Nothing Lasts To Infinity

By: Kent Engelke | Capitol Securities

Today is not different, there are just different people defined as history typically repeats itself.

Digressing considerably, the other night I was watching a documentary about Winston Churchill and the week centered on the Dunkirk disaster. He was elected in a bitter election several weeks before the “low water mark of the British Empire.” The Establishment was steeped in appeasement, an Establishment led by Lord Fairfax and Neville Chamberlin.

For those who may not recall, Neville Chamberlin was the British PM who said, “We have won peace for our time,” several months before the commencement of the greatest war that ever occurred that claimed between 85 and 100 million lives. Lord Fairfax was an extremely powerful and influential aristocratic politician that also championed appeasement, seeking peace with Germany.

In my view, the similarities, both politically and personality, between Churchill and President Trump are/were uncanny. Churchill challenged the Establishment, a challenge that almost failed miserably. Today most historians believe he is a major factor why England did not fall to the Germans.

Donald Trump is challenging the Establishment. He is reviled by both the left and the right. Comments made and attitudes about Trump are similar to those made about Churchill. Similar to Churchill, Trump is/was rallying the masses in believing that tomorrow will be better.

Many times I have commented about consumer and business sentiment surveys; surveys that have surged since November 2016 and in many regards are at the highest levels in over 30 years. Talk about Hope and Change.

Politics and economics are blood sports. The Establishment does not like change for a myriad of reasons, most specifically, all know the rules and respond politically and financially accordingly.

As I commented the other day, I do not know if there is free trade. What I do know is that the rules are changing, rules that the Establishment has spent billions in crafting

Speaking of change, the other day I referenced a JP Morgan report stating the impact of AI (algorithmic trading) had upon the markets during February’s swoon. Yesterday, Bloomberg referenced the losses in a $52 billion quantitative (algorithmic) hedge fund, the greatest since 2008, losses that are considerably greater than losses sustained in the S & P 500.

The co-founder of the fund states, “We have made easy money for a long time; that cannot go forever and I think we are in period of adjustment….it is hard to say how this unfolds given the similarities of and proliferation of these types of funds.”

Many times I have opined when everyone adopts a similar trading strategy, that days of that strategy are numbered. Are we there today?

Commenting about yesterday’s market action, equities were again lower. Some believe the decline was the result of politics. Others point to disappointing retail sales or concerns about monetary policy. While some suggest market mechanics are now completely broken where the popular cross-correlated trade is dead.

I think it is a combination of the above.

Perhaps the only certainty to write is today is considerably different than yesterday; a change that should have been expected given nothing lasts to infinity.

What will happen today?

Last night the foreign markets were up. London was up 0.07%, Paris was up 0.14% and Frankfurt was up 0.12%. China was down 0.01%, Japan was up 0.12% and Hang Sang was up 0.34%.

The Dow should open flat. The 10-year is unchanged at 2.82%.


A Mixed Day

By: Kent Engelke | Capitol Securities

JP Morgan has accused 12 artificial intelligence hedge funds (aka algorithmic) of playing a major part in the equity sell off that hit global markets in early February. The bank believes AI funds, which use machine learning in their trading processes to predict market trends, played a “big role in February’s de-risking” as the models rushed to unwind positions as volatility rose.

The “AI” funds slumped 9.3% in average in February, the worst monthly decline since the index began in 2011. JP Morgan writes there are just 12 funds as well as 11 defunct ones.

Wow! I rhetorically ask what happens in a crisis? Does the cheapest execution morph into the greatest cost? I think the odds suggest yes.

Market activity yesterday was mixed. This week’s economic calendar is comprised of retail and inflation data that can greatly influence perceptions.

Commenting about inflation and growth, real GDP or growth minus inflation has averaged about 1.5% since the end of the great recession. Gluskin Sheff writes real GDP has averaged 3.8% in comparable post war periods. Nominal GDP, which is growth not adjusted inflation, has averaged 3.1% since June 2009.

I believe it is lack of nominal GDP growth that is why the populist movement is so strong in the US and the result of the world.

What will happen today? Will the CPI impact trading?

Last night the foreign markets were mixed. London was down 0.04%, Paris was up 0.35% and Frankfurt was up 0.03%. China was down 0.49%, Japan was up 0.66% and Hang Sang was up 0.02%.

The Dow should open flat ahead of the CPI. The 10-year is unchanged at 2.87%.


