In contrast to the last month, it was a good day for the markets today. So I want to do a mini-recap.
All eyes on Apple
First up: Apple is slated to report tomorrow afternoon after the closing bell. Expectations for their earnings report are favourable based primarily on the new iPhone, but also on the new iPad and execution on the Mac.
Some people are saying the market needs this. After a lot of volatility in October, the S&P 500 closed up 1.1% today. But, it still fell 6.9% on the month, the worst showing since September 2011.
And I’ve seen comparisons between Apple today and RCA in 1929, pre-stock market crash, talking about the fall in RCA in mid-September 1929 as the “warm up move”. That’s how negative some people are.
This is all about interest rates
I don’t see it. Let me remind you again of what I said in February when we saw the last bout of volatility:
…as inflation expectations increase, the interest rates investors will accept will climb slowly. Equity markets won’t throw a fit at 2.85% interest rates… Instead though, it could be smooth sailing until 10-year interest rates hit 3.00%. And then we see more market volatility. But once that level settles in, the acceptable rate might climb to 3.25%. And we will repeat the process all over again.
This is how late-cycle interest rate hike regimes work. But at some point, there will be a negative impact on credit and that will feed through into the real economy.
So I think this is all about interest rates. We got 3.25% on the 10-year and the market panicked. But that phase is now over. The market has accepted 3.25%. Now we may need to blast through 3.50% to get the next rout.
Notice that the 10-year is now at 3.153% from somewhere near 3.06% at the end of last week. That’s a sign that we are back to risk on mode. And it’s not just in the US but worldwide. 10-year rates in a broad range of countries — Germany, France, Spain, Australia, Japan, and Italy — were all up today.
So, we can breathe a sigh of relief that October is over because I think it means an end to extreme volatility.
The real economy is less robust
The one outlier today was in oil, where both Brent and WTI ticked down to 74.62 and $65.02 per barrel respectively. For Brent, that’s the lowest level since August. For WTI, it’s the lowest since May. And the reason oil prices are declining is not just because of the potential for increased supply. It’s also because of the prospect of lower demand. The rising US dollar is another factor I will mention later.
Regarding a downbeat economy, for one, in Asia this morning we saw that China’s official manufacturing Purchasing Managers’ Index (PMI) for October fell to 50.2. That’s both lower than the 50.6 analysts had expected and also down from a 50.8 reading in September. It’s also the lowest official PMI reading since July 2016. The forward-looking sub-indices for production and new orders were negative and new export orders contracted for the fifth straight month as well. Remember that 50 is the line that separates contraction from growth
The Chinese services PMI was also poor. The official non-manufacturing Purchasing Managers’ Index fell to 53.9 from 54.9 in September. That pulled the composite PMI down to 53.1 in October from September’s 54.1.
Moreover, Europe’s growth is uneven. I’ve mentioned the goose egg that Italy reported earlier in the week. And while the US numbers for growth have looked good, I am concerned about the dynamic in the housing market having a big impact going forward.
So, it’s not clear to me how long it will take to get to the 3.50% level on the 10-year US Treasury. We may never reach it before the economy rolls over. We’ll just have to wait and see.
For now, the market has to be focused on higher rates though because the Fed hasn’t signalled it would back down from its rate hike timetable. Moreover, with equity market volatility receding, the chance of a Fed pause wanes. I believe we can see the impact of this divergence in policy in the US dollar, where the US dollar index is coming close to the 97 level for the first time in over a year.
A strong dollar is a clear indication of interest rate differentials, stemming from policy divergence, as the Fed moves way ahead of other major central banks. And it has a residual impact on commodities, where we see oil prices trading down. It also is causing the Chinese Yuan to fall. In March, the Yuan was trading for 6.2 to the dollar. Now, we are bumping against the psychologically-important 7 yuan to the dollar level. And while the Trump Administration is likely to see this currency change in isolation, it really is very much in line with the divergence in policy happening now in the global economy.
Overall, I am rather more bullish on equities than government bonds over the near term because equities are coming off oversold levels. And the flight to safety is likely to dissipate. At the same time, I do expect a slowing in the real economy globally. But it’s still unclear how that will play out do to the policy path that different central banks are now on.
I continue to believe the risk is greatest that the Fed will guide up to four rate hikes in 2019. That is mildly bearish for bonds – in the context of a weakening real economy. But it is bullish for the dollar.