Step aside global central banks.It’s time for the pattern called risk-on/risk off to set the direction of global financial markets again.
In my book on volatility, Juggling with Knives, I’ve included an entire chapter on correlations between assets and markets. In an Age of Volatility I argue, correlations among asset classes can change over night and the trend that once drove markets–stocks rise with a stronger dollar, for example–can breakdown so quickly that it throws an entire investment strategy into chaos. (Buy Juggling with Knives at Amazon http://www.amazon.com/Juggling-Knives-Investing-Coming-Volatility/dp/1610394801?ie=UTF8&qid=1463761996&ref_=tmm_hrd_title_0&sr=1-1. )
Well, that’s where we are today now that markets have decided that programs of quantitative easing from central banks–the Federal Reserve, the Bank of Japan, and the European Central Bank–aren’t enough to drive economies or financial markets.
The new pattern is an old pattern, one known as risk-on/risk off.
Yes, the glorious (sarcasm alert) days when money sloshed from one asset class to another as investors decided that the markets felt risk and that this asset felt more or less risky than that asset are back.
The evidence in correlations between asset classes over the last 120 days, compiled by Bloomberg, is rather compelling.
For example, the correlation between an index of 20 emerging-market currencies and global stocks has climbed back to 0.6 to approach its level on April 8. That was the strongest correlation since December 2013. In other words emerging market currencies are moving in lockstep with global stocks. The correlation between commodities climbed to an almost six-year high of 0.7 this month. In late 2014, neither asset had a significant correlation with emerging-market currencies.
Or to take another example, the correlation between the dollar-yen exchange rate and stocks reached 0.7 in February. That was the strongest correlation since Bloomberg began collecting this data in 1987. Since then the correlation has fallen to 0.5. So, yes, while the yen still tends to weaken when equities rally, the move is a bit less strong than earlier in the year.
Why the shift back to a risk-on/risk-off market? Worries over the Brexit referendum next month on United Kingdom membership in the European Union, the chaos that is the U.S. election, a potential June or July interet rate increase from the Fed, the big sell-off in stocks earlier in 2016.
Why is this important? Because the shift in correlations should result in a rethink of some old strategies and consideration of some new possibilities. For example, the new correlations suggest taking a look at going long the Mexican peso, one of the worst performing currencies in 2016, with an increase in commodity (especially oil) prices.
Yesterday’s release of the minutes from the Federal Reserve’s April meeting has produced a massive change in market sentiment. Monday before release of the minutes financial markets were giving odds on a June interest rate increase of just 4%. After the meeting those odds soared and they continued to move up today to reach 26%. Odds for an interest rate increase in July have climbed to 47%.
Today has brought new remarks from Federal Reserve members, including the heads of the New York and Richmond Federal Reserve banks, pointing toward a move by the Fed at its June or July meeting.
That has all led Wall Street to jump on the sooner rather than later bandwagon. This morning Jeffrey Gundlach of DoubleLine and Rick Rieder of BlackRock both advised bond investors to note a major shift in Fed plans. Whereas the Fed had been saying, Gundlach told Bloomberg, that it will raise rates if the economic data improve, now the Fed is signaling that it will move if the economic numbers don’t weaken.,
Stock have continued to move down modestly on the change in sentiment. The Standard & Poor’s 500 fell about 0.37% today to close at 2040. That’s a relatively small decline but it puts the index solidly below the 50-day moving average at 2059.
Secondary indexes such as the small cap Russell 2000, which had already moved below support, continued to decline with the Russell 2000 dropping another 0.74% to 1095. The 50-day moving average for this index is at 1111 and the 200-day at 1118.
The U.S.dollar continued to firm with the Bloomberg Dollar Spot Index gaining 0.1% today after picking up 0.8%yesterday.
Stocks in emerging markets, which are sensitive to gains in the dollar, fell. The iShares MSCI Emerging Markets ETF (EEM) dropped 0.96% to $31.58 today. The 50-day moving average for that ETF is at $33.64 and the 200-day is at $33.01.
Important upcoming dates for figuring out the Fed’s June and/or July timetable include May 27, when we’ll get a second estimate on first quarter U.S. GDP (the first estimate showed the economy growing at just 0.5%, which led financial markets to conclude that the Fed would not raise rates this summer); June 3, when we’ll get May jobs numbers; and May 27 and June 6, when Federal Reserve chair Janet Yellen gives speeches in Cambridge and Philadelphia.
Update May 18. On May 12 Middleby (MIDD) reported first quarter earnings of 96 cents a share, 12 cents a share above Wall Street projections on revenue of $516 million. Revenue was just slightly above analyst projections (by $800,000) but analysts had already estimated that revenue would climb 27% year over year. (About 25% of this revenue growth came from acquisitions.)
