Gold Rallies While U.S. Real Estate Falls

Tech Leads The Way

The table below shows the year to date performance of a few different assets. As you can see, the tech sector has done well which is consistent with their mostly great earnings reports. The sector outperforming the market during the correction is a good sign because tech needs to be the market leader. Often tech does worse during corrections because it has a high beta. When tech and consumer discretionary lead, it’s a good sign because they represent the ‘risk on’ trade. When telecom and utilities lead it’s a bad sign because those are the ‘risk off’ trade.

U.S. real estate has had a terrible year because of rising interest rates. I’m curious how housing will react to mortgage rates hitting 5%. The home ownership rate has barley improved in the past couple years and housing is expensive for many median income earners. The increase in interest rates could catalyze a decline in home values. I’m not expecting a crash like 2008, but if they fall half that amount in the midst of a recession, it could seriously hurt the consumer. Unsurprisingly, emerging markets are having a great year as their economies gain steam. Inflation linked treasuries have done much better than other bonds. If you’re looking for safety, it’s a no brainer to buy TIPS instead of regular bonds because inflation is picking up this year. Gold has done well which is expected since there was volatility in stocks and inflation picked up. That should be the perfect mix for gold.

Buybacks Stumbling

I expect buybacks to increase in 2018 because earnings are improving and firms are repatriating overseas capital. Some bearish investors thought the peak in buybacks, which occurred in 2016, was going to lead to a recession and a stock market crash. The reality is buybacks are affected by earnings changes; they don’t cause stocks to go up and down. The lack of buybacks doesn’t cause a crash.

The chart below is suspect because there’s only relevant data from the last cycle and this one. Buybacks weren’t in vogue before the 2000s. There have been a few historical charts such as jobless claims which have suggested a recession will occur soon based on the previous two cycles. Clearly, you need more data than just the past 25 years. If more relevant data was available for buybacks, you could have easily seen that there wasn’t going to be a crash in 2016. Earnings growth can stall or can even decline for a year or two without a recession.

Amazing Jobless Claims Report

To be clear, I’m saying only looking at the past 25 years of jobless claims data is a bad idea. The indicator itself is great if you’re not constantly looking for a bottom. Since there’s not much economic data to suggest the labor market will weaken, I wouldn’t go looking for a spike higher in the next few months. React to the data how it comes out. Just because the jobless claims to population to ratio is at a record low, doesn’t mean it will increase soon. The latest report forces that line of thinking into action as the claims were up 7,000 from last week to 230,000. The claims probably won’t go much lower than here, but they won’t necessarily go higher in the next few months unless there’s a negative catalyst. The best catalyst for an increase would be inflation combined with Fed rate hikes. The Fed is still relatively dovish because it has rates below the CPI. With CPI hitting 2.1%, the Fed would need to raise rates 4 times to be hawkish.

Expectations & Current Results Diverge

Thursday was a huge day for economic data. One of the reports which came out was the Empire State manufacturing report. As you can see from the chart below, the current conditions for the Empire State index fell 4.6 points to 13.1. However, the expected growth increased 1.9 points. This shows the improvements from the tax cut haven’t been experienced yet. The most important trend is inflation. The prices paid index increased 12.4 points month over month. It’s the highest print in almost six years. This matches the 10 year bond yield hitting the highest rate in 9 years and the CPI showing 2.1% inflation. The overall index makes it look like we’re about to fall into a manufacturing recession like 2015-2016, but the expectations index doesn’t confirm this.

This tells me the economy could have fallen into a weak period in 2018 if the tax cut wasn’t passed. An infrastructure plan could further boost manufacturing activity. President Trump’s plan is to boost manufacturing. It may not be great for the overall economy if manufacturing strengthens while services weaken because services is a much larger sector. As you can see from the chart below, even without the infrastructure plan, the 3 month moving average of the manufacturing capital spending outlook is at the highest level in 11 years.

Philly Fed Also Shows Increase In Expected Capex

The Philly Fed index showed the exact opposite trends in that the current index increased 3.6 points to 25.8 and the 6 month expectations index decreased 1 point to 41.2. Just like the Empire State index, the prices paid index increased a lot. It was up 12.1 points to 45. These reports signal the February CPI could be higher than last month’s 2.1%. The future expectation for the prices paid index increased 11 points to 65.2. As you can see from the chart below, the 6 month expectation for capex increased to the highest level since 1989. This latest print was up 4.2 points from last month.

Conclusion

The negative aspect of this economy is consumer spending is weak. The positive is manufacturing is strong. Inflation is picking up which is good for gold, emerging markets, and commodities. Nominal wage growth is coming, but accelerating real wage growth remains elusive. The jobless claims report shows the economy isn’t close to a recession, like some fear. I’m concerned about how housing prices will react to rising mortgage rates. It seems like a no-brainer than valuations will decline.

 

 

 

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Don Kaufman: Trade small and Live to trade another day at Theotrade.