HIGHLIGHTS

• Markets roughly flat with the lowest one-week volatility since 1972.
• Fed to begin unwinding its balance sheet.
• War of words and name calling between Trump and Jung-un

PERFORMANCE

Not much happened in the market last week. US equities scratched out a 0.25% gain and international equities fell by 0.30%. The range on the S&P 500, from high to low, was only 0.49%, the lowest percentage since 1972. Kind of surprising given the threat of war (see below). Interest rates rose so bonds were down by 0.13%. The dollar was up by 0.54% and crude oil advanced by 1.54%.

FED TO BEGIN ASSET SALES

The long-awaited unwinding of the Federal Reserve’s balance sheet is finally about to begin. The Fed’s intent is to make the process as boring as possible so as not to upset the markets. Bonds will be allowed to mature and won’t be replaced. This will be the first time the Fed has attempted to engage in this process in such large amounts. While the market has so far ignored the announcement, only time will tell if the unwinding does not lead to market disruptions or impact the economy in a negative manner. For now, other central banks around the world, like the ECB, continue in quantitative easing mode, so that eases this transition. But at some point, they will reverse direction also.

TRUMP/NORTH KOREA/TWITTER

Trump said the US would destroy North Korea if they threatened the US or its allies and called the North Korean Leader Kim Jong-un a “little rocket man.” Jong-un, not to be outdone, called Trump a “frightened dog” and a “dotard.” And so the war of words has begun as if we are watching two out-of-control kindergarten children. It would be funny if it was not so serious. Both leaders need some basic lessons in common sense and civility.

Apparently, though, a crisis as severe as North Korea is not enough for our President to concentrate on. He thought it a good idea to start a spat with Seth Curry, and then followed it up by taking on the NFL. How is this guy President of the United States?

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PERFORMANCE

The S&P 500 hit a new all-time high and in the process took another step forward in a continuation of the stair-step pattern we wrote about last week. The index was up 1.09% while the overall US market increased by 1.67%. International equities rose by 0.94%. Bonds were down by 0.48% as interest rates were up by 10 to 12 basis points across the curve. The dollar advanced by 0.70% and oil had a big rally, +5.08 percent.

WHEN ACTUAL INFLATION DEVIATES FROM EXPECTED INFLATION

High valuations by some metrics in the equity markets have been justified by low-interest rates and low inflation. James Mackintosh writes in his Friday Wall Street Journal column that “what matters most to stock prices isn’t where inflation stands, but where it will stand in the future compared with what is currently priced in.” 1980 is an example, a period when inflation was ramping higher, before it was about to fall, as a good time to buy stocks.

Likewise, a bad time to invest in equities was when inflation is low and expectations for future inflation are also low, but then jumps higher. In the mid-60s, the economy was going on its seventh year of sub-2% inflation, at the same time, the Shiller P/E ratio was at its highest point since 1929. Once inflation broke above 2% at the beginning of 1966, the market fell by about 25%.

EQUITIES SPEND MOST OF THEIR TIME IN BULL MARKETS

There are lots of reasons why the market might go down, and we have outlined many of them at our webinars and in this column. But historically, staying in the market has always rewarded long-term investors. According to an analysis done by Bespoke, equities have spent about 88% of the time in a bull market since 1947.

ECONOMY

An early impact of hurricane Harvey was reflected in the August reading for US industrial production, it dropped by a seasonally adjusted 0.9%. That was the biggest fall since the 2007-2009 recession. The hurricane hurt oil drilling, petroleum refining, and other activity.

Initial jobless claims came in at 284,000 this week. That is down from 298,000 the prior week. But both of these numbers are big jumps from the 250,000 or so level that we had seen for many months. The increase is probably due to Hurricane Harvey. The impact of Irma will start being seen in the next few reports. The hurricanes will most likely hurt near-term economic performance before beginning to improve GDP in a few months as the recovery kicks in.

The Atlanta Fed’s GDPNow estimate for Q3 dropped by 0.8% to 2.20% on reports for retail sales, industrial production, and capacity utilization. The New York Fed’s Nowcast also fell by 0.80% to 1.3% The Q4 estimate is now at 1.80%.

