The Magic 8-Ball Market

The Magic 8-Ball Market

Last week ended with equity markets taking another dive that accelerated into Friday’s close as the trade war with China intensified heading into its eighteenth month with China announcing that it will impose retaliatory tariffs on US goods. The S&P 500 closed down 2.5% for the third time this month. After the close President Trump launched a twitter storm to announce additional retaliatory tariffs in response to China’s. So that’s going well.

Investors face challenging times as the major market movers have simply been words (tweets) coming from politicians and bureaucrats, the prediction of which is akin to assessing the next missive from a Magic 8-Ball.

While many continue to talk about the ongoing bull market, the major US equity market indices have seen four consecutive weekly declines and are all in the red over the past year with the small cap Russell 2000 down well over 10%, sitting solidly in correction territory. On the other hand, this year has seen the strongest performance out of long-maturity Treasuries since at least 1987.


Source: Bespoke Investment Group

How many bull markets see the total return for the long bond outpace the S&P 500 by over 16%.

This comes at a time when the domestic economy is in it 121st month, the longest is post-war history, which means that many have not lived through a recession as an adult.


Yield Curve

As the adage goes, expansions don’t die of old age, but their footing becomes less sure over time and we are seeing signs of rockier terrain. One sign comes from the yield curve which has been flattening steadily since October 2018 with the spread between the 10-year and the 3-month falling from over 100 basis points to -39. The most widely watched part of the curve, between the 10-year and 2-year, has inverted four times in the past few weeks.


This 2-10 inversion is most closely watched as over the past 50 years it has preceded all seven recessions. Credit Suisse has found that on average a recession hit 22 months after the 2-10 inversion occurred.

The third of August’s four inversions came as Kansas City Federal Reserve President Esther George and Philadelphia Fed President Patrick Harker stated in a CNBC interview that they don’t see the case for additional interest rate cuts following the cut in July. Mr. Market was not looking to hear that.

This past week we also received the meeting minutes from the prior Fed meeting with led to July’s 25 basis point cut which gave the impression of a Fed far less inclined to cut than the market was expecting with most Fed participants seeing July’s cut as part of a recalibration but not part of a pre-set course for future cuts. Keep in mind that central bank rate cuts are a relative game and ECB officials have been signaling a high likelihood of significant accommodative measures at the September meeting, saying the ECB “will announce a package of stimulus measures at its next policy meeting in September that should overshoot investors’ expectations.”

Manufacturing

Another source of bumps on the economic road comes from the manufacturing sector, both domestic and international. A recent IHS Markit report found that the US manufacturing sector is in contraction for the first time in nearly a decade as the index fell from 50.4 in July to a 119-month low of 49.9 in August – readings below 50 indicate contraction.

According to the Institute for Supply Management, US manufacturing activity has slowed to a nearly three-year low in July. By August New Orders (a key leading indicator) had dropped by the most in 10 years with export sales falling to the lowest level since August 2009.

New business growth has slowed to its weakest rate in a decade, particularly across the service sector. Survey respondents mentioned headwinds from weak corporate spending based on slower growth expectations both domestically and internationally – likely caused by the ongoing trade war that got much, much worse this past week.

In a note to clients on August 11th, Goldman Sachs stated that fears of the US-China trade war leading to a recession are increasing and that the firm no longer expects a trade deal between the two before the 2020 US election. The firm also lowered its GDP forecast for the US in the fourth quarter by 20 basis points to 1.8%.

Global manufacturing has also been slowing, with just two of the G7 nations, Canada and France, currently showing expansion in the sector. In July, China’s industrial output growth slowed to the weakest level in 17 years.

Germany is seeing the most pronounced contraction with its manufacturing PMI dropping from 63.3 in December 2017 to 43.6 this month. German car production has fallen to the levels last seen during the financial crisis.

Overall, we see no sign of stabilization in global manufacturing as global trade volumes look to be rolling over, leaving the economy heavily dependent on growth in the Consumer and the Service sectors. Keep in mind that the last time global trade volumes rolled over like this was back in 2008.

The Consumer

The consumer is yet another source of bumps on the economic road. Ms. Pomboy’s tweet is perfect.

As for that debt, Citigroup recently reported that its credit-card delinquency rate had risen to 2.91% in July from 2.56% in June versus its three-month average of just 1.54%. With all the positive stock moves we’ve seen in retail, keep in mind that the story for many has been more about earnings than actual growth.

For example, Nordstrom (JWN) shares rose 21% after it delivered stronger-than-expected earnings, but that was off of weaker than expected revenue of $3.87 billion versus expectations for $3.93 billion. Nordstrom also slashed net sales guidance for the fiscal year as well as earnings guidance. Management forecast net sales for the year to decrease by about 2%. It previously estimated sales would be flat to 2% down. It also slightly lowered guidance on earnings per share to a range of $3.25 to $3.50, compared with the prior guidance of between $3.25 to $3.65. Did I mention shares rose 21%?