Employment Data At 8:30 AM

By: Kent Engelke | Capitol Securities

Markets were relieved the tariffs are not as onerous as first expected. President Trump followed through on his pledge to impose tariffs on imported steel and aluminum, while excluding Canada and Mexico and leaving the door open to sparing other countries if they met one on one with the US.

In some regards, the President is utilizing the time honed strategy of brinkmanship. As I commented the other day, I am a free trade advocate, but I do not have a clue as to whether or not free trade actually occurs. To comment is meaningless, but to comment about the environment is perhaps informational.

What is documented, during the Cold War America permitted the dumping of products on our markets to lessen the probability of a communist takeover for such was more palpable and cheaper than conflict. As noted the other day, some believe this concept morphed during the last eight years in an attempt at global wealth redistribution.

The issue at hand is the global economic infrastructure is based upon today’s policies and any change will be tectonic. All have learned to live in the current structure regardless if it is “fair” or not. There are billions of dollars in sunken costs that may or may not be recovered if current rules change, rules that indicate whether or not “free trade” actually exists.

Today all will focus on the all-inclusive February GDP data that is released at 8:30. Analysts are expecting a 205k increase in farm and non-farm payrolls, a 4.0% unemployment rate, a 0.2% increase in hourly earnings, a 34.4 hourly work week and a 62.7% labor participation rate. Will the data confirm January’s statistics?

Last night the foreign markets were mixed. London was down 0.05%, Paris was up 0.03% and Frankfurt was down 0.38%. China was up 0.57%, Japan was up 0.47% and Hang Sang was up 1.11%.

The Dow should open flat, but this could change dramatically if the 8:30 data is sharply different than consensus. The 10-year is off 5/32 to yield 2.89%.


The New Versus The Old Normal

By: Kent Engelke | Capitol Securities

Friday, the all-inclusive BLS employment report is issued. January’s data was the primary catalyst for February’s equity and Treasury swoon as wages unexpectedly accelerated.

Many times I have commented about the gargantuan change from “QE” to “QT.” How will such impact markets? A central bank has never attempted such a feat. It is not a question that if mistakes are to be made, but rather how significant these mistakes will be.

We are about six months into the Fed’s balance sheet normalization and its impact is now showing up in the data. The Fed allowed $10-$15 billion of assets to mature in both January and February. The previous three months, a total of $7 billion matured. Generally speaking, the Fed has reduced its holdings by approximately $30-$32 billion during the past five months, an amount that is expected to increase considerably over the coming quarters.

Yields across the Treasury spectrum have increased considerably over the past five months. Is the rise in yields the result of “QT” or from greater than expected economic activity? To write the obvious, dichotomies rarely occur. I think the rise in yields is the result of a number of factors with the greatest weighting on stronger than expected economic and wage growth.

What happens if costs push or wage inflation continues to accelerate above 3% as many of the PMI surveys suggest? Will the Treasury market begin to fear the unanchoring of “inflationary expectations,” amplified by the normalization of the Fed’s balance sheet via asset sales and maturities?

As discussed at length, the last 10 years was unprecedented with some stating that we have entered into the New Normal. For a myriad of reasons, I think the economy is now gravitating back to the Old Normal, a transition that will contain an infinite number of surprises.

The Old Normal is defined as more normalized balance sheet and growth closer to the 75-year average. As stated above, the equity and bond markets believe the New Normal will last into infinity. Yesterday, I referenced a Bloomberg article stating that bonds and equities are the most negatively correlation in 250 years, “an environment that is unlikely to persist.”

Commenting about yesterday’s market activity, equities were mixed as signs mounted the President could be dissuaded from enacting tariffs. Treasuries were flat.

Last night the foreign markets were mixed. London was up 0.05%, Paris was down 0.10% and Frankfurt was up 0.40%. China was down 0.55%, Japan was down 0.77% and Hang Sang was down 1.03%.

The Dow should open moderately lower on the prospect of escalating protectionism. What I find interesting is that the economy that is most dependent upon trade — China — has said little. The greatest outcries are from our closest allies where the imbalances are not as great as with other countries. The 10-year is up 10/32 to yield 2.86%.


Globalism Versus Economic Nationalism

By: Kent Engelke | Capitol Securities

Equities slumped again Friday, but the mega capitalized shares felt the brunt of the selling, an inverse of long term trends. As noted Friday, tariffs would impact the multinational companies more than the firms whose business is done domestically.

By education, I believe in free trade and tariffs are detrimental to such. But is there free trade? I do not know how to answer this question.

I would like to digress. Following WWII the vast majority of political scientists/economists would agree the US opened its borders to any country resisting communism based upon the theory that if the country is doing well economically, the odds of it falling to the communists fall. Trade deficits were more palatable than more communist satellites.

