Window Of Vulnerability Opening Up
Over the weekend, President Trump had U.S. military forces deploy 125 aircraft, Tomahawk missiles, and 14 Massive Ordnance Penetrators to strike Iranian nuclear sites in Fordow, Natanz, and Isfahan. The strikes marked the U.S. entrance into the Israel-Iran conflict as we await any retaliatory actions Iran decides to take. I’ll repeat what I opened with last week: I’m not a geopolitical expert, and outside of attempting to keep up with the latest news, my interest in this conflict on a professional basis starts and stops with thinking through various scenario analysis as it pertains to markets and the global economy. So if you’re looking for deeper analysis on the Iran file, I encourage you to seek alternative outlets.
The most significant reaction over the weekend when U.S. futures opened was a spike in oil prices by nearly 6%, with U.S. equities mildly softer amid fears of a disruption to global energy supplies. Crude has since given back all of its gains, and stocks have erased their losses as Iran (so far) withheld strikes on U.S. assets. Remember that the Middle East produces roughly a third of the world’s crude oil, and a fifth of global crude oil shipments pass through the Strait of Hormuz. It’s the potential threat to the shipping channels that run through the Strait of Hormuz that has oil prices up over +20% in the last several weeks.
My understanding of the situation is that Iran taking action to shut down this key shipping lane would equate to economic suicide for the nation in that it would escalate the situation to where the U.S. and Israel go full monty on its aggressions. A very back-of-the-envelope analysis on the impact on growth is that a $10 rise in oil prices for a duration of 30 days would be a drag of about 15 basis points on GDP growth. So, the rise in the price of oil matters, but the length of time that prices are elevated above the baseline is the fundamental economic constraint – one month is minimal impact, but six months is a problem. Therefore, it makes sense to have some energy exposure (I prefer the companies over the commodity at the moment) in your portfolio as a geopolitical hedge and less so in transports and consumer discretionary (two areas that get squeezed from higher oil prices).
The most meaningful development I see when working through my market signal screens is a potential short-term bottom in the U.S. dollar. A weaker dollar has been a significant tailwind for global liquidity, corporate profits, and financial conditions year-to-date, but in the last week, we’ve seen both the Yen and Euro (two biggest global currencies outside the U.S. dollar) start to rollover. As you can see from the chart below, the DXY dollar index is threatening to push above the negative trend line that has been in place since the start of the year. The 50-day trend line is just a little higher at 99.5, and a sustained break above this level could get squeezy for investor positioning that is very lopsided toward further weakness.
On a longer-term structural time frame, I remain of the view that the setup is ripe for a protracted U.S. dollar bear market. However, I also see a window of vulnerability opening up as we progress through the Summer and into the Fall, when markets flip from ‘risk-on’ to ‘risk-off,’ which is a challenging backdrop for everything except the U.S. dollar, T-bills, and gold.
It’s not just the U.S. dollar signaling early indications that a subtle regime shift may be afoot, but so are interest rates, with yields along the curve starting to rollover. The yield on the 2-year T-bill peaked at 4.40% on January 13th, a lower high of 4.36% on February 12th, and is currently trading at 3.82% while looking to revisit the lows for the year at 3.62% reached on April 30th. Same goes for the yield on the 10-year T-note, where it peaked at 4.80% on January 13th, put in its low print on the year at 3.99% on April 4th, and is currently yielding 4.30%.
From my vantage point, markets are starting to price in the economic growth scare reported in recent data releases. The May employment report looked okay on the surface, but it had plenty of blemishes when you looked under the hood. Not terrible, but enough warts to confirm the labor market is weakening at a more aggressive clip. Furthermore, so far in May, we have a trend developing where the hard data is catching down to the soft data with a lag. No, it's not an omen of an oncoming recession, but it is confirming a soft patch is starting, and we’ll have to measure and map it along the way to see what it turns into. So far in May, we have housing starts down nearly 10% month-over-month (no shocker there with the state of stasis the housing market finds itself in with mortgage rates pegged around the 7% level), building permits -2.0%, retail sales -.9%, and industrial production -0.2%. Not to mention jobless claims, which are trending higher and settling in around the 245k level – a push above the 265k level will start to catch investors' attention.
