Time for a pause

Was Friday's payroll report a game changer?  Not as such...markets were already leaning towards a Fed rate hike in December, so the strong report really just gave them a further push.   The January Fed funds contract, for example, moved just 2.5 ticks on the day...representing an increase of 10% in the probability of a 25 bp hike next month.

What the report did do, on the other hand, was unleash the pent-up demand for trades like the dollar, where there was perhaps some reticence to add risk last week despite a strengthening of conviction in the theme.  Markets have been burned so often by ill-timed bad data releases over the past couple of years that to add risk ahead of payrolls seemed more akin to gambling than trading or investing.

At this juncture, the Fed will have to get pretty creative to execute yet another U-turn by the time of the December meeting.  Over the past few weeks they had ample opportunity to emphasize the inflation shortfall relative to target and chose not to do so; if the FOMC were to arbitrarily and suddenly decide to focus on that rather than the full picture over the next six weeks, it seems like even they would realize how stupid it would make them look...and no one likes to look stupid.

That US equities shrugged off the number was certainly notable, and would appear to confirm Macro Man's general thesis that stocks just want the Fed to make a decision, whatever it may be, rather than fannying about as they've done for much of the year.  That being said, this will certainly be an atypical rate hike, insofar as a) the US economy has never been hooked on the monetary heroin of QE and ZIRP before,  b) there isn't exactly the sort of tailwind from interest-rate sensitive sectors that usually accompanies the onset of a tightening cycle, and c) never before in Macro Man's calculations has monetary liquidity explained so much of equity returns.

On the last factor, let's be clear: earnings have grown over the years, well outstripping the rise in nominal GDP.   So the SPX rally from 666 hasn't all been about liquidity.   More recently, of course, SPX earnings have flattened out, but here we are a stone's throw from the ding-dong highs in the SPX.  Meanwhile, we're more or less at the highs in the NDX, thanks to a more robust performance of technology earnings and the love affair with all things tech.

Even there, of course, there is some reason for concern.   The NDX P/E is 23 and the Nasdaq Composite, 30...and that's with the largest company, Apple, hanging a P/E of just 13!  Now, PE's are normally negatively correlated to earnings; during recessions earnings tend to fall dramatically more than economic activity, and while equities usually decline too, a multiple expansion is common thanks to the sharp decline in the denominator.    The flip side is that during earnings upswings, equity indices usually increase at a slower rate than earnings, leading to declining multiples.



What's notable with the NDX is that since mid-2011 (the "forward guidance era"), PEs have generally trended up even as earnings have ratcheted higher.   There are a number of possible explanations for this, but "easy money" seems like it would come pretty high on the list.   As such, one does wonder how much further index-level valuations can go in the context of Fed lift-off before normal service is resumed in the relationship between earnings and multiples.  Macro Man finds himself increasingly inclined to side with the Opportunists for the time being....

He would also not be surprised to see the dollar take a little bit of a breather early this week.   It's come a reasonable way over the last few weeks, and the post-payroll gap left fresh USD longs with relatively little cushion relative to current levels in EUR/USD in particular.   Moreover, as Macro Man noted in his second post on Friday, gold is sitting close to its longest losing streak of the last 35 years.   Only 6 previous times since 1980 has gold fallen 8 or more days in a row, the most recent being in March of this year.


On that occasion, after the 9-day streak ended, gold dropped another two days....and then rallied 7 days in a row and $70.


Elsewhere, China released FX reserve and trade data over the weekend, and what do you know...reserves confounded expectations and actually increased last month- only the second monthly increase over the past year.  The rise was notable given the increase in the dollar's value against many of the other currencies in China's reserve basket over the course of the month.


Meanwhile, the trade balance remained close to all-time highs, albeit largely because of the ongoing vacuum in import demand.   Indeed, the y/y change in the 3mma average imports (Macro Man's preferred analytical method to smooth out the effects of the lunar new year) is now at its lowest level since the crisis.


This is the conundrum in analyzing China.  One would normally expect an exporting powerhouse to see its trade surplus decline when trade volumes collapse....yet China has actually seen a remarkable surge in its trade balance to accompany declining trade.  The trend seems unlikely to continue indefinitely; whether imports level off or export growth takes a dive will dictate the next chapter in the saga.  Imports are already down 28% from their (admittedly non-seasonally adjusted) highs; by way of comparison, that's nearly as much as Italy's peak-to-trough decline in imports during the crisis.

Obviously, with China you never know how much of the trade data is based on fudged orders from business to hide FX transactions.  Nevertheless, while Macro Man would expect a bit more weakness on the export side, he reckons that we're closer to the end than the beginning of the slide in imports....even if the eventual rebound is tepid at best.

Anyhow, we can use the spread between FX reserve growth and the trade balance to get a quick and dirty estimate of capital flow into/out of China.  On this basis, the flow is still negative...but is nevertheless the slowest outflow in six months.  Macro Man continues to expect a muddle-through scenario in China for the foreseeable future.  If and when that outlook changes....well, that will be a real game changer.


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Anonymous
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November 9, 2015 at 11:41 AM ×

Looking at another side of the coin ( China )
"UK exports to China collapse by 40%"
"The implications for the condition of the Chinese economy are plain. While monthly figures are more volatile, there is no respite, with monthly declines of 19% into July, 18% into August and 9% into September."

http://touchstoneblog.org.uk/2015/11/uk-exports-to-china-collapse-by-40-per-cent/

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abee crombie
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November 9, 2015 at 2:00 PM ×

I heard a lot about China pressing the breaks on capital outflows after the devaluation so that probably had a lot to do with it. Remember the party still wields a lot of power in that area. How long those measures stay in force is another story. Apparently chinese are used to this stop and go policy but generally expect more liberalization LT. if that were not to be the case then at some point it would probably boil over, but for now it doesnt look like an issue.

