Category Archives: Context and Perspectives

Turning Heads I Win, Tails You Lose Inside Out

Turning Heads I Win, Tails You Lose Inside Out

For much of the current expansion, cycle investors have been forced taught to believe in a Heads-I-Win-Tales-You-Lose investing environment in which good economic news was good for equities and bad economic news was also good for equities. Good news obviously indicates a positive environment, but bad news meant further central bank intervention, which would inevitably raise asset prices.

Those who didn’t buy-the-dip were severely punished. Many fund managers who dared to take fundamentals into consideration and were wary, or put on portfolio protection, saw their clients take their money and go elsewhere. An entire generation of market participants learned that it’s easy to make money, just buy the dip. That mode just may be changing as the past two weeks the major indices have taken some solid hits. Keep in mind that while the headlines keep talking up the equity markets, the total return in the S&P 500 has been less than 5% while the long bond has returned over 18%. Austria’s century bond has nearly doubled in price since it was first offered less than two years ago!

Earnings Season Summary

So far, we’ve heard from just under 2,000 companies with the unofficial close to earnings season coming next week as Wal Mart (WMT) reports on the 15th. The EPS beat rate has fallen precipitously over the past week down to 57.2%, which if it holds, will be the lowest beat rate since the March quarter of 2014. Conversely, the top line beat rate has risen over the past week to 57.4% which is slightly better than last quarter, but if it holds will be (excepting last quarter) the weakest in the past 10 quarters. The difference between the percent of companies raising guidance versus percentage lowering is down to -1.8% and has now been negative for the past four quarters and is below the long-term average.

With 456 of the 505 S&P 500 components having reported, the blended EPS growth estimate is now -0.72% year-over-year, with six of the eleven sectors experiencing declining EPS. This follows a -0.21% decline in EPS in Q1, giving us (if this holds) an earnings recession. The last time we experienced such a streak was the second quarter of 2016.

The Fed Disappoints

Last week Jerome Powell and the rest of his gang over at the Federal Reserve cut interest rates despite an economy (1) the President is calling the best ever, (2) an unemployment rate near the lowest level since the 1960s, at a (3) time when financial conditions are the loosest we’ve seen in over 16 years and (4) for the first time since the 1930s, the Fed stopped a tightening cycle at 2.5%. We have (5) never seen the Fed cut when conditions were this loose. They were looking to get some inflation going, Lord knows the growing piles of debt everywhere would love that, but instead, the dollar strengthened, and the yield curve flattened. Oops. That is not what the Fed wanted to see.

The President was not pleased. “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world,” he said in a tweet. “As usual, Powell let us down.”

The dollar’s jump higher post-announcement means that the Fed in effect tightened policy by 20 basis points. Oops2. The takeaway here is that the market was not impressed. It expected more, it priced in more and it wants more. Now the question is, will the Fed give in and give the market what it wants? Keep in mind that both the European Central Bank and the Bank of England are turning decisively more dovish, which effectively strengthens the dollar even further.

Looking at past Fed commentary, the track record isn’t exactly inspirational for getting the all-important timing right.

But, we think the odds favor a continuation of positive growth, and we still do not yet see enough evidence to persuade us that we have entered, or are about to enter, a recession.” Alan Greenspan, July 1990

“The staff forecast prepared for this meeting suggested that, after a period of slow growth associated in part with an inventory correction, the economic expansion would gradually regain strength over the next two years and move toward a rate near the staff’s current estimate of the growth of the economy’s potential output.” FOMC Minutes March 20, 2001

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems to likely be contained.” Ben Bernanke, March 2007

“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.” Janet Yellen, June 2017 (This one is going to be a real doozy)

This time around Fed Chairman Powell told us that what we are getting is a “mid-cycle policy adjustment.” Wait, what? We are now (1) in the longest expansion in history with (2) the lowest unemployment rate in over 50 years as (3) corporate leverage levels reaching record levels at a (4) time when more of it is rated at just above junk than ever before in history. This is mid-cycle? I’m pretty sure this one will be added to the above list as some serious Fed facepalming. Now I think these folks are incredibly bright, but they are just tasked with an impossible job and live in a world in which their peers believe they can and ought to finesse the economy. So far that theory hasn’t turned out all that well for anyone who doesn’t already have a good-sized pile of assets.

Domestic Economy (in summary because it is August after all)

  • We are 3-year lows for the US ISM manufacturing and services PMIs.
  • We are seeing a shrinking workweek, contracting manufacturing hours and factory overtime is at an 8-year low.
  • Just saw a contraction in the American consumer’s gasoline consumption.
  • American households just cut their credit card balances, something that happens only about 10% of the time during an expansion. Keep in mind that Q2 consumer spending was primarily debt-fueled when looking towards Q3 GDP.
  • The Organization for Economic Co-operation and Development (OECD) Leading Economic Indicator for the US fell to a 10-year low in June, having declined for 18 consecutive months. A streak of this nature has in the past always been indicative of a recession. Interestingly that same indicator for China just hit a 9-month high.
  • The Haver Analytics adjusted New York Fed recession risk model has risen from 50% in early January to a 10-year high of 80%.

Global Economy

  • The IMF has cut world GDP forecasts for the fourth consecutive time.
  • We have 11 countries so far in 2019 experiencing at least one quarter of shrinking GDP and 17 central banks are in cutting mode with Peru the latest to cut, the Royal Bank of Australia hinting at further cuts and Mexico and Brazil likely next in line.
  • Some 30% of the world’s GDP is experiencing inverted yield curves.
  • Over half the world’s bond market is trading below the Fed funds rate.
  • Despite the sanctions on Iran and OPEC output cuts, WTI oil prices have fallen over 20% in the past year.

Europe

  • The Eurozone manufacturing PMI for July fell to 46.5, down from 47.6 in June and is now at the lowest level since the Greek debt crisis back in 2012 as employment declined to a six-year low with a decline in exports. Spain came in at 48.2, 48.5 for Italy and 49.7 for France.
  • Germany, long the economic anchor for the Eurozone and the world’s fourth-largest economy, has negative yields all the way out 30 years and about 40% of Europe’s investment-grade bonds have negative yields. The nation’s exports declined 8% year-over-year and imports fell 4.4% in June as global demand continues to weaken.
  • France had its industrial production contract -2.3% in June versus expectations for -1.6%.
  • Italy’s government is back in crisis mode as the two coalition ruling parties look to be calling it quits. Personally, I think Salvini (head of the League) has been waiting for an opportune time to dump his Five Star partners and their recent vote against European Infrastructure gave him that chance. The nation is likely heading back to the polls again at a time when Europe is facing a potential hard Brexit, so we’ve got that going for us.
  • The UK economy just saw real GDP in Q2 contract 0.2% quarter-over-quarter. Domestic demand contracted -3%. Capex fell -0.5% and has now been in contraction for five of the past six quarters. Manufacturing output also contracted -2.3% in the worst quarter since the Great Financial Crisis.

Asia

  • South Korean exports, a barometer for global trade, fell 11% year-over-year in July. The trade war between South Korea and Japan continues over Japan’s reparations for its brutal policy of “comfort women” during WWII.
  • The trade war with China has entered the second year and this past week it looks unlikely that we will get anything sorted out with China before the 2020 election. The day after Fed’s rate decision Trump announced that the US would be imposing 10% tariffs on $300 billion of Chinese goods starting September 1st. In response, China devalued its currency and word is getting out that the nation is preparing itself for a prolonged economic war with the US. The rising tension in Hong Kong are only making the battle between the US and China potentially even more volatile and risky. Investors need to keep a sharp eye on what is happening there.
  • Auto sales in China contracted 5.3% year-over-year in July for the 13th contraction in the past 14 months.
  • Tensions are rising between India and Pakistan thanks to India’s PM Modi’s decision to revoke Kashmir’s autonomy.

US Dollar

When we look at how far the dollar has strengthened is have effectively contracted the global monetary base by more than 6% year-over-year. This type of contraction preceded the five most recent recessions. While the headlines have been all about moves in the equity and bond markets, hardly anyone has been paying attention to what has been happening with the dollar, which looks to be poised the breakout to new all-time highs.

Reaching for new all-time highs?

A strengthening dollar is a phenomenally deflationary force, something that would hit the European and Japanese banks hard. So far we are seeing the dollar strengthen significantly against Asian and emerging market currencies, against the New Zealand Kiwi and the Korean Won, against the Canadian dollar and the Pound Sterling (Brexit isn’t helping) and China has lowered its peg to the dollar in retaliation against new tariffs in the ongoing trade war. There is a mountain of US Dollar-denominated debt out there, which is basically a short position on the greenback and as the world’s reserve currency and the currency that utterly dominates global trade. As the USD strengthens it creates an enormous headwind to global growth.

The deflationary power of a strengthening US dollar strength in the midst of slowing global trade and trade wars just may overpower anything central banks try. This would turn the heads-I-win-tales-you-lose buy-the-dip strategy inside out and severely rattle the markets.

The bottom line is investors need to be watching the moves in the dollar closely, look for those companies with strong balance sheets and cash flows and consider increasing liquidity. The next few months (at least) are likely to be a bumpy ride.

