Classic Q2 Seasonal Bounce in the U.S. Economy, Inflation. The Fed now has some ammo for a Hike

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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“The risk-reward in betting on Fed action in the July – September time frame is the most attractive in three months. Global credit and economic risks shot the March and June rate hikes right between the eyes, took the steering wheel out of Janet’s hands. This will position the Fed to start signaling for a July hike, sometime in the next 45 days. That would be a dollar positive; gold / commodities / EM negative. She’ll likely try and get back in the driver’s seat. In recent years, the rebound in Q2 vs Q1 GDP has been meaningful, north of positive 1%.”

The Bear Traps Report; May 2, 2016

We’re seeing a hint of inflation coupled with Fed governors on the speaking tour keeping a summer rate hike in play.  In just eight trading days, the U.S. 2 Year Treasury bond yield has surged 15bps to +0.83%, a substantial move for a short term government bond.  The German 2 year yield is all the way down to -0.51% (see below).

As we stressed to subscribers in our May 2nd Bear Traps report, we don’t think they will hike in June, July or September, but they will give it a try.  Once again, the beast inside the market will stop them, as it did in September of 2015 and March 2016.

US 2s

As oil has nearly doubled since February, gas prices just came in with largest surge since August 2012.  The yield spread between U.S. 2 year Treasuries and German 2 year bunds is near record levels (see below).  You get 1.35% more for lending to Uncle Sam, this is putting a bid into the US Dollar.

2s

Pick up our latest Bear Traps Report here.

Headline industrial production advanced 0.7% in April, exceeding the consensus forecast of a 0.3% gain.

IP

After the Fed shot the March rate hike right between the eyes, the U.S. dollar plunged during the 60 day period between early March and May.

The Winner?

In April, U.S. overall industrial output surged (see above), there was  greater output of consumer goods, particularly motor vehicles and parts.

 

CPI Pop

Stripping out fuel and food, the gain in so-called core consumer prices was propelled by services, with costs for rents, medical care, auto insurance and airline fares all increasing. Prices for goods — such as household furnishings, which fell the most since in six years — acted as a check on the CPI’s advance. Federal Reserve policy makers will likely want to see whether the higher prices stick as they consider the appropriate time to raise interest rates again. – Bloomberg noted.

  • Rose 0.4 percent (forecast was 0.3 percent), most since February 2013

CPI Surge

CPI

  • Increase driven by higher prices for gasoline, rents and medical care
  • Core CPI, which excludes food and fuel, advanced 0.2 percent after 0.1 percent gain
  • CPI increased 1.1 percent year over year; core CPI up 2.1 percent

Bloomberg data

Bottom Line

Remember, the Fed doesn’t have to hike rates.  Last summer, they signaled for a September rate hike, the U.S. Dollar surged and global credit risk took the steering wheel out of Janet Yellen’s hands.

On August 22, 2015 We Tweeted @convertbond:

1. Fed hints at #ZIRP Exit
2. US $ Surge
3. Commodity Plunge
4. Global Economic Risk
5. Corp Default Risk
6. EM Currency Risk
7. Fed on Hold

There are three key trades around this latest dollar surge….

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Futures: Chances of a June / July Rate Hike Surge Most in 3 Months

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

Pick up our latest Bear Traps Report here.

“The risk-reward in betting on Fed action in the July – September time frame is the most attractive in three months. Global credit and economic risks shot the March and June rate hikes right between the eyes, took the steering wheel out of Janet’s hands. This will position the Fed to start signaling for a July hike, sometime in the next 45 days. That would be a dollar positive; gold / commodities / EM negative. She’ll likely try and get back in the driver’s seat. In recent years, the rebound in Q2 vs Q1 GDP has been meaningful, north of positive 1%.”

The Bear Traps Report; May 2, 2016

 

As you can see in the quote above, earlier this month we emphasized that long dollar position trades should benefit from a hawkish shift from the Fed.

We’re happy that the Fed Funds Futures for July have moved from 14 to 24% over the last week.

The U.S. Treasury curve is the flattest since 2007. The 2-year has gone from 68 to 80 bps over the last few weeks. The market is starting to price in July Fed action.