The cold war ended and for about 7-10 years, global trade expanded as formerly closed markets opened.

The above is well accepted.

Some believe the period from 2008-16 was an era where the Administration attempted global wealth redistribution via trade. The entire global business industry was built upon multipolarity and interdependency with the US absorbing any losses in this global redistribution attempt.

I question if globalism/interdependency is the pathway to economic growth and wealth dispersion, why did economic growth sputter and the global wealth divide expand? As noted many times, the last time there were four consecutive quarters of 3% growth or more was 2003-04, the longest such stretch since the early 1930s.

Obviously there is a massive disconnect, hence the global rise of economic nationalist governments.

To reiterate, I believe during the past 10 years there was a massive transfer of wealth from Main Street to Wall Street, a transfer that created today’s wealth disparity and political environment.

President Trump is turning the global business environment upside down in his quest to return wealth back to the individual.

It is my firsthand experience, any organization that is losing power or influence will take any means necessary to maintain it. Politics/economics is a blood sport.

The path and the ramifications are infinite.

This week’s trade data has now risen to considerable significance.

Friday, the all-inclusive employment data is released. All will scrutinize the data in an attempt to discern wage inflation. The individual will welcome wage inflation, but the markets do not for such will alter monetary policy assumptions, assumptions that are a large variable to algorithmic trading programs.

What will happen today?

Last night the foreign markets were mixed. London was up 0.14%, Paris was up 0.16% and Frankfurt was up 0.54%. China was up 0.04%, Japan was down 0.66% and Hang Sang was down 2.28%.

The Dow should open nominally lower on fears of an escalating trade war. Politics is emerging as the primary variable. The anti-establishment party in Italy surged in yesterday’s election. China hosts its National People’s Congress. And then there is the upcoming announcement from the Trump Administration regarding trade. Will it be as draconian as some fear? There are also announcements from the ECB and BOJ about monetary policy. Wow! It makes Friday’s employment data a second tier event.

The 10-year is up 4/32 to yield 2.85%.


Oil Market Fears: War, Default And Nuclear Weapons

The U.S. is one of the few areas of the world in which there is an energy investment boom underway, a development that could smooth out the uncertainties of geopolitical events around the world. At the same time, outside of the U.S., there is a deterioration of stability in many oil-producing regions, aggravating risks for both oil companies and the oil market, according to a new report.

Financial risk firm Verisk Maplecroft explores these two trends as they play out simultaneously. The U.S. shale sector has emerged from years of low oil prices, damaged but still intact. Importantly, the shale industry “can ride out price dips and respond quickly to upticks, weakening OPEC in the process,” James Lockhart-Smith, director of financial sector risk at Verisk Maplecroft, wrote in the report. Combined with deregulation at the federal level, the oil industry is in the midst of an investment boom in the U.S.

Meanwhile, things are not so rosy elsewhere. Verisk Maplecroft surveyed a long list of countries, and produced its Government Stability Index (GSI), which uses some predictive data and analysts forecasts to take stock of geopolitical risk in various countries over the next few years.

The results are not encouraging. The number of countries expected to see a deterioration of stability “significantly outnumber those we see becoming more stable,” the firm said. The reasons are multiple, including low oil prices, but also the erosion of democratic institutions.

“We don’t see increasing instability necessarily ending in coups or significant political upheaval, but a less predictable above-ground-risk environment is likely to emerge,” Verisk Maplecroft’s Lockhart-Smith said. “Arbitrary decision making, possible measures to buy off key stakeholders or an inability to pass regulatory reforms will be the main risks to projects in these countries, as their governments seek to stabilize and maintain their influence.”

Not all of the countries expected to suffer from a decline in stability are that important for the oil market, such as Romania or Kenya. Also, some countries might be on an improving path, but at the same time present a downside risk that, while unlikely, could be huge.

In this case, Iraq stands out. Verisk Maplecroft says that Iraq “has a business-friendly upstream environment” and the forecast is for stability to improve. However, even if it seems somewhat reasonable that things could trend in the right direction, the downside risk is massive. And there are is no shortage of potential catalysts: The report points to elections in May, plus the “deep ethno-sectarian divisions and weak institutions.”

Venezuela is another obvious flashpoint. The deterioration of the country’s economy and oil sector have been profound. But Venezuela also illustrates a different problem – that disruption need not come from a coup, a civil war or some other obvious geopolitical development. Verisk Maplecroft points to the purge of state-owned PDVSA following the unsuccessful coup in 2002 as a poignant example. The country’s oil production has steadily eroded over the past decade and a half since the Venezuelan state sacked experienced professionals at PDVSA and used revenues for other purposes while failing to invest in existing oil assets.