Don’t Judge a Book by Its Cover

Don’t Judge a Book by Its Cover

 

It’s the end of July and has been hot as hell for much of the world this week, around 107 Fahrenheit in Paris yesterday! So I’ll do my best to keep this look into economy and markets a bit shorter than my usual. When economies and markets are near a turning point, often the headlines tell a very different story than is revealed by digging deeper into the data – you can’t judge a book by its cover. In this week’s issue of Context & Perspectives:

  • Budget Debate Off the Table Until 2020
  • Investors Just Not That into the Stock Market
  • Global Manufacturing Weakness Continues to Spread
  • Next Week, the Fed Re-Takes Center Stage

 

Budget Debate Off the Table Until 2020

Apparently, the Democrats were also feeling the heat as they managed to work out a deal on a 2-year budget with the President, so at least that drama is off the table until after the elections. Maybe at some point during the elections, someone will mention the enormous level of debt the government has accumulated, while Social Security remains a massively underfunded elephant in the room. Or maybe not. We live in interesting times.

 

Investors Just Not That into the Stock Market

While the market continues to grind higher, digging into the details we find that investors have really not been loving this stock market. Over the past 52 weeks, according to data from the Investment Company Institute (ICI), investors have pulled $329.4 billion out of equity funds, another $94.0 billion out of hybrid funds and put $75.7 billion into bond funds. So how has the market continued to march higher? Over the past five years, investors have been net sellers of the market with corporations themselves the net buyers through stock buybacks, which isn’t quite as rosy as it may first seem.

Some of these buybacks are being funded through debt, which has led global corporate debt to reach unprecedented heights, as I discussed in my last piece when I pointed out the proliferation of not just corporate debt, but also the increasing numbers of zombie corporations. There are a few others also concerned with this, as was discussed in a Barron’s article yesterday, you might recognize just a few of these names.    

Part of why investors are selling while corporations are buying back their own shares is likely a function of demographics. As the Baby Boomers move adjust portfolios as they move into retirement, their portfolio construction will naturally have to change and that shift, in a period of central bank interest rate suppression, is much harder than it was for generations past. The level of income that can be feasibly generated from a portfolio today is much less than what the Baby Boomers’ parents enjoyed. At the other end of the spectrum, Millennials are saddled with unprecedented levels of student debt, so they aren’t exactly big buyers of shares either. Between central bank manipulations and demographics, this is a very different investing environment.

Given the relative strength of the US economy compared to the global economy, which is slowing more dramatically, it is interesting to note that large-cap stocks, (which tend to have more international exposure) have been outperforming small-cap stocks at a level not seen since January 2008 – ahem, share buybacks, anyone? 

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Global Manufacturing Weakness Continues to Spread

This week’s Markit manufacturing PMI came in at 50.0, meaning no change in output, and was the weakest level since March of 2009. The United States wasn’t alone as Germany’s Markit Manufacturing PMI was the lowest since July of 2012 and the Euro Area as a whole came in at the lowest level since December 2012. A composite of the five Federal Reserve manufacturing activity indices (courtesy of Bespoke Investment Group) reveals that all nine subcomponents have declined year-over-year, with Prices Paid leading the decline, down -24.2% and New Orders coming in the second worst, down -22.2%. New Orders are also down -10.2% from just this past April. That is not exactly a rosy leading indicator. The International Monetary Fund has cut global growth forecasts four times this year.

When looking at manufacturing globally, the first company to come to mind is Caterpillar (CAT). The company reported results for the June quarter that confirmed the overall slowing we’ve been seeing in the global industrial sector. Sales growth for the company has weakened along with various indicators of slowing we’ve been seeing come in from all over the world. We aren’t seeing an imminent crash, but Caterpillar’s results certainly support the theory of spreading weakness. Sales for the bellwether company peaked in North America in February 2018 at 30% year-over-year and have been falling ever since, with June’s 12% year-over-year growth rate the weakest in 18 months. North America remains the strongest region for the company and one of only two posting positive growth. The rolling three-month average global sales growth rate is down to its lowest level in about 14 months and the company’s streak of 28 consecutive months of rising sales is being threatened. This tells you an awful lot about the global economy.

 

The Consumer & Government Props Up GDP . . . with Debt

Friday morning the first estimate for GDP for the second quarter was released, rising 2.1% versus expectations for 1.8% – 2.0% and up from 3.1% in the first quarter. This quarter was all about the consumer with personal consumption expenditures up 4.3% (annual rate), the strongest performance in six quarters. At the same time, American Express (AXP) and Capital One Financial Corp (COF) reported an increase in the number of accounts overdue by 30+ days in the second quarter. Personal Savings also declined -3.6%. Spending up, debt up and savings down – not exactly a sustainable trend?

Looking further at the consumer, on the positive side, the solid quarterly earnings report from short-term staffing provider Robert Half (RHI) provided evidence that we are seeing domestic wage growth with the bill rate (which is basically the cost of waters for the company’s customers) was up 5% year-over-year in the past three quarters. That’s good news for the consumer, but keep in mind this is not a leading indicator. On the other hand, employment at small businesses, which does tend to be a leading indicator as small businesses are quick to respond and adjust to the changing economy, fell by 23k in June after having fallen 38k in May. The last time we saw back-to-back drops of that magnitude was in early 2010. For all the hoopla over employment, the last Job Openings and Labor Turnover Survey found that job openings were down -4% from the cycle high and new hires were down -4.4%. Again, not saying we are falling off a cliff here, but we are looking for indicators that the trend is changing direction and these data points clearly point towards that assessment.

Friday’s GDP report also found that gross private domestic investment declined -5.5%, the worst showing since the December quarter of 2015 with spending on non-residential structures falling -10.6%. This drop on business investment took a full percentage point off of GDP – to be fair, they are awfully busy buying back their own shares. If businesses are cutting back on investments in machinery and structures, isn’t hiring going to be affected? That will affect consumer spending. When looking at that fall in domestic investment, keep in mind the trade wars and how Chinese foreign direct investment has declined by about 90% over the past two years. 

Along with a jump in consumer spending, government spending also jumped, rising 5% on an annual basis. That is the biggest increase in spending since the second quarter of 2009 when the economy was literally falling off a cliff. Not to be a negative Nancy here, but digging into the math a bit we see that consumer spending and government combined rose at a 4.4% annual rate while the rest of the economy contracted at a -12.1% rate.

In the end, and I’m doing my best to wrap this up quickly for all of you struggling with the heat, all eyes remain on the entities most responsible for the health of the stock market these days – central banks. The European Central bank policy announcement this week kept the benchmark despite the rate at negative 40 basis points but indicated the bank is considering additional quantitative easing and potentially a tiered deposit rate scheme to help protect bank profitability – not exactly a shocker given the poor condition of many of the region’s banks. The outgoing head of the ECB, Mario Draghi, stated that the outlook “is getting worse and worse.” In response, the German 10-year yield traded as low as negative 42 basis points. For context, the US 10-year closed the same day at 2.075%. 

 

On Tap Next Week, the Fed Re-Takes Center Stage

Next week the Federal Reserve is expected to cut its key rate by at least 25 basis points and the market is pricing in further cuts to follow. Many are arguing that the Fed needs to be Gretzky and move to where the economy is going to be, not where it is today. They may be right, but the Fed has backed itself into a really tough corner. A typical rate-cutting cycle sees 525 basis points of cuts. Today, it has about half of that to work with and over the coming months the economy is facing quite a few potential shocks:

  • Brexit – now that Boris is in charge it could get ugly.
  • The feud between the odd-couple political coalition in Italy is intensifying at a time when European leadership is particularly weak and facing Brexit. Just what the EU needs, more instability.
  • Trade wars. 
  • Iran tossing around missiles and threats in the Strait of Hormuz

The Fed may want to keep some of those precious few arrows in its quiver. It is also facing competition in the race to the bottom as many of the world’s central banks are either cutting or are looking to begin cutting rates in the near future. Meanwhile, the market continues to grind higher.

Central Bankers’ New Clothes

Central Bankers’ New Clothes

In this week’s musings:

  • Earnings Season Kicks Off 
  • Central Bankers’ New Clothes 
  • Debt Ceiling – I’m Baaack
  • Trade Wars – The Gift that Keeps on Giving
  • Domestic Economy – More Signs of Sputtering
  • Stocks – What Does It All Mean

It’s Earnings Season

Next week banks unofficially kick off the June quarter earnings season with expectations set for a -2.6% drop in S&P 500 earnings, (according to FactSet) after a decline of -0.4% in the first quarter of 2019. If the actual earnings for the June quarter end up being a decline, it will be the first time the S&P 500 has experienced two quarters of declines, (an earnings recession) since 2016. Recently the estimates for the third quarter have fallen from +0.2% to -0.3%. Heading into the second quarter, 113 S&P 500 companies have issued guidance. Of these, 87 have issued negative guidance, with just 26 issuing positive guidance. If the number issuing negative guidance does not increase, it will be the second highest number since FactSet began tracking this data in 2006. So not a rosy picture.

