Central Bankers’ New Clothes

Central Bankers’ New Clothes

In this week’s musings:

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

It’s Earnings Season

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

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

Central Bankers’ New Clothes

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

https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-EU-EM-Neg-Yields.png https://www.tematicaresearch.com/wp-content/uploads/2019/07/2019-07-12-Greek-below-UST.png

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

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

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

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

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

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

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

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

Debt Ceiling Debate – I’m baack!

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

Trade Wars – the gift that keeps on giving

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

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

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

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

Domestic Economy – more signs of sputtering

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

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

Stocks – what does it all mean?

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

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

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

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

The U.K. moves from fighting sugar to fat and calories 

The U.K. moves from fighting sugar to fat and calories 

We’ve known for some time the hidden costs of obesity here at Tematica as it’s one of the factors behind our Fattening of the Population investment theme. The fight to limit sugar has led beverage companies to change drink sizes as well as alter formulations, which has stoked demand at flavor companies given the need to preserve taste. We see this latest move to fight calories as having a similar impact, and it means we’ll continue to keep those flavor companies on the Tematica Select List.

The British government has a new enemy: calories.After cracking down on sugar and salt, Public Health England said Friday it now wanted companies to slash the calories in food to tackle an obesity epidemic among children.It plans to set calorie targets for fast food and other meals popular with kids by the start of 2018.”

Ready meals, pizzas, burgers, savory snacks and sandwiches are the kinds of foods likely to be included in the program,” the government’s health body said in a statement.Dominique Lemon, spokeswoman at Public Health England, said the program would cover food sold at all kinds of outlets, from grocery stores to coffee shops and fast food restaurants.

The government has already set similar targets for sugar and salt content.The initiative could force food manufacturers to slash the size of their products and use different ingredients.

It’s been down this road before, introducing a sugar tax on soda makers last year.The U.K. introduced the tax as part of an effort to reduce childhood obesity. Drinks with total sugar content above 5 grams per 100 milliliters are affected by the levy with a higher rate ($0.30 per liter) for drinks with over 8 grams. The measure appears to have worked. Rather than risk higher prices damaging sales, Coca-Cola (KO) and Pepsi (PEP) have already reduced the sugar content of many products.

Source: U.K. to food industry: Cut the calories in pizzas and burgers – Aug. 18, 2017

Ukraine – Why and What’s Next

Ukraine – Why and What’s Next

As if things in Europe aren’t complicated enough, the situation in Ukraine is getting more troubling by the day. The turmoil there is having vast geopolitical impacts that are keeping the investing world as nervous as a long-tailed cat in a room full of rocking chairs. Here’s the quick, errrrhhh, fair enough, as quick as a verbose Irish lass can get, version of how we got to today.

 

In late 2013, Ukrainian President Viktor Yanukovich was expected to sign some agreements that could eventually integrate Ukraine with the European Union economically. Ultimately, he refused to sign the agreements, a decision thousands of his countrymen immediately protested. Demonstrations eventually broke out with protesters calling for political change. When Yanukovich resisted their calls, they demanded new elections. Eventually the protestors won, Yanukovich was forced to flee the country and now we have a nation in flux.

 

So why does anyone outside of Ukraine, population 44.6m and with 233k square miles, care? Ukraine is central to Russian defenses, sharing a long border with the former Soviet Union and more importantly, Moscow sits all of 300 flat and easily traversed miles from Ukraine. Therefore, from a Russian perspective a tighter Ukrainian-EU integration represents a threat to Russian national security. Putin appears to be disinterested in actually governing Ukraine, but rather his goal seems to be to effectively have negative control, the ability to prevent Ukraine from doing anything Russia dislikes. With that in mind, it appears that even the very idea of further EU integration was provocation enough for Putin. The European Union’s and the Germans’ public support for opponents of Yanukovich crossed his red line.

 

From a European perspective, Ukraine isn’t quite as interesting. Economically the Eurozone wasn’t enamored with having the nation join the EU, it just liked the possibility of such. Adding a country as weak and disheveled as Ukraine to an already strained union didn’t make much sense, but the idea of the possibility someday is attractive. The talk about joining was really more about inviting Ukraine to make a cultural shift towards Europeanism, with a constitutional democracy and a more liberalized economy. Germany found itself between the proverbial rock and a hard place as it continues to work with Russia on its mutual energy and investment interests while trying to manage coalitions within the European Union, particularly attempting to appease the Baltic States and Poland who would like to see Ukraine closer to them and further from the Russian camp, giving them an additional buffer.

