The S&P 500 chalked up yet another low volatility day on Monday as the equity markets continue to question the likelihood of significant tax reform. At present, it appears that several GOP senators are probably aligned against the bill, including Bob Corker, Jeff Flake and James Lankford. It is notable that Senator Rand Paul, who I have observed to be a very consistent voice for traditional conservative ideas such as small government and low taxes, has endorsed the current version of the Senate bill. In an article for Fox News, Senator Paul stated that he is pleased with the new proposed bill because it eliminates the Obamacare mandate and makes significant across the board cuts on taxes. However, since the current version is what he endorses, any significant changes to it would likely cause him withdrawal his support.
What appears to be happening in my observation is that a relatively small group of GOP senators are focused on essentially an all-or-nothing approach to this bill. Some of the concerns are no doubt legitimate, but to be honest it appears that some of them have an undisclosed interest in making sure the bill doesn’t pass. After all, this is something that the GOP has campaigned about throughout the Obama administration and during the 2016 election. Therefore, my suspicion is that the bill is more likely to fail at this point than to pass, which means that the markets are likely to decline substantial in the event that the bill does not move forward. At any rate, we’ll see what the ultimate outcome will be as we move into early December. Until then, expect the markets to continue to realize low volatility.
As we enter this last week of November and are about to end 2017, it is crucial for us to recognize that the financial markets are now rotating around what I like to call the “Big Three”. As noted in the title of this post, the Big Three are taxes, stock buybacks, and interest rates. While this have always been important to the markets, especially in the case of rate hikes, to the best of my knowledge we have never before seen a situation in the markets where taxes and stock buybacks were comparably as important as interest rates. This is yet another reason why I believe that the current market environment is vastly different than those before it, and more importantly I am convinced that the only serious sources of volatility we are likely to see going forward through 2018 will be the Big Three. But why is this?
With respect to taxes and buybacks, we are on the cusp of the first major corporate tax reform since the 1980s. While there are have been many laws passed which have had tremendous impacts on the US financial markets since then, we did not have a significant change in the corporate tax rate. US companies have stashed away trillions of dollars in offshore accounts, and until now they have had little reason to be expected to repatriate those funds. This of course is strongly due to the higher corporate rate they would have to pay in the United States as opposed to those of tax havens abroad. Although those funds are often placed into the US markets through foreign affiliates (essentially shell companies) in the form of investments in US stocks or government treasuries, such funds are still considered to be “foreign” and therefore the companies can avoid paying the US corporate rate. Most importantly, these foreign funds cannot be used to purchase company stock. But if a corporate rate cut is passed and a repatriation initiative goes with that cut, then companies are likely to keep more funds in the US as well as repatriate more funds currently parked offshore. Much of those funds will inevitably be used for more buybacks, which would serve to sustain and advance equity prices.
With respect to interest rates, we are now seeing some indications that the FOMC might decide to slow down the pace of normalization. Part of this is due to a feared slowing inflation, which is a very big area of focus by the Fed. Current FOMC chair Janet Yellen has made it clear that she sees any slowing of inflation as a major concern and would halt any future hikes until inflation was up to par. Add to this the current uncertainty as to the success of the GOP tax bill, and the risk posed by the changing of FOMC chairs in February, and we have a situation where increasing interest rates might stall in 2018. This would likely provide a boost to the markets in the short term, but it would also prolong the life of the current debt-fueled bubble in US equities that we are now seeing.
In the end, I expect that 2018 will be dominated by trends in the Big Three. I will only speculate at this point that rate hikes are likely to continue provided that the GOP tax bill is passed in a form similar to the current wording, at least in terms of the corporate rate. However, if that effort fails, then I expect the markets to decline significantly as buybacks will stall along with any boost in corporate profits. We will get our first glimpse of what is to come with the Senate decides to vote on the tax bill, presumably by early December.
The financial markets were hit by another hack today, but it wasn’t on a mainstream company. Instead, it was a hack of the cryptocurrency company Tether, which offers to “tokenize” fiat currency into cryptocurrency. In this way, the company offers to allow clients to utilize blockchain technology to facilitate transactions on popular cryptocurrency platforms such as Bitfinex and Poloniex. Tether reported on November 21st that they had been hacked and $31M worth of its coins were stolen.
Blockchain is the underlying technology for the popular cryptocurrency Bitcoin. Since cryptocurrencies are not universally accepted for commerce in the United States or most major countries, exchanges have become a popular means of converting them into government backed currencies. However, with Tether, the idea was to create another means of exchanging fiat currency for cryptocurrency by making a proxy version of US dollars.