Naturally, in the post-financial crisis bad-is-good-and-good-is-bad-world, the S&P 500 is up nearly 20% in the face of contracting earnings — potentially three quarters worth — and experienced the best first half of the year since 1997. In the past week, both the S&P 500 and the Dow Jones Industrial Average have closed at record highs as Federal Reserve Chairman Powell’s testimony before Congress gave the market comfort that cuts are on the way. This week’s stronger than expected CPI and PPI numbers are unlikely to alter their intentions. Welcome to the world of the Central Bankers’ New Clothes

Central Bankers’ New Clothes

Here are a few interesting side-effects of those lovely stimulus-oriented threads worn in the hallowed halls of the world’s major central banks.

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Yes, you read that right. Greece, the nation that was the very first to default on its debt back in 377BC and has been in default roughly 50% of the time since its independence in 1829, saw the yield on its 10-year drop below the yield on the 10-year US Treasury bond. But how can that be?

Back to those now rather stretchy stimulus suits worn by the world’s central bankers that allow for greater freedom of movement in all aspects of monetary policy. In recent weeks we’ve seen a waterfall of hints and downright promises to loosen up even more. The European Central Bank, the US Federal Reserve, the Bank of Canada have all gone seriously dovish. Over in Turkey, President Erdogan fired his central banker for not joining the party. Serbia, Australia, Dominican Republic, Iceland, Mozambique, Russia, Chile, Azerbaijan, India, Australia, Sri Lanka, Kyrgyzstan, Angola, Jamaica, Philippines, New Zealand, Malaysia, Rwanda, Malawi, Ukraine, Paraguay, Georgia, Egypt, Armenia, and Ghana have all cut rates so far this year, quite a few have done so multiple times. From September of 2018 through the end of 2018, there were 40 rate hikes by central banks around the world and just 3 cuts. Since the start of 2019, there have been 11 hikes and 38 cuts.

That’s a big shift, but why? Globally the economy is slowing and in the aftermath of the financial crisis, a slowing economy is far more dangerous than in years past. How’s that?

In the wake of the financial crisis, governments around the world set up barriers to protect large domestic companies. The central bankers aimed their bazookas at interest rates, which (mostly as an unintended consequence) ended up giving large but weak companies better access to cheap money than smaller but stronger companies. This resulted in increasing consolidation which in turn has been shrinking workers’ share of national income. For example, the US is currently shutting down established companies and generating new startups at the slowest rates in at least 50 years. Today much of the developed world faces highly consolidated industries with less competition and innovation (one of the reasons we believe our Disruptive Innovators investing theme is so powerful) and record levels of corporate debt. It took US corporations 50 years to accumulate $3 trillion in debt in the third quarter of 2003. In the first quarter of 2019, just over 15 years later, this figure had more than doubled to $6.4 trillion.

Along with the shrinking workers’ share of national income, we see a shrinking middle class in many of the developed nations – which we capitalize on in our Middle Class Squeeze investing theme. As one would expect, this results in the economy becoming more and more politicized – voters aren’t happy. Recessions, once considered a normal part of the economic cycle, have become something to be avoided at all costs. The following chart, (using data from the National Bureau of Economic Research) shows that since the mid-1850s, the average length of an economic cycle from trough to peak has been increasing from 26.6 months between 1854 and 1919 to 35 months between 1919 and 1945 to 58.4 months between 1945 and 2009. At the same time, the duration of the economic collapse from peak to trough has been shrinking. The current trough to (potential peak) is the longest on record at 121 months – great – but it is also the second weakest in terms of growth, beaten only by the 37-month expansion from October 1945 to November of 1948.

https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-Economic-Cycles.png

Why has it been so weak? One of the reasons has been the rise of the zombie corporation, those that don’t earn enough profit to cover their interest payments, surviving solely through refinancing – part of the reason we’ve seen ballooning corporate debt. The Bank for International Settlements estimates that zombie companies today account for 12% of all companies listed on stock exchanges around the world. In the United States zombies account for 16% of publicly listed companies, up from just 2% in the 1980s. 

This is why central bankers around the world are so desperate for inflation and fear deflation. In a deflationary environment, the record level of debt would become more and more expensive, which would trigger delinquencies, defaults and downgrades, creating a deflationary cycle that feeds upon itself. Debtors love inflation, for as purchasing power falls, so does the current cost of that debt. But in a world of large zombie corporations, a slowing economy means the gap between profit and interest payments would continue to widen, making their survival ever more precarious. This economic reality is one of the reasons that nearly 20% of the global bond market has negative yield and 90% trade with a negative real yield (which takes inflation into account).

Debt Ceiling Debate – I’m baack!

While we are on the topic of bonds, the Bipartisan Policy Center recently reported that they believe there is a “significant risk” that the US will breach its debt limit in early September if Congress does not act quickly. Previously it was believed that the spending wall would not be hit until October or November. As the beltway gets more and more, shall we say raucous, this round could unnerve the markets.

Trade Wars – the gift that keeps on giving

Aside from the upcoming fun (sarcasm) of watching Congress and the President whack each other around over rising government debt, the trade war with China, which gave the equity markets a serious pop post G20 summit on the news that progress was being made, is once again looking less optimistic. China’s Commerce Minister Zhong Shan, who is considered a hardliner, has assumed new prominence in the talks, participating alongside Vice Premier Liu He (who has headed the Chinese team for over a year) in talks this week. The Chinese are obviously aware that with every passing month President Trump will feel more pressure to get something done before the 2020 elections and may be looking to see just how hard they can push.

Trade tensions between the US and Europe are back on the front page. This week, senators in France voted to pass a new tax that will impose a 3% charge on revenue for digital companies with revenues of more than €750m globally and €25m in France. This will hit roughly 30 companies, including Apple (AAPL), Facebook (FB), Amazon (AMZN) and Alphabet (GOOGL) as well as some companies from Germany, Spain, the UK and France. The Trump administration was not pleased and has launched a probe into the French tax to determine if it unfairly discriminates against US companies. This could lead to the US imposing punitive tariffs on French goods.

Not to be outdone, the UK is planning to pass a similar tax that would impose a 2% tax on revenues from search engine, social media and e-commerce platforms whose global revenues exceed £500m and whose UK revenue is over £25m. This tax, which so far appears to affect US companies disproportionately, is likely to raise additional ire at a time when the US-UK relationship is already on shaky ground over leaked cables from the UK’s ambassador that were less than complimentary about President Trump and his administration.  

That’s just this week. Is it any wonder the DHL Global Trade Barometer is seeing a contraction in global trade? According to Morgan Stanley research, just under two thirds of countries have purchasing manager indices below 50, which is contraction territory and further warning signs of slowing global growth. This week also saw BASF SE (BASFY), the world’s largest chemical company, warn that the weakening global economy could cut its profits by 30% this year.

Domestic Economy – more signs of sputtering

The ISM Manufacturing index weakened again in June and has been declining now for 10 months. The New Orders component, which as its name would imply, is more forward-looking, is on the cusp of contracting. It has been declining since December 2017 and is at the lowest level since August 2016. Back in 2016 the US experienced a bit of an industrial sector mini-recession that was tempered in its severity by housing. Recall that back then we saw two consecutive quarters of decline in S&P 500 earnings. Today, overall Construction is in contraction with total construction spending down -2.3% year-over-year. Residential construction has been shrinking year-over-year for 8-months and in May was down -11.2% year-over-year. Commercial construction is even worse, down -13.7% year-over-year in May and has been steadily declining since December 2016. What helped back in 2016 is of no help today.

While the headlines over the employment data (excepting ADP’s report last week) have sounded rather solid, we have seen three consecutive downward revisions to employment figures in recent months. That’s the type of thing you see as the data is rolling over. The Challenger, Gray & Christmas job cuts report found that employer announced cuts YTD through May were 39% higher than the same period last year and we are heading into the 12thconsecutive month of year-over-year increases in job cuts – again that is indicative of a negative shift in employment.

Stocks – what does it all mean?

Currently, US stock prices, as measured by the price-to-sales ratio (because earnings are becoming less and less meaningful on a comparative basis thanks to all the share buybacks), exceed what we saw in the late 1999s and early 2000s. With all that central bank supplied liquidity, is it any wonder things are pricey?

On top of that, the S&P 500 share count has declined to a 20-year low as US companies spent over $800 million on buybacks in 2018 and are poised for a new record in 2019 based on Q1 activity. Overall the number of publicly-listed companies has fallen by 50% over the past 20 years and the accelerating pace of stock buybacks has made corporations the largest and only significant net buyer of stocks for the past 5 years! Central bank stimulus on top of fewer shares to purchase has overpowered fundamentals.

This week, some of the major indices once again reached record highs and given the accelerating trend in central bank easing, this is likely to continue for some time — but investors beware. Understand that these moves are not based on improving earnings, so it isn’t about the business fundamentals, (at least when we talk about equity markets in aggregate as there is always a growth story to be found somewhere regardless of the economy) but rather about the belief the central bank stimulus will continue to push share prices higher. Keep in mind that the typical Federal Reserve rate cut cycle amounts to cuts of on average 525 basis points. Today the Fed has only about half of that with which to work with before heading into negative rate territory.

The stimulus coming from most of the world’s major and many of the minor central banks likely will push the major averages higher until something shocks the market and it realizes, there really are no new clothes. What exactly that shock will be — possibly the upcoming debt ceiling debates, trade wars or intensifying geological tensions — is impossible to know with certainty today, but something that cannot go on forever, won’t.

