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.
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
The results of the election last weekend in Italy continue the international trend of angry and frustrated voters dumping those in power, desperately seeking some way to improve their conditions. While many continue to trumpet an improving global economy, and there are some improvements to be sure, many nations have not yet recovered from the damage of the financial crisis. The Brexit vote, Trump vote, weakened Angela Merkel in Germany and this weekend’s vote in Italy are all signs that voters in those nations want to see significant changes. Voters don’t do that when they are satisfied with their pocketbooks today and opportunities for tomorrow.
Sunday, March 4th Italians headed to the polls amidst and economic backdrop that has become increasingly frustrating. Economic growth in the nation has been weaker than many other European Area Nations.
Even more telling is the weakening trend in per capita GDP.
Italy’s unemployment rate remains well above historical norms and well above that of Germany.
Youth unemployment has been even more grim, peaking at 43.40 in March 2014 after having been as low as 19.40% in 2007. This high level of youth unemployment has meant that the best and the brightest are much more likely to leave the struggling nation than to stay and fight an uphill battle.
Wage growth (year-over-year) has been weakening for decades but has been sitting at record lows post-financial crisis, below 2% since 2011 and below 1% since 2016.
The bottom line is while the markets have been priced for sunshine and roses, we continue to see voters around the world frustrated with weak economies, poor wage growth and the lack of opportunities to improve their circumstances. While the 2017 markets may have been a bit like watching a sunny summer afternoon PGA tournament, 2018 looks to be more like the latest reality TV drama.
The recent US manufacturing data has gone biopolar while over in Europe and even Japan, manufacturing is more solidly strenghtening. Then there is Fed Chair Janet Yellen’s recent assurances… this week is shaping up to be full of entertainment outside of yesterday’s fireworks!
ISM Manufacturing data for June indicated solid growth in most areas but was also considerably better than expectations (57.8 versus expectations for 55.3, up from 54.9 in May, a 3-year high) at a time when most economic data is coming in at or weaker than expectations.
- New orders rose to 63.5 from 59.5
- Backlogs gain 2 points to hit 57
- Supply deliveries rose by near 4 percent to reach 57
- Employment hit 3-month high at 57.2 from 53.5
- But…. The prices paid index fell to a 7-month low of 55 from 60.5 in May, 68.5 in April and 70.5 in March. Ehh? Production and demand rising but prices are dropping month after month after month?
To further emphasize that this month’s ISM manufacturing report might not be all that telling is the U.S. Census Bureau Construction Spending report which was flat for May versus expectations for a gain of 0.3 percent month-over-month. Given that this one measures what was spent rather than sentiment, we tend to give it more weight. Most of the components saw a month-over-month drop in spending, including manufacturing (down -1.7 percent), residential (down -0.6 percent), commercial (down -0.7 percent), highway and street (down -1.0 percent), lodging (down -0.3 percent), communication (down 1.9 percent), transportation (down -1.2 percent). Overall total private construction dropped 0.6 percent month-over-month while public construction rose 2.1 percent. Other than that all good – sheesh!
Bear in mind that the last time ISM manufacturing came in around 58 was August 2014, after which the annualized GDP growth rate slowed to 2.3 percent. The time before that was early 2011 which preceded a slump to 1.9 percent growth for GDP.
On the other hand, the Markit manufacturing survey told a very different story, one that was more consistent with what we saw in the Construction Spending report, falling to a six-month low of 52 from 52.7 in May. We like to confirming data points and sorry Mr. ISM, your cheese is standing alone this month.
Also contradicting the ISM, June auto sales declined 0.9 percent month over month, dropping to 16.5 million units at an annual rate and making for the fifth decline in the past six months. The first half of the year has seen sales drop at a 20 percent annual rate. A drop of this magnitude occurred last in 2010 when markets were fretting about the likelihood of a double-dip and the Fed was moving towards loser policies.
We’d point out that this lack of pricing power isn’t just here, as the Eurozone and Japan are experiencing the same phenomenon, with Japan experiencing a 43-year high for labor shortage without much in the way of upward pricing pressures.
In contrast, the Markit Nikkei Japan Manufacturing PMI continued to improve in June, extending the current sequence of expansion to ten months with gains in both production and new orders.
IHS Markit Spain Manufacturing PMI revealed that Spanish manufacturing completed a strong second quarter with growth of output, new orders and employment remaining elevated. June saw further sharp rises in output and new orders with the rate of job creation at near-record highs. Purchasing activity increased at the fastest pace so far in 2017.
IHS Markit Italy Manufacturing PMI saw sharp and accelerated increases in output and new orders in June with output picking up on the back of robust export orders. Even employment rose amid a rebound in business sentiment.
IHS Markit France Manufacturing PMI saw new orders increase at a sharper pace in June with output growth moderating. The index rose to 54.8 from 53.8 in May and was only just shy of April’s six-year high.
IHS Markit/BME Germany Manufacturing PMI rose to a 74-month high with the fastest growth in new orders since March 2011 as input prince inflation slowed to a 7-month low. The 12-month outlook for production remained strongly positive.
Back in the U.S., on top of the contradictory manufacturing data, there is the ECRI leading indicator which has fallen now for three consecutive weeks, with a decline in six of the past seven and now sits at its lowest point since December 9th, 2016.
Mr. Market seems utterly unimpressed with continued trend for economic data to disappoint relative to expectations as the CBOE VIX net speculative shorts is now at the highest level ever – so apparently there is nothing of concern here.
Fed Chairperson Janet Yellen seems to agree, “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.”
Really? That’s quite a statement, but then…
“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
“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
Facebook once again delivered knockout metrics in its December quarter earnings report, but what caught the team Tematica eye was how the social media giant is leveraging the rising middle class that is a part of our Rise & Fall of the Middle Class investing theme. Several years ago Facebook launched a lite version of its app that allowed users in lower-bandwidth countries (those either lack 4G/LTE coverage entirely or have spotty at best coverage) to utilize the social media platform and it has paid off in spades. In less than 2 years, Facebook Lite has more than 200 million users — that’s nearly 2/3 of the entire US population! Now to watch Facebook monetize those users to drive its average revenue per user (ARPU) even higher.
Facebook’s stripped-down but speedy Lite app is growing fast and adding countries so it can keep connecting people and building the company’s business in the low-bandwidth world where revenue increased 52% this year.
Facebook Lite launched in June 2015, it rocketed to 100 million monthly users by March 2016, and now it’s doubled in size to 200 million users, Mark Zuckerberg says.
Average revenue per user is up 28% this year from $1.10 to $1.41. And that pushed its Rest Of World revenue up 52% this year to $839 million per quarter.
By making it enjoyable for users to sign up and spend more time on Facebook even with a weak network connection, Facebook is starting to make money in places other apps don’t.