Tether promised to maintain an account where all fiat currencies deposited would back the cryptocurrency tokens it issued on a 1:1 basis. In theory, this would allow more rapid settlement of exchange transactions by circumventing traditional channels for transferring funds, backed by the promise that each token was fully backed by existing US dollars in the possession of Tether. However, cracks began to appear in this story recently, as speculation on social media implied that the company was fraudulently inflating its declared reserves so as to issue many more tokens than it had reserves to back. Moreover, it has been suggested by several online blockchain publications such as CoinDesk that Tether is owned by the same group behind Bitfinex, which is presently the largest cryptocurrency exchange in the world.
The allegations are that owners of Bitfinex are using unbacked tokens issued by Tether to artificially inflate Bitcoin prices, and then cashing in on those inflated prices either through trading fees or by actually selling Bitcoin on the exchange. Since no transparent regulation exists for cryptocurrencies or their exchanges at this time, it is impossible to prove whether or not this is true. However, there are a substantial number of reports that seem to suggest that it is far from unlikely that this is occurring. We’ll see what impact these developments will have going forward on moves to regulate cryptocurrencies and their exchanges.
Mario Draghi, the head of the European Central Bank, stated in comments made yesterday that the Eurozone is still in need of cheap credit in order to create inflation. After the financial crisis of 2008-2009, the ECB along with other global central banks, embarked on a path of easy lending and quantitative easing in order to hopefully stimulate growth to the european economy. However, nearly 10 years later, the EU is still unable to maintain its inflation targets and thus the ECB continues its previous policies, with the expressed intent of winding them down sometime next year (provided that growth targets are met).
It has long been my opinion that the ECB will be stuck in the recovery phase much longer than the United States, and thus interest rate disparities will grow larger between the two economies. At present, the FOMC has raised interest rates multiple times since late 2016. However, the ECB has not, as economic conditions in the eurozone have continued to lag behind. Draghi mentioned that the ECB still remains confident that the euro zone’s economic recovery would continue, but he also stated that lagging wage growth dictates that they continue the current economic policy. It remains to be seen if the markets will continue to show confidence in the ECB given this lackluster growth.
Like all of the other banks, JP Morgan (JPM) routinely sends out reports to its customers that could affect their funds in the bank. For the rest of November, and surely into December, JPM believes that three issues could roil the markets: weak commodity data out of China, Russia not extending oil cuts, and a “reality check” on tax reform. It believes that the tax issue is the most important of the three, and we agree.
From JP Morgan’s research department…
The growth trade that has dominated markets since late summer – higher yields, equities and commodities; tighter credit spreads and lower volatility – has stalled for a third-consecutive week, depending on one’s benchmark. US small cap stocks, probably the best barometer of US tax reform hopes, peaked in early October. Base metals began moving lower a week later. Most major stock indices are flat-to-down over the past week while credit spreads have widened (US high-grade +5bp, US high yield +20bp) and volatility has rallied (VIX +2%, VXY +0.5%) To be sure, these retracements are trivial relative to what risky markets have delivered year-to-date: returns are still running at least twice their long-term average for most equity markets, and in some EM sectors (local bonds, FX carry).
Multiple spoilers are converging in November, such as a reality check on US tax reform, weaker-than-expected China data, a Russian rethink on extending oil cuts. We’ll focus on the first issue, because tax overhaul seems the most complicated market driver given its fluid composition and tortuous legislative process. By contrast, China’s slowdown looks familiar and was already part of our economists’ baseline; hence, our neutral recommendation on base metals ex aluminum. The November 30th oil producers’ summit is not a drop-dead date for extending their year-old agreement, but we took profits anyway on a long Brent trade last week because oil’s geopolitical premium looked excessive.
The central question around tax reform should be What’s priced? Obviously the higher the expectations, the less upside on stocks and maybe bond yields and the dollar into year-end if Congress meets its somewhat unprecedented timetable of passage by Christmas. Conversely, another stalemate as befell healthcare reform could trigger a decent correction. We call Congress’s schedule somewhat unprecedented because proper tax overhaul like Reagan’s involving both lower rates and simplification required over 10 months to agree, as measured from the first House vote to Presidential signature. Just cutting taxes has been easier: Clinton’s initiatives in 1997 and Bush’s in 2001 and 2003 only required two months.
