On March 13, 2017
AAM Viewpoints – The Canary in the Coal Mine – Still Tweeting?
As we near the end of the first quarter of 2017 our focus has been on a new U.S. president, rising interest rates and equity markets hitting one new high after another. However, we are very aware that this bull market is getting quite old, by historic standards, and we want to be vigilant for any signs that the market could be turning. From our viewpoint, the economic expansion that plateaued a bit in 2015 and re-accelerated in 2016 shows no signs of turning. We remain steadfastly bullish on U.S. equities and believe this old bull has lots of room to run. The canary in the coal mine is still tweeting.
Our analysis first centers on the bond market which has consolidated higher yields and we find the U.S. 10-year bond in a range between 2.2% to 2.6%. The inflation numbers continue to come in the hottest since 2006 with wage growth leading the way up 2.8% year over year. Even though we expect a rate hike in the next Fed meeting, it will likely only be a 25 basis points move, which will hardly even begin to remove accomodation. Remember that the monetary policy administered since 2009 has been the easiest in history in both scope and duration. It is not only uber easy in the United States, but around the globe. The Fed has ballooned their balance sheet to $4.5 trillion with securities. Their focus is on higher inflation and will be content to be nicely behind the curve in raising rates. In short, they had said they will let this economy run “hot.” Our view that the interest rate on the 10-year will be higher by the end of the year as long-term interest rates rise with inflation expectations.
The next leading indicator is PMI or “Purchasing Managers’ Index.” We look at this because it is a reliable leading signal of growth in demand. That index globally has expanded for the past six months, which is a good sign that demand is growing. The global Purchasing Managers’ Index advanced to a 69-month high of 52.9 in February. The index confirmed strong showings in the United States, Europe and China. Demand for commodities continues to grow as that market continues to recover from a long bear market that ended last year. These trends are long dated and there has not been any capital globally to find new stores of these depleting assets. Countries that mine and export these materials have turned the corner as well and we expect emerging markets to put in another strong showing in 2017.
Greater demand for building materials did not just begin to rise after President Trump’s trillion dollar infrastructure spending promise. These markets all turned in mid-2016 and are showing upside reversals that date back decades. Note copper, which many folks correctly point out as being another fairly accurate leading economic indicator, has just broken a very long downtrend line and is moving higher. Some folks even refer to copper as “doctor” copper (as in PhD) for its predictive value as copper is used in so many parts of the economy and is the first to experience an upturn in demand or a downturn. Copper continues to tell us we are likely at the beginning of a long upturn in demand rather than at the end of one.
The story is the same for oil. We have seen a doubling of oil prices off the bottom in 2015. The supply-demand balance in the oil market appears to have been restored. The “term structure” which is indicative of the balance has gone from cantango (spot prices less than future delivery prices) noting that the commodity was “bidding for storage” to breaking into backwardation (spot prices higher than future delivery prices). OPEC (The Organization of the Petroleum Exporting Countries) has indicated that with Russia they will curtail the production of crude to the market in order to speed the rebalance process. History shows us that such production cuts actually work in that each time they have been done the price of oil rises over the period following the production cut.
Last year energy and material shares were clear winners; this year they have not been. We think this is simply a normal correction after a huge run. Bull markets in commodities, like other bull markets, tend to last for years rather than just months. We are seeing strength globally for demand again as supplies have not expanded for years. This is a prescription for higher prices and higher profits. We think this “pause” in prices gives investors a chance to snap up energy and material shares at really great prices.
What worries us? Well there are a couple of items that could upset our thesis of higher global growth, inflation, interest rates and equity prices. First, there is some real risk that the U.S. economy is still close to stalling speed. Sure, job growth and PMI are rising, but the Atlanta Federal Reserve GDPNow indicator has fallen over the past few weeks from estimating 1st quarter U.S. GDP to now just under 2% growth. Are we seeing this corroberated in other indicators? The answer is “no” but this bothers us just as much.
Then the more obvious risks loom out there. There is a risk of protectionist policies coming out of the White House that could slow economic growth. There is a risk that North Korea actually can get a rocket to hit something other than water and cause a war. There is a risk that China’s military expansion in the South China Sea might spark a conflict. All of these risks are ever present and the market generally climbs this “wall of worry” over time.
Yes, it appears to us that the canary is still tweeting in the coal mine indicating the bull is still intact. Recent corrections in energy and materials shares provide an excellent entry point here. Global synchronized monetary policy is giving way to global fiscal stimulus. This should provide support for global expansion of growth and demand. The translation to the financial markets will likely mean higher profits and higher share prices in the future.
CRN: 2017-0306-5846 R
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