US Consumer sentiment fell to 92.1 in August, the lowest reading for 2019, versus expectations for 97 and down from 98.4 in July. If sentiment continues to degrade, how long will the consumer continue to load up credit cards in order to spend?

Debt

It isn’t just the consumer that is taking on more debt – yet more economic bumps. The federal government deficit rose by $183 billion to $867 billion during just the first 10 months of this fiscal year as spending grew at more than twice the rate of tax collections. The Congressional Budget Office expects the annual budget deficit to be more than 1 TRILLION dollars a year starting in 2022. Total public debt, which includes federal, state and local has reached a record 121% of GDP in 2019, up from 69% in 2000 and 43% in 1980.

Keep in mind that debt is pulling resources out of the private sector and at such high levels, fiscal stimulus becomes more challenging in times of economic weakness. The only time debt to GDP has been higher was after WWII, but back then we had relatively young population and a rapidly growing labor force compared to today.

I’ve mentioned before that I am concerned with the strengthening dollar. Dollar denominated on balance sheet debt is over $12 trillion with roughly an additional $14 trillion in off-balance sheet dollar denominated debt – that’s a huge short USD position. The recent resolution of the debt ceiling issue means that the US Treasury now needs to rapidly rebuild its cash position as I had been funding the government through its reserves. This means that we will see a drain on global liquidity from the issue of over $200 billion in Treasury bills.

I’ve also written many times in the past concerning the dangers that lie in the enormous levels of corporate debt with negative yielding corporate debt rising from just $20 billion in January to pass the $1 trillion mark recently – more bumps on the road.

Bottom Line

As I said at the start of this piece, this expansion is the longest in post-war history which doesn’t itself mean a recession is imminent, but it does mean that the economy is likely to be more vulnerable. Looking next at the economic indicators we see quite a few that also imply a recession is increasingly likely.

The President’s twitter storm in response to China’s tariffs and the continually rising geopolitical uncertainties that create a strong headwind to any expansions in the private sector only increase risks further. Perhaps by the time you read this piece some part of the rapid escalation of the trade war will have been reversed, as foreign policy has become increasingly volatile day-to-day, but either way, the view from here is getting ugly.

Debt, Debt and More Debt

Debt, Debt and More Debt

 

While U.S. Consumer credit increased less than expected in January, we are concerned with what we are seeing in consumer loans and debt in general across the world.

Auto Loans

With our Cash-Strapped Consumer investing theme, the average amount financed and the duration of new auto loans continues to rise – same car, bigger loan and for longer means a more highly leveraged car owner.

Credit Cards

We also see warnings sign with credit card debt as our Cash-Strapped Consumers struggle to make ends meet. At small banks, the share of outstanding card balances written off as a loss after consumers failed to pay hit 7.2% in the fourth quarter of 2017, up from 4.5% a year ago, according to Federal Reserve data. While overall card losses across all banks remain below the historical average of the last 30 years, they’ve been slowly climbing in the last two years. We believe these smaller banks are canaries in the coal mine as the average charge-off rate at those smaller banks is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010.

If an effort to compete with the large and increasingly larger banks, some smaller banks have taken to lowering lending standards, which means their credit cards are held by those that are first to feel economic angst. The subprime borrower is always the first to get hit when the economy weakens. For years, wage growth has been slower than the growth in expenditures, forcing many families to take on credit card debt just to pay for necessities. The rising charge-off rates indicate that these folks are in a perilous economic condition if wage growth doesn’t accelerate sufficiently and soon.

Student debt

Education debt swelled to nearly $1.38 trillion at the end of 2017, with 11% of borrowers 90 days or more delinquent, according to the New York Fed. The U.S. federal government now owns over 30% of total consumer debt in the U.S., thanks to its utter dominance of the enormous student loan industry. Prior to the financial crisis, that number was less than 5%. Think about what that means concerning the reduced firepower of the federal government in the case of another financial crisis.

This area of lending reminds us of the dynamics in the housing market that led to the subprime mortgage disaster. The problem in subprime was that too many players had no real skin in the game. Thanks to various legislative acts, the banks issuing mortgages were incentivized to immediately turn around and sell them to Fannie Mae or Freddie Mac – particularly the subprime loans. This meant the issuing bank had no real interest in the quality of the loan.

With student loans, the student or prospective student has little ability to estimate the relative earnings advantage potential for any particular education. The seller of the education, the college or university, is financially indifferent as to whether the student will ever be able to pay off the loans and with the way student loans work, has no incentive to tie the cost of tuition to the improvement in future earnings it provides through its curriculum. This creates an entirely new generation of Cash-Strapped Consumers that start off their young lives already saddled with brutal debt levels, which often postpones the traditional cycle of car and home purchases as well as starting a family.

