October 16, 2018
The People’s Bank of China had been allowing the yuan to steadily depreciate to keep China competitive, despite three separate waves of U.S. tariffs. Naturally, a weaker yuan is inflationary for imported goods, like commodities priced in U.S. dollars, so interest rates in China began rising. However, if credit is cut off in China, its economic slowdown will accelerate, which is a threat to overall global GDP growth.
On Thursday, the Labor Department reported that the Consumer Price Index (CPI) rose 0.1% last month, which was below the economists’ consensus expectation of 0.2%. The core CPI, excluding food and energy, also rose 0.1%. In the past 12 months, the CPI and core CPI rose 2.3% and 2.2%, respectively.
President Trump has become increasingly concerned about rising interest rates, especially since inflation has not accelerated. Last Wednesday, when walking off of Air Force One, President Trump said that the Fed “has gone crazy” by continuing to raise key interest rates. Clearly, the President wants to see a higher stock market heading into the mid-term elections, so the Fed has become the President’s official whipping post for the stock market correction and higher Treasury yields. It will be interesting to see how this battle between the White House and the Fed comes out, but I suspect that Fed Chairman Jerome Powell will soon have some reassuring comments to calm down both the President and the financial markets.
Speaking of interest rates, U.S. mortgage rates are now over 5%, the highest level in almost eight years, so home price appreciation will likely stall, despite tight inventories. Existing home sales have been slowing down and higher mortgage rates are expected to further slow home sales, since it raises the cost of home affordability. As the housing market continues to cool, it will eventually impact GDP growth, but right now there is no evidence that GDP growth has been adversely impacted by slowing home sales.
Some regional Fed Presidents remain outspoken about the course of interest rates, with the hawks apparently outnumbering the more outspoken doves. Dallas Fed President Robert Kaplan, who favors three more key interest rate increases, said last week that he is hopeful that the Federal Open Market Committee (FOMC) will not invert the yield curve, since inversions are a “good forward indicator” of a recession. He elaborated by saying that “if you get in a situation where a financial intermediary cannot borrow short and lend long and make a spread because of inversion, it’s logical to me that it’s going to put strains on credit creation.” Translated from Fedspeak, that would effectively cut off access to credit.
There is a fear that higher interest rates could cause stock buy-backs to dry up, but so far there is no evidence of buy-backs slowing. According to Goldman Sachs, stock buy-backs so far this year are running a whopping 88% above the same period a year ago. Through mid-September, $762 billion in stock buy-backs have been authorized, so $1 trillion in total stock buy-backs remains possible for all of 2018.
The Market Now Turns its Attention to Earnings
The stock market is now turning its focus from recent interest rate gyrations to third-quarter earnings announcements. Fortunately, estimated earnings for the S&P 500/400/600 indices continue to steadily rise. The S&P 500 large-cap index is expected to post 21.5% annual third-quarter earnings growth, while the S&P 400 (mid-cap) index is forecasted to post 23.4% growth and the S&P 600 (small-cap) is expected to post 35.3% annual third-quarter earnings growth. In other words, as you go down the capitalization ladder, the underlying earnings environment gets stronger as the stocks get smaller.
You might find this ironic, since the mid- and small-capitalization stocks have gotten off to a rough start this October, but short sellers love to try to hit the most powerful stocks before earnings announcements begin. The strongest S&P sectors this season are expected to be Energy (+101.5%), Financials (+40.8%), Materials (+28.8%), Technology (+20.5%), Industrials (+16.9%), Communications (+14.8%), Consumer Discretionary (+12.7%) Healthcare (+10.8%), and Consumer Staples (+7.3%). Utilities (+4.8%) and Real Estate (+4.3%) are also expected to post positive results, but they are largely high-dividend value stocks.
Overall, I cannot wait for the third-quarter earnings announcement season to start, since I am expecting wave after wave of positive sales and earnings surprises, as well as positive guidance. I will be assessing how each stock reacts to their news and if some stocks do not react properly and get too volatile, I may look for good exit points. The conundrum that many stocks have is that liquidity is pulsing in and out, causing many stocks to move in a herky-jerky manner, so it is best to strive to sell some selected stocks into near-term strength. The liquidity drought that suddenly materialized in October and was exacerbated by the algorithmic selling pressure in the Russell 2000, as well as other indices, should dissipate as Wall Street refocuses on wave after wave of positive third-quarter announcements in the upcoming weeks.