Last week today – Vladimir Putin inaugurated for his second consecutive (and fourth overall) Presidency of Russia; Kim Jong Un summoned to China for second time in two months (no doubt related to the upcoming summit between Trump and Kim); Trump withdrew from the Iran nuclear deal (despite pressure from France, Germany, and Britain); North Korea released three U.S .hostages (again, no doubt related to the upcoming summit between Trump and Kim); Trump announced date (June 12) of meeting with Kim Jong Un; Producer Price Index (PPI) and Consumer Price Index (CPI) measures of inflation for April were below expectations.
Global equities rallied more than 2% for the week, with U.S. equities leading the way (S&P 500 + 2.5%) on the back of strong earnings reports. In Q1, Earnings per Share for the S&P 500 increased by 23%, the fastest rate since Q2 2011. Its worth noting that roughly 20-percentage points of the year-over-year growth are related to a combination of stock buybacks and tax cuts, leaving only a handful of percentage points from organic (i.e., non-financially engineered) earnings growth. Yields on U.S. Treasury bonds maturing in 2-10 years rose a few basis points, while 30-year bond yields declined modestly. The yield curve flattening trend remains firmly intact as investors handicap the odds of the Fed continuing to tighten in the absence of strong inflation pressure. Commodity prices were generally higher as precious metals (Gold +0.4%, Silver +0.8%) recorded gains, and the price of a barrel of WTI Crude increased by 1.4% to $70.70 per barrel.
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Crude Facts I – Having surpassed Saudi Arabia last year, the U.S. is now neck-and-neck with Russia as the world’s top oil producer. Granted, Saudi Arabia and Russia committed to cap production in early 2017, as both countries wished to remove excess supply from the market to boost the price of crude. Saudi Arabia led the production cut initiative seeking to increase the value of the planned IPO of state-owned Saudi Aramco – the world’s largest oil company. Saudi Arabia is a country undergoing significant change. In addition to loosening its rigid social conservatism (women are now allowed to drive), the royal family sees the future and is desperate to diversify the Saudi economy away from a reliance on hydrocarbons.
Source: The Wall Street Journal
Russia is desperate as well, but not for change. Instead, Russia’s President Vladimir Putin is known to look backward, seeking to re-establish Russia to the vaunted world power status once commanded by the U.S.S.R. Vlad’s playbook is defined by possessing a strong military and a foreign policy known as “realism.” That is, Russia believes foreign policy is a zero-sum game in which one state can only make gains if others lose. The problem for Vlad is that his approach has brought international condemnation (conflicts in Syria and Ukraine, and meddling in the 2016 U.S. presidential election) and crippling sanctions that threaten his military spending. Vlad sees higher oil prices as an elegant solution to offset the negative impact of current sanctions and any new sanctions that may be forthcoming as he pursues his vision of a great Russia.
So you have two oil-rich countries, willing to cap crude production, to secure very different versions of the future. In the meantime, for U.S. oil companies, higher crude prices mean its time to “pump, baby, pump.”
Crude Facts II – No single state in the union has benefited more than Texas from Saudi Arabia/Russia production caps. Saudi Arabia famously tried to crush the U.S. fracking industry by refraining from production cuts in the face of declining oil prices and the price of WTI crude eventually hit $26.21 in February 2016. Low oil prices caused real pain in the U.S. oil industry, but U.S. energy producers were more resilient than the Saudi’s had bargained for. Not only did the industry survive, but producers became more efficient, and reduced breakeven extraction prices by an average of 25% in key Texas oil fields (2015 breakeven prices shown in red; 2016 breakeven prices in blue).
Source: Eagle Global Advisors
Rising oil prices combined with lower extraction costs helped drive the Texas state economy to a 5.2% annualized growth rate in Q4 2017, twice the pace of the broader nation’s 2.6% GDP growth rate. Fast growth requires labor, and Texas added more manufacturing jobs (oil field jobs are considered a “manufacturing” job by the Bureau of Labor Statistics) than any state in 2017.
