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
As someone famous (or infamous depending on your leanings) once said, “there are known knowns….there are known unknowns…but there are also unknown unknowns.”
We’ve got a whole lot of the second two going around these days and that is not good for growth. Life and investing requires dealing with uncertainty to be sure, but holy cow these days investors and businesses are facing a whole other level of who-the-hell-knows and that is a headwind to growth.
- The bumbling battle over Brexit
- China’s earnings recession
- Slowing in Europe
- Yield curve inversions
- Record levels of frustration with
- The Cost of Corporate Uncertainty
- The battle over the GDP pie
- Beware Reversion to the Mean
The United Kingdom, in or out? The mess that has become of Brexit is wholly unprecedented in modern history. As of March 29th, the day the UK was set to leave the EU, Brexit has never been more uncertain nor has the leadership of the UK in the coming months. This graphic pretty much sums it up.
Many Brits are unhappy with the state of their nation’s economy and are blaming those folks over in Brussels, as are many others in the western world – part of our Middle Class Squeeze investment theme.
Its economy is slowing, but just how bad it is and just how dire the debt situation in the nation is difficult to divine given the intentional opacity of the nation’s leadership. The ongoing trade negotiations with America run as hot and cold as Katy Perry depending on the day and when you last checked your Twitter feed.
Most recently China’s industrial profits fell 14% year-over-year in the January and February meaning we are witnessing an earnings recession in the world’s
Last week the markets ended in the red, driven in part by weaker than expected German manufacturing PMI from Markit with both output and new orders falling significantly – new orders were the weakest in February since the Financial Crisis.
It wasn’t just the Germans though as the French Markit Composite Index (Manufacturing and Services) dropped into contraction territory as well in February, coming in at 48.7 versus expectations for 50.7, (anything below 50 is in contraction). The French PMI output index is also in contraction territory.
This led to the largest one-day decline in the Citi Eurozone Economic Surprise Index in years, (hat tip TheDailyShot).
Yield Curve Inversion
This pushed the yield on the German 10-year Bund into negative territory for the first time since 2016 while in the US Treasury market, the 10-year to 3-month and 10-year to 1-year spreads went negative – an inverted yield curve which has been a fairly reliable predictor of US recessions. The 10-year 3-month inverted for the first time in 3,030 days – that is the longest period going back over 50 years. The Australian yield curve has also inverted at the short end.
No Love for Capital Hill
Americans’ view of their government is the worst on record – another manifestation of our Middle-Class Squeeze Investment theme. Gallup has been asking Americans what they felt was the most important problem facing the country since 1939 and has regularly compiled mentions of the government since 1964. Prior to 2001, the highest percentage mentioning government was 26% during the Watergate scandal. The current measure of 35% is the highest on record.
Few issues have every reached this level of importance to the American public: in October of 2001 46% mentioned terrorism; in February of 2007 38% mentioned the situation in Iraq, in November 2008 58% mentioned the economy and in September 2011 39% mentioned unemployment/jobs.
While America appears to be more and more polarized politically, the one thing that many agree upon, regardless of political leanings – government is the greatest problem.
It isn’t just the US that is having a tiff with its leaders. Last weekend over 1 million (yes, you read that right) people protested in London calling for a new Brexit referendum – likely the biggest demonstration in the UK’s history and then there are all the firey protests in France.
The Cost of Corporate Uncertainty
When companies face elevated levels of uncertainty, they scale back and defer growth plans and may choose to shore up the balance sheet and reduce overhead rather than invest in opportunities for growth. So how are companies feeling?
A recent Duke CFO Global Business Outlook Survey found that nearly have of the CFOs in the US believe that the nation will be in a recession by the end of this year and 82% believe a recession will have begun before the end of 2020.
It isn’t just in the US as CFOs across the world believe their country will be in a recession by the end of this year – 86% in Canada, 67% in Europe, 54% in Asia and 42% in Latin America.
All that uncertainty is hitting the bottom line. Global earnings revision ratio has plunged while returns have managed to hold up so far.
It isn’t just the CFO that is getting nervous as CEOs are quiting at the highest rates since the financial crisis – getting out at the top?
The GDP Pie
To sum it up, lots of unknowns of both the known and unknown variety and folks are seriously displeased with their political leaders.
So what do we actually know?
