The Fed and Brexit likely to dominate this week

Friday’s US jobs data was very strong in February with total new (non-farm) jobs created reaching 235k. This was higher than even the revised forecast of 200k (revised up from 190k after surprising ADP employment data a few days prior). January non-farm jobs were also revised up to 238k from 227k. Unemployment fell to 4.7% last month and average hourly earnings rose 2.8% y/y from 2.5% in January. The biggest driver of job growth last month was construction and manufacturing.

The Fed will hike by 25bp this week (Wednesday), or they should pack up and go home. This is almost old news however as it’s fully priced in. What is more important is what the Fed says about the pace of rate hikes going forward – ie the new ‘dot plot’. December’s dot plot showed the Fed expected to raise interest rates 3 times this year; but this is not fully priced into bond market yet. If the Fed indicates it may now be considering MORE than three rate hikes in 2017 (say 1 per quarter), then look for another boost to the USD and another sell-off in bonds.

Watch oil, cable

Oil prices fell below $50 per barrel at the end of last week, a level last seen before OPEC agreed to cut production in November. I flagged the downside risks to oil prices here and these still remain very much in play. Positioning in the oil market could see further downside from current levels.

Over in the UK, the government is asking MPs (on Monday) to reverse amendments to the Brexit law made by the House of Lords over the last couple of weeks. The changes made by the (unelected) Lords guarantees the rights of EU citizens currently living in the UK to remain post-Brexit, regardless of reciprocal agreement for Brits living in the EU; and forces the government to give parliament a binding vote on the outcome of Brexit negotiations, even if there is no deal reached. While these are noble sentiments, including these in the Brexit law are (in my opinion) daft in the context of what is about to occur.  Don’t get me wrong, I DO believe EU citizens already living in the UK should be allowed to remain as long as they want, and I do think parliament should offer some checks & balances on the final deal.  However, enshrining this in law before you even start negotiating is like sending your soldiers into battle with blanks in their guns and one hand tied behind their backs, against a much bigger army, and then wondering why they’ve lost.

Here’s a question I can’t get my head around: what happens if there is no deal after 2 years of talks, and the UK parliament votes to ‘reject’ this non-deal? From the European perspective, under the terms of the EU Treaty, the UK would leave the EU with nothing (i.e. no access to the common market for goods and services, no visa free travel, no rights for UK citizens already living in the EU – nothing).  Trade reverts to WTO rules and tariffs according to the EU.  Only, if I understand the amendment passed by the House of Lords correctly, the UK parliament can vote to reject this state of affairs and…behave as if the UK is still a member of the EU? My mind is boggling.

Trading update: take profit on LGI Homes

Finally!  I’ve like the story behind LGIH for a while (I bought shares mid-Dec 2016) and added in February.  It’s a growth stock, and the company builds ‘affordable’ or entry level housing in the US.  January closings were disappointing and with only a few analysts covering the stock, prices fell on a downgrade by Wells Fargo last month.

However, Q4 results beat expectations today, and the stock was up over 17% at one stage after open.  I’ve taken profit (near the high at $34.10) on my shares just because after a move like that it’d be stupid not to, especially with US interest rates likely to be raised next week.  I still like the fundamentals though, the PE is still suggesting there is value there but will look to get back in again at a lower level.

I’ve been keeping an eye on financial stocks ahead of the expected rate hike next week. A few look interesting: ALLY financial; CASH; Citigroup, Metflife.  However, none jumping out as screaming buys.  Also keeping an eye on Allergan, which I took profit on last month, and which has come off a bit in recent days.  Still, risk/ reward profile doesn’t look too attractive right now so I’m holding fire.

Over in the UK, the drop in GBP has boosted my favourite online retailer Boohoo.com (BOO LN) and I’m holding on to this for further upside.  I am also still long Crest Nicholson, which has held up well despite the weaker pound.  Nice dividend due there later this month.