Emerging Market Debt

It isn’t just domestic debt that has us concerned. Another area of concern that we are watching has been in emerging market debt which has helped generate the Rise of the Middle Class investing theme in these economies. The 26 largest emerging markets monitored by the Institute of International Finance have seen their sovereign debt load rise from 148% at the end of 2008 to 211% of GDP at the end of the third quarter of 2017. Couple that with the pricing perversions driven by investors’ search for yield that have the 10-year Kenyan bond trading at 7.5% and the Dominican Republic 30-year at 6.5% while the 10-year and 30-year U.S. Treasury bonds trade at 2.87% and 3.15% respectively. Really? Not a whole lot of risk premium priced in there.

Then there is the incredible size of China’s financial system. As of the end of last year, assets in Chinese commercial banks were approximately $40 trillion, which is around 51% of global GDP. The highest the U.S. every reached was 32% of global GDP in 1985 and Japan at 27% in 1994. For additional perspective, at the end of last year, in the United States, that number was $17.4 trillion versus U.S. GDP of $19.4 trillion while China’s GDP is around $13.1 trillion. This is wholly unprecedented in the history of global finance.

Let’s not forget that over the weekend China removed term limits for Xi Jinping, allowing him to possibly rule for life. History tells us that a nation, controlled by a single leader, who is no longer bound by any sort of accountability thanks to his/her ability to rule for life, rarely experiences increasing individual freedoms, increased open trade and responsible debt management – yet another geopolitical concern to add to the pile.

The bottom line is the world has been awash in a whole heck of a lot of liquidity thanks to the concerted efforts of the world’s major central bankers. The intention was to suppress interest rates, thus induce borrowing. Well, it worked. The secondary effect, which was also intentional, was to inflate assets prices so as to induce the so-called wealth effect.

Done! Thanks to stock prices rising at a much faster rate than the economy, household wealth as a percentage of disposable income has reached a new record high.

The Federal Reserve is now attempting to increase interest rates and take away that liquidity and asset-price-inflating punchbowl without any major disruptions.  The European Central Bank may join in here soon too as all are concerning that this post-financial crisis party may shift into inflation-mode, which no one wants. This too is wholly unprecedented in human history. While the mainstream financial media is all about the Goldilocks outcome, we remain skeptical and wary of highly leverage assets or those whose risks are significantly underpriced.

Rising consumer credit card debt to be a headwind to GDP in 2018

We are starting to get not only holiday sales results from the likes of Kohl’s (KSS) and others, but also December same-store-sales results from Tematica Investing Select List resident Costco Wholesale (COST) and its retail brethren. Thus far the results are positive and in some cases much better than expected, but when we see we think about the other shoe to drop. In this case, that is “How are consumers paying for all of this given that wages barely budged in 2017?” 

The answer is they have been turning to their credit cards. Before the holidays began, the Federal Reserve found consumer credit card debt hit $808 billion exiting September. Now let’s add findings from MagnifyMoney that “people who used credit cards for holiday purchases charged an average of $1,054, about 5%  more than last year.” This helps support the view that consumer credit card debt will eclipse $1 trillion this year.

For us here at Tematica, it’s more reason to think consumers, especially Cash-Strapped Consumers, are likely to use the benefits of tax reform to get their financial houses in order, pay down debt and spend less than the Wall Street herd is thinking. In other words, we see this supporting views that were laid out by Chris Versace and Lenore Hawkins on last week’s Cocktail Investing podcast, and that’s before we factor in potential Fed rate hikes this year.

 

“The scary number — $1 trillion — we’ll definitely hit in 2018,” said Jill Gonzalez, an analyst with WalletHub. “It seems to say a lot of American consumers did not learn their lesson from the recession and are returning to living beyond their means.”

Credit card debt stood at $808 billion on Sept. 30, the end of the third quarter, according to the most recent data from the Federal Reserve Bank of New York. That’s $280 billion more than the previous high hit in 2008, at the height of the financial crisis that led to the Great Recession.

As consumers keep spending away on their credit cards — which typically come with interest rates starting at about 16 percent — the Federal Reserve is expected to have two or three quarter-point hikes this year to a key rate that affects consumer debt. It did so three times in 2017.”Every time there is a Federal Reserve rate hike, that adds about $1.5 billion to our collective financing rates,” Gonzalez said. “That has to do with these delinquency rates rising. And when you factor in mortgages, student loans and auto loans, that becomes a scary picture.”