The market is going great so no need to worry, right?

The market is going great so no need to worry, right?


There are weeks when sitting down to write this piece is tough because not much worthy of note has happened in the markets or the economy outside of the usual noise. This week, that was most definitely not the case. Thank God it is Friday – we all need a break.


New Market Highs and the Economy Gets Uglier

Thursday the S&P 500 closed at a new all-time high and is now above its 50-day, 100-day and 200-day moving averages. The post Federal Reserve Open Market Committee meeting debrief gave the market essentially what it wanted, a significantly more dovish stance with plenty of reasons to believe future rate cuts are imminent. Perhaps the Marty Zweig adage, “Don’t fight the Fed,” has been flipped on its head to “Fed, don’t fight the markets.” Unemployment is at multi-decade lows with more job openings than unemployed persons, rising hourly earnings, and improving retail sales while the market hits all-time highs and yet the Fed is preparing to stimulate. Yeah, something’s off here.

Stocks may be partying like it is 1999 (for those who remember that far back) but the yield on the 10-year closed at 2.01% Thursday. To put that in context, on June 9th when the 10-year was down to 2.09%, the Wall Street Journal ran an article asserting that, “Almost nobody saw the nosedive in bond yields coming, but a few players were positioned well enough to profit. Some think there is more room for yields to fall further,” along with this chart. To be clear, despite not one respondent predicting the yield on the 10-year would fall below 2.5% in 2019, none of these economists are idiots, but the thing is they all tend to read from the same playbook.

The stock market is giddy over its expectations for lower rates, yet the spread between the 3-month and the 10-year Treasury has been inverted for four weeks as of this writing, not exactly a ringing endorsement for economic growth prospects. Every time this curve has been inverted for 4 consecutive weeks, it has been followed by a recession (hat tip @Saxena_Puru) for this chart. Note that the chart uses 10-year versus 1-year until the 3-month became available in 1982. Much of the mainstream financial media and fin twit believe this time is different. Time will tell.

The red arrows denote 4 consecutive weeks of inversion and the blue arrows mark bear-market lows (20% declines).

Then there is this, with a hat tip to Sven Henrich whose tweet with a chart from Fed went viral – that in and of itself says a lot.

Both US imports and exports have declined from double-digit growth in 3Q 2018 to essentially flat today. The recent CFO Outlook by Duke’s Fuqua School of Business found that optimism about the US and about their own companies amongst CFO’s had fallen from the prior year.

The shipments of goods being moved around the country have plummeted since the beginning of 2018, as shown by the Cass Freight Index.

The Morgan Stanley Business Conditions Index fell 32 points in June, the largest one-month decline in its history.

If all that doesn’t have your attention, consider that the New York Fed’s recession probability model puts the probability that we are in a recession by May 2020 at 30%. Note that going back to 1961, whenever the probability has risen to this level we have either already been in a recession or shortly entered one with the exception of 1967 – 7 out of 8 times.

But hey, the market is going great so no need to worry right? If that’s what you are thinking, skip this next chart from @OddStats.


Geopolitics – From Bad to Oh No, No No

Brinksmanship with Iran continues as in the early hours of Friday we learned that the US planned a military strike against Iran in response to the shooting down of an American reconnaissance drone. The mission was called off at the last minute after the President learned that an estimated 150 people would likely have been killed. Frankly, the official story sounds a bit off, but what we do know is that we are in dangerous territory and one can only hope that some cooler heads prevail, and the situation gets dialed back a whole heck of a lot.

Given we weren’t enjoying enough nail-biting out of the Middle East news, an independent United Nations human rights expert investigating the killing of Saudi journalist Jamal Khashoggi is in a 101-page report recommending an investigation into the possible role of the Saudi Crown Prince Mohammed bin Salam citing “credible evidence,” and while not specifically assigning blame to bin Salam, did assign responsibility to the Saudi government. This week the US Senate voted to block arms sales to Saudi Arabia, rebuking the President’s decision to use an emergency declaration to move the deal forward. This matters when it comes to investing because there are some seriously high-stakes games being played out that have the potential to suddenly rock markets without any warning.

Over in Europe more and more data points pointing to a slowing economy, which led to European Central Bank President Mario Draghi to announce that more stimulus could be in the works if inflation fails to accelerate. At the ECB’s annual conference in Sintra, Portugal Draghi stated that, “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.” It isn’t just inflation that is troubling the region. Euro Area Industrial Production (ex Construction) has only seen increases in 2 of the last 11 months.

Italy continues to struggle with its budget deficit outside the limits allowed by the European Union, leading to a battle between Rome and Brussels. Friday Deputy Prime Minister Matteo Salvini (head of the euro-skeptic Lega party) threatened to quit his position if he is not able to push through tax cuts for at least €10 billion. While the US has been laser-focused on the Fed (and the president’s tweets) the Italian situation is getting more tense and a time when UK leadership with respect to Brexit is also getting a lot more tense. To put the Italian problem in perspective and understand why this problem is not going away, look at the chart below.

Today, Italy’s per capita GDP is 2.8% BELOW where it was in 2000 while Germany is 24.8% higher. Even the beleaguered Greece has outperformed Italy. Italy’s debt level is material to the rest of the world, its economy is material to the European Union, its citizens are losing their patience and its leadership consists of a tenuous partnership between a far-right, fascist-leaning Lega and a far-left, communist(ish) 5 Star movement lead by folks that very few in the nation respect. So that’s going well.

As if the European Union didn’t have enough to worry about as its new parliament struggles to find any sort of direction or agreement on leadership, the parliamentary process for selecting the next Prime Minister of the UK is down to two finalists. Enthusiam is rampant.

A hard Brexit is looking more likely and that is not going to be smooth sailing for anyone.


The Bottom Line

All this is a lot to take in, but there is a bright light for the week. Anna Wintour, Vogue’s editor-in-chief and eternal trend-setter, has given flip-flops her seal of approval. So, we’ve got that going for us. If that didn’t put a little spring into your step, I suggest you check out this twitter feed from Paul Bronks. Your soon-to-be more swimsuit ready abs will thank me, but your neighbors will wonder what the hell is going on at your place.

Betting on Central Banks as it Gets Plain Ugly

Betting on Central Banks as it Gets Plain Ugly


In this week’s piece

  • The Central Bank Prayer
  • Labor Markets Take a Dive
  • Global Wobbles
  • Geopolitical Angst
  • Definitive Proof of Peak


Central Bank Prayer

The market is hoping, praying and pricing for a Federal Reserve rate cut ostensibly driven by the now dual trade wars, which means the actions of the president are driving both monetary and fiscal policy – surely this will not end well. That is not a political statement as in this game one cannot afford (literally) to be influence by biases towards either the left or right, but it is rather a lesson of history. One individual driving both fiscal and monetary policy for a nation has never come to a utopic end.

The market participants, however, have learned their lesson over the past 10+ years, weak fundamentals are meaningless, trivial details in the face of the power of the world’s major central banks. Or are they? It has been said that something that cannot go on forever, won’t. I know, I know, this time it’s different.

This week Federal Reserve officials gathered in Chicago for a research conference and signaled in interviews and speeches that they are aware of the rising risk of a weaker-than-expected economy. According to the CME Group, traders in futures markets have placed about a 25% chance of a rate cut at the Federal Reserve’s June 18-19 meeting and a 75% chance of at least one cut by the July 30-31 meeting. Chairman Powell on Tuesday stated that, “We do not know how or when these trade issues will be resolved…We are closely monitoring the implications of these development for the US economic outlook and, as always, will act as appropriate to sustain the expansion.”

Across the pond, European Central Bank president Mario Draghi, while wearing the bright blue tie that has often accompanied unexpected stimulus announcements, surprised markets on Thursday by making it clear that the ECB expects rates to stay at their current levels until at least mid-2020. That is longer than had previously been indicated which pushed the euro unexpectedly higher. Investors back in the States ought to take note that central bankers may not be quite as eager as the market hopes to provide immediate support upon signs of weakness. In the US, the issue may very well be complicated by one of the drivers of the weakness – the trade war. One can imagine that as Fed officials ponder the data coming in, the question could arise, “Would it be wise to use stimulus to counter the effects of trade negotiating tactics? Where might that road lead?”

In the Fed’s most recent Beige Book the word ‘uncertain’ appears 21 times, a 6-year high. For a longer-term perspective, in data going back to 1996, that word only appeared more between 2011 and 2013 during the debt ceiling drama, the US debt downgrade, two rounds of quantitative easing and the euro area recession. Uncertainty, you think?


Labor Markets Take a Dive

It was a dour week for labor market data as our Middle-Class Squeeze investing theme came to the forefront.

This week’s ADP private sector payroll report was a big surprise to the downside with only 27k net new jobs added versus consensus expectations for 185k and an enormous decline from the prior month’s addition of 271k and the previous 12-month average of 223k. This was the weakest growth in jobs since March 2010 (in orange below). Looking back to prior to the financial crisis, this rate was similar to the warning signs from the December of 2006 report (in red below). The declines were widespread across sectors, making it tough to write this one off, which undoubtably the bulls will be looking to do. Small businesses, which typically lead the cycle, saw employment contract by 52k in May, also the weakest result since March 2010. To really hammer it home, the goods-producing sector saw a drop in jobs of 43k – this is the same level of decline we saw back in December 2007, the month that the Great Recession began. In the good-producing sector, there were declines across the board from small, mid-sized and large firms with the small businesses (that canary in the economic coal mine) seeing the lion’s share.

