U.S. in Weakest Recovery Since 1949 U.S. economic growth sputtered this spring—growing a meager 1.2% in the second quarter—with cautious business investment largely offsetting robust consumer spending. The data marked the worst first-half performance since 2011.
Gross domestic product, the broadest measure of goods and services produced across the U.S., grew at a seasonally and inflation adjusted annual rate of just 1.2% in the second quarter, the Commerce Department said Friday, well below the pace economists expected.
Economic growth is now tracking at a 1% rate in 2016—the weakest start to a year since 2011—when combined with a downwardly revised reading for the first quarter. That makes for an annual average rate of 2.1% growth since the end of the recession, the weakest pace of any expansion since at least 1949. (…)
Personal consumption, which accounts for more than two-thirds of economic output, expanded at a 4.2% rate in the second quarter, the best gain since late 2014.
On the downside, the third straight quarter of reduced business investment, a large paring back of inventories and declining government spending cut into those gains. (…)
Nonresidential fixed investment, a measure of business spending, declined at a 2.2% pace. (…)
Nominal GDP growth is back to the bottom of its recent range at +2.5% YoY, right where the Employment Cost Index currently stands. Something’s going to have to change if we are to avoid a margin squeeze.
Multiple revisions for multiple reasons are in play. Constant revisions make predicting GDP a real crap shoot.
Nonetheless, the trend is not friendly:
Why U.S. GDP Figures Might Be Better than They Look A fall in inventories suggests the economy is ready for a rebound next quarter
(…) If the rate of inventory accumulation had remained unchanged, the economy would have expanded 2.4%. (…)
U.S. businesses have been accumulating inventory stock at a slower pace for the last five quarters. In the second quarter of this year, they actually recorded a fall in inventories for the first time since mid-2011. This suggests businesses will need to start accumulating stock pretty soon, which would give a boost to the U.S. economy in the near term. (…)
- After all, economists have finally been positively surprised after nearly 2 years of downshifting:
- And the ECRI has jumped to its best reading since the crisis!
Yet, with all these positive surprises, the economy is not rebounding from its sputtering state.
- Same with the E.U.:
The pace of eurozone economic growth halved between the first and second quarters of the year. After a 0.6% expansion of GDP in the first three months of the year, the second quarter saw the economy grow by just 0.3%. That’s a rate comparable with the second quarter signal from IHS Markit’s PMI surveys, so is therefore a reading that we feel more accurately reflects the true underlying pace of growth in the single currency area than the surprisingly sprightly picture seen at the start of the year.
It looks like this slower pace of expansion has persisted into the third quarter, albeit with downside risks to suggest that growth is slowing slightly. The flash PMI for July dipped to an 18-month low of 52.9, but we would need to see further falls in the survey data in coming months to get a GDP growth signal weaker than 0.3% for the third quarter.
The flash PMI surveys have added to suspicions that the ‘Brexit’ vote has exacerbated political uncertainty across Europe and aggravated banking sector vulnerabilities, notably in Italy. Business confidence about the outlook in the service sector has deteriorated to the worst for just over one-and-a-half years. Growth also looks all-too-dependent on Germany, with France stagnating and signs from the PMIs of weakening growth outside of the core.
Markit’s PMI saw the weakness:
The actual print was in line with soft second quarter PMI data from IHS Markit, which found companies fighting against headwinds such as the strong dollar, the energy sector downturn and growing hesitation in committing to new spend ahead of the presidential election. (…)
Markit PMI v GDP
The good news is that firms should hopefully start rebuilding stock levels in the second half of the year, boosting growth.
However, so far, the first indicators of the third quarter also point to growth remaining sluggish, albeit with employment continuing to grow at a solid pace. At 51.5 in July, the flash PMI covering both manufacturing and services was unchanged on the second quarter average and continued to run at a rate signalling annualised growth of approximately 1.0%.
The question nobody is asking: have inventories fallen enough to begin a new cycle?
Up to May, inventories were still very high throughout the economy:
Meanwhile, Q2 Goods Final Sales are not showing any signs of acceleration to help clear the excess inventory:
The world is not helping:
Fitch Ratings says its global growth forecast revisions since May have been modest but this belies a significant deterioration in the balance of global macro risks post-Brexit. This will mean central banks remain cautious and monetary policy normalisation is even further away, says Fitch in its latest bi-monthly Global Economic Outlook report.