At the same time, the Citi Economic Surprise Index has spent most of this year below the zero line, and at -23.9 last week, is down to an eight-month low while faltering a hefty 35.3 points in just the past three weeks. To be fair, this indicator says as much about expectations being too high as it does about incoming data being disappointing. Nevertheless, I find myself less and less in agreement with Jay Powell as he continues to characterize the economic backdrop as “solid”. I’d use that term to describe the stock market, asset prices, corporate profits, and boomers ’ portfolios, but not the state of the U.S. economy as we head into Q3.
As I said last week, I find myself in agreement with President Trump that the Fed should be more forward looking and get going with loosening monetary policy, but calling Jay Powell a “national disgrace” and hinting that he should “appoint himself” to head the central bank undermines the credibility of both the Fed and Executive branch of government. However, in the last several days, I’m seeing several prominent FOMC members warming to the idea that rate cuts are not that far off. Governor Chris Waller was interviewed on CNBC on Friday, saying he thought a rate cut should be on the table for the July meeting (July 29th – 30th). Then this morning, FOMC member Miki Bowman said she could support a July rate cut:
“Should inflation pressures remain contained, I would support lowering the policy rate as soon as our next meeting in order to bring it closer to its neutral setting and to sustain a healthy labor market.”…
As a result, we are seeing a modest shift up in probabilities of a rate cut in July – up to 23% probability from 14% on Friday – so still low, but on the move. Keep in mind that the initial reaction by markets to a more accommodative monetary policy path is likely to be risk-positive and one I’d be inclined to go along with to a point. Rate cuts that support a slowing economy and put a floor under a growth scare are constructive for risk assets, but should economic growth and the labor market continue to soften, then investors have something to worry about that won’t be solved in the near-term by lower interest rates.
As for the equity market, I remain unenthused with the S&P 500 trading around the 6,000 level. To me, it reflects a lot of good already in the price (both current conditions and future expectations), where just meeting future earnings expectations and economic growth, not softening much further, leaves little upside. It looks like analysts are done cutting earnings estimates, and perhaps the bar has been lowered enough that upside surprises will be the positive catalysts to push the S&P 500 to new all-time highs. However, that wouldn’t cause me to alter client portfolio allocations, although it would provide some fundamental validation for the S&P 500 to be trading at current levels.
Nevertheless, I’m seeing signs that this rally, which got underway on April 8th, is entering the early stages of upside exhaustion. The percentage of stocks trading above their 200-day moving averages has slipped to below 50%, while the percentage above their 20-day moving averages has fallen to below 50% as well. This is not a very strong technical backdrop. Don’t get me wrong, going through what has now amounted to 8 months of consolidation (S&P 500 is at the same level it traded at in early November) after two years of +20 gains is better than a sustained correction. Still, fundamentals further catching up to price would temper some of my trepidation.
Meanwhile, the cyclically-sensitive Dow Transports are off 17%, consumer cyclicals are down 14%, and asset managers remain some 13% below their cycle high. Furthermore, most sentiment and positioning metrics indicate investors are decisively in the neutral camp, with neither too extended in either direction. Although the NAAIM survey shows net positioning has moved back up to its highs for the year. As you can see from the chart below, the last four times this metric neared the 100 level coincided closely with near-term market peaks. Something to keep in mind when thinking about committing new capital to the broad averages at this point, not that one factor should be used as a tool to make investment decisions.
Bottom line, I remain in the camp that a diversified portfolio with exposure to U.S. equities, foreign equities, bonds, gold, commodities, and cash provides a very prudent way to compound capital at the moment. Equities (both domestic and foreign) provide an upside call option on good outcomes. Gold and commodities provide a good geopolitical hedge, a call option on a stagflationary outcome, and protection against continued currency debasement. While bonds and cash provide stability with a solid yield as well as optionality to take advantage of opportunities should worse than expected outcomes materialize. It’s a tough environment to have conviction on any one outcome and position accordingly given the risk/reward in any one asset class doesn’t offer an asymmetric payout that makes sense. Stay patient. Stay disciplined, and continue to filter the signal from noise – there is a whole lot of the latter, and not much of the former.
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