We know that US corporate profits after tax as a percent of GDP (say that five times fast) are at seriously elevated levels today, (nearly 40% above the 70+ year average) and have been since the end of the financial crisis. No wonder so many people
Corporate profits have never before in modern history been able to command such a high portion of GDP. This is unlikely to continue both because of competition, which tends to push those numbers down and public-policy. If the corporate sector is going to command a bigger piece of GDP, that means either households or the government is going to have to settle for a smaller portion.
It isn’t just the corporate sector that has taken a bigger piece of the GDP pie. Federal government spending to GDP reached an all-time high of 25% in the aftermath of the financial crisis and has remained well above historical norms since then.
Given the level of dissatisfaction we discussed earlier concerning
That leaves the households with a smaller portion of the economic pie – evidence of which we can see in all the talk around how wage growth remains well below historical norms.
Reversion to the Mean
Given the current political climate, it is unlikely that government spending as a percent of GDP is going to decline in any material way, which leaves the battle between the corporate and household sector. Again, given the current political climate (hello congresswoman AOC) it is unlikely that the corporate sector is going to be able to maintain its current outsized share of GDP – the headlines abound with forces that are working to reduce corporate profit margins and as we’ve mentioned earlier, global earnings are being revised downward significantly. If the corporate sector’s portion of GDP falls to just its long-term average (recall today it is 40% above and has been above that average for about a decade), it would mean a significant decline in earnings.
The prices investors are willing to pay for those earnings are also well above historical norms.
Today the Cyclically Adjusted PE Ratio (CAPE) is 82% above the long-term mean and 93% above the long-term median. What is the likelihood that this premium pricing will continue indefinitely? My bets are it won’t.
The bottom line is that the level of both corporate profits and what investors are willing to pay for those profits are well outside historical norms. If just one of those factors moves towards their longer-term average, we will see a decline in prices. If both adjust towards historical norms, the fall will be quite profound
While D.C. is full of fireworks over health care and Russians, the Treasury is scrambling to pay the bills, yet the markets are peacefully awash in Xanax. The spread between the 6-month and 3-month Treasury bills is now pricing in a potential technical default, but given that the rest of the Treasury market looks unaffected, the expectations would be for a quick resolution.
The Treasury yield curve over the past week has adjusted to reflect this pricing. How weird is that to see?
Got to love pricing in a technical default of the U.S. government, not exactly an everyday occurrence, while the VIX has closed below 10 for 6 consecutive days. To put that in perspective, going back to January 1, 1990, the average for the CBOE S&P 500 Volatility Index (VIX) has been 19.5 and the median 17.6. As of yesterday, the average for 2017 has been 11.5 and the median 11.3! In the past 27+ years, the index has fallen below 10 all of 23 times, but 57 percent of those occurrences have been in 2017!
In the past 27+ years, the VIX has fallen below 10 all of 23 times, but 57 percent of those occurrences have been in 2017!
Beware of reversion to the mean.
Treasury volatility is also hitting record lows. Apparently, there is nothing to see here. Thank God it’s Friday.
The spread between the 30 year Treasury yield and the 2 year Treasury yield is back down to the lows of last year. The only time in over a decade that we saw the yield curve this flat was back in 2007 when all hell was breaking loose.
Look a little further up the curve, the spread between the 30-year and the 5-year is down to levels last seen in 2007: the bond market is making a statement here.
The yield on the 10-year Treasury, which is a measure of future economic growth expectations, is down to 2.16 percent today, which is astounding when you consider we are repeatedly hitting record highs in the U.S. stock markets with a 4.3 percent unemployment rate!
Lest we forget that the Atlanta Fed GDPNow forecast for the second quarter was just lowered to 1.9 percent, after a painful 1.2 percent in Q1, then back down to 1.5 percent for Q3 – accelerating economy?
Oh yes, and manufacturing production is lower today than it was in December 2005.
The CEO and Chairman of Goldman Sachs (GS), Lloyd Blankfein, is arguably one hell of a sharp fellow, which leads us to believe there are reasons behind this that go beyond a straightforward assessment of the economy.
Perhaps consumers see something different than what we hear in the mainstream financial media. The University of Michigan’s Consumer Sentiment Index dropped to 94.5 in June, which was well below expectations for 97.1.
