The Most Important Vital Sign for Capital Markets
Today begins the calendar third quarter (CQ3) reporting season for the S&P 500® Index (SPX) as Yum Brands (YUM) will report after the close. On Wednesday, Alcoa (AA) will report after the close. Both companies derive at least 40% of their revenue outside the United States and so will provide decent insight into how they navigated the 6% rise in the value of the U.S. dollar during the third quarter.
The U.S. dollar remains the most important vital sign for the capital markets. I suspect the elevated rise in volatility and the recent lower trade for risk assets are both attributable to the dollar’s rise (Figure 1).
Figure 1: U.S. Dollar Index, Prior 365 days
While U.S. economic data is improving, it is not coupled with strong global economic growth. If strong global growth were prevalent at the same time the U.S. dollar is appreciating, that would be optimal for risk assets. However, growth beyond the U.S. cannot be categorized as robust, and thus there is concern that SPX companies will be able to retain their pricing power. Furthermore, central banks overseas are embarking upon aggressive monetary easing measures, monetizing their debt, cheapening their currencies, and presenting the perception of a disruption to SPX companies’ ability to retain pricing power.
Today begins a very critical period that I expect will set the tone and direction for the SPX (Figure 2) for the remainder of 2014. If deflation truly is being exported to our shores from Japan and Europe, the answer will be in CQ3 SPX earnings. There is no doubt that global connectivity exists, and just as in 2009 when China was the engine of growth to lift capital markets from multi-years lows, the current global weakness could easily curtail further SPX appreciation.
Figure 2: SPX, Prior 365 Days
Finally, major domestic economic numbers, such as last week’s September ISM manufacturing reading of 56.6, continue to exhibit U.S. economic strength. In fact, the past three months of ISM manufacturing (Figure 3) readings have been the strongest since the first quarter of 2011. I am beginning to wonder if the FOMC is waiting to signal a potential change in monetary policy until they are comfortable that global economies beyond the U.S. can absorb higher U.S. rates.
Until full confirmation from the upcoming CQ3 earnings unfolds, “nimble” might be the optimal strategy and position.
Figure 3: U.S. ISM Manufacturing, 2011 to 2014