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HIGHLIGHTS

• US equities down 0.61%, international stocks up 0.61%.
• Treasury rates continue to fall.
• US stocks still in a stair-step pattern.
• Debt ceiling and hurricane relief bill passes in bipartisan cooperation.
• Hurricane Irma hits Florida hard as we are writing this, Miami Financial District is under water.
• Hurricanes and low inflation might give the Fed pause on raising rates.
• Chinese yuan is on the rise.
• ECB might pullback on stimulus soon.

PERFORMANCE

US equities were down by 0.61%, but international stocks increased by the identical percentage, +0.61. Bonds were up 0.43% as interest rates generally fell by 8 to 10 basis points across the curve. The dollar fell by 1.53% and crude oil was up by 0.40%.

Not much can shake this market. The threat of nuclear war, hurricanes, mayhem in Washington, the market just hangs in there and ignores the news for the most part, continuing to focus on rising earnings and very low interest rates. But while US equities have not fallen, they haven’t risen much either lately. The S&P 500 is priced about the same as it was on July 20th. This is consistent with its pattern over the last year. Trading in a range and the breaking out to a new range in a stair-step fashion. Equities hit new highs, then consolidate and trade within a range, and then break out to another high, and higher-level range.

The market is way overdue for a correction or a pullback of some sort, but this is not news to investors. Maybe the fact that everyone is expecting the pullback is what has been keeping the stair-step pattern intact.

DEBT CEILING/HURRICANE RELIEF

Trump found some new friends in Democrat minority leaders Chuck Schumer in the Senate and Nancy Pelosi in the House, and in quick order, they put together a deal that provides hurricane relief and raises the debt limit through December. We would have preferred a longer-term deal, but are good with Trump making a bipartisan effort on legislation. Maybe that formula can work on other important initiatives down the line and lower the acrimony in Washington.

As we write this week’s column, Hurricane Irma is pounding Florida. While the storm’s center is aimed at the west coast of Florida, initial reports show that the east coast will not be spared. Miami’s financial district on Brickell was a few feet deep in water on Sunday afternoon, only midway through the storm.

Expect billions and billions in damages. The government must step in and help the communities devastated by the hurricanes. But from a bottom line perspective, this continues the pattern of more aid out of Washington, less fiscal discipline, more deficits and a larger intrusion by the government in the economy. With interest rates close to all-time lows, bigger deficits may not be a problem now, but will be at some point in the future when interest rates get to higher levels.

Near term impact of the hurricanes will be a slight increase in inflation (mainly due to higher gasoline prices), slower growth over the next few months (to be offset in the months following), lower employment and higher initial claims for unemployment. Total property losses from Harvey should be in the $70b to $100b range, which would be about 0.5% of GDP.  There are no estimates on the damage from Irma yet, but it will be immense.

HURRICANES/LOW INFLATION TO GIVE FED PAUSE

A combination of two monster hurricanes and an inflation rate that won’t budge higher are giving Fed officials pause as to whether to follow through on another interest rate increase this year. Inflation continues in the sub-2% range, short of the Fed’s 2% target. On top of the low inflation, hurricanes Harvey and Irma will likely have a negative impact on GDP growth in Q3 and Q4, although that will be offset later. Ironically, the dual hurricanes might increase inflation in the longer run as the shortage of construction workers becomes more severe, pushing wages higher as employers compete for workers.

YUAN ON THE RISE

In another example of the markets moving in the opposite of consensus, the Chinese yuan hit a 16-month high this week. It is now up 7% versus the dollar for 2017, and has made up all its 2016 decline. A combination of a weak dollar and currency controls by the Chinese central bank have given a lift to the yuan. Currency reserves are now up for the 7th straight month to $3.092 trillion. The higher yuan has dampened demand for Chinese products overseas. Year-over-year growth in sales to the US from China were down 8.5% in July.

ECB

The European Central Bank indicated it is getting closer to putting the brakes on its expansive monetary policy, but will wait a little longer before taking action. President Mario Draghi said he will probably announce at its October meeting some details of changes it plans to implement.

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HIGHLIGHTS

• Market rallies, 4-points off all-time high.
• How this bull market might end.
• Q2 GDP revised up to 3.0%.
• Nonfarm payrolls increase by 150,000, below consensus estimates.
• North Korea sets off a hydrogen bomb.
• Hurricane Harvey lowers the chance of a government shutdown.