The day after the ADP report, the Challenger, Gray & Christmas Job Cut report revealed that US-based employers announced plans to cut 58,577 jobs from their payrolls in May, a 46% increase from April and an 86% increase from May of 2018. Year-to-date cuts are up 39% over the same period from last year with most of the cuts coming from the tech sector. Cuts in the Auto industry for the first five months of 2019 are 211% higher than 2018 and have hit the highest 5-month total since 2009. Keep in mind this sector is highly sensitive to the business cycle.

Those that were looking for the Bureau of Labor Statistic’s Nonfarm Payroll report to contradict ADP’s report from earlier in the week were stunned on Friday to see the economy added just 75k jobs in May versus expectations for 175k.

Average hourly earnings rose just 0.2% month-over-month versus the 0.3% expected. More concerning is that while net new jobs were just 75k, the number of persons employed part time for economic reasons (meaning they cannot get a full-time job) declined by 299k, meaning these people lost the only work they could find. So far monthly job gains have averaged 164k in 2019 versus 223k in 2018.


Global Wobbles

The JPMorgan Global Manufacturing PMI dropped from 50.4 in April to 49.8 in May, the lowest reading since October 2012. The slowdown has been broad – Austria, Canada, Czech Republic, Denmark, Germany, Japan, Italy, Malaysia, Poland, Russia, Switzerland, Taiwan, Turkey, and the U.K. are all in contraction. Germany, the main horsepower for the EU, experienced the biggest drop in Industrial Output in four years, down -1.9% in April versus expectations for -0.5%. US exports of capital goods (ex. Autos) fell by 5.7%, the sharpest decline since September 2008, while imports fell 3.0%. Capex momentum has left the building. In the US the HIS Markit Composite PMI Index (Manufacturing and Services) saw activity drop to its lowest level since May 2016.


Geopolitical Angst

With the drama of the trade wars dominating headlines, it would be easy for US-based investors to miss the fireworks going on elsewhere. Here’s a quick rundown:

  • The recent European Parliament elections saw the coalition of center-left and center-right parties lose its majority for the first time ever. The Greens group became the fourth-largest voting block and the far-right (anti-euro and anti-immigration) gained ground, but less than expected. Silvio Berlusconi (who has become the unbeatable mole in the game of political whac-a-mole) managed to get elected as a member of the European Parliament for his Forza Italia party, go figure. Bottom Line: The widening political divide we see in the US is happening in Europe as well, with those against the EU gaining ground and common ground becoming a lot less common.
  • Friday Theresa May formally steps down as leader of the Conservative Party in the UK. She will remain prime minister of record until undoubtedly. The betting markets currently have Boris Johnson in the lead by a material margin. Now this matters because Boris and the EU don’t exactly get along. Given the ugly relationship there it is unlikely that the European Union would grant him a Brexit deal that would be more attractive to the UK than the one they gave May.  Bottom Line: Brexit is becoming more of a barbell with the most likely outcomes either a hard exit (brutal for both the UK and the European Union) or not exit at all.
  •  This week the European Commission issued a report that Italy has missed targets to rein in public spending and having failed to put its sovereign debt on a diet, is set to break through a cornerstone rule requiring deficits to remain below 3% of GDP. Within Italy, the leader of the far-right, Matteo Salvini, has been gaining political ground, setting the stage for one hell of a showdown. His tweet below says, “The only way to cut debt generated in the past is to cut taxes via the flat tax and allow Italians to work more and better. With the cuts, the sanctions and austerity, the only things that have grown are debt, poverty, temp-employment, and unemployment, we must do the opposite.” I’m getting out the popcorn for this battle! By the way, for those who think President Trump tweets a lot for someone with a full-time job, check out Salvini’s feed. My twitter feed is telling me that I clearly do not drink nearly enough coffee.
  • While the trade wars between China and now Mexico are taking much of the headlines, many of you might have been hearing how China is facing pressures internally from its banking sector. Recently Baoshang Bank was taken over by China’s banking and insurance regulator, the first such takeover in nearly 20 years. This may be just the tip of the banking iceberg. While China and India sit comfortably in our New Global Middle Class Investing themes, that growth is anything but linear and the level of debt China has been taking on to fuel growth has many very concerned. Remember that during the Great Recession, China served as the buyer of last resort, putting a floor under global demand. Its public/private sector balance sheet is a lot less attractive today.


Definitive Proof of Peak

Finally, if you aren’t yet convinced that we have already hit the peak of the economic cycle with the major economic risks now to the downside as we look forward, consider Cangoroo and this $890 BMW Scooter – yes, a scooter. I need a drink.

Seeing Through the Smoke of the Trade War

Seeing Through the Smoke of the Trade War

I’d like to open this week’s piece with a bit of Twitter wisdom – as much as an oxymoron as that sounds.

The impact of Federal Reserve Chairman Powell’s sweet whispers to the market that the 2018 rate hikes are on hold for 2019 is wearing off as politics and trade tensions dominate the markets. I’m going to go out on a limb here and suggest that prescriptions for Xanax and the like have been on the rise inside the beltway in recent weeks. Those headlines investors are trying to navigate around are dominated by talk of the trade war with China, which has evolved from last year’s Presidential tweet.

Fourteen months later, the May 23rd, 2019 comment from Ministry of Commerce spokesperson Gao Feng in Mandarin, (according to a CNBC translation) casts a different tone.

“If the U.S. would like to keep on negotiating it should, with sincerity, adjust its wrong actions. Only then can talks continue.”

So that’s going well. China appears to very much be digging in its heels and preparing for a prolonged battle. We are hearing talk of a ‘cold war’ on the tech sector and the New York Times wrote, “Mnuchin Presses Companies For Trade War Contingency Plans.”

With all that, it is no wonder that the CBOE S&P 500 Volatility Index (VIX) has moved above both its 50-day and 200-day moving average.

May has not been kind to the major US indices.

^SPX Chart

^SPX data by YCharts

Many market bellwethers that had previously been investor darlings are in or shortly will be in correction territory.

GOOGL Chart

GOOGL data by YCharts

But the US economy is strong right? As we’ve mentioned in prior pieces here and here, not so much. This week the Financial Times reported that non-performing loans at the 10 largest commercial US banks rose 20% in the first quarter. That was in a quarter in which GDP came in above 3% and above expectations. What happens in a weak quarter? Those banks aren’t being helped by falling interest rates either, which crush their margins. The yield on the 10-year Treasury note has fallen below the mid-point on the Fed’s target range for the overnight funds rate. A flat-to-inverted yield curve just screams economic party-on.

As we look at growth in the second quarter, remember that the first quarter build-up in inventories was a function of the trade war. Businesses were stocking up before tariffs and in response to all the uncertainty. This buildup was a pull forward in demand for stockpiling which serves as a headwind to growth in later quarters.

We are also seeing reports of trade war related supply chain disruptions, which means declining productivity. Remember that the growth of an economy is a function of the growth of the labor pool (all but tapped out) and growth in productivity. The Atlanta Fed’s GDPNow estimate reflects this with second quarter growth down to 1.3% from 1.6% on May 14th. Following the week’s slump in April core-capital goods orders the New York Fed’s Nowcast reading for the current quarter fell to 1.4% from 1.8% last week.

While the headlines are dominated by the trade wars or the latest drama in DC, what most aren’t watching is the most important factor in the global economy today – the rising dollar.

The US Dollar Index (ICE:DX) has been in a steady uptrend for over a year.

The broader Federal Reserve Trade Weighted US Dollar Index has broken above is December 2016 high and may be on its way to new all-time highs – if it breaks above 129.85, we are in unchartered territory.

Why does the dollar matter so much? About 80% of global trade relies on the US Dollar. Last year the Fed’s rate hikes drove up the price (AKA interest rate) of the dollar for other countries. As the US looks to reduce its trade deficit with many of its trading partners, that means less dollars available outside of the US. When the US imports, goods and services come into the country and dollars leave. A shrinking trade deficit creates a double whammy on the dollar of rising interest rate effects (higher price) and a reduction in supply.

The rising dollar obviously hurts the sales of US companies internationally, (think on this in light of that 20% rise in non-performing loans at US banks) but it is also major headwind to emerging markets, particularly given the massive amount of US dollar denominated debt in emerging economies. As quantitative easing pushed the dollar down, emerging economies gorged on US dollar denominated debt. That seemingly free lunch is now getting expensive, and if the dollar breaks into unchartered territory, that free lunch could turn into spewed chunks.

In addition to the problems with existing dollar denominated debt, the rising dollar increases the scarcity of capital in emerging markets. As the dollar increases relative to another nation’s currency, domestic asset values decline which means banks are less willing to lend. Investment declines and there goes the growth in emerging economies.

