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? 



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.

Data or Divination?

Data or Divination?

You’ve probably already learned that on Wednesday the Federal Reserve Open Market Committee increased its Fed Funds rate to 0.75 – 1.0 percent. The markets were concerned that we would hear a much more hawkish tone from the Fed, which would have implied a possibly faster pace of rate hikes. Chair Janet Yellen’s prepared speech coupled with the Dot Plot, (that marks the interest rate expectations of participants over time) assuaged those fears as the median rate projections over the next few years remained largely unchanged, with two more expected in 2017.

The markets interpreted this release as more dovish than expected, which likely has thrown the Fed for a bit of a loop and makes further tightening more likely. There is just no way they wanted to see stocks get even more over-priced after hiking this week.

Watching her talk and then listening to some of the financial media’s usual suspects I found myself unsuccessfully trying to stifle rants at the television. Luckily I stopped short of hurling my Apple TV remote at the big screen.

In her remarks, Yellen referred to the employment participation rate and how it will continue to naturally be below historical norms due to the evolving demographics in the U.S. She is correct to some degree, as this year the first baby boomers are turning 70 years old with around 1.5 million joining them every year for the next 15 years – fair enough Janet and thanks for validating our Aging of the Population investing theme. She is also correct in that there has been a profound decline in the rate of growth of the working-age population. For the native population, this is a function of two things. First, the percentage of the population in the child bearing and raising years is lower today than it was when the baby boomers were in this phase of life. Second, people — some of which fit our Cash-strapped Consumer investing theme — simply have fewer children. The growth rate of the work age population peaked in the late 1990s early 2000s and has been steadily declining ever since.

That, however, doesn’t explain why the percent of the working-age population, (those aged 25 – 54 years) employed remains well below where it has been for decades and is today back where it was in the early-1990s. In fact, the percent of this group that is actually in the workforce remains below the levels we saw from those early 1990s through to the middle of the financial crisis when it plummeted to levels not seen since the mid-1980s. While Chair Yellen is correct to some degree, her statement was misleading. Plenty of people who would have been working in decades past are choosing to opt-out. This is something that needs to be looked at as it is a material headwind to growth, and could mean greater costs our society has to bear in the coming years.

Also, while the Fed’s mantra for years has been, “We are data dependent,” neither she nor many of her colleagues appear to be all that interested in today’s data. In her opening statement at yesterday’s press conference, she asserted that, “Waiting too long to scale back some accommodation could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession.”

Some of her colleagues appear to have already upgraded their forecasts in anticipation of a successful implementation of fiscal policy changes by the new administration. That is pretty far from being data dependent – that’s more crystal ball economics.

So how about looking at some of that real data?

Over the past 13 weeks, commercial and industrial loans have contracted at an annual rate of 1.5 percent. The last time we saw this level of decline was in October of 2010 when the Fed decided to launch multiple rounds of quantitative easing. This time they are in the midst of a rate hike cycle.

In fact, in the fourth quarter of 2016, U.S. nonfinancial companies reduced net borrowing such that while the five years ending in September 2016, annualized net borrowing for this group average $420 billion. In the 4th quarter of 2016, that annualized rate dropped to $68.5 billion

Residential real estate credit is experiencing the same decline, falling at a nearly 2 percent annual rate on a 13-week rolling basis. We haven’t seen this kind of a slide since December 2014. Overall the growth in consumer lending has been nearly cut in half since the start of 2017, with the biggest drop in auto loans and credit cards.

Looking at those auto loans, annualized losses on subprime loans in January were 9.1 percent, up from 8.5 percent in December and 7.9 percent in January 2016. January’s rate is the worst we’ve seen since January 2010 and is driven in part because lenders are getting lower prices than expected on their repossessed cars after a flood of used cars has hit the market thanks to generous lease terms offered by manufacturers. This trend is unlikely to change given that in January 5.09 percent of subprime car loans were at least 60 days delinquent versus 4.66 in January 2016.

As always, we like to look for confirming data points on slowing lending and voila, the M2 money velocity is down 3% from its pace in March of 2016. This number declines as there is more saving than spending.

But there is so much optimism in the soft data!

Well, I’m optimistic about the shape of my abs come June, but frankly, there is a bit of work to be done between now and then before I’m getting anywhere near a bikini. Optimism doesn’t replace the gym and lots of sweat.

The National Federation of Independent Business Small Business Optimism Index dropped slightly in February to 105.3 from 105.9 in January, which is the first decline since September and a three-month low, but on its face nothing particularly worrisome. However, hiring plans dropped to the lowest rate since November at 15 percent versus 18 percent previously. Capex also took a hit, falling to 26 percent in February after falling to 27 percent in January from 29 percent in December. Yes, but that economy is just getting ready to take off…

Hold on there partner, because the number of net companies expecting stronger sales dropped to 26 percent in February from 29 percent in January from 31 percent in December – quite the pattern here.

Earlier this week we learned from the Bureau of Labor Statistics that weekly wages declined over the past year and wouldn’t you know it, the NFIB’s index on plans to boost labor compensation follow this same trend, falling to 17 percent in February from 18 percent in January and 20 percent in December.

Speaking of jobs, one of the market mantras for future growth is how the new administration’s plans around trade will boost American jobs. Hmmm, the economy is going to get rockin’ and rolling because all these great new jobs will appear. But today, the share of small businesses reporting that the quality of labor is one of their biggest problems sits at 17 percent, the highest level since November 2001 and up from 15 percent in January and 12 percent in December.  Yesterday’s Job Openings and Labor Turnover Survey revealed that job openings remain unchanged at 5.6 million with hires and separations also relatively unchanged. Recall that we’ve seen one of the widest divergences between job openings and hirings in history, which shows that there are jobs, but companies can’t find the right person. Talk about a rather confirming data point for our Tooling & Retooling investing theme.

Obviously having more jobs that pay well and help continually develop skills in the nation is a beautiful thing, but today companies are already having a tough time filling the positions they have available, which is a drag on the economy. It isn’t obvious how using trade policy to create a whole bunch of new positions to fill without doing something to help develop or find the right talent to fill those positions will be a boon for the economy.

But, but, but…. inflation!

What about all this impending inflation? The NFIB’s share of companies reporting inflation as their top concern is now tied at a record low 1 percent, down from 2 percent in January and December which was down from 3 percent in November. Yet if you watch the financial news media, it is as if rising inflation is an absolute given.

Wait a rootin’ tootin’ minute  High Priestess of Global Macro, that headline Producer Price Index (PPI) came in well above market expectation for 0.1 percent, rising 0.3 percent month over month with the year over year pace at 2.2 percent versus expectations for 1.9 percent. Gotcha!

Fair enough, but as always, let’s look a little deeper. Whenever we look at a percentage increase, it is important to look at the base we are coming off of relative to history. The second half of 2015 saw PPI energy plummet, hitting a low in February 2016. PPI energy is up nearly 20 percent year over year which added a full percentage point to the headline PPI inflation rate. Energy isn’t the only commodity that bottomed out last February while their rebound rates have been slowing recently, so their impact is declining.

Clearly, a lot to ponder as we assess the true vector and velocity of the economy. Given that it’s St. Patrick’s Day tomorrow, this Irish high priestess will do that pondering over a lovely pint of Guinness.