PERFORMANCE

It was another good week for investors as equity and fixed income markets were generally up by about 1/2%. The US markets increased by 0.57%, international +0.36% and the bond aggregate +0.50%. The US dollar fell by 1.60% and crude dropped by 1.65%.

The markets have been helped by strong earnings, which in turn have been helped by a lower dollar. The dollar is now down about 7% on the year. A lower dollar provides a tailwind to earnings. According to Dubravko Lakos-Gujas from JP Morgan, S&P500 earnings increase by about 1% for every 2% decline in the dollar. Overall, 19% of S&P 500 companies have reported earnings this quarter, and they have come in 7.8% above estimates (per FactSet).

Interest rates generally declined but at the short-end of the curve, they increased. The 5, 10 and 30 year bonds all had lower yields. But the two-year was up by 1 basis point and the 3-month yield increased by 12 basis points. Bond investors are worried about the up-coming battle over the debt ceiling, probably sometime in October, 3-months away.

POLITICS

While the market continues to advance, the political environment continues to deteriorate. Special Counsel Robert Mueller expanded his investigation into Trump’s Russia connections, including historical personal transactions. White House Press Secretary Sean Spicer resigned and Trump criticized his attorney general. The Republicans cannot pass a healthcare bill and cannot even figure out how to take a vote on one. That was just this week.

ECONOMIC

The Conference Board’s Leading Economic Index was up by the most since December of 2014, increasing 0.6%. A strong report on building permits led the way.

Initial jobless claims fell to 233,000. Down 15,000 from last week.

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REVIEW

The market broke out to another high, continuing the stair-step pattern of consolidation, then another step higher. Fed Chair Janet Yellen testified before Congress and emphasized that rate hikes would be very deliberate and moderate. The market took that as good news and shot equities higher.

Bonds moved up by 0.43% as interest rates dropped on the testimony. The 10-year fell to 2.33% from 2.39%. Crude rallied by 5%.

Investors now view the probability of another interest rate hike this year as less likely. Yellen’s testimony, coupled with less than sanguine economic reports, makes it more likely that a September hike is off the table and lowers the probability of a December increase.

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PERFORMANCE

US equity markets were basically even, +0.06% while international markets fell by almost 1/2%. Bonds declined as interest rates continued to rise and the yield curve steepened. The dollar was up and crude was down.

INTEREST RATES

It was one year ago, on July 6, 2016, that the 10-year treasury bond hit its all time-low yield of 1.367%. One year later, we are one point higher at 2.37%. The 10-year has traded in a range between 2.1% and 2.6% since the election and we are back in the middle of that range now.

Over the last couple of weeks, consensus has tilted back towards higher rates going forward. Minutes released from the June Federal Reserve meeting showed that members want to begin reducing the balance sheet before year-end. And European Central Bank minutes indicate that there were discussions of ending their pledge to buy bonds if the economy weakened. Depending upon the rate of increase, higher interest rates at some point would likely put pressure on equities. The interplay between higher earnings and interest rate will have a lot to do to determine the direction of the equity markets.

EMPLOYMENT

The June employment report came in strong. Non-farm payrolls increased by 222,000 and the two prior months were revised higher by 47,000. The unemployment rate increased to 4.4% from 4.3% due to more entries into the workforce, which is considered a positive sign. The average workweek rose by 0.1 hours to 34.50 and average hourly earnings were 2.50% higher year over year.

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PERFORMANCE

US equity markets were down by about 1/2% while international markets managed a 0.19% advance. The dollar fell and crude rallied by 7%.

Interest rates rose. The yield curve got steeper. The 10-year rose by 16 basis points. Central bankers are beginning to align themselves on the path to higher rates. The Fed has been increasing rates and have signaled more is on the way, as well as laying out the plan to reduce their bond holdings. But now some central bankers overseas might be joining the party. Mario Draghi of the ECB suggested that the bank might be close to ending its bond buying. And Mark Carney of the Bank of England suggested that a rate hike might be on the way.

EARNINGS

As the quarter ended, analysts are forecasting Q2 earnings of $31.50, down from $32.13, according to FactSet. The 2% decline is lower than the drop-in forecasts in prior quarters, which have averaged 5.9% over the last 10 years.

ECONOMY

Q1 GDP was revised up to 1.4% from 1.2%. The original estimate for Q1 real growth was 0.7%, and that was later revised up to 1.2%. GDP growth has picked up in Q2, the Atlanta Fed’s GDPNow model currently has Q2 growth at 2.7%. The first official estimate from the Commerce Department will be released on July 28.

The current economic expansion began in July of 2009 and is currently the third longest on record, surpassed only by expansions in the 1960s and the 1990s. However, the growth rate during this expansion has been sub-par, probably due to lower productivity and a decline in the labor force.

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PERFORMANCE

The US equity markets were up about 0.30% while international markets fell slightly, down 0.10%.  Health care had a big week, up 3.7%. A new Senate health plan would limit regulation in the sector.

