This week was eventful on a couple of different fronts: Fed communications and tensions with Iran. Let’s take a quick look at each of these events individually before getting on to the real meat and potatoes (economic data and corporate earnings/guidance).
It’s not too much of a stretch to say that Fed communications were a disaster this week. On Thursday, New York Fed President John Williams said in his speech at the annual meeting of the Central Bank Research Association that “It’s better to take preventative measures than to wait for disaster to unfold.” Later that same day, Fed Vice Chair Richard Clarida said that cutting interest rates quickly is a good strategy. Between these two comments, the market ramped up expectations for a 50bp rate cut at the July meeting. How much so? As of Thursday’s Fed Funds futures close, the probability for a 50bp rate cut in July skyrocketed from 23% at the beginning of the week to 60%. According to this article, the probability was even higher on an intraday basis. After observing how markets moved, a New York Fed spokesperson clarified Williams remarks stating that his comments were “not about potential policy actions”. And with that clarification, the probability of a 50bp cut in July fell back to 24% on Friday.
As for Iran, tensions seesawed and so did oil prices. On Tuesday, oil prices dropped more than 3% after State Secretary Pompeo said that Iran was ready to negotiate about its missile program and President Trump said that he was not looking for regime change. Of note, this same news flow barely impacted gold. Oil patch fundamentals drove continued declines in oil prices during the middle of the week after data showed a build in US fuel inventories and US Gulf oil platforms returned to service post Hurricane Barry. The chart below shows the air coming out of the oil bubble this past week.
Renewed tensions at the end of the week, however, halted the decline in oil prices (see the slight rebound on Friday in the chart above) and were clearly a factor in driving gold prices higher on that same day. What happened? On Thursday, President Trump said that the US destroyed an Iranian drone. On Friday, Iran seized a British tanker in the Strait of Hormuz and allowed a second one to proceed after issuing a warning. If you are interested in examining the recent timeline of tensions with Iran in further detail and the impact on oil prices, have a look at last week’s report.
So now let’s get to the main course and where I stand in terms of an outlook. First, recent economic data, on balance, has been better than expected. This has stabilized the Q2 Atlanta Fed GDPNow real GDP estimate which stands at 1.6% as of July 17th. Keep in mind that the chart below is really one based on real-time data as opposed to a forward projection.
Second, corporate earnings (another real-time performance measure) continue to meet or exceed current expectations. Coming into this week, 24 companies out of the S&P 500 had reported and the aggregate expectation was for Q2 earnings to decline 3.0% on 3.7% revenue growth. As of today, 81 companies or 16% of the index have reported and the blended earnings decline now stands at 1.9% on a 3.8% increase in revenues. Putting two and two together, you can infer that profit margins are expected to shrink on a year over year basis but that this dynamic has been effectively baked into analyst estimates.
What about guidance? Again, as of today, 11 companies have issued negative EPS guidance and 5 have issued positive EPS guidance in conjunction with their earnings release. Per Factset, and using a 5 year average, the percentage of companies issuing negative EPS guidance is lower than normal. So that sounds good, right? Well it is good for near-term market stability but I would caveat that by saying that expectations are muted for Q3 and the bar starts to get significantly higher as we enter 2020 (see below). Also, it is still relatively early in the earnings season.
|Analyst expectations per FactSet|
As I see it, the biggest positive in all of this is that revenues continue to grow and that participants seem to be willing to look through margin pressures so long as that continues to be the case. Last week, I said that in order for a recession to be in play, guidance would have to indicate the potential for a decline in revenues. Given all of the data above, we just aren’t seeing that yet.
So how does all of this impact the outlook at the end of the day? I still believe that these new market highs provide a good opportunity to rotate more defensively. But this is not a rush to the exits – recent incoming data advocates for selectivity and patience. I’ve been using the below chart on yield curve inversions from this MarketWatch article as a guideline to try and anticipate when the markets may peak while monitoring incoming data to determine whether or not this cycle will fall above or below the median.