Middleby shares are have a decent 2016–up 9.78% for 2016 versus 0.18% for the Standard & Poor’s 500 stock index. For the last 12 months the shares are ahead 8.69% versus as 1.69% decline in the S&P 500. (Middleby is a member of my long-term 50 stocks portfolio.)
For a while last year it looked like Middleby’s growth formula had faltered. The company continued to buy companies in the fragmented kitchen equipment market but sluggish growth in the U.S. fast food (execuse me: quick service) sector made it difficult to get the same kind of improvements in efficiency and sales out of these companies post-acquisition that Middleby has historically generated. And the company experienced higher expenses from a product recall at Viking related to legacy products manufactured before the Middleby acquisition and lower sales in some lines in anticipation of the launch of new products in its residential equipment market that led to lower margins (31% down from 37% in the first quarter of 2015)
But in the first quarter Middleby was able to record better than 20% growth in organic sales in its international markets to make up for flat domestic sales. (Domestic sales faced tough year to year comparisons because of large rollouts by U.S.-based chains in the first quarter of 2015.)
In other words, the “problems” in this very solid quarter look fixable as the passage of time should let Middleby put those tough year to year comps and the product recalls at Viking in the rear view mirror.
Today Middleby announced that it will acquire the Follett Corporation, a leading manufacturer of ice machines and other refrigeration products, with $140 million in annual revenue. Seems like a move from the old playbook.
It didn’t take much to put an interest rate increase at the Federal Reserve’s June meeting back on the table today.
Just minutes from the Fed’s April meeting indicting that most Fed members thought a June hike would be appropriate if the economy continued to improve…
…and statements from the head of the Atlanta and San Francisco Federal Reserve banks saying that they were still looking for two or more interest rate increases in 2016…
…and data on wages and prices showing stronger than expect income and inflation growth.
Odds of a June increase priced into the financial markets have gone from 4% on Monday to 12% yesterday to 32% after the release of the Fed minutes this afternoon.
The release of the minutes took the Standard & Poor’s 500 stock index from plus 0.55% at 1:45 p.m. New York time to minus 0.49% as of 2:25 p.m.
The odds for a July increase climbed today to 48.3% and for a September increase to 64.2%. That 64% chance of an increase is in the range of what the Fed likes to see in the way of market preparation for an interest rate move.
On Wednesday the Federal Reserve will release the minutes from its April meeting–against a background set by today’s release of numbers showing stronger than expected wage and inflation growth.
The wage growth figures come from the Federal Reserve Bank of Atlanta’s wage growth tracker, which some economists on Wall Street believe gives a more accurate picture of wage growth than the average hourly earnings data published by the Bureau of Labor Statistics. The Atlanta Fed’s model showed a 3.4% year over year increase in pay as of April. That’s the highest rate of wage growth since 2009.
Today we also got the Consumer Price Index inflation rate for April. The headline CPI climbed at the highest rate in three years. Consumer prices increased by 0.4%, the biggest gain since February 2013. (Consumer prices rose by 0.1% in March.) Core inflation, which strips out changes in the prices for food and energy rose by 0.2% after a 0.1% gain in March. The biggest contributor to the jump in headline inflation was higher gasoline and energy prices with gasoline prices showing the biggest increase in four years.
Unfortunately, the April Fed minutes set for release on Wednesday won’t tell us what Fed members make of this new data. Certainly strong wage growth argues for the strength of the U.S.economy and for an interest rate increase sooner rather than later. The CPI inflation data cuts two ways in my opinion. (The Fed does not use the CPI as its inflation measure but this index does generally point in the same direction as the Fed’s preferred inflation measure.) On the one hand, higher inflation suggests a need to raise interest rates so that inflation expectations don’t get out of control. On the other hand, higher energy costs are a kind of tax on the U.S. economy and the Fed may figure that rising prices for energy are enough to slow the economy without the added burden of higher interest rates.
Right now the Fed’s Funds futures market is pricing in just an 11.3% chance for an interest rate increase at the June meeting–but that’s still up from just 3.8% yesterday. Odds on a July increase have climbed to 30% from 20.5% yesterday and for the September meeting to 47% from 39.1% yesterday.
The Fed minutes, though, are likely to tell us how much weight the Fed is giving to worries about volatility in global financial markets–with those markets firming, the more worry the Fed felt in April, the more likely an interest rate increase. Any clues on what the Fed is thinking about Brexit will be welcome since Britain holds a referendum on staying in or leaving the European Union just a week after the Fed’s June meeting. The more worry in the minutes about Brexit, the less likely the Fed is to increase interest rates in June. Also look for any clues that the Fed was inclined to look past first quarter weakness in the U.S. economy as just more of the recent pattern of weak first quarters in years posting decent growth for the 12-month period.