 

 

The stars are aligned for a March rate hike

There was a lot of potential for things to go horribly wrong last week.  President Trump gave his first address to joint houses of congress, there was a bunch of important economic data released and Janet Yellen spoke on Friday.  In the event, everything went rather well.  President Trump managed to read his teleprompter without going off on an unscripted rant (that markets rallied on a sigh of relief shows just how low the bar is for him) even if he didn’t actually say anything of substance; the economic data was mostly great and Janet Yellen provided forward guidance to the market about interest rates.

I’m not going to say anything about the speech to Congress because there really isn’t anything to say. Moving swiftly on to monetary policy then:

After several FOMC members dropped hints all last week that a rate hike at next week’s meeting was possible/ likely, Janet Yellen’s speech in Chicago on Friday was fairly clear.  Barring an absolute disaster in the February non-farm payrolls data (due this Friday), the Fed will probably raise the benchmark rate by 25bp at the 14-15 March meeting.   This is now fully priced in from a fixed income/ bond market perspective.  The consensus forecast for February payrolls is a gain of 190k new jobs.  I suspect anything over 120k would be acceptable, especially as economic data over the last couple of weeks has been very good.   The manufacturing surveys have been exceptionally strong, consumer confidence is near the highest level in more than decade and inflation has 2% in sight. The only real weakness in the recent data appears to have been on the consumer spending side since the start of this year, which is at odds with the high consumer confidence readings.  After rallying on Friday, equities have started this week a tad softer, with observers saying higher interest rates are negative for equities.  I think it’s more profit taking after a really good run, and as valuations are looking stretched to me.

In any event, several of the major retailers posted disappointing results last week, including Target and Best Buy.  I had bought some shares in Target last month after the company gave guidance on weaker holiday spending than expected and the share price fell sharply.  The stock had rallied nicely ahead of the results last week as Walmart and Macy’s had beaten expectations.  However, in the end, the Q4 results were bad, and the stock is down 10% on my purchase price, which was c.10% down from the start of the year.  Target is now at an all-time low, and what’s more, the management appears to be changing the strategy completely and going downmarket.  I am always reluctant to sell a stock at a record low, and this is a blue-chip name, so I will wait a while before deciding what to do.  This strategy (of waiting after a sell-off before deciding what to do) has worked for Gilead Sciences (US) and the Restaurant Group PLC, which both sold off more than 10% on bad news but have since erased those losses.  I am still long both of those stocks in the hopes of some gains.  The Restaurant Group announces full Q4 results tomorrow though so I shouldn’t  speak too soon. LGI Homes is also announcing Q4 results tomorrow, and I am hoping for a positive surprise this time. Let’s see.

Further upside for oil looks limited

Following OPEC’s volte-face in November 2016, when the organisation finally agreed to cut oil output over H1 2017, oil prices have enjoyed four months of relative calm, trading in a $50-57 per barrel range.  Although there is still only 1 month of data since the OPEC agreement started, compliance among member countries is the highest it’s ever been at 90%.  Saudi Arabia cut production by more than it said it would in January, and total cuts from OPEC countries totalled over 1mn bpd last month.  This was a great start in terms of showing commitment to the agreed cuts.  However, this has been partially offset by rising US production – which has just topped 9mn bpd for the first time in 9 months, and rose more than 230,000 bpd in January alone.  Nigeria and Libya, both of whom were exempt from OPEC’s agreement, also increased crude output by 200k last month.

In addition, rig counts in the US and Canada have continued to rise.  US rig counts topped 600 last week, double what they were just 6 months ago and the highest since October 2015.  This suggests that North American crude oil production is only likely to rise further as long as prices remain at these levels.  Furthermore, inventories have shown little sign of declining, so the situation of oversupply isn’t being fixed by OPEC’s cuts (yet).  However, we are only 2 months into the agreement and gulf oil exporters at least are saying they will stay the course and stick to their agreed cuts.  If OPEC can hold the line, we may see some reduction in inventories in Q2, but will OPEC be willing to keep cutting in the face of rapidly rising North American crude output?  I’m not willing to bet on that.