“The political debate in the UK over Brexit highlighted concerns with the impact of globalisation and immigration which are present not just in Europe, but in other major economies around the world,” says Brian Coulton, Chief Economist at Fitch. “The risk of political events disrupting market confidence has increased. A rise in trade protectionism in the context of faltering growth would be damaging for the global economy. Threats to European integration could impinge on eurozone growth prospects over the medium term.”
Brexit is likely to amplify the divergence in global monetary policy that sparked the US dollar’s rally in mid-2014, with central banks now focussed on preventing a widespread tightening in credit conditions. (…)
While Brexit sent shockwaves through financial markets it is unlikely to spark a global recession as direct trade linkages from the UK to the rest of the world are small. Overall, world growth based on the ‘Fitch 20’ group of countries we use as a proxy for global growth is 0.1% weaker than forecast in May in both 2017 and 2018. With advanced economy growth now expected to remain steady at just over 1.5% over the next two years, world growth is no longer expected to return to 3% by 2018. (…)
MEANWHILE IN CHINA
From the China Daily, we learn that qualifiers of the economy are changing for the worse:
China’s economic growth still faces heavy downward pressure, a meeting of the Political Bureau of the Communist Party of China Central Committee presided over by General Secretary Xi Jinping heard on Tuesday.
There are “some risks and potential threats that deserve high attention“, the gathering decided.
Beijing also recently spoke of “severe challenges” in the economy after acknowledging “persistent downward pressure” on the economy. China’s budget deficit reached 4.2% of GDP during the last 12 months. It was 2.2% during the 2009 crisis. Needless to say, Beijing’s target of 3.0% for 2016 will not be met…
The employment-cost index, a broad measure of workers’ wages and benefits, grew a seasonally adjusted 0.6% during the second quarter of 2016, the Labor Department said Friday. Economists surveyed by The Wall Street Journal had forecast the 0.6% rise.
The first-quarter gain was unrevised at 0.6%.
Wages and salaries, reflecting more than two-thirds of compensation costs, advanced 0.6% last quarter. Benefits rose 0.5%.
From a year earlier, total compensation increased 2.3%, a slight acceleration from the 1.9% annual gain recorded in the prior quarter.
From a year earlier, wages and salaries rose 2.5% in the second quarter. Benefits advanced 2.0%
THE STATE OF THE CONSUMER
Americans are in a jolly mood these days, willing to dip into their savings to sustain the economy. Are they really that joyful? Dining out is considered the best indicator of trends in discretionary spending:
(…) As a result of softer sales and a dampened outlook among operators, the National Restaurant Association’s Restaurant Performance Index (RPI) declined for the second consecutive month. The RPI stood at 100.3 in June, down 0.3 percent.
“The uneven trend that the RPI followed during the first half of 2016 was due in large part to choppy same-store sales and customer traffic results,” said Hudson Riehle, senior vice president of research for the National Restaurant Association. (…)
- Stifel’s Restaurant analyst is getting worried by the drop in restaurant comparable store sales growth rate (via ValueWalk):
Factset’s weekly summary:
Overall, 63% of the companies in the S&P 500 have reported earnings to date for the second quarter. Of these companies, 71% have reported actual EPS above the mean EPS estimate, 13% have reported actual EPS equal to the mean EPS estimate, and 16% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (70%) average and above the 5-year (67%) average.
In aggregate, companies are reporting earnings that are 4.4% above expectations. This surprise percentage is above both the 1-year (+4.2%) average and the 5-year (+4.2%) average.
The blended earnings decline for the second quarter is -3.8% this week, which is smaller than the blended earnings decline of -4.7% last week. If the Energy sector is excluded, the blended earnings growth rate for the S&P 500 would improve to 0.1% from -3.8%.
In terms of revenues, 57% of companies have reported actual sales above estimated sales and 43% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is above both the 1-year average (49%) and the 5-year average (55%).
In aggregate, companies are reporting sales that are 1.2% above expectations. This surprise percentage is above the 1-year (0.0%) average and above the 5-year (+0.6%) average.
The blended revenue growth rate for Q2 2016 is 0.1%. If the index reports growth in sales for the quarter, it will mark the first time the index has seen year-over-year growth in sales Q4 2014 (2.0%). If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would improve to 2.8% from 0.1%.
At this point in time, 56 companies in the index have issued EPS guidance for Q3 2016. Of these 56 companies, 36 have issued negative EPS guidance and 20 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 64%, which is below the 5-year average of 74%.
Throughout Q2, I was pointing out the good guidance ratios, suggesting that Q2 results could surprise more positively than average. They have but not so significantly with EPS, so far, beating by 4.4% vs the +4.2% historical average.