For the record, the US Treasury 10-year – 2-year yield spread HAS NOT inverted this cycle. However, the 10-year – 3-month yield spread HAS and it first inverted on 3/22/19. This does not adjust for QE/QT, Morgan Stanley’s preferred approach, which I discussed in the June 2nd market report and argues that the 10-year – 3-month inversion took place in November 2018 (no specific date given). While admittedly a bit of apples and oranges, using the median number of months until market peak of 19 from the chart above would place the next market top in October 2020 (June 2020 if using the adjusted Morgan Stanley inversion date). Using the median SPX gain of 21% against an index level of 2,800 on the unadjusted inversion date would generate an S&P target of 3,388. Please note, however, the wide disparity in data at arriving at those median levels and that I am applying 10-year, 2-year inversion experience to the current 10-year, 3-month inversion. That is why monitoring the incoming data is so critical.
Let’s end the lead-in with a bit about gold. Clearly gold is benefitting from geopolitical tensions and there is a premium for this built into the price. Any material reduction in those tensions should be a headwind – just look at what happened to oil this week. With expectations of Fed dovishness dialed way up again (back to a greater than 60% chance of 3 rate cuts by December), near-term support for gold (or lack thereof) will likely hinge on the direction of those tensions. Considering the significant easing built into expectations, it would seem to me that gold prices are increasingly dependent on these tensions and therefore, poor economic data and/or corporate earnings announcements are needed to sustain additional gold investment returns. On an intermediate term basis, a potential business downcycle in the offing would provide those catalysts and be supportive of another leg up for the yellow metal.
What’s your view on the gold money relationship and how gold as an investment will perform? Here’s the rest of the groundwork to help you form your own opinion.
The S&P 500 experienced a choppy week and ultimately finished down 1.2% to close at 2,976.61. In the process, we temporarily lost the magic 3,000 level, and Art Cashin’s S&P hat that I mentioned last week went quickly out of style. The market whipsawed around Fedspeak (which turned out not to be news) as well as further changes in the geopolitical landscape (primarily Iran). At current S&P 500 index levels, the forward 12-month P/E ratio is 17 which is above both the 5-year and 10-year averages. The ratio continues to be the beneficiary of low and declining interest rates. As the market declined this week, the VIX rose from 12.39 to end the week at 14.45. This small bit of mean reversion brings VIX levels using log normal data back within one standard deviation of long-term averages.
In the face of a falling equity market, US Treasuries rallied with the 10-year yield falling from 2.12% to end the week at 2.05%. 3-month T-bills (the best barometer for future Fed action) experienced an 8bp decline in yield to 2.06%. This is the lowest level in yield for 3-month T-bills in 2019 and with the current Fed Funds rate in the range of 2.25% to 2.5%, 3-month T-bills are beginning to posture for the possibility of a 50bp cut in rates. To note, the yield curve between these two maturities is barely inverted but the extended period of inversion that we just experienced has already done damage as far as the NY Fed is concerned. The NY Fed Probability of US Recession has climbed to 32.88% for the 12 months forward period ending in June 2020.
Looking at other spread relationships, US Treasuries and German Bunds remain rock solid at +240bps and have failed to reach new cycle lows for several weeks now. This is a testament to weakness out of Europe and their need for more accommodative monetary policy as well. The coming week will be interesting for this spread relationship as the ECB will release its next monetary policy announcement.
With yet another Fed-driven rally in the shorter end of the curve this week, the US Treasury – Precious Yield spread* descended further into negative territory at -.20%. 2-Year Treasury notes finished the week at 1.80%, down from last week’s close of 1.84% while Precious Yield continues to offer 2-year physical gold term deposits of 2%. Since Precious Yield offers investors in gold the opportunity to earn interest, the US Treasury – Precious Yield spread is tighter than the US Treasury – gold yield spread. To remind our audience, the gold yield is negative in most other holding forms outside of Precious Yield. This includes paying for storage of physical metal whether investor-owned or via a physically -backed storage program and paying management fees for GLD or similar ETFs. See our white paper for a more thorough discussion. Precious Yield provides a much needed yield alternative in this environment of ultra-low / negative global bond yields.