 

The U.S. strongly supported the Orange (anti-Yanukovich) Revolution, siding with the Germans and the Eurozone, which was no doubt going to get under Putin’s skin; but then the U.S. owed him one after the Snowden situation. Throughout history, many of the global conflicts, and for that matter noteworthy familial brawls, have been catalyzed by the little things.

 

The situation has evolved into a tense standoff between the G7 nations and Russia. On March 12th, the U.S. Department of Energy announced that it would draw down from the U.S. Strategic Petroleum Reserve in what it claimed was a “test sale to check the operational capabilities of system infrastructure.” In reality, this was a warning shot fired at Putin. Later that same day Bloomberg reported that the U.S. has escalated the situation even further, with General Martin Dempsey, the Chairman of the Joint Chiefs of Staff, claiming that “in the case of an escalation of unrest in Crimea, the U.S. Army is ready to back up Ukraine and its allies in Europe with military action.” The G7 has threatened sanctions against Russia if it continues, with the U.S. Congress passing a resolution on March 11th to work with European allies and others to “impose visa, financial, trade and other sanctions” against key Russian officials, banks, businesses and state agencies. In a quick tit-for-tat, Russia responded on March 13th that it is prepared to retaliate with sanctions of its own against the west. Germany responded to this by announced that Angela Merkel is prepared to cancel a summit with Russia if Moscow does not help to defuse the situation.

 

To add a little extra flame to the fire, Iranian Oil Minister  arrived in Moscow late March 13th to meet with Russian Energy Minister Alexander Novak and Deputy Prime Minister Igor Shuvalov, IRNA reported. Namdar-Zanganeh will discuss ways to deepen economic cooperation between the countries, because there weren’t nearly enough strained relationships!

 

Militarily things are also nail-biter as around midnight on March 5th the Russian navy used tugboats to maneuver a 9,000-ton hulk of a mothballed anti-submarine cruiser into the inlet to Crimea’s Donuzlav Lake, effectively blocking access to the sea from Ukraine’s primary naval installation on the peninsula. Reportedly seven of the Ukrainian’s twenty five ships are trapped, picture at left.

 

According to the Ukrainian Defense Ministry, on Saturday March 15th, Ukrainian forces repelled an attempt by Russian troops to land in the southern Ukrainian region of Kherson Oblast. The landing reportedly occurred on Arbatskaya Strelka, a long spit of land running parallel to the east of Crimea. Earlier, it was reported that four Russian military helicopters deployed around 60 Russian troops near the town of Strilkove, forcing around 20 Ukrainian border guards and servicemen to retreat from their positions. Later in the day Ukrainian and Russian defense ministries announced a truce in Crimea until March 21st. Anyone else feel like renting Red Dawn (the original of course)?

On Sunday March 16th, the people in the Crimean region reportedly voted to have Russia annex Crimea by an overwhelming majority of some 95%+. On Monday the EU announced that it would impose travel bans and asset freezes on 21 Russian and Ukrainian officials that are considered central to Crimea’s move to separate from the Ukraine. The U.S. issued sanctions as well, via an executive order signed by the President, to freeze the assets of and ban visas for seven Russian officials and four Ukrainians.

 

Tuesday the Kremlin announced that it had officially annexed Crimea, which could be the most dangerous geopolitical event of the post-Cold World era. The two most likely outcomes are:

  1. Russia will quickly prevail, gaining the power to redraw its borders and set the precedent for exercising veto powers over the governments of its neighbors or,
  2. Western-backed Ukrainian government will push back and the second-largest country by area in Europe will descend into a Yugoslav-style civil war that will likely pull into its turmoil, Poland, NATO and eventually the U.S.

 

An alternative outcome is unlikely as Putin cannot at this point give up Crimea. It would mean a publicly shaming on a global level that could destroy his presidency.

 

Bottom Line: This situation has the potential to rock the markets, which are for now keeping a wary eye. Europe desperately needs Russian fuel. London and much of Europe is greatly beholden to the nouveau riche Russians for their highly demonstrative consumption of luxury goods and services, which only adds more pressure. There’s even a reality TV show called “Meet the Russians” which follows the lives of some ultra-bling Russians who are buying up Britain and “setting a new benchmark for extravagant living.” Europe can’t afford to push too hard back against Russia, but they also cannot ignore a precedent for unfettered Russian aggression. It is impossible to predict exactly how this will play out, but close attention is warranted.

