Summary
- Latest net foreign inflows to U.S. markets highest on record
- Incoming data suggests U.S. economic growth to accelerate
- Riskier areas of market appear to be stabilizing
Last Friday I penned a piece looking at current supports for the U.S. stock market, one of which I argued was an influx of foreign capital into our markets (see story). On Tuesday this week the U.S. Department of Treasury released data for September confirming this and showed the largest net inflow of long-term capital into the U.S. on record, rising by $164.3 billion. The large inflows were not entirely from foreign buying as U.S. citizens sold $70.1 billion of foreign securities as foreigners simultaneously purchased $94.2 billion of U.S. securities.
Foreigners had been slowing the pace of their U.S. security purchases throughout 2013 but then reversed course earlier this year. From a foreigner's perspective there is a lot to like about the U.S. economy compared to our peers. For starters, our interest rates are higher than many other developed nations, which is why the dollar has been so strong this year. Shown below is a composite I created of spreads between the U.S. Fed and other central banks along with the annual appreciation of the USD Index. When U.S. interest rates rise relative to other foreign central banks, the dollar tends to appreciate. Consequently, much of the current strength in the dollar can be attributed to divergences in central bank interest rates and the anticipation that the U.S. Fed will raise rates next year.
Source: Bloomberg
In addition to diverging interest rates we also see a divergence in central bank balance sheets that is affecting currency exchange rates. For example, when the Fed is expanding its balance sheet faster than the European Central Bank (ECB), the euro tends to appreciate relative to the dollar. Today, we see the reverse with the euro sliding against the dollar as investors anticipate further expansion by the ECB while the U.S. Fed is on hold.
Source: Bloomberg
We see a similar dynamic with the Japanese yen which tends to weaken relative to the dollar when the Bank of Japan (BoJ) expands its balance sheet at a faster pace than the Fed. Back in 2012, one dollar would buy 77-80 yen. Today, one dollar can now buy nearly 110 yen as the BoJ’s balance sheet relative to the Fed is the largest it has been in four years.
Source: Bloomberg
In addition to higher interest rates and a more hawkish central bank, foreign money is also flowing into the U.S. due to our higher economic growth rates. Year-over-year (YoY) real gross domestic product (GDP) in the U.S. is running at a 2.3% rate, above the 0.8% rate in Europe and the -1.2% rate in Japan, and looks to accelerate even further based on recent leading economic indicator (LEI) data. Today, we received November data for the Philadelphia Fed’s Business Outlook Survey that came in at a reading of 40.80, nearly double October’s 20.7 reading and the highest reading in 21 years! There were 56 estimates tabulated by Bloomberg and the highest estimate was for 25.8. Shown below is a graph of the number of estimates on the y-axis and the value estimates on the bottom axis. Take a look at the actual result which is the yellow diamond way on the right.
Source: Bloomberg
The details of the report were just as encouraging: new orders jumped while inventories fell and there were also some encouraging developments in the special questions section of the report. Manufacturers were asked to provide details about expected changes in employment over the next 12 months. The results were quite bullish as the percentage of employers planning on increase employment rose to 56%, which is higher than anything seen since 2011. The second question asked manufacturing firms the three most important factors behind their plans to increase payrolls and the biggest reason by far was “expected growth in sales is high.”
Source: Philly Fed
As seen below, the Philly Fed survey (red line) tends to lead U.S. real GDP (black line) and suggests U.S. GDP accelerates into Q1 2015 (yellow box).
Source: Bloomberg
The recent string of positive surprises continues as the Conference Board’s Leading Economic Index grew by 0.9% over the prior month in October and beat all 49 economic estimates.
Source: Bloomberg
Likewise, the NAHB Housing Market Index came in at 58, beating all 50 estimates for November.
Source: Bloomberg
As was highlighted in my last article (click for link), the string of positive economic surprises is the longest stretch we’ve seen since the economy came out of recession in 2009. Not only has the Bloomberg Economic Surprise Index remained in positive territory for 142 consecutive days now but it is also accelerating and should be supportive of the equity markets.
Source: Bloomberg
Has the string of positive economic news been discounted by the markets? It’s a tough call given the deterioration in the credit markets (see here), but we may be seeing the first signs of stabilization since the short-term peak in the junk bond market last month. We have a potential trend change in the SPRD Barclays High Yield Bond ETF (JNK) which invests in junk bonds. Initial conditions for a BUY signal from Bloomberg’s TrendStall indicator have been met (shown by the purple paint bars below) and now we are waiting for a trigger (green arrow). This indicator has done a decent job in calling short-term tops and bottoms in JNK and should we get a confirmed BUY signal that should translate into improvement in the credit markets and remove a dark cloud hanging over the stock market.
Source: Bloomberg
Another area showing cause for concern this month was the small cap space, which had been underperforming the S&P 500 and rolling over the last two weeks. The small cap Russell 2000 Index now looks to be firming just above its 200-day moving average (200d MA), which is bullish. If the Russell 2000 can close above its November highs of 1188 that would give even more fuel for the bulls for a Santa Claus year-end rally.
Source: Bloomberg
Summary
Data shows that foreigners are now accelerating their purchases of U.S. securities. It’s no surprise given the U.S. Fed is slowing its asset purchases while other central banks are expanding. In addition, the U.S. has higher interest rates and higher economic growth, which looks to be accelerating as seen by the increase in leading economic indicators.
Whether or not the U.S. stock markets have already discounted this news based on the strong surge off the October lows remains to be seen. Recently we’ve seen deterioration in the corporate junk bond market and in small cap stocks like the Russell 2000 Index, which were warning of a possible pullback. However, we are close to getting a Bloomberg TrendStall BUY signal on the SPDR junk bond ETF (JNK) and the Russell 2000 is firming at its 200d MA. Should both the junk bond market and Russell 2000 continue to improve that would indicate the riskier areas of the market were taking a breather after the strong move off the October lows. However, should they continue to weaken, we could be in store for a small pullback and investors would be wise to keep a close eye on JNK and the Russell 2000 for clues.