The US Dollar strengthened 0.35% last week, regaining a significant portion of the prior week’s weakness. The Euro shed 0.4% and the Pound shed 0.6%. Of note, the Yen strengthened marginally against the dollar. What could have driven this divergence amongst these three major currencies? First of all, it may be helpful for readers to note that the Yen has historically acted as a safe haven currency despite Japan being the most indebted country in the world. This is because its citizens own most of the debt and therefore there is little pressure from foreign holders. More recently, the Yen has reacted to US-China trade war news. This week provided conflicting signals on that front. Early in the week, President Trump reiterated his threat to impose further tariffs. On Thursday, US and Chinese officials spoke by telephone and data showed that China made its largest purchase of sorghum since April. Using the USD/CNY exchange rate as a measure for progress or lack thereof with respect to trade negotiations, the market essentially viewed this week’s trade related news as a wash. i.e. There was little movement in the currency pair this past week. As a result, the Yen’s strength this week is likely attributable to the weakness we saw in US equities coupled with the decline in US rates this week.
As measured by the LBMA afternoon fix, the price of gold increased nearly 2.3% for the week finishing at $1,439.70/oz. Of note, gold adeptly defended the $1,400/oz level mid week before logging the bulk of its gains on Thursday and Friday due to the aforementioned tensions with Iran. Below is a chart of gold price performance YTD (up 12.3% for those keeping tabs).
Silver must be mentioned this week given its 7.8% increase from $15.14/oz to $16.31/oz. Here’s a YTD chart of silver and you can see an even more dramatic move (vs. gold) since the beginning of June. Notably, silver is only up 5.5% for 2019.
One may argue over the validity of looking at the gold silver ratio, but the fact is that people do it. And because they do it, the ratio influences investor behavior in the same way any other technical analysis (moving averages, bollinger bands, relative strength indices, etc…) does. Read this article for a sample view from a couple of analysts that use this ratio to help assess the outlook. Below is a 30-year chart of this ratio courtesy of macrotrends.net. Many are using this ratio to support a bullish view on silver.
As for gold volatility, it picked back up with the late week surge in gold prices. Using the “Gold VIX” (Ticker – GVZ ), volatility increased from 14.65 from 15.83. To remind our readers, the Gold VIX measures the market’s expectation of 30-day volatility of gold prices by applying the VIX methodology to options on SPDR Gold Shares (Ticker – GLD ). GLD is an exchange-traded fund (ETF) that represents fractional, undivided interest in the SPDR Gold Trust, which primarily holds gold bullion. As such, the performance of GLD is intended to reflect the spot price of gold, less fund expenses.
While an investment in gold has historically been associated with negative carry, Precious Yield offers investors the opportunity to earn a yield on gold. If you are a long-term holder, turning gold as an asset for diversification purposes into an alternative investment with Precious Yield allows for some cushion against gold price movements via the gold yield. To learn more, please browse our website or contact us for more information. For up to the minute thoughts, please follow me (@CIORobPerry) or Precious Yield (@PreciousYield) on twitter.
* Note that while I use the US Treasury – Precious Yield spread as a relative value metric, a better apples to apples comparison of similar instruments would be US Treasuries vs. a fully hedged gold position. For more information on a fully hedged gold position as a yield alternative, please visit our www.kilofutures.com website and read about The Cash and Carry Trade.
Gold 1-Month Price Chart
Silver 1-Month Price Chart
Platinum 1-Month Price Chart
Palladium 1-Month Price Chart
About the Author
Rob Perry is an avid student of the markets and an aspiring tennis player. He is currently Chief Strategist for Precious Yield as well as Chief Investment Officer of Pecan, a single-family office based in San Diego, CA. Most recently, he was located in New York City working as Chief Strategist of and a Portfolio Manager for Kingsland Capital, a multi-billion dollar boutique asset management firm focused on below-investment grade corporate credit. Twitter: @CIORobPerry
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