China And The Fed Inject New Fear Into A Cautious Market

Volatility suddenly returned with a vengeance last week – to both stocks and bonds. In fact, on Wednesday, while the -3.1% single-day selloff in the S&P 500 didn’t quite equal the -4.1% fall on February 3, the normal “flight to safety” into US Treasuries when stocks sell off didn’t occur, which was quite distressing to market participants and pundits alike. But on Thursday, bonds caught a bid while equities continued their fall. Suddenly, talk has become more serious about the potential for slower global growth due to rising interest rates and escalating trade wars.

But has anything really changed from a fundamental standpoint? I would say, absolutely not. Although the risk-off rotation since June 11 continues to hold back Sabrient’s cyclicals-oriented portfolios, our quantitative model still suggests that little has changed with the fundamentally strong outlook characterized by global economic growth, impressive US corporate earnings, modest inflation, low real interest rates, a stable global banking system, and historic fiscal stimulus in the US (including both tax relief and deregulation). Moreover, it appears to me that equities are severely oversold, and now is a good time to be accumulating high-quality stocks with attractive forward valuations from the cyclical sectors and small caps.

When a similar correction happened in February, the main culprits were inflation worries and hawkish rhetoric from the Federal Reserve regarding interest rates. After all, the so-called “Fed Put” has long supported the stock market. But then the Fed commentary became less hawkish and more data-driven, which was helpful given modest inflation data, but the start of the trade war rhetoric kept the market from bouncing back with as much gusto as it had been displaying.

So, what caused the correction this time? Well, to an extent, bipartisan support for heightened regulation and consumer privacy protections hit some of the mega-cap InfoTech stocks that had been leading the market. But in my view, the sudden spikes in fear (and the VIX) and in Treasury yields and the resulting rush to the exit in stocks was due to a combination of the Federal Reserve chairman’s suddenly hawkish rhetoric about interest rates and China’s extreme measures to offset damage from its trade war with the US.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings remain bullish, while the sector rotation model has switched to a neutral posture due to the recent correction. Read on....

Market Commentary:

As I have discussed in prior commentaries, the market has not been behaving quite the same ever since the February correction. And then on June 11, a sudden and significant “risk-off” shift in investor sentiment emerged, as global investment capital rotated out of “risk-on” market segments (like US small caps, industrial metals, commodities, emerging markets, and international developed markets) and into the perceived safety of US large cap equities. And within the large caps, capital rotated out of economically-sensitive cyclical sectors like Materials, Steel, Homebuilding, Energy, Industrials, Financials, and Semiconductors and into defensive sectors like Utilities, Telecom, and Consumer Staples – even as the major cap-weighted market indexes continued to hit new highs.

This was not a “healthy” rotation, in my view; so not surprisingly, this sudden bout of investor caution and defensive sentiment ultimately turned last week into a full-scale correction (which, by the way, I think likely has run its course). Let me expound a bit on those two main culprits (the Fed and China).

A suddenly hawkish Fed:

Regular readers of mine know that I have been in the “lower for longer” camp regarding the 10-year US Treasury yields for a long time (and by the way, lower yields support higher equity valuations). The market dynamics supporting persistent demand for US Treasuries include geopolitical turmoil and aging demographics seeking the safety of the US; divergent central bank monetary policies (with some countries still easing while the US tightens, which strengthened the dollar to the detriment of emerging markets); the relatively higher rates offered in the US; and the structure of large fixed-income mutual funds and ETFs whose mandate is to track the cap-weighted market indexes (i.e., they must buy Treasuries in their proportion to the broad fixed-income market).

And Fed policy seemed to be encouraging this demand for longer-dated Treasuries, given Chairman Powell’s previous comments that as long as the unemployment rate remains low and inflation stable near the 2% target, he didn’t see a need to accelerate his slow-but-steady path of interest rate increases. Moreover, St. Louis Fed CEO James Bullard stated, “The Phillips Curve has disappeared and neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure,” further suggesting the Fed should watch the yield curve in deciding monetary policy. And with the US dollar strengthening and the yield curve flattening in a distressing way, the Fed seemed to be acknowledging the negative impact of divergent central bank policies and signaling a potential slowing of Fed rate hikes. Powell had actually stated that the marketplace seemed to be telling the Fed that it had already brought the fed funds rate near the “neutral rate” (the rate that neither hinders nor stimulates growth). Dovish talk.

But then on October 3, the Fed chairman changed his tune during a PBS interview and shocked the market by opining, “The US is experiencing a remarkably positive set of economic circumstances… There’s really no reason to think this cycle can’t continue for quite some time… The really extremely accommodative low interest rates that we needed when the economy was quite weak; we don't need those anymore… Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral. We may go past neutral, but we're a long way from neutral at this point, probably.” No wonder bonds sold off. Given the vulnerability of a highly-leveraged global economy to the financial burden of rising interest rates, it seems a bit Pollyanna-like to make such a statement. Emerging markets with dollar-denominated debt are particularly vulnerable. But even here at home, interest expense in the federal budget is forecast to be 50% higher next year than in 2017, with interest on the federal debt expected to overtake Medicaid expenditures in 2020.

In response, the normally placid Treasury market suddenly got volatile, with the 10-year T-note yield briefly spiking to 3.25% before closing the week at 3.14%, while the CBOE Volatility Index (VIX) spiked to 28.84 on Thursday before closing the week at 21.31, which is above the 20 “panic threshold.” The 2-year T-note closed Friday at 2.86%, so the closely-watched 2-10 spread is only 28 bps, which means we are still at risk of a “Fed inversion” of the yield curve with the next one or two rate hikes. In spite of this recent surge in rates, I still see plenty of market demand for US Treasuries keeping longer-term rates in check, and modest rates support higher equity valuations. After all, the current forward P/E for the S&P 500 of about 16x equates to an earnings yield of 6.25%, which is about double the 10-year yield. And assuming the P/E remains stable, equity prices should be able to rise along with the rate of EPS growth – which is influenced both by total earnings growth (increasing the numerator of EPS) and share buyback programs (reducing the denominator).

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