U.S. Economy Starting 2016 on Solid Footing The U.S. economy looks to be off to a solid start to the year after ending 2015 on a sour note, with consumer spending showing signs of a pickup and the fourth quarter’s initial growth reading looking a bit better than thought.
Consumer spending grew in January at the fastest clip in eight months, new data showed Friday, as a strong job market and robust wage gains boosted Americans’ propensity to spend. Inflation also ticked higher, a positive sign for Federal Reserve officials considering whether the U.S. economy can withstand higher interest rates.
The pickup followed other improvement across the economy in January including stronger retail sales and home purchases. A report Thursday showed new orders for big-ticket durable goods also increased last month following their worst annual performance since the recession, suggesting the U.S. manufacturing sector could be on the mend.
Resilient U.S. economic data in recent weeks contrasts with volatility in global financial markets, unsettled by concerns over China’s economic slowdown and steep declines in commodity prices. Fears about jitters translating into a U.S. recession have yet to hit many underlying economic fundamentals. (…)
On Friday, the Commerce Department said personal spending rose 0.5% in January from the prior month. Americans’ pretax earnings from salaries and investments increased at the same pace.
Separately, the department said gross domestic product advanced at a 1% seasonally adjusted annual rate in the fourth quarter, revising up its earlier estimate of 0.7%. That followed annualized growth of 2% in the third quarter and 3.9% in the second.
Friday’s release also showed the Federal Reserve’s preferred inflation measure, the price index for personal consumption expenditures, up 1.3% from a year earlier, firming from an annual inflation gain of 0.7% in December. Inflation has run below the Federal Reserve’s 2% inflation target for nearly four years.
Excluding volatile food and energy costs, so-called core prices were up 1.7% from a year earlier in January–the strongest increase since July 2014. Core inflation has risen faster than the Federal Reserve predicted in December, when it decided to raise the benchmark federal-funds rate for the first time in nearly a decade.
Core inflation is now higher than the Fed expected it to be at the end of this year, a development that could give the central bank confidence the U.S. economy can cope with less central-bank support to spur spending and investment. (…)
The shifting Fed expectations weighed on stocks Friday and helped push the dollar to a three-week high against the euro and the strongest level against the pound since 2009.
Developments in the U.S. contrast sharply with economic data and monetary policy in other advanced economies. Policy makers in Europe and Japan have been pushing interest rates down to negative levels and buying assets in a bid to fuel growth and combat weak inflation.
For the U.S., Friday’s GDP revisions confirmed that trade and business investment were drags on the economy during the final three months of last year, a clear sign that the U.S. hasn’t been immune from global weakness.
The improvement in overall economic growth in the fourth quarter was largely due to the fact that companies pulled back on inventory less than originally expected. Economists cautioned that a faster rate of inventory accumulation could hinder first-quarter growth as companies take longer to work through their well-replenished stockpiles.
“While this is good news for the fourth quarter, it is bad news for early 2016; inventories are a bit higher than businesses would like, and so they will be adding less to them over the next few months, weighing on economic growth,” said PNC economist Gus Faucher.
Households consumed less than originally estimated in the final quarter of 2015. The updated reading for personal consumption rose 2% in the fourth quarter, down from an initial estimate of 2.2% and below the third quarter’s 3% growth rate.
The best summary of Friday’s GDP report:
“All the revision was in the inventory and imports component, with everything else—consumption, fixed investment, government spending and exports—revised down modestly….The bottom line here is that while this revision is welcome, it does not help answer the key questions for growth this year, namely, when will oil sector capex stop falling, and will the personal-saving rate mean-revert, boosting spending?” —Ian Shepherdson, Pantheon Macroeconomics
This Haver Analytics table effectively sums up the important Christmas season:
- Nominal wages & salaries: +5.3% annualized in the last 3 months.
- DPI and PCE both +4.0% a.r. in last 3 months.
