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.