Let’s start with a look at the Citi Economic Surprise Index, better known at the “CESI,” which has hit a multi-year low.
While US stocks look to have decoupled recently from this measure.
But we’re sure that stock prices aren’t anything to worry about. 🙄
The Cyclically-Adjusted Shiller P/E ratio today sits at 29.95, just shy of the 32.54 peak from 1929. The fact that this metric has only been at these levels twice in history, just prior to the Stock Market Crash of 1929 and again before the bursting of the DotCom bubble, is likely immaterial – so say those who derive their paychecks from investors staying fully invested. 🙄🙄
One other thought for those so inclined, in 1929 the Fed rate was at 6 percent – that’s a lot more room to move than we have today.
As we head into the summer driving season, US crude oil stockpiles declined much less than expected while gasoline inventories have actually increased over the past two weeks versus expectations for a decline. Gasoline stockpiles are now above the 5-year average for this time of year as gasoline demand has unexpectedly fallen to well below last year’s level.
According to a recent Bloomberg study, back in March, 31 percent of economists were boosting their GDP forecasts. Today 27 percent are cutting them.
US CPI recently disappointed to the downside, coming in at 1.87 percent versus expectations for 2 percent. Core CPI came in at 1.73 percent versus expectations for 1.9 percent and the 3-month moving average of year-over-year change for Core CPI indicates that this key measure of inflation is rolling over to an impressive degree. This puts that Fed rate hike into a different light!
Used car and truck prices have rolled over hard and are continuing to drop significantly.
Housing has also rolled over, both for multi-family…
and single family…
According to the U.S. Commerce Department, housing starts declined 5.5 percent in May, after falling in April and March. Building permits fell 4.9 percent.
The cost of putting a roof over one’s head rolling over has rolled over as well.
The cost of medical care has also rolled over.
While retail sales growth is still pretty decent, it has been declining since early 2015.
Restaurants and bars are having a hell of a tough time, with their businesses experiencing a more severe decline, over the past two years.
Manufacturing inventories remain frustratingly elevated. That is basically capital sitting on the shelves, earning nothing and in many cases wasting away.
With elevated inventory levels, not a big surprise to see that U.S. factory output fell in May as manufacturing production dropped 0.4 percent, the second decline in the past three months. Overall factory output was lower in May than in February. Output fell across a wide range of industries, from motor vehicles and parts production to fabricated metal. Manufacturing capacity utilization fell 0.3 percent in May with overall industrial capacity utilization falling 0.1 percent. Where’s the accelerating growth?
There is some good news for a segment of the economy. Online sales continue to command a greater and greater portion of retail sales as our Connected Society intersects with the Cash Strapped Consumer where online shopping is not only fun from one’s couch, but it is a lot easier to compare prices and get the best deal for families concerned with watching their pennies in an economy with weak-to-no wage growth.
The bond market is not telling a tale of accelerating growth, with the 30-year Treasury yield now back where it was in November.
While the 10-2 Year Treasury yield spread is back down to where it was in late 2007.
The 30-10 Year Treasury yield spread is also showing a flattening yield curve – more signs of an economy that is do anything but accelerating to the upside.
Finally, we have the Bloomberg Commodity Index heading back towards those lows from early 2016, not exactly an indicator of accelerating demand.
Here at Tematica, we are a fairly jovial bunch, with innately optimistic personalities, but we let the data first do the talking and that data is giving us a plethora of warning signs.
Turns out, we aren’t alone in our skepticism as the New York Federal Reserve now expects the economy to grow at an annualized rate of just 1.9 percent in the second quarter!
For 2014, the S&P 500 was the strongest performer of the major international indices with Japan’s Nikkei the second strongest, the remaining indices were relatively flat to slightly negative. From this we can see those areas with the most aggressively loose monetary policy had the strongest performing equity markets, something to keep in mind as policies diverge in 2015.
For 2014, the S&P 500 was the strongest performer of the major international indices with Japan’s Nikkei the second strongest, the remaining indices were relatively flat to slightly negative. From this we can see those areas with the most aggressively loose monetary policy had the strongest performing equity markets, something to keep in mind as policies diverge in 2015.