Investors are pretty impressed with earnings so far but a closer examination tempers my enthusiasm:
Revenues ex-Energy are up +2.8% compared to +1.6% at the same time after Q1. This is while GDP Final Sales growth decelerated from +3.1% in Q1 to +2.9% in Q2. The table below reveals that 3 sectors provide the bulk of the growth in revenues. The growth in HC is ACA (Affordable Care Act) influenced and that in CD is driven by AMZN (+30%, what else is new), HD and LOW (housing and weather-impact). Other than these (and the 3 Telecom cos.), revenue growth is pretty weak across sectors along with the overall economy as these Factset numbers show:
The same 3 sectors provide the bulk of Q2 EPS growth (+6.9% on average for these 3 sectors) so far. The other sectors are -1.7% on average (ex-Materials and Energy). IT EPS is also down 2.0% even with FB and GOOG shooting the lights out. AAPL weighs much on the sector, however.
On the other hand, corporate guidance has been quite positive so far with a low 64% negative guidance on Q3. Hence
During the month of July, analysts lowered earnings estimates for companies in the S&P 500 for the quarter. The Q3 bottom-up EPS estimate (which is an aggregation of the EPS estimates for all the companies in the index) dropped by 0.7% (to $30.44 from $30.66) during this period. During the past year (4 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.7%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.3%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has also been 2.3%. Thus, the decline in the bottom-up EPS estimate recorded during the first month of the third quarter was smaller than the 1-year, 5-year, and 10-year averages.
In fact, this marks the smallest decrease in the bottom-up EPS estimate over the first month of a quarter since Q2 2014 (+0.4%).
Not that I want to ruin the party, but we must recall that negative guidance was 67% at the same time during the Q1 earnings season but it ended at 72% as negative guidance hit 77% during the second month of the season. During May, of the 32 IT and CD companies that provided Q3 guidance, 25 (78%) were negative.
I refer you back to the earlier chart suggesting a potential margin squeeze unless either revenue growth accelerates or compensation costs decelerate. The resiliency of American companies is well known but, economy-wide, one’s cost cutting is someone else’s revenue drop.
So we find ourselves at 2171 on the S&P 500 Index with EPS expected down 3.8% YoY in Q2 per Factset (-3.0% per Thomson Reuters) and expectations of +0.9% in Q3 (down from +2.0% on July 1st) and +8.9% in Q4 (+9.5%). If we assume these forecasts will be met, 2016 EPS will total $118.21 for a P/E of 18.4x. Let’s now assume that the current $134.62 estimate for 2017 will also be met and average 2016 and 2017 to get a mid-2017 EPS estimate of $126.41. The S&P 500 now sells at 17.2x this 12-month forward estimate.
The chart below will let you appreciate how many times equities have sold anywhere between 17.2 and 18.4x forward earnings since 1950:
Yes Virginia, we are told left and right that interest rates are so low and central banks so pushy that we should accept historically high equity valuations. But rates are artificially low, precisely to lure people to accept unreasonable risks. We have all known that all along but now that we are where central bankers wanted us, equity cheerleaders are telling us not to worry, this is the new normal.
Now look at the Rule of 20 chart, which uses trailing EPS and takes inflation (a proxy for “normal” interest rates) into account, and appreciate how many times we have been at the current reading of 21.3 since 1957…and what generally happens next:
One can still make money at these “high heat” levels but things must go smoothly to prevent the Wizard of Odds to strike. Importantly, the yellow line, the Rule of 20 Fair Value which measures trends in earnings and inflation, is better to be rising which is not the case now.
With these two charts, we can’t say where equity markets will be 6 or 12 months from now (nobody can). But we sure know that we are in “buy-high” territory and that a lot of things have to go right from here on end.
One of the things that could go wrong is the $134.62 estimate for 2017 which has yet to get the normal axing:
This next guy, who knows a thing or two about risk/reward analysis, is not optimistic on what’s ahead:
(…) Noting the recent run-up in the benchmark Standard & Poor’s 500 index while economic growth remains weak and corporate earnings are stagnant, Gundlach said stock investors have entered a “world of uber complacency.” (…)
“The artist Christopher Wool has a word painting, ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good,” Gundlach said in a telephone interview. “The stock markets should be down massively but investors seem to have been hypnotized that nothing can go wrong.”