- Real PCE: +3.6% a.r. in last 3 months.
- Spending on Goods rose at a 5.3% annualized rate in the last 3 months
As I have been saying, the official consumer-related stats are now converging with corporate releases, confirming that the consumer is out there spending his rising disposable income. The strength in Goods during the holiday season is important. The inventory overhang will get cleared more rapidly, hopefully paving the way for faster manufacturing growth in coming months.
But maybe we are seeing a new problem emerging, threatening both the consumer and the Fed:
U.S. Consumers Face Quickening Inflation American consumers are facing the strongest inflation pressures since before oil prices began plummeting and the dollar strengthening over the past year and a half, a sign of economic vitality likely to be welcomed by the Federal Reserve.
(…) January’s annual gain in so-called core inflation was at the top of the 1.5%-to-1.7% range most Fed officials said in December they expected to see late in 2016. (…)
Other measures of inflation are also firming. The Labor Department’s consumer-price index advanced 1.4% from a year earlier in January, the fastest annual gain since October 2014. Excluding food and energy categories, prices were up 2.2%. (…)
Core PCE inflation jumped the most in 2 years in January and it seems to have set itself on a 2.0-2.5% trend in recent months. The Cleveland Fed Inflation Nowcasting puts February’s core PCE at +0.14% which, combined with January’s +0.26%, puts the last 2 months at +0.4% or +2.4% annualized.
This is happening even though Goods inflation remains negative (-3.7% a.r. in last 3 months). Services inflation is already in the 2.0-2.5% range (+3.6% a.r. in January) as rising wages are pushing prices up. The Fed is correct in saying that weak oil and import prices are transitory but it could well find itself wishing they were not, especially if consumer spending on Goods keeps accelerating, helping merchants pass along their cost increases, be them wages, energy or import prices. Even the omnipotent central banks may find it difficult to have their cake and eat it too. Here’s a potential nightmare sequence for the Fed:
- Wages keep accelerating under diminishing labor slack. Wages and Salaries rose at a 2.7% a.r. from June to September 2015 and at a 5.8% a.r. between October and January.
- Consumers spend up, particularly on Goods. Real expenditures on Goods rose at a 2.6% a.r. from June to October 2015 and at a 5.3% a.r. between November and January.
- Inventories correct rapidly and production turns up, boosting manufacturing and transportation employment.
- Oil prices firm up.
- The USD stabilizes or declines.
Transitory deflation suddenly disappears just when domestic demand accelerates, providing merchants with renewed pricing power. Goods deflation suddenly disappears, immediately adding to the already flaring Services inflation. Core inflation quickly jumps above 2.0% YoY and pushes total inflation, already at +1.3% YoY, towards the 2.0% Fed target much earlier than anticipated.
Just a scenario…
BTW, in today’s FT:
Michael Hasenstab is chief investment officer of Templeton Global Macro.
(…) Some commentators have gone so far as to claim that inflation has been consigned to the history books. But what if they are wrong? If inflation is not dead, then investors are making two big mistakes and risk being left dangerously exposed when it returns.
The first error is that investors are bailing out of anything deemed to carry risk, even high-quality long-term investments, due to a fear that the world is now in a permanent state of stagnation and deflation.
Just look at the indiscriminate sell-off in anything connected to emerging markets; no account is being made for whether specific countries enjoy strong fundamentals. The view is that everything must go.
Investors’ second error is complacency towards US Treasuries. Because of the belief that inflation is now dead, there is an assumption that the “risk-free rate” will be a shelter from declining markets.
This is important, given the correlation between inflation, interest rates and bond prices. In simple terms, when inflation returns, the risk premium on bond yields will increase leading to a decline in US bond valuations. If the Federal Reserve reacts by hiking this will further the move; if the Fed does nothing they risk losing credibility, which in itself would also increase the risk premium of longer date treasuries.
If we are right, and inflation returns more quickly than anticipated, the market’s decision to buy supposedly risk-free Treasury bonds will compound the earlier error to bail out of riskier assets.