By the beginning of October, the U.S. stock market rally had been going on for 66 months, since bottoming out in March 2009, enjoying a correction-free streak that had already been a year longer than average, despite corporate profit growth that was not only in the low single-digits, but was driven more by cost-cutting than revenue growth and EPS improvement driven often by share-repurchase programs rather than actual business improvements. During this time there was really only one significant correction from late April 2011 to early October 2011 when the Russell 2000 lost about 30% of its value and the S&P 500 lost nearly 20%.
Then last week things changed… and what a ride it is! On Tuesday October 7th, the S&P 500 fell 1.5%. The next day, October 8th was the strongest day in the markets so far this year. The markets experienced the biggest intraday swing, started down then shot massively up, with the S&P 500 to close up 1.8%.
What caused this rather dramatic upturn turn-around? The meeting minutes from the Federal Reserve’s Open Market Committee meeting, indicated that there was great concern over global economic weakness and the strength of the dollar. So a struggling global economy AND the dollar has strengthened significantly which could hurt U.S. exports, harming the domestic economy? Market participants knew that the day before… what was newsworthy is that THEY are concerned which gave the market comfort that the Fed isn’t going to raise interest rates in the near future. Yippeee! Oh, wait, but because things are still pretty rough out there…
So… the equity markets woke up the following day, on October 9th, and stocks once again dropped across the globe, with the S&P 500 reversing most of the prior day’s rally to close down 2.07% and small caps tumbled even more on continued concern about global economic strength with the Russell 2000 (small cap index) falling 2.66%.
At this point small-cap stocks, as measured by the Russell 2000, have fallen below the 200-day moving average for the first time since November 2012. Almost half of the stocks in the Nasdaq are down 20% from their one-year highs, which means they are already in a bear market. Doug Kass of Seabreeze Partners has been calling this “The Ali Blah Blah Top,” suggesting that the Chinese tech company’s monster initial public offering on September 19th was a signal that markets were too frothy.
The CNN Money Fear and Greed Index sums up today’s market sentiment fairly clearly.
We have seen some very interesting moves in the bond market this year as well. Over the past year longer-dated bond yields have fallen while the shorter-term (such as the 5-year) have actually risen, which is indicative of a flattening yield curve. The red line below shows the declining difference between the 30 year and 5 year rates.
In a normal environment the yield curve slopes upward, which makes intuitive sense. You’d charge someone more to borrow money from you for 10 years than 1 year.
When the yield curve inverts, that means you would charge more for a 1 year loan than a 10 year loan which is counter-intuitive to say the least. This happens when the market believes that long-term prospects are grim, thus the longer you go out, the lower the yield. A flattening or inverted yield curve is often interpreted as a sign that the economy is starting to cool and that the Fed may start to lower short-term rates. In contrast, a steepening yield curve usually points to a strong economy with increased inflation expectations.
Currently, the yield curve is considered steep due to the difference between long- and short-term interest rates. The bond market has been in this steep yield curve due to the Fed’s decision to keep rates near zero. However we are seeing the curve getting flatter as the prior chart illustrated, with the red arrow showing the difference between the 30-year rate and the 5-year rate declining. Looking ahead, the curve could flatten further, similar to what happened during the last increase in the federal funds rate, and may eventually invert.
On September 9th, Jeffrey Gundlach, CEO and CIO of DoubleLine Capital, (whose fund Meritas utilizes) gave his thoughts on the recent flattening of the yield curve. Gundlach thinks that this trend is remarkable. He suggests that strong economic data are driving the short end of the yield curve higher on expectations that the Fed will start tightening sooner. However, the economy might be more vulnerable to rate hikes than is widely appreciated. He concludes that “if you read the tea leaves of the bond market, it might be if the Fed raises rates even moderately like to 1% or 2%, maybe the economy can’t take it.”
The chart below shows how the price of longer-dated bonds have been falling, which is what happens when yields go up, while the shorter term bond prices have been rising, which is when yields go down.
Across the Atlantic, European equities have followed a similar pattern to the U.S., peaking in early June, with the Italian MIB up almost 20%. All are now down for the year, with the exception of the Italian MIB, but it sure looks to be following suit!
As you’ve likely heard, Europe is now fighting to stay out of another recession, with the German economy, long the primary source of strength in the region, capitulating as well. This is material to the U.S. stock market as the U.S. stock market is not all about the U.S. economy. Foreign sales accounted for about 33% of aggregate revenue for the S&P500 in 2013 according to Goldman Sach’s analyst Amanda Sneider. In addition to weakening international sales, the U.S. also has to worry about the impact of a strengthening greenback, (we’ll have more on that later in this letter).
