S&P 500 Is Up 1.5%, A New All-Time High; Oil Production Up +0.68% by Richardson GMP
Contributors: Craig Basinger, CFA; Gareth Watson, CFA; Derek Benedet, CMT; Chris Kerlow, CFA; Shane Obata
S&P 500 Is Up 1.5% – Endless Summer
Markets have rallied considerably this week, the S&P 500 is up 1.5% and made new all-time highs. The S&P/TSX Composite rose 1.6% to its highest level since last August. Equity markets certainly are riding a wave of optimism, and it’s nice to see that bonds now taking the drop. U.S. 10-year yields are now up 20% off of the July 6th record lows. While still low in absolute levels, the direction is in line with what we’re seeing in the stock market. Investor confidence is rising, recent sentiment data has increased sharply, with AAII Bullish sentiment up over 60% since the post-Brexit lows. Although it is nice to see some optimism in the market, the pessimistic side of our psyche has shifted its attention from a certain surprising major macro event. The rapid removal of uncertainty surrounding the U.K. leadership situation is a welcome relief. Theresa May is the new British Prime Minister, and while many are questioning her choice of Foreign Secretary (Boris Johnson) sometimes known knowns are better than the unknown knowns. Ok, back to the surf, and what has some thinking the waves will die down. It’s the valuation buzz-kill. Valuations are stretched, forward earnings for the S&P 500 are currently at 18.36 times, the highest they have been since early 2015. The positive spin on this is the popular rational that lower bond yields means a lower discount rate that would be applied to future cash flows. A lower discount rate pushes up the present value, aka share prices.
While a pragmatic mentality is often an investor’s best friend, the strength of the recent U.S. economic data cannot be ignored. The Citigroup Economic Surprise Index is up to 15.4, rising strong momentum over the zero barrier for the first time in nearly two years. Unfortunately, the data for Canada is heading in the opposite direction, it continues to surprise to the downside. It’s nice to see the U.S. manufacturing shift into growth mode for the first time in a year, the industrial recession may finally be over. Over the past year, the continued economic growth of the U.S. has been put into question, thanks largely to global uncertainty. The cornerstone of the U.S. economy has been and remains the consumer. And while we’ve seen bouts of uncertainty, the U.S. consumer remains strong.
As legendary surfer Laird Hamilton has said “Surfing’s one of the few sports that you look ahead to see what’s behind.” Admittedly, we had to think on this one, but we like this quote. The future can dictate the past (present), as only by adding subsequent measurements, can we reveal what current measurements were “really” saying.
The swell is growing
The U.S. Department of Commerce released its report on retail sales this morning and the results were encouraging. Twelve of the fifteen segments they monitor advanced versus last year, and the numbers were stronger than even the most optimistic forecasts, according to Bloomberg. The American economy, which was floundering at the start of the year with whispers of a possible recession, is firmly back on both feet and driving equity markets to new highs. The best pockets of strength were seen in receipts by online merchants such as Amazon & Wayfair and by health & personal care outlets such as CVS & Walgreens. We recently initiated a long position in CVS for the Connected Wealth Core Income Fund. CVS is a market leading U.S. pharmacy that generates all of its revenues domestically and trades at a reasonable 17x forward earnings. This is great because it has become increasingly difficult to find value in a market trading at all-time highs. The fastest growing segment – “nonstore retailers” – has increased sales by 14% over the past 12 months. Not surprising since Amazon’s Jeff Bezos continues to steal market share from traditional retailers. Moreover, mall traffic continues to slow as consumers prefer deliveries to actually leaving the house. It is undeniable that Amazon is disrupting the shopping experience and doing it in an innovative way. Putting a button on your washing machine that you touch when you are low on detergent is just one example of the ideas pouring out of the world’s largest online merchant. From an investment standpoint, we find it challenging to invest in a stock that trades at 302x earnings, even though it does have an upcoming web services division.
There was also a resurgence in demand for building supplies, fueled by growth in the U.S. housing sector, an area we are convinced will prosper from higher wages and consumer confidence. Building supply demand grew by nearly 4% from last month and 8% year-over-year. A U.S. housing recovery is a theme that resonates across our portfolios. We play it directly with names like DR Horton, one of the largest medium and low-end housing builders. We also play it indirectly with derivatives such as West Fraser Timber and Wells Fargo, the largest mortgage loan originator in the U.S. who just reported net income of $5.6bb.
With a strong consumer, improving housing market and now growing manufacturing sector it’s not a surprise that the U.S. economic surprise index is trending higher. The labour market has also rebounded nicely following the recent blip, with the most recent employment report showing a 287,000 gain in nonfarm payrolls. This was much higher than the 180,000 forecast. On the housing front, the S&P Case-Shiller house price index is rising as demand exceeds supply. Housing starts and sales data are also improving. On the consumer front, spending remains robust, which is reflected in the retail sales numbers. Consumer confidence measured by the Conference Board is at 98, its highest level since last October. Confidence should continue to improve going forward as consumers digest the post-Brexit rally in global markets. All in all, U.S. economic data support a stronger U.S. dollar. Especially considering the fact that data in Canada, Europe and Japan is less than stellar.