With respect to China and the dollar, as the US imposes tariffs on China, the roughly 8% decline in the renminbi versus the US Dollar has helped to offset the impact. This week the renmimbi dropped to nearly a six-month low, falling briefly below 7. To put that move in context, from the mid-1990s to July 2005, China had pegged its currency to 8.28 to the dollar. It only dropped below 7 in 2008 before the nation halted all movement as the financial crisis rolled across the globe. Trading resumed in 2010 officially within a managed band of a basket of currencies, but in practice primarily against the dollar. The big question now is will China let the renminbi stay below the 7 mark.

As global trade slows amidst trade wars, rising populism and dollar scarcity, exports in April in Asia showed the strain.

  • Indonesia -13.1%
  • Singapore NODX -10%
  • Taiwan -3.3%
  • China -2.7%
  • Thailand -2.6%
  • Japan -2.4%
  • South Korea -2%
  • Vietnam 7.5% (woot woot)

Looking at South Korea, semiconductors account for 1/5th of the nation’s exports and we’ve seen global semiconductor sales decline the fastest since 2009. With the ubiquitous nature of these chips, this says a lot above overall global growth. And that’s before the growing ban placed on China telecom company Huawei, which reportedly consumes $20 billion of semiconductors each year, is factored into the equation.

Worldwide Semiconductor Sales Chart

Worldwide Semiconductor Sales data by YCharts

It isn’t just the emerging economies that are struggling with a rising dollar. The Brexit embattled UK, (who just lost its current Prime Minister Theresa May) has seen its currency weaken significantly against the dollar, losing around 25% over the past 5 years – effectively a 25% tax on US imports from currency alone.

Pound Sterling to US Dollar Exchange Rate Chart

Pound Sterling to US Dollar Exchange Rate data by YCharts

The euro hasn’t fared well either. While above the 2017 lows, it has lost nearly 20% versus the dollar in the past 5 years – effectively a 20% tax on US imports from currency alone.

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

If all that isn’t enough to get your attention, then just wait until later this summer when we have another debt ceiling drama to which we can look forward. With how well the left and right are getting along these days on Capitol Hill, I’m sure this will be smooth sailing. With volatility still relatively low (but rising) perhaps putting on a little bit of protection on one’s portfolio would be in order?

And on that note, have a great holiday weekend!

Recession Proof, Bull Market and More of the Emperor’s New Clothes

Recession Proof, Bull Market and More of the Emperor’s New Clothes

This week the markets have been all about the on again/off again trade talks between the US and China and the latest updates from the Tweeter-in-Chief. The Volatility Index (VIX) is reaching a four-month high, which is seriously hurting all those who helped build up the record net short position on VIX futures during the last week of April.

The headlines are now asking, is this going to break this ever-so-fabulous bull market despite the booming economy. Bull market? Robust economy? These days I feel an awful lot like one of the few that see the emperor in fact does not have new clothes.

  • The S&P 500 is up 17% this year while the New York Fed recession probability measure has risen from 21% at the end of 2018 to 27%, the highest in 12 years, and has risen every month this year. This measure typically is flagging a recession when it moves between 30% and 40%.
  • First quarter earnings so far for the S&P 500 companies have fallen year-over-year and are expected to be negative next quarter as well yet Barron’s roundtable report on portfolio managers found 66% are bullish.

The NYSE Composite Index which is a much broader market metric than the S&P 500 is up all of 1% over the past year as of Wednesday’s close and has not made a new high in almost eight months while the small-cap Russell 2000 was down 1.3%. Yes, the S&P 500 was up 6.7% and the Dow Jones Industrial Average up 5.8%, but the iShares 20+ Year Treasury Bond ETF (TLT) was up 5.5% and the iShares 7-10 Year Treasury Bond ETF (IEF) was up 4.7%. When a longer-term bond ETF is outpacing the overall equity market by a material margin like that, we are not in a massive equity bull market.

^NYA Chart

^NYA data by YCharts

When the Utility sector has outperformed the Transport sector by nearly 14% over the past year, I’m not thinking the Bulls are stomping on the Bears nor is it telling me that Mr. Market thinks the overall economy is going like gangbusters.

IYT Chart

IYT data by YCharts

The Cass Freight Index backs up the lack of activity implied by the underperformance of Transports with the volume of shipments falling on a year-over-year basis for four consecutive months. How exactly is the economy accelerating when the volume of shipments has been declining?

Commodities support what we see in transportation.

^SG3J Chart

^SG3J data by YCharts

The Institute for Supply Management (ISM) Purchasing Managers Index (PMI) isn’t all that supportive of the S&P 500’s recent moves and also indicates an economy not exactly revving up.

US ISM PMI Chart

US ISM PMI data by YCharts

But what about last week’s jobs report that had everyone cheering? Just like the first Q1 GDP estimate, which we debunked here, the April jobs report was strong on headline data, weak in the details and lacking confirming data from other sources. The headline new jobs number came in 70k over expectations at 263k, which sounds fantastic, but as always, the details need to be investigated.

  • 93k (35%) of those jobs came from the BLS birth-death model which is a total guestimate of how many jobs were created from net new businesses.
  • The workweek actually contracted 0.3% in April and has now decreased or been unchanged in 3 of past 4 months. That is not telling me that employers are desperate to hire additional staff. Rising hours worked indicates that a company is in need of additional hands, but this decline in hours worked– add hours to translates into a loss of 373k jobs. If we add that number to the headline payroll number and you get a reduction of 110k in employment. Talk about lack of confirming data.
  • There may have been an estimated 263k new jobs, but the total aggregate hours worked declined 0.1%! This figure has declined in 2 of the past 3 months and has remained flat since the start of the year. That means the total hours worked in the economy for everyone hasn’t changed in 4 months – that’s not growth.
  • The headline unemployment rate dropped to 3.6% from 3.8% in March, the lowest since December 1969. That’s got to be good right?
    • Don’t forget that back in 1969, a recession started the very next month, in January 1970.
    • Last month’s drop in the unemployment rate came because of a 490k drop in the labor force. The total pool of available labor is today at the lowest level since May 2001! Remember that economic growth is the sum of growth in the labor pool and improvements in productivity.

We always look for confirming data points both within any particular report but also from similar reports. There is another employment report that didn’t get much attention Friday, the Household survey. This report has been around since the late 1940s and has a completely different methodology.

  • This report found a drop of 103k in employment in April and has declined in 3 of the past 4 months by a total of 300k.
  • Full-time employment dropped by 191k after 190k decline in March.
  • Those working for economy reasons, which means they cannot get a full-time job but want one, rose 155k after a 189k increase in March.

No confirming data on that booming jobs report is coming from the Household survey.

Another area of non-confirmation of the rumored US economy firing on all cylinders comes from the Federal Reserve’s Senior Loan Officer Survey. When times are good and folks feel confident in the future, they are more likely to borrow. So let’s take a look, shall we?

Mid-sized and large companies aren’t looking to borrow.

Small guys are also not in the market for a loan.

The consumer isn’t looking to buy a car.

Or borrow for anything else.

Still not convinced? Over 70 million Americans are hearing from the debt collector. With an estimated 247 million Americans aged 18 and older, that makes for roughly 28.3% of the population in financial distress – and this is when we are being told that things are bloody fantastic and the labor market is just fabulous. What happens when we do go into the inevitable recession?

Oh, wait, never mind. That isn’t going to happen, ever, at least according to this expert.

Between you and me, isn’t this the kind of thing you hear before it all goes pear-shaped?

Q1 GDP . . . Don’t Break Out the Champagne Quite Yet

Q1 GDP . . . Don’t Break Out the Champagne Quite Yet

This morning we received the first estimate for Q1 2019 GDP, and it looked at first glance to be considerably better than was expected with the economy expanding at a 3.2% annual pace versus consensus expectations for 2.3% and growth of 2.2% in Q4 2018. Just don’t break out the champagne quite yet as right away we see reasons to dig deeper.

Net exports plus a build-up in inventories contributed 1.68% to GDP. That’s the biggest bump in 6 years and muddies the economic waters. We’ve now had three consecutive quarters of buildup in nonfarm inventories, likely in defense against further tariff increases. That buildup is a pull forward of growth from the future. The 103-basis point contribution from net exports in the face of ongoing cuts to global growth makes this unlikely to continue. The 46% annualized increase in food exports looks to be more about trade wars than sustainable improvements in trade. Despite the government shutdown, government spending, (primarily at the state and local level) contributed 41 basis points, driven primarily by 35 basis points at the state and local level in “Gross investment.” Given the condition of most government budgets, this isn’t sustainable.

Digging further into the details we find areas of weakness that are more in line with the weaker expectations:

  • Final sales to private domestic purchases fell to the weakest level since Q1 2016.
  • Disposable personal income was the weakest in 6 quarters.
  • Real consumer spending slowed to 1.2% on an annual basis, the weakest rate in a year with spending on those big ticket “durable goods” items falling -5.3%, the worst pace since the end of 2009.
  • Gross domestic purchases were the weakest in 3 years.

On the plus side, durable goods orders grew at the fastest pace in 7 months with a sign that business investment is rebounding. Perhaps on the hope that those China trade talks might actually get somewhere beyond hopeful sound bites that something wonderful is right around the corner? The bigger picture year-over-year factory orders data is less rosy, painting a picture of more slowing. Keep in mind that orders can be cancelled. Shipments for capital goods on a year-over-year basis is solid, but has been consistently slowing.