The focus this week will be on President Trump’s speech to congress on Tuesday evening.  Markets have already become skittish, perhaps feeling that they were a little too optimistic about what the new administration would deliver on economic policy.  So far the focus has been on immigration, protectionist trade measures and attacking the media, rather than on the promised tax cuts and infrastructure spending.  DT could fix this on Tuesday by providing some details about his ‘phenomenal’ tax cuts and infrastructure program.  However, the new budget will only be put to congress in a few weeks time, and will only come into effect in October, so it seems unlikely the economy will benefit until Q4 2017 at the earliest.  The benefit of any infrastructure investment is likely to be even more lagged.  The risk is that we don’t hear much about economic policy on Tuesday night but rather more verbosity about walls, immigration, trade barriers and the media.  I’m inclined to reduce my exposure and take profits on US positions ahead of this.   If we get through Tuesday ok, the next biggie is Janet Yellen’s speech on Friday where we will all look for clues about whether she is leaning towards a March hike – my sense is the Fed will likely wait until May/ June.

 

A sigh of relief

Last week was exhausting, as markets continued to try and make sense of the new US administration’s policies and the impact these might have on risk appetite, the economy and global geopolitics.  At one stage, everything seemed to be turned on its head, with President Trump seemingly pissing off Australia, China and Mexico almost all in one day; appearing to undermine the independence and oversight of the judiciary; and reportedly calling a national security advisor at 3am to ask whether a stronger or weaker USD was in the country’s best interests.

Thankfully, there was some relief by Friday.  DT managed to get through a meeting with Japanese PM Abe at the end of the week without starting a new trade or real war with a long-time ally.  Aside from the PM’s obvious discomfort with the public ‘handshake’ after the press conference, it seems no harm was done and renewed discussions could lead to a new bilateral trade and investment deal to replace the TPP.  Markets were also buoyed by news that DT struck a more conciliatory tone with China in a phone call, renewed promises of fiscal stimulus in the US and discussions about rolling back some financial regulation that had been imposed post-financial crisis (more on the last in a separate post later).

This week is all about Janet Yellen’s testimony before congress.  Several FOMC members have come out recently to say that March should not be written off in terms of a Fed rate hike, but the market is not pricing this in.  I expect Yellen to take a neutral stance as always, saying the Fed will look at all the data in the run-up to the March meeting before deciding.  We also get US housing, retail data and some Eurozone stuff, nothing key in the UK.

Trading update

3 of the stocks in my portfolio tanked after disappointing results/ announcements: the Restaurant Group PLC, Gilead Sciences (US) and LGI Homes (US).  I’m holding onto the first two until they recover somewhat before deciding if I should dispose of them, but would not recommend adding/ entering these at trades at this stage as fundamentals have deteriorated since I first bought in last year.  However, I used the sell-off in LGIH US as an opportunity to add to my holdings – the disappointing January closings number was apparently more to do with lack of stock than weak demand, and the management still believes they can deliver their annual sales target for 2017.

I also believe that any announcement on tax cuts/ financial deregulation in the next couple of weeks should support housing and retail (I’m long both).

On the plus side, Allergan had a great Q4 and rallied further last week.  it is now well into overbought territory and up 30% since the low in Q4; I’ve taken my profit on this to be cautious, will look to re-enter at a later stage if the opportunity arises. Nokia jumped 5% after I added to my position, and still looks good.  Crest Nicholson has also done really well in the last week, and still has further to run in my view.

 

Rhetoric ‘trumps’ economic data

US economic data since the start of the year has been largely positive, and this continued today with January’s ISM manufacturing index rising from December.  Corporate results released so far have also been pretty good and several companies have upgraded their outlook for 2017 as well, including Apple yesterday. Nevertheless, we have seen stocks slide in the last week, along with the US dollar, following recent policy decisions (the badly executed immigration ban, firing of the acting Attorney General etc) and aggressive ‘talking down’ of the dollar from the new US administration.  Germany and Japan were both singled out this week for apparently benefitting from artificially weak exchange rates.  While Germany has benefitted from its euro membership (the Deutsche mark would be stronger than the euro), it’s difficult to see how this problem can be resolved without the destruction of the European Monetary Union, so comments from the US singling out Germany are unhelpful to say the least.