(…) the evidence suggests that it would take a set of heroic assumptions to believe that headline inflation will remain at the current extremely low levels. Our forecasts are ahead of the US Federal Reserve and, crucially, those priced in by financial markets. We believe headline CPI inflation in America will exceed 2 per cent by the end of 2016 or early 2017.
There are a number of reasons to think that the market has got it wrong and that inflation could return far more quickly than most are anticipating. It is already running at high levels and above target in a number of emerging markets — from Malaysia to Russia, for example, as well as large swaths of Latin America. Bear in mind that emerging markets account for a significantly higher share of the global economy than they ever did previously.
Similarly, while the collapse in commodity prices has indeed hit headline inflation rates, the falls have masked the relative stability of core inflation. A recovery in oil prices and other commodities would quickly feed through to a boost in headline inflation.
In the US, still the largest driving force in the global economy, there are good reasons to think that inflation is on the way back too. The labour market is now essentially back to full employment, following several lean years in the wake of the global financial crisis. Ultimately, this should feed through to consumer spending, driving up prices.
If inflation does return more strongly than most anticipate, and the Fed responds as we predict, then Treasuries may not seem like such a haven after all. That might not be explosive enough for another Brad Pitt movie, but it would be potentially disastrous for investors who are caught out.
The European Union’s statistics agency Monday said consumer prices were down 0.2% from February 2015, having been up 0.3% on the year in January.
The decline was the first since September of last year, and a steeper drop than economists had expected. (…)
Eurostat said its measure of core inflation—which excludes prices for energy and food that are very volatile and largely beyond the ECB’s influence—eased to 0.7% from 1% in January. That development has likely concerned policy makers, since it indicates the decline in energy prices is spreading to prices of other goods and services. Eurostat said services prices were up 1.0% on the year, having been 1.2% higher in January, while prices of manufactured goods rose by just 0.3%, less than half the January rate of 0.7%.
G-20 Hears China Say There Will Be No Yuan Devaluation China emerged from the weekend Group of 20 meeting with a new measure of trust from major trading partners that it won’t significantly devalue the yuan.
(…) The message was “heard loud and clear” that Beijing has “no intent, no determination, no decision whatsoever to devalue the yuan,” said Christine Lagarde, the managing director of the International Monetary Fund, after the weekend meetings in Shanghai. (…)
The G-20 cited volatile capital flows, plunging commodity prices and the U.K.’s potential exit from the European Union as threats that could pitch the world into recession; it didn’t explicitly mention China. The financial chiefs vowed to speed up economic overhauls and to “use all policy tools—monetary, fiscal and structural” to strengthen growth, boost investment and ensure stability in financial markets. (…)
“There’s clearly a sense of renewed urgency,” Ms. Lagarde said after the meeting.
Although the G-20 said countries may need to explore increasing spending, its promises fell short of calls by the IMF and others for a coordinated stimulus package to revive flagging output. And there was no discussion of the sort of currency accord suggested by some investors as a way to temper global economic turmoil, as officials insisted there was no major currency misalignment. (…)
The statement reiterated a pledge for countries to refrain from weakening their currencies to gain a competitive edge—a sign that concern remains about China, among others. (…)
Chinese officials stopped short of pledging the yuan won’t lose value, only that they aren’t pursuing policies aimed at a devaluation. A continued erosion of China’s exchange reserves at the recent rate of around $100 billion a month could alter Beijing’s calculus and prompt it to blunt speculative yuan selling with a one-off devaluation. Chinese officials cite the country’s $3 trillion-plus pile of foreign currency as a huge source of stability. (…)
Still murky after the G-20 is how Chinese authorities are actually managing the yuan.
Officially, the central bank attaches the yuan’s value to as many as three baskets of currencies of its trading partners—though Mr. Zhou told reporters Friday that among those, the dollar remains the most important, indicating the central bank continues to seek flexibility.