For a different view on the economy, we can look at how 3M (MMM) and Intel (INTC) have fared, both of whom are bellwether cyclicals. Both companies have seen their shares get pummeled recently thanks to their less-than-rosy outlook. Take a look at United Parcel Service (UPS) whose profits are down 17%. What can be more reflective of the economy than deliveries?

So far Q1 earnings are at a -3% year-over-year decline and Q2 forecasts are expected a -0.5% decline. At the start of the year, expectations were for both to be in positive territory. At the same time, the major market indices have managed to break through to new highs with the Nasdaq up 22% and enjoying its best year since 1991 and the S&P 500 up around 17% and enjoying the best performance since 1987. Then again, look at how 1987 ended. The market’s rally so far this year has been all about multiple expansion, rising from 16.5x to 18.7x on a trailing basis.

As the Federal Reserve once again indicates that it has the market’s back, the S&P 500 has decided that the economic data just isn’t all that relevant.

Yes, jobless claims are still exceptionally low by historical standards, but we always look for confirming data points and we aren’t finding them.

  • The Household Survey found that employment has contracted by 197k since the start of the years.
  • The nonfarm payroll report showed slowing of hiring at temporary employment agencies. This figure tends to be a leading indicator as companies often first fill a roll with a temp before committing to a full-time position.
  • The JOLTS (Job Openings Labor Turnover Survey) report for February was overall the weakest since 2013.
  • The latest Manpower report saw hiring intentions declined for the second quarter of 2019.
  • The Challenger, Gray and Christmas report found that announced job cuts are up 35.6% year-over-year for the first quarter and the worst first quarter since 2009.
  • Finally, while initial jobless claims do remain very low, this year they have risen above where they were the same time last year, possibly indicating a shift in momentum.

For a different look on how the consumer is faring, household formation declined in the first quarter – the kids are back to living at home with mom and dad. Mortgage originations at Wells Fargo (WFM), the nation’s fourth largest bank by assets, declined 23% year-over-year in the first quarter and 18% and JP Morgan (JPM), the nation’s largest bank by assets. In fact, revenues at Wells fell across all business lines with profits only coming as a result of cost reductions. Today’s GDP report saw residential construction decline -2.8% on an annual rate, the fifth consecutive quarterly decline.

Let’s keep this simple and just look at growth in the major parts of the private sector on an annual basis – consumer spending, housing, nonresidential construction, business capital spending:

  • Q2 2018 4.0%
  • Q3 2018 3.0%
  • Q3 2018 2.3%
  • Q1 2019 0.9%

Tell me again how the economy is growing like gangbusters?

In the Midst of Rising Unknowns, Focus on What We Do Know

In the Midst of Rising Unknowns, Focus on What We Do Know

As someone famous (or infamous depending on your leanings) once said, “there are known knowns….there are known unknowns…but there are also unknown unknowns.”

We’ve got a whole lot of the second two going around these days and that is not good for growth. Life and investing requires dealing with uncertainty to be sure, but holy cow these days investors and businesses are facing a whole other level of who-the-hell-knows and that is a headwind to growth.

  • The bumbling battle over Brexit
  • China’s earnings recession
  • Slowing in Europe
  • Yield curve inversions
  • Record levels of frustration with Capital Hill
  • The Cost of Corporate Uncertainty
  • The battle over the GDP pie
  • Beware Reversion to the Mean

Brexit

The United Kingdom, in or out? The mess that has become of Brexit is wholly unprecedented in modern history. As of March 29th, the day the UK was set to leave the EU, Brexit has never been more uncertain nor has the leadership of the UK in the coming months. This graphic pretty much sums it up.

Many Brits are unhappy with the state of their nation’s economy and are blaming those folks over in Brussels, as are many others in the western world – part of our Middle Class Squeeze investment theme.

China

Its economy is slowing, but just how bad it is and just how dire the debt situation in the nation is difficult to divine given the intentional opacity of the nation’s leadership. The ongoing trade negotiations with America run as hot and cold as Katy Perry depending on the day and when you last checked your Twitter feed.

Most recently China’s industrial profits fell 14% year-over-year in the January and February meaning we are witnessing an earnings recession in the world’s second largest economy.

Europe

Last week the markets ended in the red, driven in part by weaker than expected German manufacturing PMI from Markit with both output and new orders falling significantly – new orders were the weakest in February since the Financial Crisis.

Markit German Manufacturing PMI

It wasn’t just the Germans though as the French Markit Composite Index (Manufacturing and Services) dropped into contraction territory as well in February, coming in at 48.7 versus expectations for 50.7, (anything below 50 is in contraction). The French PMI output index is also in contraction territory.

This led to the largest one-day decline in the Citi Eurozone Economic Surprise Index in years, (hat tip TheDailyShot).

Yield Curve Inversion

This pushed the yield on the German 10-year Bund into negative territory for the first time since 2016 while in the US Treasury market, the 10-year to 3-month and 10-year to 1-year spreads went negative – an inverted yield curve which has been a fairly reliable predictor of US recessions. The 10-year 3-month inverted for the first time in 3,030 days – that is the longest period going back over 50 years. The Australian yield curve has also inverted at the short end.

No Love for Capital Hill

Americans’ view of their government is the worst on record – another manifestation of our Middle-Class Squeeze Investment theme. Gallup has been asking Americans what they felt was the most important problem facing the country since 1939 and has regularly compiled mentions of the government since 1964. Prior to 2001, the highest percentage mentioning government was 26% during the Watergate scandal. The current measure of 35% is the highest on record.

Few issues have every reached this level of importance to the American public: in October of 2001 46% mentioned terrorism; in February of 2007 38% mentioned the situation in Iraq, in November 2008 58% mentioned the economy and in September 2011 39% mentioned unemployment/jobs.

While America appears to be more and more polarized politically, the one thing that many agree upon, regardless of political leanings – government is the greatest problem.

It isn’t just the US that is having a tiff with its leaders. Last weekend over 1 million (yes, you read that right) people protested in London calling for a new Brexit referendum – likely the biggest demonstration in the UK’s history and then there are all the firey protests in France.

The Cost of Corporate Uncertainty

When companies face elevated levels of uncertainty, they scale back and defer growth plans and may choose to shore up the balance sheet and reduce overhead rather than invest in opportunities for growth. So how are companies feeling?

A recent Duke CFO Global Business Outlook Survey found that nearly have of the CFOs in the US believe that the nation will be in a recession by the end of this year and 82% believe a recession will have begun before the end of 2020.

It isn’t just in the US as CFOs across the world believe their country will be in a recession by the end of this year – 86% in Canada, 67% in Europe, 54% in Asia and 42% in Latin America.

All that uncertainty is hitting the bottom line. Global earnings revision ratio has plunged while returns have managed to hold up so far.

It isn’t just the CFO that is getting nervous as CEOs are quiting at the highest rates since the financial crisis – getting out at the top?


The GDP Pie

To sum it up, lots of unknowns of both the known and unknown variety and folks are seriously displeased with their political leaders.

So what do we actually know?

We know that US corporate profits after tax as a percent of GDP (say that five times fast) are at seriously elevated levels today, (nearly 40% above the 70+ year average) and have been since the end of the financial crisis. No wonder so many people are angry about the 1%ers.

Corporate profits have never before in modern history been able to command such a high portion of GDP. This is unlikely to continue both because of competition, which tends to push those numbers down and public-policy. If the corporate sector is going to command a bigger piece of GDP, that means either households or the government is going to have to settle for a smaller portion.

It isn’t just the corporate sector that has taken a bigger piece of the GDP pie. Federal government spending to GDP reached an all-time high of 25% in the aftermath of the financial crisis and has remained well above historical norms since then.

Given the level of dissatisfaction we discussed earlier concerning Capital Hill, it is highly unlikely that we will see a reduction in government deficit spending. When was the last time a politician said, “So you aren’t satisfied with what we are doing for you? Great, then we’ll just do less.”

That leaves the households with a smaller portion of the economic pie – evidence of which we can see in all the talk around how wage growth remains well below historical norms.

Reversion to the Mean

Given the current political climate, it is unlikely that government spending as a percent of GDP is going to decline in any material way, which leaves the battle between the corporate and household sector. Again, given the current political climate (hello congresswoman AOC) it is unlikely that the corporate sector is going to be able to maintain its current outsized share of GDP – the headlines abound with forces that are working to reduce corporate profit margins and as we’ve mentioned earlier, global earnings are being revised downward significantly. If the corporate sector’s portion of GDP falls to just its long-term average (recall today it is 40% above and has been above that average for about a decade), it would mean a significant decline in earnings.

The prices investors are willing to pay for those earnings are also well above historical norms.

Today the Cyclically Adjusted PE Ratio (CAPE) is 82% above the long-term mean and 93% above the long-term median. What is the likelihood that this premium pricing will continue indefinitely? My bets are it won’t.

The bottom line is that the level of both corporate profits and what investors are willing to pay for those profits are well outside historical norms. If just one of those factors moves towards their longer-term average, we will see a decline in prices. If both adjust towards historical norms, the fall will be quite profound.