Of course everyone will be closely watching the Fed’s statement tonight, to see if they are sticking with the ‘3 hikes this year’ view, if they are becoming more concerned about US political risk, and whether or not they say anything about the level of the dollar.

Recent trades
Feeling rather more cautious and unsettled this week, I took profit on my Facebook (FB US) shares on Monday, locking in  just over 10% (net) return in less than 1 month. The shares are in overbought territory ahead of Q4 earnings tomorrow and while the market is expecting a good result, I don’t want to risk my gains so far.  I will look to get into the stock again once the dust has settled post earnings.

I also bought some shares in US retailer Target (TGT US) at $63.10 on 27 January. The shares had sold off nearly 20% following disappointing Q4 guidance from management, and I thought they were a bit of a bargain. The company is solid, owns most of its stores (so it has a good real estate portfolio if nothing else), and the dividend yield is over 4%. The shares are oversold on the RSI and at the lowest price in nearly 2 years. Target saw 40% growth in its online sales over the holiday season and is somewhat ‘recession proof’ as a low-cost retailer. If and when the new tax-cuts are announced, retail stocks should rebound nicely (as they did in November). In the meantime, I’m happy to sit on this stock and collect the dividend as downside risk to capital is limited at these levels, in my view.

I’ve also add to my position in Nokia (NOK US). I had bought some shares in late December, and the price has declined further since then, approaching oversold territory in the last couple of sessions. The news flow has been positive however, with several new tie-ups and initiatives (including with the UK’s SKY TV) announced this week. There is 30% upside from current price to analysts’ target price ($5.90). Earnings due tomorrow (Thursday 2 Feb) so if you are very risk averse perhaps wait until this is over.

 

Where to from here?

I had fully intended to write something post-inauguration outlining the key economic policies of the new administration and the potential consequences for financial markets.  However, the events of the last week have left me feeling depressed and fearful about the direction in which the world appears to be moving.  I keep hoping that someone in the circle of advisors will prevail on DT to, well, think things through in a rational way, and to consider the real and potentially lasting consequences (for the US and the world) of the policies he espoused while on the campaign trail.  It seems that was too much to hope for, however.

 

DT is pushing forward with isolationist, protectionist measures that threaten to disrupt global supply chains, potentially push up US inflation while also slowing economic growth for both the US and the rest of the world (or in the worst case tipping the economy into recession).  At the same time he is destroying goodwill and damaging diplomatic relations that have been built with neighbours and allies over decades, with the sweep of his Presidential pen.

 

In spite of this, US equities have hit new record highs, with the Dow finally breaking above 20,000 last week.  I’m not sure how long the euphoria will last.  The chaos and uncertainty caused by the Muslim ban – that is exactly what it is – may just be the start, as Corporate America finally realizes that there are real disruptive consequences to this administration’s seemingly random implementation of ambiguous and ill-conceived measures.

 

Focus is now shifting to the so-called ‘border tax’ – a 20% tax imposed on all imports which would 1) pay for a wall on the border with Mexico and 2) encourage US firms to make things in the US rather than in other (cheaper) countries.  As always there are more questions than answers when it comes to the specifics of this ‘policy’.  Does it apply to imports from all countries which run a trade surplus with the US (eg China, Saudi Arabia) or just imports from Mexico?  Will it tax all imports or only some?  If all imports are taxed, this would include oil imported into the US, which would almost certainly result in higher gasoline prices for US consumers. That’ll go down well in the rust belt, after they also start paying 20% more for cars, car parts, machinery, tomatoes and avocados (all key imports from Mexico).  Higher oil prices are negative for US consumption and US growth.  Neither of these will lead to more jobs for Americans.

 

As for the border forcing companies to relocate manufacturing to inside the US, this would further increase production costs. The reason those firms chose to relocate factories to Mexico/ Asia in the first place was the high cost of production in the US.  Add to that the strength of the dollar and it would be almost impossible for US manufactured items (eg cars, machinery) to compete with lower cost versions produced in the rest of the world (China, Japan, even Germany), even before equal tariffs against US exports are imposed in other countries.

 

Honestly, it’s enough to make me want to find a cave to hide in for the next 4 years.  Or a small farm in New Zealand where I can keep some sheep and grow my own tomatoes and avocados.