Pick up our latest Bear Traps Report here.

WIRP June 2
US Dollar Ripping

DXY hit $94.70 today up from below $92 earlier this month.

The next President of the United States is going to have an enormous impact on the Federal Reserve as Fed Chair Yellen’s term ends in 2018.

Pick up our latest Bear Traps Report here.

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Defense Stocks Love The Donald

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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In late March, as the GOP nomination was in doubt, the ITA defense sector ETF was up 12.3% from the February lows, while the S&P 500 SPY was 15.5% higher.  That’s 320bps (3.2%) of underperformance for the defense sector.

Today, the S&P is 17.8% above the lows, while defense stocks have surged 20.3%.  Bottom line, defense related equities have substantially outperformed the S&P 500 over the last 45 days.

ITA

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From the moment Ted Cruz and John Kasich dropped out of the race, defense stocks have outperformed the broad stock market.  Someone is pricing in a Trump Presidency.

Even more telling, volume found in the ITA ETF above:

Pre-Trump Nomination Secured: 26k shares a day

Post Trump Nomination Secured: 103k shares a day

“I’m gonna build a military that’s gonna be much stronger than it is right now, It’s gonna be so strong, nobody’s gonna mess with us. “

Donald Trump, said on Meet the Press, in March

The Defense Department budget for 2016 is $575 billion. President Barack Obama’s 2017 proposal increased it to $583 billion. By comparison, China spent around $145 billion and Russia around $40 billion in 2015…..

For the rest of our report and 2016 election trade ideas,, find value in our menu here.

 

 

 

 

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Great Rotation

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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Two years ago Wall St. started lecturing us on the “great rotation.”

They confidently said the Federal Reserve would hike rates seven times in 2015 and 16.  Their target of the US 10 year yield by the end of 2016 was 3.50% vs 1.70% today.

“It’s time to get ready for life after liftoff.”

The argument went, you must take down your exposure to bonds and add to stock holding as this historic rotation takes place, two year later we’re still waiting:

2016 Inflows vs Outflows (ETFs and Mutual Funds)

Bonds: +$53B

Stocks: -$85B

Bloomberg, IIF data

Last year, we told them they were wrong here.

When you see and hear this kind of “group think” from sell side analysts, run don’t walk the other way.

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Pound back to the Lovely Days of Princess Diana

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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With ACG Analytics

Brexit risk looks fully priced in to us.  Reminiscent of Y2K, fears have gone viral.  The British Pound is back to the lovely days of Princess Diana.

The In / Out referendum on Britain’s future in the EU will be held in just over six weeks, on June 23, 2016. Prime Minister David Cameron is in favour of continued British membership, under the terms he negotiated early in 2016. Cameron has the support of the Chancellor the Exchequer George Osbourne, and the majority – but not all – of his Cabinet. Several cabinet members, including prominent Tories are campaigning for a so called Brexit. Outside of the Cabinet, the popular former Mayor of London Boris Johnston will also campaign in favour of Brexit.

British Pound, on Key Support

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Pound

The next three largest parties in the House of Commons – Labour, the SNP, and the Liberal Democrats, are all campaigning for Britain to remain in the EU. The Eurosceptic UKIP has only one seat in parliament but received 12.7% of the vote in the 2015 general election. Unsurprisingly, it is campaigning for Brexit.

ICM Poll, May 6-8

Leave: 46%

Stay: 44%

Undecided: 10%

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Record Low Yield for the Australian 10 Year

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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AUSTRALIAN 10-YEAR BOND YIELD DROPS TO RECORD LOW AT 2.22%Aus 10s

Most wish it was a growth story, but there’s little faith in the global economy.

Since February, emerging market asset prices have been supported by two factors, both of which will prove fleeting.

Up until May 3rd, Janet Yellen had her foot on the US Dollar’s neck, while the PBOC expanded credit in China at the fastest pace since 2009. The dollar index DXY plunged 6.7% between March 2nd and May 3rd.  In a reversal, as the dollar surged emerging-market currencies fell for seven consecutive days through Friday, the longest losing streak since March 2015.