The Trump Administration has proposed Reagan-like reform, but our economists’ view has been that Congress will probably only manage Bush-like cuts. This means $1.5trn of gross unfunded tax reductions over 10 years, but more like $1trn net due to expiring provisions. These sums translate into little growth impulse once considered in annual increments, then discounted further to account for household and corporate tendencies to save some portion of tax givebacks. JPM Economics didn’t raise 2017 or long-term growth estimates after Trump’s election, nor after his tax proposal emerged in October. We’re still at 2.2% yoy for 2018.
Strangely given surging news trends around the tax topic, most survey and market-based measures suggest limited optimism. For example, consensus growth expectations (Blue Chip survey) have barely moved since the election. In January 2017, forecasters expected 2018 US growth of about 2.4%; that projection only risen to 2.5% since. It’s true that the S&P500’s forward P/E multiple has risen by about two points since the election, but EPS projections for 2018 (IBES basis) have not – they’ve been in a $146-$148/share range since November 2016. The implied 10% year-on-year growth in earnings next year would match 2017’s pace, even next year should deliver stimulus. By contrast, our Equity strategists think that just lowering the statutory corporate tax rate from 35% to 20% would add $12/share boost to any baseline.
We have been saying for some time that investors should take into consideration that the tax reform bill could stall or even fail to pass in the Senate. Either would be bad for the market because so much of the gains up to this point have been predicated in the reform passing and then giving a boost to the economy, which is then good for corporate profits, etc.
It should go without saying that, if it fails, it would be far worse than just being delayed or watered down. The market, however, doesn’t want a hollow tax reform bill either, because that wouldn’t deliver the expected future EPS growth.
Yesterday we wrote about run-of-the-mill economic data and gave the tax issue a rest. Well, we can’t do that today, because once again, it was a major part of the daily action in the markets. Before that happened, however, central planners (read: bankers) in China decided to intentionally boost (read: rig) stock indices.
The markets got a huge helping hand from the Chinese central bank, or People’s Bank of China (PBoC) before the US session opened. A good portion of the prior day’s weakness was due to commodity fluctuations (lower) in China spilling over into its equity markets, causing them to fall, which then led to the US weakness. Well, after a few days of the non-approved lower movements, the PBoC decided to lend a helping hand: it supplied the largest cash injection to its banking system in many months.
The markets got the picture: no downward moves shall last long before it’s propped up yet again – so everyone switched to PANIC buying and the results were massive gains in all indices.
To help things along, the House of Representatives passed their version of the Tax Reform Bill. Since this is what the US market has been pricing in for MONTHS, it could only help. Now the bill will move the the Senate, where it will surely stall…and may even fail to pass.
With the changing tides of the current tax bill in congress causing swings in the markets, we have written about it quite a lot lately. Today, however, we’ll go back to regular data. Both of the following reports came out before the open.
Last month’s retail sales data were huge, which reflected the necessary replacement buying after the massive summer storms. Last month’s reading for retail sales was a healthy +1.6% that was revised higher to 1.9%. This morning’s reading, that reflected the October data, was a far more normal 0.2%. Excluding auto sales, the report missed expectations with a 0.1% reading.
Econoday reports: Retail sales roughly hit expectations in October, slowing to a 0.2 percent monthly gain following September’s revised 1.9 percent hurricane-related surge. Ex-auto sales managed only a 0.1 percent gain though two core readings both show respectable growth, at 0.3 percent each for ex-autos ex-gas and control group sales.
Hurricane effects are evident in autos, slowing sharply to a still very strong 0.7 percent gain from September’s 4.6 percent replacement surge. Building materials reversed sharply, down 1.2 percent following a 3.0 percent gain, with gasoline down 1.2 percent vs September’s plus 6.4 percent. On the plus side, furniture along with electronics & appliance stores both rose 0.7 percent in October with health & personal care stores up 0.8 percent.
Year-on-year rates did moderate in October but only slightly and remain at respectable levels: total sales are up a yearly 4.6 percent, down 2 tenths in the month, with control group sales at 3.4 percent, also down 2 tenths. Yet the month of October, for retail sales, dims in importance to the holiday months of November and December going into which expectations are very strong for very solid results.
The other important data this morning was the closely watched (by the FOMC) inflation reading: CPI. The Consumer Price Index (CPI) came in at the expected number of 0.1% for the month.
Again Econoday reports: Very slight improvement is the message from October’s consumer price report where all key readings, except for one, did no better than meet expectations. The CPI managed only a 0.1 percent rise in the month with the year-on-year rate sinking 2 tenths to 2.0 percent. The core rate, which excludes food and energy, managed only a 0.2 percent monthly rise though the yearly rate, and this is the good news, rose 1 tenth to a slightly better-than-expected 1.8 percent.
