Reality Check

Reality check!  Equities traded off sharply yesterday in response to rising yields and renewed trade fears.  Reports of Chinese manufacturing companies embedding chips capable of spying on US companies into their products caused many to fear that a trade war with China could only get worse, if not cause it to last longer.  The reports further went on to imply that these chips may already be deployed in Apple’s and Amazon’s infrastructures putting pressure on stocks.  The two stocks are both in the top 5 weightings of the S&P 500 as well as the NASDAQ 100, which added pressure to the already fear ridden markets.

Where did the fear come from?  It seems that investors had a sort of delayed reaction to the Fed removing the word “accommodative” from their policy statement last week, Powell’s Tuesday night speech in which he said that the Fed would likely have to go beyond neutral (which means raising rates to slow things down), and a hot employment number from earlier in the week (Wednesday’s ADP jobs report).  Investors started to believe that perhaps the economy could overheat causing the fed to have to apply the brakes sooner than expected.  Remember that those “brakes” ultimately cause recessions and the sharp rise in treasury yields, which started on Wednesday, caused traders to re-look at that scenario. Another theme that reemerged in yesterday’s session was the actual effects of higher rates. Namely on the interest rate sensitive housing industry, which was hit hard in yesterday’s trading. Builders and buyers alike rely on borrowing and higher rates mean higher costs, which ultimately means a slowdown in both building and sales.  The housing industry impacts many other areas of the economy including employment, materials, and industrials so a slowdown in housing can have some broad affects on earnings and economic output.

Additionally, you may recall that one of the reasons cited for the recent selloff in small caps was the rising rate environment and the small caps’ reliance on borrowing.  Many traders look to the small caps as a leading indicator for that and many other reasons (the small cap Russell 2000 has been under pressure for the past month).  The silver lining with rising rates is that the long-afflicted financial sector should benefit with higher profitability, although a flat yield curve doesn’t make things easy.  Recall that banks borrow short term and lend long term, so the spread between short and long rates is a good indicator of lending institutions’ ability to generate profits.  In any case, banks like higher rates in general and investors like the financial sector when rates are rising so the financial sector was the only sector that managed to trade up in yesterday’s messy session.  The S&P 500 closed off its session lows right on a round number support line of 2900 and will get further support at 2864 (see chart 4 in my attached daily chartbook).  The Dow Jones too closed off its session lows but has only weak support around 26500.  The NASDAQ 100 gave up significant ground yesterday due to its concentration on technology and growth stocks, which are always the first to get hit in fear selling (the converse is true in joy buying).

Despite yesterday’s route, the S&P500, Dow Jones Industrial Average, and the NASDAQ 100 are all still constructive, though the NASDAQ is losing some momentum.  The small cap Russell 2000 suffered another setback in its attempts to shore up recent selling and it remains neutral but has to be watched closely as it could de-trend causing a risk-off signal.  Ten year treasuries will start today’s session around 3.20% and the 2/10 yield curve is around 30 basis points (which is around its 100 day moving average).

This morning we will get the Bureau of Labor Statistics’ monthly employment situation number which is expected to show that 185k new non-farm jobs were created last month and the unemployment rate is expected to come in at 3.8% down from last month’s 3.9%.  Average hourly earnings are expected to show a year over year growth of 2.8% versus last month’s 2.9%.  Labor cost is an important factor in production cost and wage growth is always closely monitored.  In the wake of the big morning number we will get a consumer credit number this afternoon which is expected to be $15 billion.  Though the indicator will not likely be a factor in today’s trading, I have highlighted it only to point out that consumer credit has grown significantly through this last recovery and will be a factor as rates continue to rise (more on that in future notes).  This afternoon we will also get the Baker Hughes rig count, which is one of the two major weekly energy supply numbers and given crude oil’s recent positive moves, the number will be carefully scrutinized by oil traders.  Today will be another day of volatility as investors continue to contemplate the reality of higher rates.

daily chartbook 2018-10-05