State of the Union

It’s been several weeks since we took a step back and looked at the broad state of the markets,  specifically developments in the US.

The last 2 weeks have been chock full of data and I thought it would helpful to discuss the most important developments of the last couple of weeks in terms of both economic data as well as price action in US markets.

I disdain lagged data, except for the fact that markets typically overreact to such data and so provide the rest of us with an opportunity to put capital to work well.

Case in point, GDP data. We received finalized Q1 GDP data the first week of June.  That’s right, we're 2/3 of the way through Q2 and we're evaluating what happened in the first 3 months of the year and markets are reacting to it.

At my asset management firm, we have a proprietary process for modeling GDP in real-time which allows us to trade based on that data, in real-time. Not on a 3-month lag.

That said, Q1 GDP data, which showed a quarter over quarter contraction, is significant for a couple of reasons. First, it will necessitate a change in the Fed's forecast for 2015 GDP. 

The core of its target is 2.5% GDP based on the March forecasts.  The risk is if they cut it to 2% at next month's meeting. In addition, the Fed has underestimated the pace at which unemployment has fallen.  This suggests that the Fed officials have not fully taken on board the slowdown in productivity.

The second reason that Q1 GDP data was is worth paying attention to is that a contraction, if due to transitory factors, won’t prevent the Fed from hiking rates in either September or December. We know this is true because the Fed has been very direct about this fact.

In fact, the monthly labor data that we received last week - both ADP and NFP reports - reaffirm the generally healthy numbers for job creation, which suggests that the Federal Reserve’s plans to start raising interest rates remains intact. In addition, the jobs reports should quiet chatter that the US was going to slip back into recession after the contraction in Q1.

The employment data solidifies expectations that the economy is rebounding in Q2. There are a couple of other aspects of Q1 growth that aren't discussed, which generally means they're the most important factors.

First, while the quarter over quarter growth rate showed a contraction of 0.7%, the year over year growth rate showed an acceleration to 2.4% from last quarter's 2.3% annual growth rate. This fact is important because annual growth rates are less noisy than quarterly numbers.

The second reason is that the acceleration in annual growth was entirely predictable, in real-time. Regular readers of TWR know that I use a couple of specific indexes in order to help me gauge the market’s expectations for US growth, and whether they’re expecting growth to accelerate or slow. These indexes have been extremely accurate in predicting GDP growth, but rather than being on a 3-month delay, they provide that information in real-time.

The 2 indexes are my US High Growth Index and my US Slow Growth Index. The former outperforms on a relative basis when US growth is accelerating and the latter outperforms when US growth is slowing.

During Q1, the High Growth Index gained 4%, versus the Slow Growth Index, which gained 1.6% and the broader US equity market, which gained 48 basis points. We can see that the relative performance of these two indexes throughout Q1 were indicating that US growth was set accelerate, not slow.

In fact, the High Growth Index outperformed the Slow Growth Index in all but just 3 weeks during Q1. This is part of the reason I felt so strongly that the Fed would hike at the June meeting, which while still a possibility, 70% of economists think that September’s meeting is the one to watch.

As a side note, as of June 5, the High Growth Index has gained an additional 1%, while the Slow Growth Index has declined 6%. That’s 700 basis points of out performance with 3 weeks left in the quarter.

I’ll bet you dollars to donuts that US growth accelerates in Q2.  Unfortunately, we'll have to wait until early September to see if I’m right. 

A couple of other important factors that signal we're on track for a rate hike were the latest auto sales and trade deficit numbers.

The markets did not fully appreciate the significance of May's strong US auto sales. They were the strongest since July 2005, accelerating 11% on annual basis. This is not only a sign of the strength of US consumers but also indicates that output is strong as well.

The smaller than expected US trade deficit also bodes well for Q2 GDP growth. Recall that in Q1, next exports took 1.9% off GDP. The real deficit, which is the key measure for GDP, narrowed. This means consumption in Q2 will be stronger than in Q1 and the headwind from trade will dissipate. Next week's retail sales report should show that consumers are once again shopping after tightening their belts a bit in Q1.

If I’m right and growth accelerates during Q2, then 2 things are for sure. First, the Fed will hike rates at some point in the next 6 months. Second, certain asset classes will perform very poorly, specifically US Treasuries and Gold.

In fact, US 10-year yields broke out of an 18-month downtrend line just last week.  If 10-year yields ($TNX) can hold the 2.34%-2.33% area, then the decline in US fixed income markets is just getting started.

Luckily, we have 2 short positions already, one in LQD and another in TLT, both of which are already profitable.

The other market that will be hurt the most if growth accelerates and yields continue to rise is gold, GLD. Last week’s price action in GLD was significant because it broke a 3-month uptrend line and never looked back, falling significantly over the following 2 days after the breakdown.

We don’t have a SHORT position in GLD but right now isn't the time – yet. I'm waiting for the right time to pull the trigger and the way the economy has been moving, it may be very soon.