So just how tough is it in Europe? The French Prime Minister, Manuel Valls, enjoyed an approval rating of over 70% when President François Hollande gave him the position. Just six months later his approval rating has fallen to 22%, barely better than Hollande’s. Valls recently reportedly said of the French economy that, “in three to six months, if the situation isn’t reversed, we’ll be foutu,” a rather colorful way of saying the economy is in a very bad place, with unemployment still above 10% and GDP flat so far for the year.
Meanwhile France’s two largest car-makers are pressing Hollande to quicken the pace of economic reform, primarily with respect to the nation’s restrictive labor regime and high labor costs, in order to help them boost their competitiveness.
According to Carlos Ghosn, chief executive of Renault, “everything should be done to lower the cost of labor in France on conditions that are compatible with economic balance” Maxime Picat, chief executive of the Peugeot brand added: “The level of taxation and (social) charges are putting huge pressure on labor costs. This is really the key and where we’ve got the biggest gap with the countries very close to France,” he said. “With 1m cars (made in France) and such an exporting position, this is clearly key to us.”
This isn’t all that surprising if we look at the long-term trends in Eurozone productivity growth.
How’s that French austerity coming along? Errr, not so much which is getting the ire up over in Germany. Despite all the talk of cutting spending, Government debt has continued to grow almost unabated while its debt to GDP ratio only gets worse.
Recently Finance minister Michel Sapin admitted that France’s government will not be able to meet its EU deficit target until 2017, from these charts you can see no one ought to be surprised!
Meanwhile Italian Prime Minister Matteo Renzi claims that Italy will not follow in France’s footsteps, but will instead remain within the 3% deficit-to-gross GDP ratio mandated by the EU, despite his nation’s protracted recession. In August the youth (aged between 15 and 24) unemployment rate in Italy reached a new record high of 44.2% in August, while the overall unemployment rate was 12.3% v expectation of 12.6%, (see chart below).
Imagine that! Almost half of the youth in Italy cannot find a job. Think about how that affects the nation for decades to come. At a time when the young most need to be developing skills and using all that energy to be productive, they are wandering around aimless and increasingly frustrated that their aging nation is giving them the cold shoulder in the workforce.
On October 6th we learned that German factory orders plunged the most since 2009, underlining the risk of a slowdown in Europe’s largest economy. Orders, adjusted for seasonal swings and inflation, fell 5.7% in August versus expectations of a 2.5% decline, after climbing 4.9% in July, according to the Economy Ministry in Berlin. On October 9th Reuters reported that German exports plunged 5.8% in August, their largest amount since the height of the financial crisis, fueling debate on whether Berlin is doing enough to prop up the domestic and European economies. Hours after the trade data was released, a group of leading economic institutes joined the International Monetary Fund (IMF) in slashing forecasts for German growth. They are now expecting growth of 1.3% this year and 1.2% next, down from 1.9% and 2.0% previously.
With so many other Eurozone nations struggling, it isn’t surprising that while Germany had a strong start to the year, it shrank by 0.2% in the second quarter. Evidence is now mounting that it barely grew in the third quarter and some economists are forecasting another contraction in that period, which would amount to a technical recession.
The U.S. economy is on a stronger footing, but one of the core facets is still struggling – what families take home at the end of the day. Yes, the unemployment rate has fallen, but so has the labor participation rate, (the percentage of the population in the work force). Granted, some of that is because of the aging population, but not all and either way, it means a smaller portion of the country is working towards growing the economy. Yes, there are more job openings, the number of jobs waiting to be filled in the U.S. has climbed to the highest level in 13 years. But those jobs are not being filled because we have a significant skill gap. Employers can’t find the right people to fill the jobs. That hurts growth in two ways: (1) the person looking for work still isn’t able to get a paying job and (2) the business isn’t able to grow as effectively as it could if those positions were filled.
The U.S. is not an island. Countries all over the world that buy from the U.S. are struggling and a strengthening U.S. dollar isn’t helping them. This impacts what types of companies will do well in this new era.
Suppressed volatility always leads to increased volatility; an immutable fact.