Verisk Maplecroft argues that Egypt is a potential contemporary example of that phenomenon. The increasingly authoritarian government in Cairo could roll back the policies that attracted investment from oil and gas companies in the first place over fears of a popular uprising.

Finally, one of the more intriguing cases is that of Russia, the largest oil producer in the world. Verisk Maplecroft sees little risk of political upheaval as Russian President Vladimir Putin seeks another six-year term in March, but a battle could ensue in the upcoming years over his succession when his term is up in 2024, and “factional struggles between liberals and statist former security officials are already ramping up in anticipation of his exit,” the report says.

Verisk Maplecroft puts the odds of a general deterioration of political stability in Russia through 2021 at 90 percent, and the “oil sector will be a strategic prize in this battle, not least because Rosneft CEO Igor Sechin is a central protagonist.”

In the near-term, there are two huge geopolitical threats to the oil market, but neither seem all that likely. Verisk Maplecroft says a potential war on the Korean Peninsula or a war between Iran and Saudi Arabia are the largest threats to the oil market, but both situations, while tense, will probably stop short of outright military conflict. Still, the mere threat of conflict, could add to the risk premium for crude oil prices.

Link to original article: https://oilprice.com/Energy/Energy-General/Kurdish-Iraqi-Deal-Could-Restore-Oil-Production.html

By Nick Cunningham of Oilprice.com


The Changes Are Indeed Tectonic… How Will The Algorithmic Trading Models Respond?

By: Kent Engelke | Capitol Securities

I think yesterday’s data clearly indicates the economy is accelerating. Jobless claims are at the lowest level since December 1969. Real disposable income posted the greatest gain since April 2015 and hourly wages rose by the greatest amount since 2009. Manufacturing increased the most since May 2004 led by strong growth in exports, the greatest jump in six years. Moreover, inventories fell which suggests pent up growth to replenish inventories.

This data coupled with Powell’s congressional testimony was weighing upon the markets before the President proposed the tariffs on steel and aluminum.

In my view, equities sold off because such is inflationary. The cost of production just rose. I will not venture into the discussion about possible trade wars, but rather focus upon monetary policy implications which in my view are the primary determinate of market direction.

It is now common knowledge the markets are dominated by technology based trading; trading that is based entirely upon momentum. According to Bespoke Investment, the technology sector now comprises about 25.1% of the capitalization of the S & P 500, eclipsing the prior record of 25% in November 2000.

A major difference however between today and yesterday is the massive concentration of wealth in just five companies versus about 50 eighteen years ago. These five companies comprise about 14% of the total capitalization. Wow!

A primary component of algorithmic trading models is interest rates. What happens if the unfolding environment is different than the assumed environment?

The assumed environment is not unfolding. Secular stagnation is replaced by accelerating global growth. Interdependency and multipolarism just received another death blow with the proposed tariffs.

As noted several times, approximately 53% of sales from the S & P 500 came from foreign countries. The comparable portion is about 20% in the Russel 2000 as per Bloomberg.

For what it is worth department, according to Bloomberg, the combined monthly import of steel and aluminum totals about $3 billion. It is the fear of retaliation that changes the inflation calculus, hence valuation models.

What will happen today? The condemnation of the proposed tariffs — nothing radical in a historical perspective as President Bush proposed similar tariffs in 2002 — is rising on all sides. Surprisingly, China’s response is relatively muted even as its economy is an export dominated economy defined as domestic growth is predicated upon shipping inexpensively produced goods to the west. Canada, who is the biggest supplier of foreign steel to the US, is loud.

Last night the foreign markets were down. London was down 0.98%, Paris was down 1.80% and Frankfurt was down 2.21%. China was down 0.59%, Japan was down 2.50% and Hang Sang was down 1.48%.

The Dow should open moderately lower from a combination of trade war rhetoric and the unexpected announcement from Japan that it may “exit” QE. The 10-year is unchanged at 2.82%.


The S & P 500 Mid-Cap Is At The Lowest Valuation In Two Years

By: Kent Engelke | Capitol Securities

Bloomberg wrote yesterday the S & P 500 mid-cap index is the lowest valuation in two years and is below the five-year average on a forward 12-month PE basis. This should not be a surprise given the myopic recovery following perhaps the narrowest advance in history.

