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Market Outlook

Macro Flags We’re Watching

By Elliott H. Gue, on Nov. 3, 2016

A few flags we watch are waving signals of concerns. Each of these have been covered in more detail for Capitalist Times Premium subscribers. And now we want to offer all readers some context and thoughts about these important indicators.

Looming Low Volatility

The Chicago Board Options Exchange S&P 500 Volatility Index (VIX) measures the choppiness in the stock market based on the weighted average of implied volatility for a wide range of options. The VIX climbs when volatility increases.

For example, the VIX surged to a 10-year high of 89.53 in October 2008, the height of the financial crisis. Over the course of the current bull market, the VIX has approached 50 on three occasions:

  • The Flash Crash of early 2010;
  • The US federal budget crisis of fall 2011; and
  • The flash crash of Aug. 24, 2015.

This year, the VIX jumped to about 30 before and after the UK voted to leave the EU.

(Click to enlarge.)

(Click to enlarge.)

Aside from these spikes, the VIX has declined steadily over the past several years, as the S&P 500 has traded in an increasingly narrow range. In fact, market volatility has receded to historic lows at a time when the pool of potential catalysts continues to grow: the Federal Reserve’s monetary policy, unexpectedly strong or weak economic data and/or political turmoil at home or overseas.

Talk the Oil Talk

As the optimism surrounding OPEC’s reported agreement to reduce production wears off, WTI prices have started to pull back, breaking below technical support at $50 per barrel. OPEC members reportedly have struggled to come up with a viable deal, primarily because of disputes over production levels in Iraq and Iran.

At this point, the much-hyped agreement to reduce oil output looks like little more than an effort to jawbone prices higher during a period of seasonal weakness. With Nigeria, Iran, Iraq and Libya ramping up production, Saudi Arabia and its allies on the Gulf Cooperation Council would have to slash their output by 6 to 10 percent to achieve OPEC’s targeted production range of 32.5 million to 33 million barrels per day.

Although Saudi Arabia’s oil production always declines during the winter months, we seriously doubt that the kingdom will unilaterally cut its output by almost 1 million barrels per day.

Meanwhile, the recent recovery in the US oil-directed rig count and the potential for Lower 48 production to start to grow in 2017 likely worry Saudi Arabia and could militate against an output cut.

The highest-probability outcome is that OPEC will announces a face-saving deal over the next few months, perhaps with a slightly higher production target or an overall goal that avoids the sticky issue of assigning country-specific quotas. Any OPEC deal is unlikely to remove a single barrel of oil from global supply.

Oil markets will rebalance naturally over the next 12 months, provided prices remain low enough in the near term to keep a lid of drilling activity and stimulate demand.

At the DUG Midcontinent conference this week, some management teams asserted that the average break-even price for the emerging STACK play in Oklahoma’s Anadarko Basin is $37 to $38 per barrel. Some operators in the region can break even with WTI prices in the high $20s per barrel.

Although WTI probably won’t retest its 2016 low, a move into the $30s per barrel could still be in the cards over the next one to three months.

(Click to enlarge.)

(Click to enlarge.)

While we doubt crude will retest its early 2016 lows, we still believe a move into the $30s is likely over the next 1 to 3 months.

The New New Economy’s Inflation

The US economy has evolved over the past decade and especially in the aftermath of the Great Recession. The rate at which US gross domestic product can grow sustainably without driving up inflation has declined to about 1.5 percent—about half the historical range of 3 to 4 percent.

This shift suggests that inflationary pressure can appear even with the economy growing at about 2 percent and that US monetary policy may be tighter than many market participants assume. That is, the US economy can’t sustain short-term interest rates of 5 percent or more.

(Click to enlarge.)

(Click to enlarge.)

Robust third-quarter GDP growth increases the likelihood that the Federal Reserve will hike interest rates in December However, the promise of ultra-low interest rates over the long term remains the primary support for a stock market that trades near its highest valuation since the late 1990s tech bubble.

If the Fed increases interest rates, expect a negative reaction in the stock market, which, in turn, could catalyze another rally in US Treasury bonds.

Financial stocks tend to outperform the broader market when interest rates increase and the yield curve steepens. The Federal Reserve appears increasingly likely to hike interest rates by 25 basis points at its Dec. 14 meeting, as US economic growth came in stronger than expected.

Although the initial estimate of third-quarter gross domestic product (GDP) resulted in a seasonally adjusted growth rate of 2.9 percent, subsequent revisions could shift this number by 30 to 50 basis points.

The Federal Reserve Bank of Atlanta’s GDPNow model pegs third-quarter GDP growth at 2.1 percent, while the Federal Reserve Bank of New York’s Nowcast estimates that the economy grew by 2.2 percent. Against this backdrop, the Bureau of Economic Analysis appears likely to revise the official number lower in coming weeks.

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(Click to enlarge.)

Much of the upside in third-quarter GDP came from a build in inventories, which contributed 61 basis points’ worth of growth. This GDP component tends to fluctuate from quarter to quarter, suggesting that the strength over this three-month period could be borrowing growth from future quarters; these inventories eventually must be drawn down.

Trade added 83 basis points to US GDP growth, though this tailwind may reverse with the recent strength in the US dollar. Personal consumption, on the other hand, fell short of expectations.

Despite the strong headline number, the drivers of third-quarter GDP don’t change our view that the US economy will continue to grow at an annualized pace of 1 percent to 2 percent. This lackluster GDP growth, coupled with elevated valuations in the stock market and the prospect of slightly higher interest rates, suggests that US equities and financial stocks are due for a correction.

Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.


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