Source: How to knock out holiday credit card debt

Consumer Spending – it isn’t all about Confidence

Consumer Spending – it isn’t all about Confidence

There was a time, in a life long, long ago, when my view of shoes was purely functional. I mostly had black ones, with no interest in wasteful spending on frivolity. What doesn’t go with black? Sandles, flats, pumps, all black, I kept it simple. Then I started to work for extended periods in Italy and after a few months, my colleagues here agreed with me that yes, California girls don’t do the whole shoe, purse, put together ensemble bit at the level that Italian women do so effortlessly. Oh really? Game on! And that is how I met two of my great loves Jimmy (Choo) and Christian (Louboutin) and found just what kind of confidence a great pair of stilettos can provide, even when all else is going to hell.

I pondered this phenomenon of stiletto-induced confidence in the face of a perilous Italian cobblestone street or a sleep-deprived workweek over my morning cup of coffee as I reviewed this week’s Michigan Consumer Confidence report and its impact on spending.

With roughly 70 percent of GDP attributed to consumer spending, expectations for more robust growth rely on expectations of increased spending. The catch is that spending is simply a function of income and credit, not confidence. If you want to spend more, you must either earn more or borrow more – pretty simple.

Earlier this week Consumer Confidence for March blew away expectations, with the index reaching 125.6, its highest level since December 2000, versus expectations for 114. Confidence levels have now surpassed those seen in the last expansion period which ended in the financial crisis.

 

Interestingly we are seeing the difference in the confidence levels by income grow increasingly wider, with those at higher income levels rising much faster and higher than those at lower income levels. Confidence is typically higher the higher one’s income level, but the spread has been growing.

Income expectations have also been rising rapidly and are reaching levels last seen during the peak of the prior expansion, which has those in mainstream financial media giddy over spending expectations. Those of us at Tematica find this fascinating given the actual trends in income over the past two years. The following chart shows the year-over-year change in real person income, seasonally adjusted, as reported by the BEA (Bureau of Economic Analysis) which defines such as,

Personal income is the income received by, or on behalf of, all persons from all sources: from participation as laborers in production, from owning a home or business, from the ownership of financial assets, and from government and business in the form of transfers. It includes income from domestic sources as well as the rest of world. It does not include realized or unrealized capital gains or losses.

 

While confidence in income gains is rising, income growth has been slowing for years. As of December 2016, personal income was growing at less than half the rate it had been growing two years earlier in December 2014. This Friday we’ll get the latest numbers and will be quite keen to see if this trend has continued.

Recall that a few weeks ago we pointed out that

From February 2016 to February 2017, real average hourly earnings decreased 0.3 percent, seasonally adjusted. The decrease in real average hourly earnings combined with no change in the average workweek resulted in a 0.4-percent decrease in real average weekly earnings over this period.

So the income story is not one that is improving, but how about credit?

Credit card standards? Tightening. Our Cash-Strapped Consumer is going to have a tougher time putting anything more than those Affordable Luxuries on plastic.

 

Auto Loan standards? Tightening.

 

Ok, forget credit cards and auto loans, what about everything else? Tightening.

 

How about banks’ willingness to extend credit? Argh, not looking so rosy either.

 

This isn’t exactly bullish for financials, and we’ve seen the Financial Select Sector SPDR ETF (XLF) go from being one of the stronger sector performers to sitting in the bottom three recently. On the other hand, a slowing economy is bullish for the iShares 20+ Year Treasury Bond ETF (TLT), which was hit when post-election inflation expectations spiked.

With income growth slowing, work-weeks shrinking and credit tightening, yours truly is rather skeptical that we will see this boom in spending, no matter how confident consumers may be feeling, even if I’ve got my mojo overflowing thanks to a pair of strappy Jimmy’s.

 

More Margin Pressure Ahead

More Margin Pressure Ahead

The era of low-to-zero interest rates on top of struggling household income levels led to the proliferation of zero-rate financing on everything from cars to hot tubs to luggage and electronics. With the Federal Reserve raising rates amidst less than robust retail sales, rising credit card balances and weak income growth, retailers will be pressured to maintain these incentives.

Now, with interest rates climbing, the cost of these arrangements will rise, pinching profits at companies that derive a large chunk of their sales from shoppers who prefer to pay in bite-size pieces. Most retailers will likely absorb the higher costs to stay competitive because customers may turn elsewhere if they are asked to pony up interest charges.

While price-to-earnings ratios have continued to expand in the Trump Trade, now at levels well above historical norms, we are seeing more indications of pressures on margins, which means those earnings may be weaker than expected. On top of the impact of rising interest rates, we may start to see some wage pressures, which would also weigh on margins. If that is the case, those multiples will look even richer. With earnings season right around the corner, the Tematica Team will be closely watching margin trends as corporate profits have been declining in recent quarters as a percent of GDP.

Source: Fed Rate Increase Makes 0% Financing Deals More Pricey for Retailers – WSJ