What the Market Overlooked in the Personal Consumption Expenditures Report

  • Most market analysts are pointing to the slight miss in May’s headline year-over-year PCE deflator reading of 1.4% vs. 1.5% expected and 1.7% previous.
  • What has been overlooked by most are the strong back-to-back personal income figures of 0.4% m/m in May and 0.3% m/m (revised from 0.4%) in April. While April was revised a tick lower, May’s rebound capped off an impressive two month gain of 0.7% in personal incomes.
  • This runs counter to the prevailing sentiment that the Phillips Curve is broken and wages are not picking up or at least holding their own.
  • The Fed has shifted focus recently, as they often do on a discretionary basis, to focus on financial stability after the epic run up in mega cap tech names, equity  valuations, and market complacency suggested market psychology was fostering an unhealthy rise in market bubble dynamics.
  • The core Fed FOMC members are now willing to overlook taming inflation for the time being as a 15% fall in the energy complex drags down PCE and CPI for the next few months. They still believe continued labor market tightening toward what is deemed to be “full employment” will eventually boost wages and keep inflation expectations on a steady projectory. Other central banks are following suit.
  • Assist FX sees the recent central bank turn toward slightly less dovish rhetoric as supportive of a more sustainable recovery. While asset valuations are still stretched and in bubble territory on a longer term basis as regularly discussed on this site, letting some pressure out of the “everything bubble” is actually productive overall.
  • Letting asset valuations and house price-to-income ratios skyrocket unchecked by a tightening reaction function in monetary policy would be one major catalyst capable of changing our S&P500 bias to negative as prices become increasingly stretched like pulling a thinning rubber band.
  • Assist FX sees moderate Fed action to trim asset purchase reinvestments in September with another 25 bp Fed Funds target increase in December.
  • Our equity, fixed income, and USD bias remains neutral.

Retail Industry Credit Risks Are in Dangerous Territory As “Taper 2.0” Approaches

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  • 95% of banks view retail industry credit risks as “significantly greater” or “moderately greater” than in previous cycles (Moody’s Investor Service).
  • 2017 retail store closings are somewhat quietly on pace to surpass levels seen during both 2008 and 2009 when we were experiencing an historic financial crisis.
  • Stalwart retailer Bed Bath & Beyond shares were down 12% today on a worsening sales outlook. Consumers are choosing to buy fewer “things” on net and more of what they do purchase is from a decreasing number of mega cap online providers.
  • Online purchases due to technology advancements can explain part, but not all, of the ongoing retail “fall from grace.”
  • Consumers are stretched from elevated real estate, healthcare, and education costs. The Fed’s bloated balance sheet promoted the same stretched asset prices that are now harming consumers and posing correction risk.
  • Overcapacity fears in the retail and energy sectors are beginning to seep into investor sentiment and inflation expectations.
  • Assist FX sees the Fed keeping interest rates on hold through at least September in order to provide a large enough window to begin trimming its balance sheet.
  • The Fed will initiate a gradual, mild, balance sheet reduction in 2H2017 as outlined in the June FOMC policy decision. This could begin as early as September. Even doves such as Evans and Bullard are nearly ready to begin tapering asset purchase reinvestment.

Bottom Line:

Previous calls from Assist FX of a low volatility grind higher in US stock indices were accurate. It is now time to increase caution modestly and move to a more neutral stance in US equity indices, long duration Treasuries, and USD. Bond market volatility should increase headed into the Fed’s asset purchase reinvestment trimming, which we are calling “Taper 2.0.” A cyclical increase in volatility will incur within the context of the secular decline previously discussed by Assist FX. This means volatility will not always be low; it will however be lower than it would have otherwise been in a previous era.

EM Currency Stability Set to Continue Near Term

  • Emerging markets are experiencing steady capital inflows and currency appreciation on a broad basis, with a few exceptions.
  • Fears of rapid US interest rate hikes due to sharp increases in economic growth and inflation expectations have subsided due to political dysfunction in the US once again. The new Republican led government has been unable to pass major reforms in healthcare, taxation, regulation, or infrastructure.
  • A period of EM stability is set to continue other than politically inspired turbulence in the Middle East over Qatar and global energy oversupply risk.
  • Value can still be found in broad EM FX vs. USD, CHF, and JPY. Expect supportive trend continuation in CNY, ILS, MXN, ZAR, RUB, and COP.
  • Spain’s troubled Banco Popular was acquired by Santander in what is being viewed as a successful ECB assisted bailout. This has relieved some near term banking system stress in the European periphery. Although Banco Popular common equity and junior debt holders were wiped out, senior debt holders were spared. This reinforces what is theoretically supposed to happen with various investor risk segments in the capital structure, although central bank involvement is not ideal.

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