The action continued to be in oil, where prices were off another 3.97%. The price of crude is now down to about $43/barrel. The consensus as recently as a couple months back was that crude would stay in the $50 range and slowly drift higher, but inventories have now been increasing for several weeks and the price has been going into reverse. There was hint that the high yield markets are starting to get nervous, the Merrill Lynch High Yield CCC Index jumped 29 basis points last week while the rest of the bond market was close to flat.

OIL

A big drop in oil prices at the beginning of 2016 contributed to the sell off at that time. But supposedly the weaker hands have gone bankrupt and the remaining companies have cleaned up their balance sheets and are in better shape. Time will tell if that turns out to be the case but it is worth watching if a divergence between high yield bonds and equities continues. More specific to the sector, oil and gas high-yield bonds are down 4% this month, according to ICE Data Services, and some of the weaker debt is down 26%.

Another knock-on effect of the lower oil prices is that it will cause the energy sector to have lower profits, and that might lower analysts projections for overall profits going forward. Investors have been counting on growing profits to power the recent market rally, but if oil continues to fall profit revisions are probably on the way.

YIELD CURVE

Investors are concerned about the flattening yield curve. A flattening yield curve normally signals slower growth. An inverted yield curve often signals recession. But before you get an inversion you start with a flattening. One argument though, is that “this time is different”, because of the suppressed yields worldwide, especially in Europe and Japan. Negative interest rates overseas have dramatically increased demand for US treasuries and thus pushed down yields further out on the curve leading to a flatter curve. Remember though that “this time is different” are often the most dangerous words in investing. The difference between the yield on the 10-year bond and the 2-year bond has flattened by 44 basis points this year and currently stands at 0.81%. For now though, the economy appears to be continuing to move along at the slow motion rate we have become accustomed to.

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PERFORMANCE

The equity markets had small increases. The overall US market was up 0.05% and international markets were up 0.06%. But don’t let the flat results fool you, there was lots of news including Amazon buying Whole Foods, a change in leadership at GE, a Fed interest rate hike, and a gun attack on Republican baseball players.

Bonds increased by 0.27% as interest rates dropped, the dollar fell slightly and oil dropped another 2.38%.

AMAZON

Amazon announced its proposed purchase of Whole Foods on Friday for $13.7b. And based on every comment by the “experts”, all the competitors might as well just close up shop now and liquidate because Amazon is just going to roll them over. They may be right given what Amazon has done to the retail sector. Kroger dropped 10%, Costco down 7% and Wal-Mart down 5%. But I would give sharp operators like Wal Mart, Costco, Target, and others some credit. The one likely winner for sure will be the consumer. Because the supermarket space is now going to become even more competitive than it was before, with just about everyone pouring more dollars into advanced technology, fresher products, and probably lower prices. And the competitive pressure on prices will be forced down the entire supply line. The consumer will be the big winner.

GDP

The Atlanta Fed’s GDPNow model is forecasting Q2 growth at 2.9%, down from 3.0% last week. A slowdown in residential housing contributed to the lower estimate as the number of annualized housing starts hit an eight-month low. That, along with several other indicators, such as new hires, lower inflation and weaker consumer sentiment have some worried that the economy is beginning to roll over. The lower numbers are reflected in the chart below, which compares the Citibank Economic Surprise Index versus the p/e on the S&P500. The Citibank index charts actual results versus expectations. When numbers are coming in less than expectations, the chart is headed down (as it is now). Normally, the S&P 500 p/e and the index roughly track each other, but recently there has been a big divergence, with the Citibank Index falling sharply while stocks remain elevated. The economic numbers have not been terrible in absolute terms (based on recent history), but they have not been meeting expectations. So, is the problem that the expectations were too high? Maybe a result of the post-election optimism. Or is the problem that this is indeed an economy where growth is now beginning to head in the wrong direction? We have been through this before over the last several years and the economy has rebounded.

This economy cannot get any serious traction north of 2% growth, and for now, we continue to believe that is the continued path for the near term. Slow growth in and around 2%.

FED

As expected the Fed raised interest rates by 1/4% and laid out plans to shrink its $4.5 trillion balance sheet. The Fed also said it plans to raise interest rates one more time this year if the economy performs in line with expectations.  To begin with, the Fed will reduce its balance sheet by letting $6b in Treasury securities and $4b in mortgage bonds mature without being reinvested. Each quarter, the amounts would increase. The program would max out at $30b per month for Treasury’s and $20b for mortgage-backed securities. The balance sheet reduction could begin soon if the economy continues to perform.

OIL GLUT

Crude oil fell 4% on Wednesday on new reports regarding inventory. Crude inventory dropped by 1.7 million barrels, significantly less than the consensus forecast of 2.6 million. Gasoline inventories increased by 2.1 million barrels, much more than the estimated decline of 700,000 barrels. According to the International Energy Agency (IEA), oil inventory in the Organization for Economic Cooperation and Development (OECD) countries increased by 18.6 million barrels, and now stand at a higher level than when OPEC cut production last year and are 292 million barrels higher than the five-year average. The IEA expects US oil production to increase 5% this year and 8% in 2018. Overall, non-OPEC production should increase by 1.5 million barrels per day in 2018 versus an expected rise of 1.4 million barrels in demand.

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