The SEC reported several weeks ago approximately 50% of volume is the result of algorithmic trading which is essentially the trading of derivatives and futures tied to equities. Another 40% is the result of indexing and ETFs, both of which are viewed as “kin” to algorithmic trading. Only 10% of the volume is the result of buying 100 shares of ABC company.

It is apparent from the data above that anyone who is utilizing traditional security and macroeconomic analysis, analysis of the typical stock is fighting a losing battle.

It is generally acknowledged that such strategies do not reflect any changes in the political or macroeconomic environment, changes which can potentially cause a shock. The selloff earlier in the month and the narrow based recovery is ample evidence of this view.

The only constant in life is change. Today’s environment will change, but the catalyst of this change will perhaps be the one that has not yet been discussed.

The marquee event of the week is today’s congressional testimony by FRB Chair Powell about the economy. Little new ground is expected to be broken with most believing he will reiterate many of his predecessor’s comments and outlook.

To write the obvious, if his comments are too economically bullish, equities could respond negatively given the potential impact on the bond market.

What will happen today?

Last night the foreign markets were down. London was down 0.04%, Paris was down 0.02% and Frankfurt was down 0.48%. China was down 0.34%, Japan was up 1.07% and Hang Sang was down 0.73%.

The Dow should open moderately lower ahead of Powell’s testimony. The 10-year is off 3/32 to yield 2.88%.


Perhaps The Most Concentrated Market Advance In History

By: Kent Engelke | Capitol Securities

Many times I have commented about the massive market imbalances, defined as a narrow based advanced focused in a handful of stocks. Many times I have used the number 5 to define this narrowness utilizing industry reports and data to back my statements.

Yesterday the front page of the WSJ read “Index of 500 Stocks is Powered by Just Three.” The article asserts three technology titans have powered nearly half of the 2018 S & P 500 advance. One issue alone accounted for 27% of the rise. Another accounted for 13% and the last 8.3%. Overall, technology has accounted for 75% of the S & P 500 gains, according to the WSJ. In 2017, technology was about 60% of the S & P 500 advance.

I do think it is noteworthy that two mega-sized financials have contributed about 12% to 2018 gains.

Wow! Talk about a myopic market. I thought 2000 was narrow.

Yesterday, the Dow advanced, but the advance was led by the oils, the most beleaguered S & P sector. It is also the sector that is trading at the greatest discount to the price of oil and to the overall S & P in history. The catalyst for the advance was an expected drop in inventories, the largest draw in five weeks and surging exports. Moreover, the data indicated the first drop in production since early January versus a forecasted rise.

The NASDAQ and S & P were nominally lower, the inverse of the status quo.

What will happen today?

Last night the foreign markets were mixed. London was down 0.21%, Paris was down 0.12% and Frankfurt was up 0.13%. China was up 0.63%, Japan was up 0.72% and Hang Sang was up 0.97%.

The Dow should open nominally higher as Treasury prices have steadied. The 10-year is up 9/32 to yield 2.89%.


January’s FOMC Minutes

By: Kent Engelke | Capitol Securities

The January FOMC Minutes stated that there is “substantial underlying economic momentum,” but indicated the Committee is in no hurry to accelerate the pace tightening. The Minutes indicated the possibility “economic growth would exceed their estimates,” they also cautioned that there were risks that inflation could “undershoot targets.”

Markets initially advanced on the Minutes, but upon further reflection Treasuries sold off. The 30-year is now at yields last experienced in July, 2015 and the 10-year is trading at over 4 year highs. Equities advanced handsomely on the data, but only to end moderately lower as Treasury yields rose.

One part of the Minutes that I found significant is that Committee Members now think the impact of the recent tax cuts could be bigger than previously believed. Moreover, the January meeting was held before the recent congressional agreement that increased both military and nonmilitary discretionary spending.

In other words, I think the mix of fiscal stimulus — both privately and by the government — could be significantly bigger over the next 18 months than assumed at last month’s Fed meeting.

Next week the FRB Chair will present before Congress the Fed’s semiannual forecast. I think this testimony could be of great significance.

For what it is worth department, according to Bloomberg, the markets still have not discounted three interest rate hikes for 2018, much less four and is only pricing in 1.5 hikes for 2019, still half of what the Fed is forecasting.

What will happen today?

Last night, the foreign markets were down. London was down 0.84%, Paris was down 0.25% and Frankfurt was down 0.61%. China was up 1.89%, Japan was down 1.07% and Hang Sang was down 1.48%.

The Dow should open choppy. The 10-year is up 6/32 to yield 2.94%.