 

A tale of two leaders

It is a sign of just how bad things have become that I was impressed by Prime Minister Theresa May’s much awaited speech on Brexit today.  Let’s face it, she doesn’t have the charisma and oratory prowess of say President Obama or Malcolm X nor does she have the ease of her predecessor David Cameron when it comes to public speaking.  But she spoke in a rational, logical way, using clear arguments that were well expressed, in full sentences that were properly structured (even if I didn’t agree with some of what she said).  Sterling rallied sharply on her comments (more on this below).

I couldn’t help but contrast PM May’s speech with the train-wreck of a press conference given by US President Elect Trump last week, who still seemed to me to be campaigning for an election he’s already won.  It was both hilarious and terrifying listening to him go on in his usual all-over-the-place way, without actually saying anything of substance.   The dollar seemingly sells off every time the President Elect opens his mouth.

So what can we take away from today’s speech?  The UK has set several objectives that it wants to achieve in Brexit negotiations, including guaranteeing the rights of EU citizens already living in the UK, national unity, keeping the border with Ireland open (in some way), social & economic reform, intelligence sharing and security co-operation with the EU.  The most important points were already leaked to the press and in fact, had been heard from PM May on several occasions:

  1. the UK would not be subject to the European Court of Justice – all laws governing the UK would be passed by national parliaments and interpreted by UK courts
  2. control over borders is not negotiable – the UK cannot remain part of the EUs single market
  3. the UK will seek to negotiate free trade agreements on a bilateral basis with any country it chooses to.  This means the UK cannot remain part of the EU’s customs union in its current form.
  4. the UK will seek to negotiate an entirely new relationship with the EU that would allow the free-est trade possible while still achieving points 1-3 above.

The only really new point in the speech, and probably one of the biggest drivers of the rally in GBP in the afternoon, was PM May’s announcement that the government would put the final Brexit deal that is negotiated with the EU over the next 2 years, before both houses of parliament for approval before it goes into effect.  This basically makes the supreme court ruling (still to come this month) a little irrelevant.

Does this mean that sterling only appreciates from these levels? I don’t think so.  The negotiations haven’t even started yet, and they will get ugly.  Let one or two banks announce they are moving a bunch of their staff out of the UK to another EU capital, or let a MNC say they will not invest in the UK because they won’t get access to the single market, and the pound will surely respond. Furthermore, the interest rate differential between the USD and GBP will continue to widen, limiting the upside for sterling.  Yes inflation in the UK was higher than forecast today, and it will only continue higher as the pound’s weakness continues to filter through to the high street and as oil prices are sharply higher than a year ago. but the BoE will be in no hurry to raise rates, if it can be helped.

I took the opportunity to buy back into Crest Nicholson (CRST) shares at under GBP5.00 this afternoon; the shares hadn’t declined on the back of GBP weakness we saw earlier this week, and as I said in my previous post, I still like the stock.  As the market seems to be getting used to the idea of a ‘hard’ Brexit, I suspect UK real estate developers will continue to do well for the time being.

 

Further weakness in sterling on the cards

Brexit uncertainty rises

PM Theresa May gave an interview on the weekend where she basically said that the UK would leave the EU i.e. leave the single market.  This seems obvious to me in light of the referendum result 6 months ago, the subsequent resignation of David Cameron and the appointment of Mrs May as leader of the CP.  However, it seems there are still those in denial about what Brexit means (including the Scots).  Immigration/ border control is the red-line for this government, and this cannot be achieved while remaining in the single market, thus the UK will leave the single market (unless the EU suddenly gives way on this, which would basically undermine its own existence).  However, this doesn’t mean that the UK cannot negotiate a new trade agreement with the EU (like Canada has recently done) to reduce some of the barriers and costs to trade.  It is in the EU’s interests to get this done, as much as it is in the UK’s, and Mrs May recognises this.   At the same time, the UK is free to negotiate trade agreements with OTHER countries, much faster than the EU could as it wont have to get approval from small provinces in Belgium.  A so-called hard Brexit need not the end of the world, but the market is wringing its hands and sterling looks poised for further weakness.  Uncertainty around this issue is only going to escalate (the SC still has to rule on the government’s appeal on the High Court’s decision on the government’s ability to trigger Article 50 without passing an act of parliament – follow that if you can) and as the European election schedule kicks off.

