Last week was a busy one, with US, European and Japanese central banks all meeting plus the announcement of tit-for-tat tariffs between the US and China capping things off on Friday. This week should be quieter, with not much in the way of US economic data. The only caveat: the US is not in the World Cup, which means American markets are not subject to the documented lower volumes that come when home teams play during market hours. Yes, this is a real thing...
The week ahead will therefore be one where investors consider the big picture, so today we have some data-driven takes on inflation, rates, trade, and a few other pressing issues. Let’s dig right in…
That US inflation will remain near 2% forever is THE bedrock assumption in global financial asset prices right now. It keeps Treasury yields low even as the Fed unwinds its balance sheet. Low yields support US equity valuations, which in turn keeps the high yield/leveraged loan market running in high gear. Lastly, they support US consumer spending, which is the economic lynchpin of Asian and European exporting economies.
Markets currently agree that 2% is the right number. Here is the inflation expectations data from 5/10/30 Treasury break-evens (TIPS vs Treasuries):
What to make of this:
Bottom line: US inflation expectations will likely rise further in 2018, but that alone is not enough to call the end of the equity bull market.
There’s an old rubric that says, “The Fed ends every bull market”. We personally don’t put much credence in that; geopolitical events that spike oil prices have a much better track record as matador than the Fed ever will. Still, with the Fed’s decision to raise rates again this week, we hear some concern they are responding to the current tax-cut fueled growth environment rather than the sustainable (lower) trajectory of the US economy.
The shape of the US Treasury yield curve tells the story:
Bottom line: unlike the prior point on inflation expectations, we are actually concerned about the shape of the yield curve because market worries of a “Fed mistake” are gaining real traction. If the levels here were an equity price chart, you wouldn’t buy that stock; the yield curve seems destined to go to zero in the next 3-6 months. After that, the recession fuse is lit and stocks can still rise but they are living on borrowed time.
We get questions along the lines of “Why isn’t all this trade chatter hurting equity prices?” Our answer: they are, just not US equity prices. The US economy is at the peak of a near term momentum cycle, and domestic stocks are responding to that. In the rest of the world, the story is different.
The year-to-date numbers for various local-currency equity returns:
Bottom line: if the US economy were as weak as Europe, or slowing like China’s, or as exposed to foreign trade as South Korea, it would be responding differently to trade war headlines. For the moment, the American economy is simply best-in-class. Should it slow in Q3 and Q4, trade war news will matter more.
We had a long exchange with a good friend and ace researcher this weekend on the role higher interest rates may play on US consumers, with the transmission mechanism being credit card debt. Interest rates here are generally tied to prime, so as the Fed raises rates it makes this debt more expensive to carry. And since US consumers owe $984 billion in revolving credit (the Fed’s name for this, and they keep the records here) that could be a substantial problem.
Here’s the rest of the data, which tells a calmer story:
The bottom line: there are some reasons to worry that higher rates will slow housing demand, but that only touches current home buyers and those with resetting mortgages. The most common form of household debt where rates can vary – credit cards – is less of a concern to us.
Summing up: we score this evaluation as 2:1 in favor of US stocks. Inflation expectations can creep higher without hitting equity values. Higher rates aren’t going to kill the marginal US consumer in one fell swoop. The one warning sign: the shape of the Treasury curve. Not an outright victory, but enough to keep the market narrative positive through the end of the quarter.