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%.
- 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.
- 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.
- 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.
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.
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.
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?
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.
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.
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.
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.
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
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.
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.
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
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
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
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.
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.
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 commonground 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
Today the Washington Post featured a piece that highlights what we at Tematica have been saying for months and is highlighted in our Middle-Class Squeeze investment theme. All is not well in many American households at a time when unemployment is at a 50-year low, there are more job openings than there are job seekers and the powers that be keep telling us how great things are. The Post article noted:
A record 7 million Americans are 90 days or more behind on their auto loan payments, the Federal Reserve Bank of New York reported Tuesday, even more than during the wake of the financial crisis era.
This is particularly concerning given that a car is often more important than even making a mortgage payment or a credit card minimum payment as it is how most people get to work.
A car loan is typically the first payment people make because a vehicle is critical to getting to work and someone can live in a car if all else fails. When car loan delinquencies rise, it’s a sign of significant duress among low-income and working-class Americans.
Given that the population has increased since the Financial Crisis, the actual percent of auto loan borrowers that were 3-months or more behind on their payments is at 4.5% versus the peak of 5.3% in late 2010, but the record high number is concerning at a time when the economy is supposedly firing on all cylinders. What happens when it really does slow?
We are seeing similar worrying signs in the recent Federal Reserve Senior Loan Officer Survey which found that demand for consumer loans is in full-on contraction. This is not something you see when the economy is strong and people are confident about their financial future.
We will be discussing this and much more in our Context and Perspectives piece to be released later this week.
Since the Great Recession, we’ve seen new auto sales rebound due in part to the attractive if not aggressive low to no interest financing. That’s helped mask the rising cost of buying a new car as original equipment manufacturers (OEMs) ranging from Ford and General Motors to Volkswagen and Honda have packed connective technology and features associated with our Digital Lifestyle investing theme their vehicles.
Over the last few quarters, the Federal Reserve has hiked interest rates and is poised to do some four more times in the coming 15 months according to its most recent economic forecast. At the margin, that will boost the cost of buying a new car or truck, and likely increase the demand for used cars for consumers that are seeing their discretionary dollars shrink as those same interest rates drive their existing debt servicing costs higher. Good news for companies like Carmax that can cater to Middle-class Squeeze consumers, not so good for the auto manufacturers.
Demand for used cars was unusually strong this summer and will remain at elevated levels through the year’s end as higher interest rates and rising prices on new cars continue to stretch buyers’ wallets, industry analysts said.
Used-car buyers are finding a growing selection of low-mileage vehicles that are only a few years old.
While used-car values have also increased in recent years, the gap between the price of a new and preowned car has also widened and is now at one of its largest points in more than a decade, according to car-shopping website Edmunds.com.
New-car prices have steadily climbed in the years following the recession as companies packed vehicles with more expensive technology and buyers shifted away from lower-priced cars to bigger and more expensive sport-utility vehicles and trucks. The average price paid for a car hit an all-time high of $36,848 in December of 2017 and remains at near-record levels, according to Edmunds.com.
With nearly 40 million in sales last year, the used-car market is more than double the size of the new-car business.
The shift in demand is a troubling sign for auto makers, which will be under pressure to deepen discounts to keep customers from defecting to the used-car market. New-vehicle sales have started to cool this year following a seven-year growth streak.
As new car prices have climbed, auto lenders have kept monthly payments low by extending loan-repayment terms to five and six years and introducing 0% financing on loans that made buying new a more attractive deal.
But as interest rates rise and credit tightens, auto companies are pulling back on such sales incentives. The average monthly payment on a new car was $536 in August, up from $507 last year and $463 five years ago, according to Edmunds.com.
It’s that time again, an update on the degree of consumer borrowing as tallied by Federal Reserve data. For those of us that have been watching other consumer spending, debt and savings metrics, the results come as little surprise and serve to confirm not only our Cash-strapped or Middle-Class Squeeze investing theme. The data also lends support to the growing concern over the ability of the consumer to thrust the consumer spending led US economy ahead as the Federal Reserve continues to boost interest rates in the coming quarters.
Americans owe $1.5 trillion in student loans
We hit this milestone during the first quarter of 2018, according to Federal Reserve data.
Outstanding student debt currently exceeds auto loan debt ($1.1 trillion) and credit card debt ($977 billion).
42% of people who’ve gone to college took out debt
A majority of them took out student loans, but 30% had some other form of debt, like credit card debt or a home equity line of credit, according to a Federal Reserve report based on a 2017 survey.
Average new grad owes $28,400Among those who finished a bachelor’s degree in 2016 with debt, the average amount was $28,400, according to The College Board. That’s up from $22,100 in 2001 (reported in 2016 dollars).