Taking profit on Crest Nicholson

Given the down-side risks to USDGBP from here, and the fact that UK real estate stocks tend to not do well on Brexit worries/ weak pound, I’ve reconsidered my stance on Crest Nicholson (CRST).  Last week, I said I would hold the stock for further upside, but I wasn’t expecting the Brexit concerns to kick off quite so soon – I thought Feb/ March was more likely.  I still like the stock on a fundamental basis, it is cheap, the dividend yield is very attractive but the stock has risen another 1.6% since Thursday, and is now technically overbought.  I’m being prudent and taking my healthy 11% profit at this point, will look to get back in at lower levels.

UK and US equities have continued to rally this week – at least the ones I’m holding.  I’m starting to get a little nervous that the rally is overdone.  Stocks like Glencore and Boohoo should continue to do well on USDGBP weakness.  In the US, Facebook has rallied 8% since I decided to buy it (I called it at USD 115 per share here) and I’m happy to hold this for now but may put a stop loss at my entry price in the next couple of days to protect my capital.  Pharma stocks have continued to grind higher and as these are sort-of defensive I’m happy to hold onto these too.  I wont be adding to any US positions though, at least until we get some of the earnings out of the way and the inauguration of Donald Trump.

December US payrolls showed wage pressure building

Friday’s non-farm payrolls were a mixed bag: the headline gain in jobs was less than the market was looking for but November was revised higher.  Unemployment rate at 4.7% and average earnings jumped by more than forecast.  If unemployment remains under 5%, and DT manages to push through a fiscal stimulus package as well as curtailing immigration then wage pressures are likely to build even more this year.  Add to that the boost to inflation from higher oil prices (remember last Jan/Feb saw crude oil below USD 30 per barrel, compared to mid-50’s now) and headline inflation could start to rise much faster than the market is expecting.  I suspect several people in the Fed are starting to worry about this as well.

UK home builders rally

On 15 December I posted here that I had bought shares in UK homebuilder Crest Nicholson (CRST) at GBP4.51.  Since then (and mostly in the last couple of days really), the stock has rallied 10%.  Several other UK-listed developers have also rallied strongly, after Deutsche Bank published a report yesterday highlighting value across the sector.  A couple of other things have helped: UK data has been excellent, with services PMI showing very strong growth in December and GBP strength vs USD over the last couple of sessions.  Typically, UK property stocks do better on a stronger pound.

Even after the rally (10% is not bad for a 3 week gain, long only and with no leverage), CRST still offers further upside in my opinion: the dividend  yield is still 4.5% with final dividend expected to be announced later this month; PE is just over 8x and consensus price targets imply another 23% upside from here (today’s close at GBP4.94).  The RSI is approaching overbought though, so I would wait for a better entry level if you haven’t already got a position.  If you followed my lead and already bought shares, adjust your stop-loss to break-even and enjoy further risk free returns 🙂

Chart: Crest Nicholson PLC share price (GBp)

source: Bloomberg

Over in the US, equities have come off today after weaker than expected ADP employment data.  I don’t put too much stock in this indicator, it isn’t a great predictor of non-farm payrolls (due tomorrow, consensus forecast 175k).  Also, other survey data from the US (ISM manufacturing and non-manufacturing surveys) point to upside risks to US growth.  The Fed minutes were relatively dovish in my view – even though Fed officials are thinking about the impact of Trump’s supposed fiscal stimulus, they will likely wait to see what is actually announced before they adjust their baseline approach of ‘gradual’ tightening.  The Fed is probably also thinking about the strength of the USD, which in itself is a monetary tightening, again giving the FOMC more time to raise rates.  The focus now is on the earnings announcements for Q4 that will start next week, and of course the upcoming inauguration on January 20th, followed by President Trump’s first 100 days.  Watch this space.