The basket model itself is a risk because it lacks transparency, and appears to provide opportunities for Beijing to cast blame elsewhere if the yuan falls, said David Loevinger, the U.S.’s former Treasury representative in China and now a fund manager at TCW in Los Angeles. Since the baskets include the euro and the yen, as well as the dollar, Mr. Loevinger said, China may now be trying to insulate itself from blame for any future currency turmoil by signaling, “Europe and Japan, you depreciate, we’ll depreciate.” (…)
China Cuts Reserve Requirement to Boost Liquidity China’s central bank said it will lower the amount of deposits banks hold in reserve by 0.5 percentage point, as a burgeoning liquidity shortage outweighs concerns over the impact of credit-easing on the yuan.
The action, which the People’s Bank of China announced late Monday and which will take effect Tuesday, will free up about 700 billion yuan, or about $108 billion, in funds for banks to make loans, analysts estimate.
The reduction in the so-called reserve-requirement ratio marks a reversal in the central bank’s stance in the past two months, when it had resisted the use of such aggressive easing tools for fears that it could add to pressures weakening the yuan. Now, a squeeze of liquidity, which poses a threat to the country’s overall financial stability, is taking over as the central bank’s top concern, according to an official close to the central bank. (…)
(…) The problem is that China has reached an inflection point. A substantial chunk of new debt is increasingly going to pay old debt, creating less activity in the real economy aside from bankers’ fees and commissions. (…)
The most egregious evergreeners are state-owned companies in industries with massive overcapacity issues. Coal mining and metals, for instance, account for 30% of evergreening, according to Deutsche.
What could alleviate the evergreening problem? A positive step would be to allow companies in those problem sectors to enter painful restructuring. This would at least remove a source of demand for evergreening loans. (…)
For now, however, China just seems to be piling up new debts on top of old ones, without cleaning up the mess. That may prevent defaults within the banking system, but it does little to get the economy going.
(…) Oil-rich GCC states have to refinance $52 billion of bonds and $42 billion of syndicated loans, mostly in the United Arab Emirates and Qatar, HSBC said in an e-mailed report. The countries also face a fiscal and current account deficit of $395 billion over the period, it said.
Expectations that these funding gaps “will be part financed through the sale of sovereign U.S. dollar debt will complicate efforts to refinance existing paper that matures over 2016 and 2017,” Simon Williams, HSBC’s chief economist for the Middle East, said in the report. “With the Gulf acting as a single credit market, the refinancing challenge will likely be much more broadly felt” and “compounded by tightening regional liquidity, rising rates and recent downgrades,” he said. (…)
Almost half of the maturities due in the next two years are in the banking sector, HSBC said, “suggesting any increase in costs at refinancing could quickly feed through into a broader monetary tightening.”
The Q4’15 earnings season is essentially complete with 96% of the companies in. Here’s Factset’s summary:
Overall, 96% of the companies in the S&P 500 have reported earnings to date for the fourth quarter. Of these companies, 69% have reported actual EPS above the mean EPS estimate, 10% have reported actual EPS equal to the mean EPS estimate, and 21% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting actual EPS above the mean EPS estimate is equal to the 1-year (69%) average, but above the 5-year (67%) average.
In aggregate, companies are reporting earnings that are 3.7% above expectations. This surprise percentage is below both the 1-year (+4.9%) average and the 5-year (+4.7%) average.
The blended earnings decline for the fourth quarter is -3.3% this week, which is smaller than the blended earnings decline of -3.7% last week.
If the Energy sector is excluded, the blended earnings decline for the S&P 500 would improve to 2.6% from -3.3%.
In terms of revenues, 48% of companies have reported actual sales above estimated sales and 52% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is below the 1-year (50%) average and the 5-year average (56%).