Indeed, Texas is not the only state benefitting from higher oil prices. Extraction activity (and associated job creation) is increasing in Pennsylvania, North Dakota, and New Mexico as operations become profitable at current price levels.
The Bottom Line – Once considered enemies of the fracking industry, Saudi Arabia and Russia’s independent motivations for higher oil prices are a boon for U.S. energy interests.
Through Friday, 82% of S&P 500 companies had reported Q1 operating results, and the numbers have been strong. According to data from Goldman Sachs, year-over-year earnings per share (EPS) growth was 23%. The lower tax rate contributed to Q1 earnings strength, but companies experienced top line (i.e., revenue) growth as well. Revenue growth is a “purer” measure of organic growth as is not influenced by financial engineering (such as stock buybacks) or the reduction in the statutory tax rate. And thus far, with more than 80% of the companies reporting, revenue growth is up 11% from last year and more than 40% of S&P 500 firms posted revenue results that exceeded expectations.
It’s also worth noting that having reported earnings, the corporate “blackout” periods are now ending for a majority of S&P 500 companies. Blackout periods prevent companies and insiders from repurchasing shares in the month before the release of corporate earnings. Flush with cash from higher earnings and tax reform, some analysts estimate stock buybacks will reach nearly $1 Trillion in 2018. Indeed, last week Apple announced a new $100 Billion stock buyback program on top of the $23.5 Billion of stock it already purchased in the first quarter. Corporations have been one of, if not the, largest buyers of stocks since the Financial Crisis and this trend is set to continue.
Weekly, month-to-date and year-to-date asset class performance are available here.
Ageism – This past Monday, April 30th, marked a milestone as the current economic expansion, at 106 months in duration, is now tied for the second longest on record. For those keeping score at home, the longest expansion occurred in the 1990’s and lasted 120 months. The first half of a legendary Wall Street adage is “Expansions don’t die of old age…” And that’s true. But just like a living creature, the older an expansion gets, the more things can go wrong from supply constraints pushing up inflation to the Federal Reserve committing a monetary policy error.
Source: National Bureau of Economic Research and Covenant Investment Research
On that latter point, the complete maxim is “Expansions don’t die of old age, they are murdered by the Fed.” Indeed, since the Federal Reserve was created there have been thirteen rate hiking cycles, and ten have ended in recession (source: Gluskin Sheff + Associates). Currently, the economy appears on solid footing and a recession in the next year is a low probability event. It would seem that 106 months is the new 90 for the U.S. economy! However, to reach or exceed 120 months, the Federal Reserve will need to raise rates at precisely the correct pace to stave off excessive inflation without constricting financing to the point where consumers and businesses no longer want or can afford, to borrow. And this delicate Fed maneuvering will be taking place against a backdrop of global synchronized tightening through the removal of ultra-accommodative stimulus measures (i.e., the proceeds from Quantitative Easing). New Fed Chairman Jay Powell has an opportunity to make history overseeing the longest expansion on record, but he and his FOMC cohorts will need to play their cards flawlessly, lest this expansion becomes another Fed casualty.
Sucking Sound – The chart below shows the monthly asset purchases since the Financial Crisis of four key central banks: the Bank of England, the Federal Reserve, the Bank of Japan, and the European Central Bank. As the chart highlights the central banks globally, coordinated stimulus program peaked at close to $200 billion of asset purchases in March 2017.
While the central banks’ largesse is waning, there remains significant residual liquidity in the system. Still, as we often say around here, change happens on the margin. Could it be a coincidence that 2018’s suddenly volatile market (following years of utter tranquility as central banks were aggressively buying bonds and equities) comes on the heels of peak liquidity? Nope. At least not to our thinking. Central bank asset purchases provided a significant buffer to financial markets as their inexorable asset purchases covered macro, economic and financial events that otherwise would have created market volatility. Now that the liquidity is being sucked out of the global financial markets, volatility should normalize along with it.