A solid week for the equity markets around the world. U.S. stocks advanced between +1.6% and +2.3% while the overseas markets were generally higher. Japan added +3.3% while both Germany and France were up 1.8%. Mainland Chinese stocks bucked the trend losing -0.4%, but Hong Kong added +1.3%.
Inflation ticked up in August (more below) and bond yields popped higher. The yield on the 10-year Treasury increased from 2.06% last Friday to 2.21% today. As a result, intermediate-term Treasury bonds lost -0.9% while long-term Treasuries dipped -1.7%. High-yield and bank loans were up +0.7% and +0.1% respectively.
Inflation Jumps on Hurricane Disruptions….
A modest pop in inflation got people a little excited earlier in the week. US consumer prices rose more than expected in August as Hurricane Harvey shut down refineries along the Gulf coast and sent gasoline prices sharply higher. The headline CPI increased +0.4% last month, the biggest one-month gain since January (as you can see below).
The advance helped push the year-on-year price increase to +1.9%, compared to the +1.7% pace recorded in July. Gasoline prices were up +6.3% in August alone. Most analysts think this increase is temporary and will reverse once refineries come back on line.
But the market wasn’t positioned for an increase in inflation, even if it might be temporary. Bond yields increased as we noted earlier, and the odds of a Fed hike in December took a meaningful jump from 32% to 53%, as you can see below:
But despite the headlines it is worth taking a deep breath. To make a more convincing case inflation is headed materially higher we are going to need to see core inflation tick up. Even in this last report which was spun as an inflation ‘surprise,’ core prices, which exclude food and energy, gained +0.2% month-over-month — in line with expectations. The 12-month rate has been stuck at +1.7% for the fourth month in a row.
…While Growth Estimates Dip
It is also going to be hard for inflation to pick up if growth underwhelms, as it looks like it might. Just this week there were some dramatic cuts in growth expectations for the third quarter. For example, the Atlanta Fed estimate fell from +3.0% to +2.2% over the course of a week (see below).
The New York Fed’s estimate fell from roughly +2.0% to +1.3% as well (chart below):
Merrill Lynch took their guess down to +1.7% from +2.5%. All of this came after a couple key economic reports this week. First industrial production fell -0.9% in August after Hurricane Harvey hit the gulf coast.
Second, retail sales fell -0.2% in August (-0.4% if you exclude gasoline). They were expected to be up.
How worried should we be about the deterioration? Our take is that the economic data is going to be very noisy the next few months. The impact of Harvey and Irma is going to mess up all the economic models and make the tough game of predicting economic growth nearly impossible. It is probably safe to say that the short-term economic numbers take a significant hit over the next couple months but bounce back eventually as rebuilding kicks in. The underlying economy in the U.S. is probably neither as weak nor as strong as the numbers may show over the coming months.
But this won’t stop the markets gyrating on noisy data.
Is North Korea Priced In?
When it comes to North Korea, though, it’s as if the markets have grown bored with the whole thing. On Thursday North Korea launched another missile over Japan. This one apparently flew the furthest yet, demonstrating its ability to hit Guam.
Markets largely shrugged the event off (President Trump couldn’t even be bothered two tweet on the topic). Certainly, the yen initially popped higher, something typically viewed as a risk off trade, and S&P futures dipped. However, the dollar quickly bounced and U.S. markets opened in the green on Friday. South Korean shares rose 0.35% on Friday, its fourth advance in the past five sessions. While the Korean equity market dipped earlier in the month after the first missile launch and nuclear test, the index has quickly recouped the losses, as you can see below.
North Korea, at least it stands now, seems to have lost the ability to sway the markets.
What Goes Up Must Come Down……Right?
If you read enough market punditry you come across the refrain that stocks are due for a correction simply because they have gone up. This somehow seems intuitively correct. ‘Trees don’t grow to the sky’ and all that. You are hearing more and more of this because the S&P has gone five straight months without a dip. You must go back to March for a negative S&P return, and that one hardly counts. The index was down just -0.04% that month.
But is there a relationship between five up months and increased odds of a negative month in the near future? Nautilus Investment Research took the time to crunch the numbers and found something interesting. The table below shows how the S&P has performed after going up for five straight months over the next one, three, six, and twelve months (see table below).
The study only goes back to 9/30/1987 (is that really 30 years ago??), but the average returns over the four subsequent periods are positive and largely in line with average market returns. For example, six months after the signal the market has averaged a return of +4.53%, basically in line with the market (+4.43%). In three instances the S&P was down while it gained in eleven. It is the same story over 12 months, and if anything, the market performs better than average. There are no negative observations over a one year horizon.
Of course, none of this means the market won’t correct over the months to come. Only that momentum, at least over the short-term, can be self-fulfilling. Selling simply because the market has gone up may not be the best strategy after all.
Have a good weekend.
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