Here Comes the Deficit

Written by:  Rich Farr, Chief Market Strategist for Bluestone Capital Management and Jim McGovern, Market Strategist for Bluestone Capital Management 

Bluestone Capital Management is the Sub-Advisor to the Cavalier Multi Strategy Fund



* Tax season ends and U.S. tax receipts tanked in early May.



Tax seasons is over folks and here comes the deficit spending.  We’re not sure why anyone would want to own U.S. Treasury Bonds when tax receipts are going down and federal spending is going up.   On that note, according to the U.S. Treasury, tax receipts are down -18.4% Y/Y through May 10th.  Furthermore, overall tax receipts slowed to +1.9% Calendar YTD (versus +3.6% at the end of April).  The decline in the month was led by Income Taxes, as Income and Employment Withholdings Taxes fell -16.7% Y/Y and slowed to +0.1% Calendar Y/Y (+1.8% Y/Y at the end of April).  Furthermore, Excise & Other Taxes declined -50.9% Y/Y and slowed to +29.4% Calendar YTD (versus +32.8% Y/Y at the end of April).  Conversely, Corporate Income Taxes increased +27.1% Y/Y but they are still down -18.3% Calendar Y/Y (-18.5% Y/Y at the end of April).



U.S. GDP:  Our GDP model points toward 3% Real GDP growth through 2018, but sees slightly slower growth in 2019.   Note that our model doesn’t factor in potential stimulus from tax reform or other policy proposals, so GDP could outperform our model.

U.S. Inflation:  U.S. inflation remains in an upward trend, and we continue to believe that wage inflation should turn higher as labor slack (particularly in prime working age groups) continues to decline.    Note that the Fed’s preferred inflation metric, the Core PCE Deflator, increased to +1.9% Y/Y in March.

U.S. Federal Reserve:  We still believe two additional rate hikes will happen in 2018 and that the FOMC will become increasingly more data-dependent as the year progresses.

U.S. Treasuries:  With inflationary pressures slowly building, and Real GDP trending toward +3.0%, we believe 10-year U.S. Treasury Yields will continue to trend higher and we would expect to see yields approach 3.25% by year end 2018. 

U.S. Equities and Earnings:  S&P 500 operating earnings are rising materially, but the question remains, will the market put a 20 P/E multiple on forward earnings?  We think a 20 forward multiple is aggressive, but 18.5 may not be.   Our SPX target is for an 18.5x P/E on 2019 forward earnings of $162, bringing our 2018 SPX target to 3,000).  We continue to favor the homebuilders, despite higher interest rates given the demographic tailwind and lack of inventory.   We also prefer financials given expectations for economic growth and our expectation for an improving (steepening) yield curve.

Argentina:  Argentina’s overall economic condition appears to still be on an improving track, but data came in weaker recently as Industrial Production slowed to +1.2% Y/Y (from +5.3%), Consumer Confidence slipped to 40 from 43.8, and Construction Activity slowed to +8.3% from +16.6%.  Any signs of weakness are a problem when you are dealing with 7.2% unemployment and 25.4% inflation.

Brazil:  Unemployment has been steadily picking up in 2018 (13.1% in March versus 11.8% in December), which raises some concerns.  However, the unemployment data is not seasonally adjusted and has been improving Y/Y.  Also, Retail Sales accelerated to +6.5% Y/Y in March and Personal Loan Defaults improved in March (to 5.0% from 5.1%).  Overall, Brazil’s data have been mixed in 2018, as PMI’s improve but Industrial Production slows.   Of all the major global bond markets, Brazilian 10-year bond yields are the richest in the world at 10.07% which is attractive given that tax receipts are up 6.7% Y/Y (so long as the money is coming in, they can pay the coupon).  As such, we remain bullish on Brazil 10-Year Sovereign Bonds.

Canada: Canada’s housing market is still on the radar, as building permits and housing starts weaken but Canada’s monthly GDP rebounded in February (+0.4% M/M to +3.0% Y/Y).  Unemployment is still trending lower, Consumer Confidence remains at high levels, manufacturing PMI’s remain strong, and retail sales are elevated (+3.5% Y/Y in February).

Mexico: Mexico’s GDP has been in a slowing trend since Q1 2017 (+3.3% then, now +1.2% Y/Y), Industrial Production is now down -3.7% Y/Y, and PMI’s slowed in April, thus Mexico remains on our macro risk watch.  The Mexican Central Bank has been increasing interest rates since late 2015 (mainly because of fear of dollar weakness).   Consumer Confidence has been trending slightly downward since September (although improved in April).  Meanwhile, Exports are up +12.5% Y/Y, Retail Sales improved to +1.2% Y/Y, and unemployment improved to 2.9%.

Venezuela: We will leave this as a placeholder in the event that Venezuela ever becomes an investible market again.  We are hopeful …


United Kingdom:  The U.K. economy has been reasonably resilient throughout the BREXIT process (PMI’s mostly better in April) and therefore the Bank of England has been raising rates.  But now inflation is slowing, Consumer Confidence has remained negative, Retail Sales have been slowing, and home prices have begun to turn lower in London.  