The next question for Fed watching markets is probably going to be what is the pace of increases. I expect that to cause some volatilty as well, probably into Q1 or Q2-16. After that it is probably smooth sailing for interest rate volatility.

Not sure I get the 'normal' relationship between earnings and PE argument. For me, they reflexive. Higher (expected) growth = higher PE

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Macro Man
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November 9, 2015 at 2:27 PM ×

@abee, the relationship is actually fairly strong. Since 1970, the correlation between SPX annual EPS growth and y/y change in PE is -0.64. See here for the scatter.

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Anonymous
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November 9, 2015 at 2:49 PM ×

Looks like massive amounts of corporate debt for sale. News out today big banks are hung with a lot of takeover debt they can't sell. Big bank rally is a reason to SELL

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AL
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November 9, 2015 at 4:16 PM ×

EURCNY is trading close to pre-deval level back in August. Pretty much the same picture against other major currencies. I would not exclude another round of deval before the end of the year by PBOC. Another 2-3%?

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AL
admin
November 9, 2015 at 4:17 PM ×

... of course I mean other major currencies except USD.

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abee crombie
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November 9, 2015 at 4:51 PM ×

Interesting chart MM, re the scatter. sort of goes in the face of conventional wisdom that (expected) higher earnings growth ==> higher PE. Perhaps it is different at the index vs stock level.

NDX doing some back filling off of PCLN, which was one of the stars in the S&P Consumer Discretionary index, up ~40% YTD prior to today, along with AMZN. Contrast that to M, which is down ~ 30% YTD and that's all you need to know about the markets today.

I'll get worried if NDX breaks below 4600.

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Adrem
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November 9, 2015 at 5:06 PM ×

No one likes to look stupid....
I dont think you can say this of the Fed. They seem to be in some interstella space while the rest of us earthlings are down here trying to survive and make a living.

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washedup
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November 9, 2015 at 5:24 PM ×

Speak for urself Adrem - I love to look stupid - why else do u think I pick fights with MM and LB?

I default to my long held view regarding the fed - they are speaking the absolute truth that they are data dependent, and their verbal diarrhea is good for about 5 % on the VIX give or take and worthless otherwise - I mean, its not exactly their fault that the 'data' has been acting like a capricious 13 yr old girl at the mall.

The truth is we have a two speed economy where if you perform cutting edge robotics or AI research, or frankly anything healthcare related, recruiters will all but blow you, and there are serious capacity constraints - manufacturing and durable goods, not so much. I think we will keep getting schizophrenic data in the foreseeable future.

I do wonder if all this is ultimately just a very slow motion transformation to a much greater reliance on the knowledge economy and services, which is now coming to the forefront much more because China is finally playing to the same script. But of course it will be a very nice, orderly, smooth transition from one to the other - right?Right??

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Anonymous
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November 9, 2015 at 8:13 PM ×

China FX reserve data is garbage, they are still selling massive dollars via fx swaps which don't show up on the data. Huge kink in the forward curve at 1Y point where PBOC is likely selling

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Nico G
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November 9, 2015 at 8:16 PM ×

me myself and i have been writing about china massive selling of $ since the summer - which is the smart thing to do, like i hoped oil producers would sell all CL future contracts liquid enough in July 2008 to lock what we call a STUPID price

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Leftback
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November 9, 2015 at 9:22 PM ×

Still room for Bucky to roll onwards here, DX 100 and EURUSD 1,05 the likely battlegrounds when resistance arrives. Gold and gold miners seem poised for a rebound, but there are likely a few more days of misery ahead. The GDX is carving out a long shallow bottom here, reaching decade lows this year, even below GFC washout levels as global disinflation continues for now. There is always money to be made in these moments - only by those with deep pockets and monumental reserves of patience.

EZ data should start to turn upward this winter, and that change will reverse the fund flows that were in effect for most of 2015 that bolstered the USD, Spoos and even Treasuries. A lower dollar will likely be the leading macro story of Q1 '16, and it's possible that we may get an early taste of that trade in December, as the Hike is already priced in and the market looks out into 2106 and doesn't see another one out there for a long time. It is probably clear from the preceding that LB is a member of the One and Done Club, with a slim but finite possibility that the Fed may still Do A Carney, skip the hike but jawbone, and join the None and Done society.

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washedup
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November 9, 2015 at 9:48 PM ×

"It is probably clear from the preceding that LB is a member of the One and Done Club"

I am leaning more towards 'One and Gone' - namely the statement raises rates but the press conference is cancelled, and the doormen at the fancy DC condo buildings the governors reside in, later report them as having left 'in a hurry with large amounts of luggage'.

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Cityhunter
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November 9, 2015 at 9:58 PM ×

SPX, DAX and major indices are going to correct from here. Friday's after non-farm move in equities was a bait. The fear of rate hike will show up in all risky assets much like the 2013 taper tantrum.

Regarding China, MM I'm with you, things starting to look interesting.

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November 10, 2015 at 12:40 PM ×

The reuters article from yesterday credited with causing additional strength in the USD, demonstrating growing consensus within the ECB to get aggressive:

Reuters article that moved USD

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