If global investors really trusted China’s recovery, they wouldn’t be piling into Aussie 10s at 2.20%.

Bloomberg’s monthly gross domestic product tracker for China shows growth slowed to 6.88% in April, from 7.11% in March.

Growth is likely far slower, 1-2% at best.

Weak steel and coal output dragged on industrial production, which increased 6% from a year earlier versus economists’ forecasts of 6.5%, while retail and investment readings also disappointed.

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Dark Side of S & P 500 Underlying Earnings

Join our Larry McDonald on CNBC’s Fast Money, Wednesday May 18, at 5pm.

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The brisk pace of Federal Reserve fueled U.S. corporate debt sales for the second quarter means that 2016 may come close to reaching last year’s record-breaking $1.3 trillion of deals.

Debt is a double edged sword, as net debt relative to the underlying earnings power of the S&P is at froth levels historically.

S&P 500

Net Debt to EBITDA*

2016: 1.5x

2015: 1.4x

2014: 1.25x

2013: 1.1x

2012: 0.83x

2011: 0.9x

2010: 1x

2009: 1.1x

2008: 1.15x

 

* x financials

 

Enterprise value (EV below in the chart) takes debt + equity market capitalization into consideration.  In the S&P 500, if you think of a pie with 12 pieces, five full of debt the other 5 equity,  it’s foolish to just focus on the stock portion of the market’s value, especially after eight year debt binge!

As the Fed has kept rates wrapped around zero going on 8 years, investor’s thirst for yield has companies reaching new dark heights in terms of their debt loads.  As the U.S. equity market has raged “risk on” since February, after the Fed agreed not to hike interest rates, stocks have become extremely expensive.  SELL Signal.

What keeps us up in the middle of the night is a surge in credit quality deterioration in the face of rising bond sales.  That’s NOT the way it’s supposed to work Janet Yellen!  S&P Global Ratings expects default rates among junk-rated U.S. cos. to jump from 3.9% in March 2016 to 5.4% in March 2017.

S&P 500 2006-2016

Investors are paying record prices for stocks when the debt portion of value is factored in relative to raw earnings power (EBITDA = earnings before, interest, taxes, depreciation and amortization).

S&P EV EBIT 4
The problem with most Wall St. strategists is they don’t get paid to get you off the dance floor, they want you in there swinging and playing.

The “Lower and Beat Game” is on Full Throttle

A look inside the S&P 500 shows, of the 460 companies that have reported, over 75% beat lowered consensus forecasts.

Keep in mind, if the bar is set so low, anyone can massage the numbers to exceed — and analysts had been aggressively cutting estimates for the quarter in the weeks before it ended.  Bottom line, Q2 will come in at -9% on the earnings front and -2.5% on the top line sales decline.

Buy Fear – Sell Complacency

We recommended subscribers buy fear in late January, there was value found in stock prices, today not so much.

“We’ve been putting cash to work as we believe a substantial relief rally is near and the Fed won’t be able to hike rates.  Great bull markets don’t end overnight. This bull withstood a violent blow in October 2014 with a 10% plunge and subsequent rally in stocks over 17 days. Last August / September, the bull took another sword, suffering nearly a 13% drop. We believe he has some fight left.. Buy the IWM Russell 2000 ETF.”

Bear Traps Report, January 20, 2016

A look at earnings year to date is not pretty.  We’ve crossed into our third of (year over year) declines, the S&P 500 is now trading at 19x earnings vs. 17x three months ago.

Over the last 40 years, 19x earnings multiples in the S&P 500 have been associated with 4-6% U.S. GDP growth, not 1.8% as we wear today.

S&P 500 PE

 

S&P PE
In early February the S&P 500 was trading at 17x earnings, today 19x

After the first two quarters, the S&P 500 is on track to make $107.70 this year vs expectations of $121.70.  We think the S&P will finish 2016 at $111.50 in earnings.

We are in search of value, join us here. Join us.

How Rich?

S&P is at 2054

Earnings of $111.50 x 16 = 1784 S&P
Earnings of $111.50 x 17 = 1895 S&P

 

The data above is from Bloomberg and Reuters.

 

 

 

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