PERFORMANCE

The S&P 500 rallied last week and is now 4.36 points away from its all-time high of 2780.91, set on August 7, 2017. Overall, US equities were up 1.5%, international equities +0.52%, bonds were flat, the dollar was up slightly, +0.19% and crude oil declined by 1.21%.

“HOW THIS BULL MARKET WILL END”

That was the cover story in this week’s Barron’s. Barron’s does not think the end of the bull run is imminent. Most bull markets end due to recession, and there is not appear to be one around the corner.

According to Barron’s, there are two conditions that currently exist that increases the odds of a selloff. One is valuation. The forward p/e on the S&P 500 is 17.7, close to the highest since the dot-com era.  High valuations have minimal short-term forecasting value, but when bear markets begin, it is usually when the market is in a high valuation zone.

The second condition is rising interest rates. The main risk is if the Fed moves too fast.

Mix in a recession with the above two conditions and then you have the makings of a bear market. Recessions led to the bear markets of 1973-1974, the tech bust and the Great Recession.

An economy that revs up would be another possible threat. This is what happened before the crash in 1987. The economy began to accelerate, inflation rates and interest rates began to rise. But back then, interest rates on long term treasuries touched 10%, we are nowhere near that now. But if economic growth were to accelerate, given the tight labor market, inflation could suddenly pick up, forcing the Fed to move faster than anticipated, which would increase the chance of error eventually leading to recession.

Other potential threats include a hard landing in China, antitrust actions against the FANG stocks, and the shrinking of the Fed’s balance sheet. The shrinking of the balance sheet has never been done to this extent before and it remains to be seen how the markets will react.

Some warning signs could include widening credit spreads, an inverted yield curve, the closing of the spread between the earnings yield and the 10-year treasury, making bonds more attractive versus stocks, a rise in the unemployment rate and an increase in jobless claims.

Changes in the structure of the market sometimes accelerate a market selloff. In the Panic of 1907, trust companies were new. They weren’t required to hold any cash reserves like banks. Over time, they increased their risky investments and when the economy turned to the downside, it led to a run on the market until JP Morgan led a group of banks to step in and save the day. In the crash of 1987 it was portfolio insurance. Today, more than $2.4 trillion are invested in exchange traded funds. Up from more than $534 billion in 2007. Some argue such a concentration in these passive type funds would accelerate the next downturn as everyone ends up selling the same stocks. Also, today, you have an acceleration in the dominance of algorithms. What happens if the market begins to sell off and all the algorithms begin sending sell signals at the same time?

GDP REVISED UP

GDP growth in Q2 was revised to 3%, up from 2.60%. That was the best second quarter in two years. It remains to be seen whether the economy can sustain that pace. Right now, Q3 growth is estimated at 3.2% by the Atlanta Fed’s GDPNow model. Some factors supporting improved growth include strong economies around the world, a tight labor market and good corporate profits.

The ISM Manufacturing Index increased 2.5 points in August to 58.8. It was the second biggest gain since June of 2013 and the highest level since April of 2011. This would suggest that GDP should be strong (by recent standards) this quarter.

PAYROLL REPORT

The payroll report came in slightly below consensus. Nonfarm payrolls were up by 156,000, falling short of the consensus estimate of 180,000, and the prior two months were revised lower by 41,000. The increase continues the longest streak ever of increasing payrolls, almost seven years at this point. Normally, August payrolls numbers are revised higher in subsequent months, that has happened in seven of the past eight years.

The unemployment rate increased from 4.3% to 4.4%. Average hourly earnings rose by only 0.1% and the average workweek declined to 34.4 hours from 34.5 hours.

NORTH KOREA

North Korea set off a hydrogen bomb on Sunday, continuing their provocative actions. For the most part, the market has ignored all of this, but this is a geopolitical threat with potentially grave consequences.

ODDS OF GOVERNMENT SHUTDOWN NOW LOWERED

Hurricane Harvey lowers the chances of a government shutdown. Given the situation in Texas, no one wants to be blamed for sidetracking the government when they need to concentrate on relief efforts. Most likely, relief funding will be coupled with legislation to increase the debt limit.

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