Asset flows may also support the USD. Foreigners, have been piling into U.S. fixed income in order to capitalize on favorable yield differentials. We would not be surprised to see the same pattern emerge in U.S. equities. If international money continues to flow into safe haven U.S. assets, then that would help to reinforce USD strength.
In terms of monetary policy, the Fed continues to diverge from other central banks. Employment data is good, the S&P 500 is at all-time highs and international financial conditions have improved. In other words, the Fed is running out of excuses not to hike. In contrast, the ECB and BOE are likely to stay easy in response to weak growth and to the Brexit. The BOJ is in the same boat. Fed fund futures are currently pricing in 8% and 22% chances of a rate hike in July and September, respectively. We believe that these probabilities are too low, providing some upside risk for the USD.
In the oceans, winds create swells, as these move into shallower waters waves begin to rise, only to crest and eventually break in a rush of white water. In our view, the winds are still blowing in the right directions to buoy the U.S. dollar. While all waves must eventually break, we still think this one has room to run.
Chart of the Week
An interesting thing happened this week, total oil production rose for just the third time this year. The +0.68% increase was the largest increase since last October. It’s not all that surprising, it’s simple economics. Higher prices begets greater supply. We’ve colloquially referred to this relationship as the “Ws”. Where prices will establish firmer upper and lower bounds and will trade within these newly established ranges. Rising supply will tilt the balance of the demand/supply dynamic and prices will likely fall in response. We’ve already begun to see this. It’s the invisible hand at work. In our chart of the week, we’ve plotted U.S. rig counts which began to tick higher at the end of May, when crude approached $50/bbl. Over the past six weeks, the rig count has risen 10%. To adjust for the delay between the rig count and production data we have shifted the rig count ahead by 26 weeks, or half a year.
While the demand picture remains cloudy, there is the added complications of the Brexit event. Credit Suisse for example is now expecting below trend oil demand growth in 2017. Coupled with what we expect to a delayed positive supply side increase in production growth led by U.S. shale.
Noted above the price recovery is faltering, not surprising given the 100% increase from February to early June. It’s only been one data point, a blip on the chart, but the sharp production growth slowdown has likely abated, and with that the most positive impetus for higher oil prices has been removed. Also don’t forget about the continued draw from elevated inventory levels. It’s not our phrase, but it looks like darker clouds are coming. If you’ve missed the energy uptick we would express caution in jumping in just yet. No one knows where this pullback will end but it’s worth devising a plan with a couple of staged entry points as we wait for yet another ‘W’.
Question of the Week
Considering our discussion concerning the U.S. consumer, how well is the Canadian consumer holding up?
Based on the information we have for 2016 thus far (which is only four months as data is released with a two month lag), monthly retail sales in Canada have been positive with exception of some weakness in March. If we look back over the past year we can also conclude that retail sales have been generally good. On top of that, we continue to receive information indicating that real estate prices remain strong (especially in Toronto and Vancouver) and forecasts that those prices could continue to rise. To nobody’s surprise those forecasts tend to come from real estate companies.
So should we be happy about all of this? We would be if we were convinced that all of these sales were paid for, but in most cases they are not as Canadians have been taking advantage of the lowest interest rates we have ever seen in this country. Cheap money leads to increased borrowing and in most cases increased spending. So the Canadian consumer appears to be holding up well if we look strictly at spending, but naturally the more important question is how the Canadian consumer is holding up with their debt levels. On that front we can say that the health of the Canadian consumer is not as good. This should come as no surprise as household debt level discussions have been common in the press for a number of years now and have even been addressed by finance ministers and the Bank of Canada.
To put things into perspective take a look at the following chart that compares Canada and U.S. household debt to disposable income:
In 1990, Canadians owed 85 cents for every dollar of annual disposable income they had, today that number has grown to a record $1.68. Now then some people will debate about how these ratios are calculated, what they include and whether they are comparable, but we believe those are semantics to the larger trend from this chart which is that the ratio has gone down in the United States since the financial crisis and it has increased in Canada.
Having debt isn’t always a bad thing as long as you can service it and eventually pay it back. This is easier to do in a low interest rate environment as we have now, but will become increasingly difficult for some households when interest rates eventually rise. Admittedly there is no expectation of rate increases in Canada any time soon, but when it does happen the strength of the Canadian consumer will no doubt be impacted. Some people will also argue that higher debt levels are fine as long as assets purchased with debt continue to increase in value and Canadians continue to save. While these points are true, it does make Canadians more vulnerable to a real estate market correction and unfortunately Canadians are saving less today than they did 20 years ago.
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