Markets Stalling Despite Central Banks’ Support

Markets Stalling Despite Central Banks’ Support

 

The early equity market strength in 2019 has many on financial television claiming we are off to the races yet again (shock) but taking a step back and looking at both the internals of the markets and the longer-term economic and geopolitical trends, we see more signs of weakness and rising risks.

  • Sideways Equity Markets Persist as First Quarter GDP Growth Expectations Remain Poor and Yields Fall
  • Brexit Uncertainty Worse Today with Just Two Week Until Brexit Day (March 29th)
  • Further Signs of Both Domestic and Global Slowing
  • Labor Market Concerns
  • The Impact of Record Levels of Corporate Debt

 

Equity and Fixed Income Markets Diverge

While the early part of 2019 the markets were going like gangbusters after the worst December in decades, the markets have been directionless in recent weeks.

For all the talk of an ongoing bull market that the prior chart would support, the total return for the index is basically flat since late January 2018 – nearly 14 months of nada. Not quite so exciting for the long-term investor when you take a step back even though the ups and downs have offered traders short-term opportunities.

During that same time, the yield on the 10-year US Treasury has fallen, after having risen to over 3.2% last November. Today it sits a mere 10 basis points above the high end of the Federal Reserve’s target Fed Funds rate, which means the bond market is pricing in negligible economic growth. That’s a cue for the Atlanta Fed GDPNow forecast for the current quarter that clocks in at all of 0.4%, well below the 1.4% consensus tallied by The Wall Street Journal. The 10-year Treasury yield is near its 2019 low while the S&P 500 hits a 2019 high – that ought to have your attention.

The biggest driver for equity markets lately has been expectations around the Federal Reserve’s next steps and the push-pull on a US-China trade deal. Rather than being in the midst of a rate hike cycle, as was the case towards the end of last year, the Fed funds futures market is pricing in 25% odds of a rate cut by year’s end versus just 7% odds a month ago. A very different outlook compared to this time last year, and one that suggests the market is increasingly concerned about the speed of the economy and the rising risk of the next recession.

The Russell 2000, a small cap index, whose constituent’s revenues are more domestically driven than the S&P 500 also reflects the markets low expectations for economic growth as the index remains nearly 11% below its August 2018 high and sits about where it was at the end of November of 2017. The message here is don’t be lulled into a false sense of security given the near 15% increase in that index thus far in 2019.

The Nasdaq Transportation Index paints a similar picture.

 

Bumbling Brexit

In this time of political polarization across much of the developed world, from riots in Paris to efforts to secede in Spain, I think there is one thing we can all agree upon – the UK’s Prime Minister Theresa May is having a bad year. Much of the developed world is facing a rise of populism, driven by the forces behind our Middle-Class Squeeze investment theme, as the countless promises political leaders have been making for decades are not being fulfilled and people, particularly those mounting financial pressures, are angry. In the UK that manifested itself in a desire for more autonomy with a side helping of anti-immigrant nationalism.

After Mrs. May suffered a record-breaking 230-margin rejection of her Brexit deal in January, she endured yet another defeat this week by a margin of 149 votes in the House of Commons. The uncertainty around Brexit has never been higher.

Confused by it all? You aren’t alone as I’m pretty sure many members of Parliament are as well! Here is the short(ish) version of what it all means.

The deal Mrs. May has worked out with the European Union has been utterly rejected and on March 13th Parliament voted that it will not exit the European Union without an agreement. So, they won’t agree to her deal – the only deal on the table – nor will they leave without some sort of deal. Eh? What this means is that now the UK has to go back to the EU leadership and ask for an extension to Article 50, the formal exit process which set the deadline for March 29.

EU leadership has indicated that they aren’t terribly excited about granting an extension if there is no clear reason to believe that an extension will actually be useful. If the same folks are just going to make the same arguments with the same non-negotiables, then what’s the point? Does your head hurt like mine?

Anything is possible now from a hard-Brexit in which the UK is forced to exit the EU under Article 50 without any deal because the EU won’t grant an extension to an extension that leads to a new referendum that results in the UK remaining in the EU.

The bottom line is that the market has absolutely no idea how to price in anything about this mess. Depending on what happens in the next few days, the markets could get suddenly quite volatile as we get closer to that deadline without any resolution.

 

Domestic and Global Slowing

Last week the European Central Bank cuts its guess estimate for 2019 GDP growth to 1.1% from 1.7% with ECB President Mario Draghi shifting towards easier monetary policy by reviving the “Targeted Longer-Term Refinancing Operations,” which is a lending program with favorable interest rates that props up the weak and weakening banking system  supports liquidity in the region. In a testament to his own genius, Draghi stated that negative rates “have been very successful for the ECB and were a powerful instrument in fostering a recovery.” For a discussion on just how destructive helpful this policy has been in the region, listen to this Tematica’s Cocktail Investing podcast late last year to hear boots on the ground stories of the havoc stimulus these policies provide.

On the plus side, Eurozone Industrial Production surprised to the upside at 1.4% versus 1% with the Citibank Economic Surprise Index for the region showing signs of improvement after having been in negative territory for over two years with the exception of a brief foray above zero in the August/September period in 2018.

Forecasts for US growth in the first quarter from the Atlanta Fed have ranged from 0.2% to 0.5% during the month to sit at 0.4% as of March 13th. The range of estimates from the Blue Chip survey is between slightly over 2% to 0.7%.

The stalling out trade talks with China provide an additional headwind to a domestic economy that is already forced to contend with weakening global growth.

The utter mess of Brexit provides even more headwinds.

Taking a step back to look at the world’s major economies, if we look at the US, Canada, Brazil, Italy, Germany, the UK, France, India, China, and Japan, 9 out of those 10 were experiencing growth in the last quarter of 2018. The one exception being Italy. The problem is that growth was weaker than the prior year. The only country that saw acceleration was the US, and the tailwinds for that are fading.

A full 8 of the 10 experienced slower real year-over-year GDP last quarter and Italy is in official recession territory. In Canada final domestic demand has fallen for two consecutive quarters – the last time we saw this the Bank of Canada cut rates twice for the year.

How long can the US fight off the slowing of the rest of the world?

 

Labor Market – Should We Worry?

Payroll reports in February reverse the January contradiction which we discussed in this prior issue of Context and Perspectives. In January the Payroll report was quite strong while the Household Survey was weak – for February the two reversed rolls and we saw some obvious impacts from weather and the end of the government shutdown. Taking a step back we get a broader, longer-term picture of the two. Of the 255k added to the Household survey payrolls in January, 90% held just a high-school education. In February that 255k gain reversed to a 251k loss. On a bright note, those working part-time for economic reasons fell 837k, the single biggest decline in that metric since January 1994 – great! But then on the downside, the 25-54 years-old cohort has seen its payroll ranks decline by 52k in the past four months – not so great.

While the February headline payroll number saw just a gain of 20k versus expectations for 180k – the weakest gain since September 2017 – January’s numbers were revised up from 304k to 311k and December’s were also revised up from 222k to 227k. Those are solid numbers. But then (you knew this was coming, right?) aggregate hours worked decline -0.3% in February to the lowest level in 3 months. Rising hours worked indicate future payroll growth while falling hours, not so much.

Overall the labor market looks like growth has been or is topping out. Employers are feeling the pressure, which isn’t necessarily a good thing for households as Jonathan Pain points out on Twitter.

Corporate Margins Under Pressure

Wage growth in February hit 3.4% year-over-year in February, which means pressure on corporate margins, but that isn’t the only thing pressuring margins. A recent OECD report revealed that over $4 trillion in non-financial corporate debt will be rolling over in the next three years out of the total $13 trillion outstanding (31%). Net issuance of non-financial corporate debt fell to the lowest volume since 20008 and the net issuance of non-investment grade turned negative in 2018. The only other time this has happened in the past 20 years was in 2000. The overall share of BBB rated bonds has reached 54%, the highest ever on record going back to 1980.

So, what does that all mean? That at a point of slowing global growth, companies are facing higher labor costs and are having to roll over some 31% of total outstanding debt in the next few years at higher rates – further pressuring margins.

 

The Bottom Line – Details Matter

The bottom line is the prevailing narrative is that the recent “soft patch” of economic data is temporary and that what really matters to the economy and the markets is the Federal Reserve. While the S&P 500 has pushed through 2,800 again (just barely) the first time it did so in early 2018 one quarter of the stocks in the index were making new 52-week highs. Today less than 9% are in that territory. Back then the average S&P 500 stock was 5% below its high. Today it is 14% below.

Not convinced? Last week’s Fed Beige Book reported that Broadway ticket prices, one of the most reliable leading indicators, “were down 5-6 percent from a year earlier.” The last time a drop of this magnitude happened was December 2007 when “Average ticket prices for Broadway shows rose less than usual this past December and were down more than 5 percent from a year earlier.”

Still thinking this is a temporary patch of weakness? How about the Federal Reserve’s Lael Brainard speech on March 7th which she concluded with, “The most likely path for the economy appears to have softened against a backdrop of greater downside risks.”

To paraphrase Eric Clapton, not even Lael will ease my worried mind.