECB stepped in and promised to do “whatever it takes” to preserve the euro, which included the threat of buying unlimited Italian and Spanish government bonds (the real threatening spot in the crisis). That sent bond market speculators, which had been running up the yields in Spanish and Italian debt to unsustainable levels, swiftly hitting the exit doors. At the height of that threat, global capital was pouring into U.S. government debt, which sent the 10 year yield to record lows. Still, U.S. stocks at the time were in solid shape, UP nearly 8% on the year in the face of record low bond yields.
What happened when the ECB stepped in and curtailed the threat? U.S. yields bounced aggressively. And U.S. stocks went even more sharply higher, finishing the year up 16%. In fact, the U.S. 10 year yield more than doubled (to as high as 3%) over the next seventeen months, and the S&P 500 added to 2012 gains, going another 32% higher in 2013.
So we have a very similar scenario now — and the drag on U.S. yields is, again, Europe and the threat to the euro and European Union.
And again, U.S. yields have hit new record lows, and stocks are putting up a solid year, as of July (the same month the tide turned in 2012).
We would argue, for the many reasons we’ve discussed in our daily notes, that stocks are in the sweet spot. As long as a global economic shock doesn’t occur, which is what central banks have proven very capable of managing over the past seven years, U.S. stocks should continue to benefit from the incentives of record low interest rates. And when market rates/yields rise, it’s only because the clouds of uncertainty clear. That’s very good for stocks too.
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As we said last week (and back in May), we think the second half of the year will be big for stocks.
Contrary to popular opinion, the world is not falling apart. In fact, the ratcheting down of expectations has set the table for positive economic surprises, which is powerful fuel for stocks.
Consider this: If you awoke today from a decade-long slumber, and we told you that unemployment was under 5%, inflation was low, gas was $2.15, mortgage rates were 3.5%, you could finance a new car for 2% and the stock market was at record highs, you would probably tell us the outlook for the economy looks really, really good.
Those are the conditions we have, yet most think the sky is falling.
As we’ve discussed, the central banks are in control, and they have been since the depths of the financial crisis. Say what you will, but they have (led by the Fed) orchestrated a global economy recovery (albeit much slower than typical post-recession recoveries) and have produced and preserved economic stability along the way. Playing a key role, in the face of intense scrutiny from the “run-away inflation” theorists, they have pinned down interest rates which have warded off a deflationary spiral and created the framework of incentives to hire, spend and invest.
With the above said, we think we could be on the precipice (if not the early stages) of an economic boom.
As for stocks, within that context, today we want to revisit some of our previous analysis on where stocks can go from here…
1) History
The long-run annualized return for the S&P 500 is 8%. If we applied that number to the pre-crisis highs from 2007 of 1,576 on the S&P 500, we get 3,150 by the end of this year. That’s 47% higher than current levels. That’s what it would take to make up for the nine years that stocks have been knocked off path — just to simply get the S&P back in line with historical norms.
2) Valuation
In addition to the above, consider this: The P/E on next year’s S&P 500 earnings estimate is just 16.9, near the long-term average (16). But we are in a very low interest rate environment. In fact, we are in the mother of all low-interest-rate environments (still near ZERO). With that, when the 10-year yield runs on the low side (it’s very low), historically, the P/E on the S&P 500 runs closer to 20, if not north of it.
If we multiply next year’s consensus earnings estimate for the S&P 500 of $126.76 by 20 (where stocks to be valued in low rate environments), we get 2,535 for the S&P 500 by next year — 18% higher.
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