Falling Bond Yields

Falling Bond Yields

With all the talk about sovereign debt  problems, from the PIIGS+ (Portugal, Ireland, Italy, Greece, Spain, and now Belgium) to the U.S. unsustainable debt trends, one would imagine that the cost of debt would show some of this concern.  But we’ve recently seen yields drop significantly.

Why the decline?  There has been a sharp drop in inflation expectations stemming from a clear decline in growth prospects in the developed countries for at least the remainder of the year.  At the beginning of this year, the vast majority of investors thought government bond yields would rise consistently over the course of the year as economies recovered and growth rates normalized.  But we’ve seen growth rates fall significantly below those initial forecasts, coupled with fears of how economies will fare as fiscal stimulus is withdrawn and quantitative easing in the States comes to an end.

Yours truly is ever watchful for rising inflation, but with a stalling economy, significant, sustained inflation is unlikely.  What is more likely in the near to medium term are bouts of rising inflation expectations followed by deflationary expectations as the developed economies struggle to get back on their feet.

Bottom LineThis shows the importance of having a diverse portfolio because any “obvious” trend can reverse itself, particularly in these increasingly uncertain times, when governments are so heavily involved in the markets.

Inflation vs. Deleveraging

Inflation vs. Deleveraging

The majority of the developed world is currently dealing with one whopper of a liquidity hangover.  Across the world households, businesses, and government got themselves hooked on the drug of cheap and easy debt.  When the markets inevitably cut the supply the liquidity drug, the Fed quickly stepped in to keep at least the U.S. junkie functioning with a rapid rise in banking reserves through the “toxic asset” bailout.  This bailout created an environment ripe for rampant inflation.  From August of 2008 to January of 2010, big-bank cash balances at the Federal Reserve increased at an unprecedented scale from $10 billion to $994 billion.  Using the historical money supply multiplier, this could result in an increase in the money supply that is 9-10x the increase in reserves, meaning an increase of almost $10 trillion dollars in the money supply.  To put that into perspective, the current supply of U.S. dollars in circulation is estimated to be a bit over $14 trillion.  Clearly an additional $10 trillion entering the economy would cause massive inflation… so why aren’t we seeing any indication of that yet?

For the additional bank reserves to make their way into the economy two things need to happen:  (1) banks need to want to lend and (2) households and businesses need to want to borrow.   The chart below shows an astounding increase in debt as a percentage of GDP from 2000 to 2007.  For the United States, the majority of that increase was in the form of residential mortgages.

If we look at the composition of debt, only the UK and Switzerland have higher household debt as a percentage of GDP.  While I love to gripe about our out-of-control national debt, household debt is currently an significant problem as well..  The BRIC nations have comparatively insignificant levels of household debt, which gave them a lot more wiggle room during the global meltdown.

Household debt in the United States is exceptionally high and unemployment continues to plague the economy.  We’ve got ourselves into quite a pickle.  Businesses are hesitant to expand with consumers unlikely to increase purchasing significantly due to their debt load and the unemployment rate.  With production well below capacity, the need for businesses to borrow when they do begin to expand is minimal.  The unemployment rate obviously impacts households’ ability to pay down their debt is unlikely to improve much as long as businesses hold back on expansion.  Add to this that we have yet to see the true impact of the real estate debacle in the commercial sector AND we still have a good ways to go on in the residential foreclosures.  All this creates a wet blanket on the potential inflation fire and creates an environment in which banks are unlikely to dip much into their pool of reserves.  That being said, I would be very surprised if we don’t experience some type of challenging inflation, but exactly when that occurs is a more difficult question to answer.  The global economy is an extremely complex system with nearly infinite variables whose level of impact is endlessly changing.  We approach this market with humility and caution, knowing that what is unknown vastly outweigh what is known.

So what are we doing about it?  Either way, we expect that with all the debt out there, interest rates will rise so we have significantly shortened the duration of our bond holdings and are underweight in domestic equities.  As I mentioned in an earlier post,  domestic equities are also currently over-valued.  This is an environment in which a good defense is the best offense as we wait for the inevitable opportunities to emerge, holding firm to our principles of valuation and tactical allocation.