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Trade Idea: U.S. Shift Work Says Short Financial Select ETF XLF: Part 1

09/05/2018 1:53 pm EST

Focus: ETFS

Landon Whaley

Editor, Gravitational Edge

In this week’s Macro Theme, we review our “U.S. Shift Work” macro theme for the third time since rolling it out on April 9, writes Landon Whaley Wednesday. He's presenting at MoneyShow Toronto Sept. 15.

We’ve discussed the ideal long candidates that will bullishly benefit from the first shift in the U.S. Fundamental Gravity in more than two years.

Today, we’re going to update the Fundamental Gravity based on the deluge of data we received during August and then detail the Quantitative and Behavioral Gravities that align with a short trade in the Financial Select Sector SPDR ETF (XLF).

Fundamental Gravity says what?

Two chief variables impact the risk and return of asset prices: economic conditions and how central banks respond to those conditions. Together, these variables drive what we call an economy’s Fundamental Gravity.

When we last updated our U.S. Shift Work macro theme August 8, we were just beginning to get July economic data. Fast forward one month, and we have a complete picture of U.S. economic activity during that first month of Q3 as well as a few early readings from August.

The picture these readings paint is one of continued slowing.

Both the IHS Markit Services and Manufacturing PMIs peaked in May and have now slowed for three consecutive months. The August readings for both surveys hit the lowest levels in over a year.

But slower growth ahead is being foreshadowed by more than just the top line number of these data sets. The August PMI readings indicate an annual economic growth rate of +2.5%. In July, that same figure came in at a heftier +3.0%.

What’s more, the August figure represents a materially slower growth pace than Q2’s +2.9% annual GDP growth rate.

chart

One of the sub-components of the manufacturing PMI is backlogs of uncompleted work, and this has historically been an accurate indicator of future manufacturing activity and hiring. In August, backlogs declined for the first time in over a year, suggesting that this growth-slowing trend is likely to persist in the months ahead.

The U.S. consumer also looks sluggish to start Q3, as retail sales growth slowed in July and has now slowed in four of the last eight months. The University of Michigan’s consumer sentiment index declined in July and August, and has now declined in four of the last five months. This is the same consumer sentiment index that hit a twenty-year high just five months ago.

Q2 was an epically good quarter for U.S. banks, and many of the metrics will be hard to beat in Q3 and Q4. Banks reported aggregate net income of $60.2B in Q2 2018, which is a +25.1% acceleration from a year ago and a brand new quarterly record.

Only 3.8% of institutions were unprofitable during the quarter, and the average return on assets was 1.37%, up from 1.13% a year earlier.

However, one overlooked data point from Q2 earnings was that institutions with assets between $10B and $250B reported the largest annual increase in average funding costs (+30 basis points), in response to the Fed’s interest rate hikes.

The bottom line is that we are seeing a dramatic difference in Q3 data compared to the first half of the year, and the economic momentum is to the downside.

The Fundamental Gravity bottom line is that it doesn’t get more bearish for financial institutions than when U.S. growth slows. During this type of FG environment, XLF typically averages a -1.53% quarterly return, with an average quarterly drawdown of -13.9%. In addition, it posts positive three-month returns 52% of the time, which is essentially a coin flip.

U.S. Shift Work and Shorting XLF Part 2

This Friday, September 7, we will release part 2 of this commentary, which is where we will dig in to the other two critical forces, or gravities, that are currently impacting financial stocks: Quantitative and Behavioral. We will also provide a detailed game plan for trading XLF.

If you can’t wait the 48 hours to get the complete picture for this macro theme and the accompanying trade details, please email us at ClientServices@WhaleyGlobalResearch.com with the subject line “U.S. Shift Work.”

We will provide you with the complete macro theme breakdown as well as offer you the opportunity to participate in an eight-week free trial of our research offering, which consists of three weekly reports: Gravitational Edge, The 358, and The Weekender.

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