Key Points
- U.S. stocks indexes finally moved to new record highs—but not exactly in convincing fashion. The bull market continues but there are risks in the near-term that warrant a bit of caution.
- The U.S. economy continues to look solid, but there are some troublesome signals that could mean a downtick in the growth rate. The Fed is adding to uncertainty as they deal with low unemployment, modest but rising inflation, and trade issues.
- China’s decision to support its currency was a good sign, but there are still risks to the country which could impact the global economy.
“Of all the American educational system’s problems, none is more severe than the academic year beginning before Labor Day.”
- P.J. O’Rourke
Short…but only partially sweet
With the unofficial end of summer staring us in the face, we thought this week’s report would be short and to the point—so you can get out and enjoy one last weekend of fun!
The bull market continues but there are warning signs that near-term pullbacks are becoming more likely. Perhaps the most telling quote over the past couple of weeks was Target’s CEO telling CNBC that, “We’re benefitting from a very strong consumer environment—perhaps the strongest I’ve seen in my career.” While positive, it’s that sentiment that gives us pause as it’s begun to carry over into investor sentiment—and at extremes, they can be contrarian market indicators. Although U.S. stocks recently hit an all-time high, leadership groups have continued to be more defensive in nature. Telecom and health care have outperformed over the past month, while more cyclical groups like industrials, materials and energy have underperformed.
Stocks finally get to new highs
Consumer spending and confidence remain robust, but a risk to watch is the deterioration in a number of housing indicators. New home sales fell 1.7% in July to a nine-month low after a 2.4% drop in June according to the Commerce Department; while existing home sales fell 0.7% in July according to the National Association of Realtors, to the lowest rate since February 2016.
Labor looks strong…
…helping consumer confidence…
…but housing is concerning.
With stimulus from tax cuts likely to fade over the coming quarters (if only due to tougher year-over-year comparisons), investors need to be mindful of an expectations bar that gets set too high. And while good in general for the U.S. consumer, we’ve seen the stronger dollar cause some problems in a few emerging market countries that hold debt in U.S. dollars—a trend that could worsen should the dollar resume its strengthening trend.
More dollar strengthening could cause problems
Lastly, we don’t want to ignore “Dr. Copper.” Long hailed as a “tell” for world economic growth, the metal has struggled lately. There are extenuating factors which explain some of the weakness, such as the stronger dollar and supply issues, but we should not ignore the message it may be sending.
Dr. Copper sending a message?
The Unknowns—the Fed and trade
Trade rhetoric calmed down a bit recently, with the United States and Mexico announcing an agreement in principle, with Canada entering the discussion. However, recent talks with China apparently went nowhere (more on that in a moment). As such, we could continue to see rallies on positive trade developments, but also pullbacks on the opposite side. Best case scenario is that trade agreements which feature more free trade will be made; but how much pain there is between now and then remains in question.
The Fed didn’t miss out on the end-of-summer fun, with its annual Jackson Hole getaway (if you’ve never been to Jackson Hole, put it on your list). There weren’t a lot of surprises which came out of Wyoming, but the minutes from the Fed’s last meeting indicated that the September meeting is assuredly on the table for another rate hike. The futures market currently places more than 50-50 odds of another hike this year—likely in December—but the data-dependent nature of forward expectations means those odds are likely to ebb and flow. The minutes noted that it may be appropriate soon to remove the “accommodative” language from their description of monetary policy—especially given that inflation is now at or above the Fed’s target—while also noting that trade remains a paramount concern as it relates to business investment plans. That uncertainty could result in more stock market volatility as investors worry that the Fed may move too far in its normalization campaign.
Turnaround in China
As mentioned, trade talks with China last week appear to have made little progress. Yet, for investors they marked an important change, since China’s currency stabilized the day the talks were announced, after falling for months to a one-year low, as you can see in the chart below.
China’s currency decline may have halted
Source: Charles Schwab, Bloomberg data as of 8/28/2018.
China’s central bank had been pushing down the yuan versus the dollar by lowering short-term interest rates (3-month SHIBOR) by almost two percentage points over the past five months as the Fed has continued to slowly raise short-term interest rates. As the yield on cash fell in China and rose in the United States, the yuan declined and the dollar went up. The weakness in China’s currency appears to us to have spread to other emerging markets as well.
That has changed over the past two weeks as in our view Chinese officials have made it clear through statements that after returning to the lows of the past 10 years, the yuan has weakened enough and they are now seeking to stabilize its value. Taking action to support these statements, and our belief, the drop in 3-month SHIBOR has halted and has rebounded by about 0.1% since August 13, along with a modest rebound of about 2% in the yuan.
We don’t expect a sharp snapback in the yuan since there are several factors that still support the dollar; including Fed rate hikes, Turkey’s crisis, and the corporate repatriation of dollars. But China’s acceleration of yuan weakness versus the dollar seems to have abated. If the dollar’s uptrend moderates for now, currency-related emerging market stock weakness (tied to the dollar-denominated debt of emerging market companies) may subside.
Moves in the dollar often coincide with moves in emerging market relative performance
Source: Charles Schwab, Bloomberg data as of 8/28/2018.
Past performance is no guarantee of future results.
The currency move has led emerging market stock investors to breathe a sigh of relief as the MSCI Emerging Markets Index rose 5% from August 16 to 28. However, the underperformance by emerging market stocks during the past five months was not just about fallout from a trade-driven currency war; there were also some concerns about disappointing economic growth in the world’s second largest economy. While not actually weak, Chinese economic data in recent months has consistently come in below economists’ expectations as trade tensions escalated, as you can see in the chart below.
Chinese economic data has been disappointing in recent months
Source: Charles Schwab, Bloomberg data as of 8/28/2018.
The economic picture may begin to change as the weaker yuan helps to boost exports (see chart below).
A weaker Chinese currency can lead to stronger export growth
Source: Charles Schwab, Bloomberg data as of 8/28/2018.
In addition, China’s economic growth is likely to be supported by recent Chinese officials’ actions to lower interest rates, accelerate government infrastructure spending, and improve bank lending. Although some of China’s economic data may continue to disappoint, the trends in leading indicators such as the manufacturing Purchasing Managers Index, industrial electricity use, and exports from Korea to China (which includes many components for use in manufacturing) are improving.
How long will China’s stimulus efforts last? China’s government may continue to support economic growth until there is a trade agreement—which might not be until after the U.S. mid-term elections. In the meantime, China’s economic data may begin to improve in response to stimulus, easing fears of a global slowdown and the stabilization in the yuan may lend some support to emerging market stocks.
So what?
The U.S. equity bull market is intact, but recent action has not been fully-convincing, and we believe risks are rising, especially if we begin to see the same kind of frothy investor sentiment which accompanied the January highs. We continue to push the merits of tried-and-true disciplines like asset class diversification and rebalancing—the latter which forces investors to do what we all know we’re supposed to do, which is buy (or add) low and sell (or trim) high. As the old adage goes, “bulls make money, bears make money, but pigs get slaughtered.”