European Union:  The stronger Euro may now be a problem for Mario Draghi as CPI has been in a slowing trend for several months.   Not to mention, Industrial Production slowed to +2.9% Y/Y, Economic Sentiment is turning lower, and PMI’s have turned back from recent highs.   We think the idea of an ECB hike within the next year is basically out the window, and as such we remain bullish on the Euro STOXX 50 Index, as well as European Financials. 

European Central Banks:  The ECB is slowly removing accommodation and will likely end its asset purchases by year end.  But Mario Draghi has given no indication about raising rates and the recent decline in CPI will give them even further pause for doing so.  We will watch to see if current ECB tapering has any meaningful impact on the economic outlook.

Eastern Europe: We continue to believe risks remain for Eastern Europe given high Debt/GDP levels, most notably Cyprus (104%), Croatia (88%, up from 66% at the end of 2013), and Slovenia (81%).   Yet, economic data have been robust this year across most of Eastern Europe.

South Africa:  Now that Zuma’s out, Confidence (Business and Consumer) appears to be on an up-swing, PMI’s have turned further positive, Retail Sales accelerated to +4.9% Y/Y, and Inflation has cooled.  But these improvements are going to need to get significantly stronger to crush unemployment (26.7% in Q4).

Turkey:  What a mess … the currency is deteriorating, inflation is accelerating and PMI’s turned negative. 


Australia:  The RBA has cut rates twice in the past year and Australian data is mixed.  So far, Unemployment Rate remains at 5.5%, Retail Sales increased +3.1% Y/Y in March, PMIs indicate solid growth, Auto Sales are up +6.7% Y/Y in December, and business and consumer confidence have been strong.    Conversely, we are starting to see mixed data in the housing market (although private sales were down -6.1% M/M, building approvals were up +2.6% M/M).  We remain neutral on Australia at this time, on concerns about China exposure but so far China is still posting strong data.

China:   With China cracking down on shadow banking, pollution, industrial overcapacity, and removing migrant workers from its cities, we expect China GDP to continue to trend lower and we are monitoring the situation closely.   PMI’s continue to indicate growth, but are now in a clear slowing trend as backlogs and new orders weaken, Industrial Profits slowed to +11.6% in March, and Durable Goods Orders fell 12% M/M in February.  Home Prices are up +5.4% Y/Y (half the rate of change from a year ago). However, CPI slowed to +2.1% Y/Y in April, Retail Sales are up +10.1% Y/Y, and Industrial Production is up +6.0% Y/Y thus far in 2018.  We are watching for further signs of stress within China’s credit and housing markets.

India:  Indian economic activity appears to have recovered nicely since the new Goods and Services Tax (GST) was implemented as Commercial Credit accelerated to +12.6% Y/Y, inflation appears to moderated, and PMI’s improved slightly in April. However, Industrial Production slowed to +4.4% Y/Y in March and Exports are down -0.7% Y/Y.

Indonesia:  Indonesia’s GDP and Private Consumption Expenditures have been stable at 5% Y/Y, Consumer Confidence has been stable, Manufacturing PMI has been stable in the 49-51 range for a year, Retail Sales are up +3.4% Y/Y, and Exports are up +6.1%.  However, Industrial Production is negative and CPI ticked higher in March.

Japan:  Overall, we remain bullish on Japan given that Japan’s economic activity remains in an improving trend: unemployment remains low (2.5% in March), Industrial Production is up +2.2% Y/Y, Retail Trade is up +1.0% Y/Y, PMI’s improved in April (but consumer confidence slipped), and Exports are up +1.8% Y/Y.

RussiaThe Russian economy isn’t setting the world afire, but GDP came in at +1.5% in 2017, despite Q4 being weaker than expected at +0.9% Y/Y, Services PMI jumped to 55.5 in April, and manufacturing PMI remains in an improving trend (+0.7 points to 51.3 in April).  Overall, economic data continue to suggest economic growth, as Retail Sales were up +4.2% Y/Y in March, Real Wages are up +6.5% Y/Y, Unemployment is improving, Industrial Production is up +1.0% Y/Y, and exports are up +21% Y/Y despite sanctions.  Meanwhile, Core CPI is muted at +1.3% Y/Y (weekly CPI as of May 7), which has allowed the Bank of Russia to remain accommodative.   Russian equities remain among the cheapest in the industrialized world and we remain bullish. 

South Korea:  While the world looks forward to peace on the Korean Peninsula, we are keeping an eye on trade data into China, which improved in March.   Overall, SK is beginning to show signs of slowing post-Olympics (imports are slowing, Industrial Production is negative, Consumer Confidence has been declining since November, and the Nikkei South Korea PMI has been below ‘50’ for two months in a row).





Source: Bloomberg


Source: Bloomberg


Source: Bloomberg


Source: Bloomberg


Source: Bloomberg


Source: Bloomberg


Source: Bloomberg

Source: Bloomberg