- The dollar's market slide finally broke on Friday as a favorable jobs report and broad hints of a one-off repatriation tax windfall sparked profit taking on short positions.
- A weak dollar means more liquidity sloshing about global markets that is funding the purchase of higher risk assets with greater yield and appreciation potential irrespective of underlying economic fundamentals.
- Meanwhile, headline inflation across the G-20 rests at an 8-year low, well below inflation targets while the Fed toys with tightening monetary policy.
Economists continue to worry about the growing buildup of financial risk after a decade of extraordinary central bank monetary activity that caused borrowing costs across the global economy to fall to historic levels. The current weakness in the dollar means all the more liquidity is sloshing around in global markets. Investors appear to be sweeping these cheap dollars into a variety of higher risk assets that run the gamut from 100-year Argentinian bonds to newly issued Iraqi and Greek government debt to energy junk bonds to emerging market debt and equity markets — all carrying comparatively outsized yields while potentially exacerbating financial risk. S&P 500 momentum issues like Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOG) (GOOGL) have been in double-digit territory for much of the year, driving the S&P 500 up 10% through yesterday’s market close (5 August). Second-quarter corporate earnings, especially those companies selling predominantly into international rather than domestic markets, further boosted S&P performance to date as US exports enjoyed strong tailwinds in world currency markets. Boeing (BA) is up 51% through yesterday’s market close (5 August) which has powered the price-weighted Dow Jones Industrial Averages into record territory. New orders for commercial aircraft soared 131% on the month through the end of June. Caterpillar (CAT) is up 21% on the year as export markets continue to be a boon for overall earnings. US companies selling abroad benefited handsomely from a weakened dollar which lifted both sales and balance sheet revenue (see Figure 1, below).
Figure 1: The US Dollar, the S&P 500, the Euro and the 10-year Treasury Note Year to Date
While the US Dollar Index (DXY) one-day trading range jumped 1.15% on Friday’s above consensus jobs report and the possible inclusion of a one-off tax incentive for companies to repatriate an estimated $2.5 trillion overseas cash hoard in the administration’s forthcoming tax reform package, the dollar has otherwise beaten a fairly steady downward path throughout much of the 2nd quarter (see Figure 1, above). Friday’s positive news did spark a good deal of profit-taking providing respite from the most sustained downward plunge of the dollar since the spring of 2011. Curiously, dollar-denominated assets still enjoy very favorable spreads with Europe, the UK and Japan, signaling markets shorts on the dollar are running rampant. The correlation between the S&P 500 and the dollar turned decidedly negative by mid-July as the two benchmarks went in very different directions. It is not just market considerations bringing about downward pressure on the dollar.
Investors remain torn. There is clearly frustration with the interminable political maelstrom engulfing the West Wing of the White House at seemingly every turn as yet another top appointee was unceremoniously shown the door after less than a fortnight in his newly appointed position. The continuing uncertainty appears to be a growing check on long-term capital investment, which declined 0.1% in June for the greater economy. Yet at the same time, investors stand favorably disposed to the chorus of pronouncements against a strong US dollar which, at least at present, is driving both earnings and share prices higher.
Equally cherubic is the administration’s regulatory bent. All the while, red flags are flapping in the breeze in response to current lending trends by banks to highly leveraged companies, especially in the energy sector. Uber-low interest rates across Europe and Japan continue to push investors into US equity and fixed income markets. While US equity markets sketch out one new record high after another, yields on investment grade debt remain stubbornly at historical lows. The yield on the 10-year Treasury note has been on a fairly constant downside pitch since hitting a year-to-date (YTD) high of just over 2.60% in the second week of March (see Figure 1, above). When spreads are narrow, debt issuers have enhanced leeway to demand more liberal repayment schedules while at the same time minimizing or even deleting traditional covenant language that protects investors from loss and default. Future but currently unrealized add-backs and balance sheet adjustments designed to make companies appear more creditworthy are becoming a growing worry.
Central banks also enter into the equation. Having spent much of the last decade pumping the financial system with unprecedented levels of liquidity, that flow appears on the cusp of reversal. While the Bank of Japan's (BOJ) asset purchase program continues apace, the European Central Bank (ECB) has made public noises that have been widely interpreted as beginning the process of curtailing its €60 billion/month asset purchasing program. Of course, the US economy is much further down the path of recovery than either Europe or Japan on a variety of measures, which places Fed monetary policy much further along in the process of actually reversing the flow of accommodation into the US economy.
