Market direction is a “must-have” for any investor, as is the understanding that market tops and bottoms usually don’t happen overnight. It’s a process that can take months.
U.S. GDP and inflation expectations for Q3 and Q4 2018 are what matter from now on. In our opinion, we’re in the transition phase between accelerating to decelerating GDP and inflation. The first GDP reading for Q2 2018 is due this Friday and the number may even beat analysts’ expectations. It would be the eighth consecutive quarter of expanding GDP in the USA.
The behavior of the equity market seems very encouraging, while the bond market seems more cautious, regardless of the pop in global yields yesterday and less-than-stellar commodity behavior.
- 10 year Treasury yield: Short-term rates keep rising in sync with the Federal Reserve’s expectations for monetary policy and a tightening labor market. Long-term interest rates, however, until last week, may have been signaling deflationary expectations for the US ahead, producing a flattening yield curve and perhaps pricing in the peak in U.S. growth and inflation in Q2 2018. While many analysts expect a strong earnings season, last quarter’s numbers will be difficult to beat and yields have been trying to recover from their May drop. This is important because the 10 year TSY yield is at an important crossroads. If it continues to move up, it would be an indication of economic strength and inflation in the U.S., regardless of high comparables and a global economic slowdown. But if yields continue lower, they may be indicating deflationary expectations for the U.S. economy.
- Rise in Oil: While the strength in oil should further boost inflation and serve to keep the Fed on its rate hike path, US corporate profits mainly suffer when oil rises. This hurts manufacturing and transportation companies, as the cost of oil and transporting goods rises in tandem. Transportation leadership is critical to one of the oldest theories of market behavior: In a true bull market, the Dow Industrials (manufacturers) and the Dow Transports (transporters) must rise together. For the time being, they are.
- U.S. Dollar and Gold: The divergence between gold and the US Dollar is important to note. Let’s remember that gold can outperform in deflationary environments, as the Dollar weakens. Currently, although we expect to see further weakness in gold (therefore, we’re bullish on the Dollar), it’s at a major support area. Often times, gold marks the change in market direction and therefore, deserves attention as we move forward.
- Copper and Commodities: Copper, the commodity most linked to industrial production, has been moving sideways since January 2018 and definitely lower since early June. Its weakness makes sense, as the global economy slows down (mainly China, Europe and Emerging Markets). Base metals have also been moving lower since early 2018. Downtrends in copper and base metals are not an indication of global economic strength. We’re watching these closely, as strength in these commodities will help boost bond yields and lower bond prices (negatively correlated with commodity prices) will continue to drive money into stocks.
Conclusion: Should you sell all your growth and high beta positions now? No. But you should seriously consider that the U.S. economy may go into a cyclical slowdown, which will require the implementation of a defensive strategy to protect your portfolio. It’s okay to be doubtful. The important thing is to know where to look for clues of the next market move.