In aggregate, companies are reporting sales that are 0.4% below expectations. This surprise percentage is below both the 1-year (+0.6%) average and above the 5-year (+0.7%) average. The blended revenue decline for Q4 2015 is -3.9%.
If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would jump to 0.3% from -3.9%.
At this point in time, 110 companies in the index have issued EPS guidance for Q1 2016. Of these 110 companies, 88 have issued negative EPS guidance and 22 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 80%. This percentage is above the 5-year average of 72%.
At the same time last year, 81 companies had issued negative EPS guidance and 15 companies had issued positive EPS guidance. Negative guidance is currently most prevalent in the Health Care and Industrials sectors while guidance from Consumer Discretionary companies is somewhat better than last year. Financials are about in line with last year.
The problem is not Q4’15 but rather Q1’16:
Most of the downward revision is due to Energy but 7 of the 10 sectors are now expected to show declining EPS in Q1 (4 in Q4’15). To overcome declining profits, investors need to be fed with lots of hopeful data on other fronts.
(…) The real damage has been in forecasts for the current quarter, expected to show a 5.7 per cent annual fall, when on New Year’s Day brokers were braced for a rise of 2.3 per cent. “Earnings management” by companies, as they steer brokers to a forecast they can beat, is common; a writedown on this scale is not.
But it is worse than that. It is global. According to the quant team at Société Générale, earnings estimates for the whole of this year for the constituents of the MSCI World index, the main benchmark for developed markets, are now 12 per cent lower than they were last summer, after the biggest monthly cuts to consensus predictions since the disaster year of 2009.
Brokers can of course be wrong. They often are. And they tend to be institutionally over-optimistic, as this helps to sell stocks. But the direction of their forecasts tends to be accurate. Earnings momentum matters. And such a sudden and sharp resetting of their forecasts shows that companies themselves, with a better grasp of their prospects than anyone else, feel it necessary to talk down the future. This is very discouraging.
But it gets worse. All of this refers to profits. In Europe, companies excluding financials are expected to see earnings decline 1.2 per cent — while revenues decline by a thumping 5.7 per cent. In the US, most S&P 500 companies announced sales below forecasts, and overall fourth quarter sales fell 3.8 per cent. Technology companies’ sales were down 4.1 per cent.
But it gets worse when we look further into the future. Tobias Levkovich of Citi estimates that US long-term earnings expectations have fallen to a 50-year low, with long-term multiples implying earnings growth of less than 4 per cent.
And now it really starts to sound bad. So far, we have been using the pro forma numbers publicised by companies and compiled by Thomson Reuters.
These numbers often will be more relevant to investors than the official numbers compiled under generally accepted accounting principles (GAAP), with all their assumptions on goodwill from acquisitions, depreciation, and so on. Provided they publish GAAP numbers, US companies have since 2003 been permitted by regulators to publish adjusted numbers that exclude numbers related to specific events. But the GAAP principles are generally accepted for a reason, and they suggest that US earnings have already been falling for five quarters in succession. The operating numbers suggest that the earnings recession only started in the third quarter of last year.
And a report by Morningside Hill Capital Management in New York shows that the gap between GAAP and adjusted numbers had widened, and reflects deliberate manipulation by groups. For 2015, the Thomson Reuters number for earnings was 29.5 per cent above the GAAP number, almost identical to the 28.6 per cent gap that had opened in 2007, on the eve of the crisis. Only two years ago, the gap was as narrow as 9.5 per cent.
Wherein lie the differences? Companies are treating management bonuses and recruitment costs as one-off expenses, even though they are part of the true cost of business. The same is true of regulatory and litigation expenses, and M&A fees. Sometimes, even the effect of currency moves is excluded.
It is understandable that in the long run GAAP earnings matter more. As research by Andrew Lapthorne of Société Générale shows, stocks tend to follow GAAP numbers in the long run, not pro forma profits (or “made up profits” as he calls them).
One final note of concern: earnings per share under GAAP have themselves been boosted by share buybacks and M&A. As these have to an extent been funded by cheap debt, even GAAP earnings look extended.