Deep contraction in wireless services prices has been holding down consumer prices most of the year but not the last two months as this closely watched sub-component has now put together back-to-back gains of 0.4 percent. Also improving in the month were housing costs, up 0.3 percent, and medical costs, also up 0.3 percent. But there are stubborn areas of weakness including new vehicles, down 0.2 percent, and prescription drugs, also down 0.2 percent.\
But the annual core rate is moving, however slowly, in the right direction toward the Fed’s 2 percent goal. Traction in wireless services is a help and perhaps also are wages which have been showing glimmers of isolated strength in recent months. Still, today’s report won’t settle the controversy between the doves, who haven’t seen enough inflation to convince them that it’s improving, and the hawks who keep expecting the low unemployment rate to give inflation a boost.
Volatility has increased recently and if it continues, the “regular data” will once again affect the direction and vol of the markets.
Congressional leaders of the Senate have now moved closer to passing a tax bill according to multiple news sources. As I’ve noted repeatedly over the last weeks and months, the upward momentum of the financial markets is heavily dependent on the presumption of a coming tax rate cut for corporations. However, it has been clear so far that significant areas of disagreement on the tax bill remain to be resolved.
Presently, Senate leaders have worked to iron out the details of a new bill and appeared to have reached the critical number of votes needed to pass the bill as part of a budget proposal, thus allowing it to be passed by simple majority. However, at the last minute, a new portion was added to the bill to include repeal of the Affordable Care Act’s mandate for coverage. With this added into the bill, it is my opinion that GOP senators have put the passage of the tax bill in serious jeopardy. It has already been clear that repealing the ACA or parts of it has been a difficult objective, particularly because several Republicans have refused to vote in favor of any major changes or repeals of the bill in previous attempts this year. While the markets are still holding for the outcome, I believe the odds are now strongly against passage of a tax bill this year as long as repeal of the ACA mandate is included. We’ll see if my expectation turns out to be correct as a vote on the proposal is likely to occur before Thanksgiving.
In an apparent confirmation of my conviction that the global financial markets have become extremely dependent upon central bank stimulus to support equity prices, heads of four of the world’s largest central banks stated that they would commit themselves to signalling clearly to the markets and general public what their next moves will be. Governors Kuroda of Japan and Carney of England, as well as Janet Yellen of the FOMC and Mario Draghi of the ECB, all expressed their conviction that it was crucial not to surprise the markets with policy decisions, but rather to gently inform the markets of upcoming policy decisions in order to reduce volatility. Clearly, these central bankers must be aware that the financial markets have been tremendously influenced by the trillions of dollars of stimulus the banks have pumped into the marketplace since 2009.
At this juncture, it is clear that the bankers expect the markets to be very sensitive to any significant policy changes, whether it be the FOMC’s unwinding of its balance sheet or the ECBs tapering of bond buying. The markets have become accustomed to easy lending and plentiful money, allowing for massive stock buybacks and corporate mergers. However, as the global central banks attempt to wean the markets off of this environment and to normalize their economic policies, it is abundantly clear that the bankers do not expect the markets to be strong enough to handle any significant policy shocks. To that end, Carney, Kuroda, Draghi and Yellen all committed to sending clear messages to the markets ahead of major policy changes. We’ll see just how well they can hold up the markets going forward, as geopolitical risks continue to spread. Stay tuned.
I suppose it now goes without saying that the fate of the market and the current Republican lead Congress hinges on the passage of a significant tax bill. The GOP and the Trump Administration have repeatedly declared that a new tax bill would be signed into legislation that would cut taxes across the board, including for corporations. If this bill were to pass in a form similar to what has been drafted so far, it would a landmark moment for the GOP and the financial markets.
While the GOP’s fate is another matter, the impact on the financial markets is of primary concern to us as traders. It was clear that the markets are hinged on the results of this bill when the VIX rose over 10% due to a mere half a percentage point decline in the S&P 500. I’ve mentioned previously that the short volatility trade is grossly overcrowded and any significant decline in the markets is likely to set off an avalanche of short covering that will propel the VIX back towards a more normal range. In fact, I suspect it will go even higher due to the number of trades that would need to be unwound and their overall size. For these reasons and more, we can expect very significant volatility in the event that it appears that the bill will not pass. We’ll keep an eye on the situation to see how it develops.
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