Traditionally, markets associate the tightening of monetary policy with the strengthening of the dollar and higher bond yields — outward signs of economic growth. Yet headline inflation is now at an eight-year low across G-20 economies, well below officially set targets. Tightening monetary policy in the wake of weak inflation measures could mean the Fed has the confidence that inflation is, indeed, reflective of temporary economic conditions. True to form, weak inflation appears not to be in the hand of the Federal Reserve — at least as of yet. The Fed is widely expected to begin shrinking its $4.5 trillion balance sheet and possibly fitting in another 25-basis point uptick in the federal funds rate by the end of the year. The probability of another 25-basis point uptick in the federal funds rate by the end of the year is currently hovering at 45% through Friday’s market close. Mario Draghi is the headline speaker at this year’s central bankers’ retreat in Jackson Hole, Wyoming. His speech is much anticipated as recent hawkish comments could mean a pullback in the Bank’s €60 billion/month asset purchase program. And just this past week, BOJ Governor Haruhiko Kuroda once again pushed back the Bank’s inflation target timetable to March 2020, a full five years beyond its original date.
Another interpretation of weak inflation turns more circumspect: Tightening monetary policy in a low inflation environment could cut off already slow growth and throw the economy into a downturn — hence the worry about the buildup of financial risk. That said, few economists are predicting a recession in the US in the near term. Still, inflation is no more than demand exceeding the supply of goods in the greater economy. We are certainly seeing a good deal of demand exceeding supply in the sale prices of houses which are steadily increasing in many market across the country. Yet, arguably, the more prevalent trend in the economy to date is much to the reverse: Supply exceeding demand. In the labor market, the demand for workers still appears less than the overall supply — despite a 4.3% unemployment rate through the end of July. Wage growth at 2.53% YOY in July remains tepid by historical measures. The biggest monthly gain in the July report went to information technology workers (4.88% YOY) — the second highest paid industrial sector. The lowest paid sector, leisure and hospitality, still enjoyed an above trend 3.76% YOY increase on the month bringing hourly compensation to $15.46. Bar and restaurant positions dominated the month’s job creation and have added an estimated 313,000 positions over the past year. Few, if any, of these wage earners are qualifying to purchase homes in any market. The wage level is currently at the threshold income for qualifying for Medicaid under the Affordable Care Act (ACA) at 138% of the federal poverty level. (In the 19 largely southern states that didn’t expand Medicaid under ACA, such a wage earner falls into the so-called Medicaid gap — too much income to qualify for Medicaid and too little to qualify for federal subsidies on healthcare insurance.) Disposable income increased 0.89% through the end of the 2nd quarter while personal outlays increased 0.94% over the same period, meaning disposal wages remained flat through the end of the 2nd quarter. Personal savings as a percentage of disposal personal income, however, fell to 3.8% for the quarter, down from 3.9% through the end of the 1st quarter — and down just shy of 27% YOY. Household debt hit $12.73 trillion through the end of the 1st quarter, up 1.2% from the 4th quarter 2016. The latest household debt figure represents a $50 billion rise above the previous peak set in the 3rd quarter 2008 and a 14.1% increase above the trough sketched out in the 2nd quarter 2013. Employer compensation costs for civilian workers nudged up slightly to 2.4% in June YOY from 2.3% in June of 2016, driven mainly by benefit cost increases that rose to 2.5% for the period, up from 2.0% in June 2016. Wages and salaries actually fell to 2.3% through June, down from 2.5% in March and 2.5% in June 2016. Consumer spending, which comprises about 70% of total US GDP output, is appearing stretched.
Weak oil prices worldwide stemming from excess supply and weak demand places downward pressure on not only crude oil prices, but on prices throughout the economy. The correlation between headline inflation and the price of oil is currently 75% over the past ten years (see Figure 2, below). Contango price structuring will likely remain for the foreseeable future. Tightening monetary policy under prevailing economic conditions readily assumes the demand side of the greater economy is about to increase relative to the supply side, causing headline inflation to rise — which remains a heady bet.
Figure 2: Western Texas Intermediate Crude and Headline PCE Inflation
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