How does this feed into the market? The bounce from the new year sell-off has now continued for two weeks, for the good reason that the last two weeks of US economic data has come in better than expected, dampening recession fears. This should limit the “downside” to the market.
But it would be unwise to expect the market to recoup all its losses and breach the record high set last spring. Stocks are expensive. The price/earnings multiple on the S&P 500, according to Bloomberg, now stands at 17.5, on earnings of $110.74 per share. This is down from last year’s peak of 18.9 and not far above its average since 1954 of 16.4.
But GAAP earnings are $90.57, which would raise the p/e to 21.5, a level it has only reached at or near market peaks. Bear in mind that until 2003, p/es were based on GAAP.
So the market looks historically expensive, even though investors have just braced themselves for a severe fall in profits. Not good.
For the record:
- The ratio of Operating to As Reported EPS has not widened out of the historical range recently. In fact, it has been relatively stable since 2009 as this chart using S&P data illustrates.
- The decline in the ration in the last 15 months is primarily the result of large pension charges in late 2014 and asset impairment charges taken by many energy companies during 2015. S&P data show Energy Operating EPS totalling –$13.98 for all of 2015 compared with –$23.51 for GAAP EPS, with most of the gap occurring in Q4. It may be orthodox to use reported EPS but only if you expect similar “one time” charges in coming years.
- “management bonuses and recruitment costs, regulatory and litigation expenses, and M&A fees, even the effect of currency moves” are generally fairly minor items. To be sure, banks litigation expenses have been significant in recent years but they have not all been treated as non-operating. In fact, Financial Operating EPS totalled $22.91 in 2015, only 4.7% above GAAP EPS.
- Finally, given that the ratio between both sets of EPS has not changed meaningfully over the long-term, Andrew Lapthorne’s assertion that “stocks tend to follow GAAP numbers in the long run, not pro forma profits (or “made up profits” as he calls them)” has little practical implication from a valuation perspective, unless one wants to add bearish colors to his picture:
Related: PICK YOUR FACTS
(…) Gundlach and other DoubleLine money managers became more sanguine about equities at a sector allocation meeting on Feb. 10, and then on Feb. 12 increased their stock position, according to a DoubleLine spokesman.
“I thought it was a good buy point two weeks ago Wednesday and so we bought some,” Gundlach told Reuters on Friday. (…)
Gundlach’s buys are somewhat curious given his decidedly bearish stance on the market not more than a few weeks ago. Back on Feb. 8, he told Reuters that equities were in a bear market and referred to the atmosphere as “not a traders market.” (…)
Here and there:
- In early results from Iran’s elections on Friday, allies of the reformist president, Hassan Rohani, won all 30 parliamentary seats in the capital, Tehran. The once-dominant hardliners also did poorly in the parallel election to the Assembly of Experts, which may have to select the successor to the 76-year-old supreme leader, Ayatollah Ali Khamenei, during its eight-year term. (The Economist)
- U.S. funds cut recommended equity allocations in February: Reuters poll U.S.-based fund managers cut their equity holdings in February and boosted cash to a nine-month high on persistent worries about a global economic slowdown, a Reuters poll found on Monday.
- Global funds flee stocks, raise bond holdings to five-year high as growth fears mount Investors dumped equities in February as allocations hit the lowest level in at least five years and world stocks fell for the fourth month in a row, with fears of a global recession keeping risk appetite subdued.
- U.S. retail investors redeemed a net $36B of global equities in the first 7 weeks of the year, the largest liquidation since the 2008 crisis. Only one third of portfolios are now made up of stocks…(David Rosenberg)
- At least 48 N.A. O & G producers have files for bankruptcy since the beginning of 2015, affecting $17B of debt (hence the imoact on the bank loan-loss reserves and High-Yield corporate bond yield spreads) with more to come. (David Rosenberg)