The Set Up In Bonds As The FOMC Considers A Second Rate Increase

Summary: Bond yields usually rise as the FOMC raises rates. This is one of the mostly strongly held consensus views in the market right now. A year ago, investors also thought yields were set to rise; instead they fell over the next half year. Might investors be wrong now once again?

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The FOMC will likely raise the target for the federal funds rates later today. We discussed the affect of rate increases on various asset classes a year ago when the FOMC enacted their first rate increase since 2006. The general conclusion was that equities, commodities and bond yields all rose in the subsequent months. That post is here.

Those conclusions were mostly right. The one exception was bond yields. On the day of the rate increase in December 2015, 10 year yields in the US hit 2.33% (arrow). That was the high until November 2016, 11 months later.  In the interim, yields fell 100 basis points over the next half year.

Fund Managers' Current Asset Allocation - December

Summary: Global equities are more than 20% higher than in February. A tailwind for this rally has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash. This was in stark contrast to 2013, 2014 and early 2015, during which fund managers were heavily overweight equities and underweight cash and bonds.

Fund managers have finally become bullish again. Optimism towards the economy has surged to a 19-month high. Cash remains in favor (although levels dropped significantly in the past two months) but global equity allocations are now back to neutral for the first time in a year.

Bearish sentiment had been a persistent tailwind for US equities in the past year and a half.  That's no longer the case. Another push higher and excessive bullish sentiment will become a headwind. Global equity allocations would already be excessively bullish if not for Europe, where sentiment has dropped. Emerging markets became the consensus long in October and the region has since been pummeled. Those markets are now in the process of resetting.

Findings in the bond market are of greatest interest. Fund managers' allocations to bonds are near prior capitulation lows. Moreover, inflation expectations have jumped to the highest level in 12-1/2 years and expectations that the yield curve will steepen are the highest in 3-1/4 years. When this has happened in the past, yields have been near a point of reversal lower, at least short-term.

The dollar is now considered the third most overvalued in the past 10 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $500b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October to 4.8% in December. That is a big drop for two months, but recall that 5.8% was the highest cash level since November 2001. Cash has remained above 5% for all of 2016, the longest stretch of elevated cash in the survey's history. A good amount of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Market Watch: Top 50 Twitter Accounts for Investors to Follow in 2017

Many thanks to the people at Market Watch for including us on their list of the Top 50 Twitter Accounts for Investors to Follow in 2017. The full list is here.

Weekly Market Summary

Summary: US equities have made new all-time highs in the past week. Breadth is good. But there is a set-up for price gains to be limited (or negative) in the next 1-2 weeks.

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In the past week, SPX, DJIA and RUT have all made new all-time highs (ATH). Each is within 1% of those highs today. All of their respective moving averages, from 5-d to 200-d, are rising. This is the definition of an uptrending equity market. Enlarge any chart by clicking on it.

December Macro Update: Employment Growth Is Decelerating

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

That said, there are some signs of weakness creeping into the data. Most importantly, employment growth is decelerating, from over 2% last year to 1.6% now. Housing starts and permits have flattened over the past year. There is nothing alarming in any of this but it is noteworthy that expansions weaken before they end, and these are signs of some weakening that bear monitoring closely.

Overall, the main positives from the recent data are in employment, consumption growth and housing:

• Monthly employment gains have averaged 188,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading.
• Recent compensation growth is near the highest in 7 years: 2.5% yoy in November. 
• Most measures of demand show 3-4% nominal growth. Real personal consumption growth in October was 2.8%.  Retail sales reached a new all-time high in October, growing 2.6% yoy.
• Housing sales are near a 9 year high. Starts made a new 9 year high in October.
• The core inflation rate has remained near 2% since November 2015.

The main negatives are concentrated in the manufacturing sector (which accounts for less than 10% of employment):

• Core durable goods growth rose 1.0% yoy in October. It was weak during the winter of 2015 and it has not rebounded since. 
• Industrial production has also been weak, falling -1.0% yoy due to weakness in mining (oil and coal). The manufacturing component grew +0.1% yoy.

Prior macro posts from the past year are here.

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Our key message over the past 3 years has been that (a) growth is positive but slow, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes (enlarge any image by clicking on it).

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.


Employment and Wages

The November non-farm payroll was 178,000 new employees less 2,000 in revisions.

In the past 12 months, the average monthly gain in employment was 188,000.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low prints of 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.