Gundlach, who oversees more than $100 billion at Los Angeles-based DoubleLine, said the firm went “maximum negative” on Treasuries on July 6 when the yield on the benchmark 10-year Treasury note hit 1.32 percent. (…)
“The yield on the 10-year yield may reverse and go lower again but I am not interested. You don’t make any money. The risk-reward is horrific,” Gundlach said. “There is no upside” in Treasury prices.
Gundlach reiterated that gold and gold miners are the best alternative to Treasuries and predicted gold prices will reach $1,400. U.S. gold on Friday settled up at $1,349 per ounce.
Gundlach lambasted Federal Reserve officials yet again for talking up rate hikes for this year while the latest GDP data showed disappointing economic growth. “The Fed is out to lunch. Does the Fed look at what’s going on in the economy? It is unbelievable,” he said.
Overall, Gundlach said the Bank of Japan’s decision on Friday to stick with its minus 0.1 percent benchmark rate – and refrain from deeper cuts – reflects the limitations of monetary policy. “You can’t save your economy by destroying your financial system,” he said.
AN INTERESTING NEW SENTIMENT INDICATOR
Via Evergreen Gavekal:
Ned Davis Research (NDR) has an intriguing new indicator that tracks the most hyperactive investors known to humanity—those who speculate in leveraged (double and triple) exchange-traded funds (ETFs). As NDR has found, you want to be selling when these folks are buying and vice versa. Right now they are moving into the max bullish zone. Caveat speculator!
THIS IS AMAZING:
The S&P 500 Index has more than tripled since its March 2009 low and yet very few sectors (2!!!) have really outperformed as this Yardeni Research chart illustrates:
Most European Banks Survive Stress Test Most European banks survived their regulators’ stress test, with only a clutch of lenders seen struggling to ride out an economic meltdown.
Struggling Italian lender Banca Monte dei Paschi di Siena SpA was at the bottom of the pack of 51 banks assessed, underscoring investor sentiment that the bank is a worrisome vulnerability in the country’s system and needs to raise substantial funds.
The European Central Bank said the exam used a less severe scenario than the toughest one used in stress tests for U.S. banks in June, in which 31 out of 33 U.S. lenders, including big firms such as Bank of America Corp. andCitigroup Inc., passed. In addition, the European Union tests didn’t include struggling Greek and Portuguese banks this year, which could help account for the relatively rosy results despite Europe’s woes. Such lenders are being privately tested by regulators, and the results won’t be made public.
In addition, the banking authority’s toughest economic scenario didn’t factor in negative interest rates or the effects of a U.K. pullout from the EU. Regulators said the scenarios tested were gloomier than most of the predicted impact from the Brexit vote.
Unlike in previous European stress tests, regulators didn’t include a pass or fail result for each bank related to a specific capital amount. Instead, the EBA has left it up to investors and regulators to interpret the results. (…)
Of the “systemically important” European banks, Italy’s UniCredit fared the worst, with a ratio of 7.1%. U.K. bank Barclays had a capital ratio of 7.3%.
Deutsche Bank had a 7.8% capital level, better than some analysts had expected. Investors had been concerned that the German lender could face an ill-timed capital crunch. The results show that Germany’s largest lender by assets must continue to cut costs and reduce risky assets to boost its buffer against losses. (…)
(…) True, banks’ capital buffers are more ample than they were five years ago. But a panel of respected academics concluded last week that EU banks need €900bn of fresh capital to convince investors they are robust. That dwarfs the €260bn which the EBA says has been pumped in since 2011.
Capital ratios are also about numerators — the quality of loans and other assets — as much as they are about those fattened denominators. As has been well documented, the Italian banking system is awash with non-performing loans — €360bn of them on a gross basis. (…)
But this year’s stress tests, like prior exercises, are still flawed. Carried out over recent months, the tests failed to model for some obvious risks, Brexit and the mounting threat of negative interest rates, among them. Nor is there direct reference to the so-called Basel 4 proposals to further toughen capital demands. They have also excluded markets such as Greece and Portugal where banks are weak.
Worst of all is the atmosphere of obscurity. The structure of the tests is labyrinthine — four different, and sometimes bickering, arms of the EU are involved (the ECB, its SSM bank supervisory arm, the EBA and the European Systemic Risk Board).
In addition, the exercise this time carries no threshold for passing and failing. There will be suspicions that political sensitivities have been pandered to. But it may just as much be a result of chaotic policing: bank capital levels have become increasingly bespoke but stubborn delays among national regulators in requiring banks to publish their own individual numbers means there is no transparency about capital baselines. There is also little clarity about how and when undercapitalised banks will be strong-armed into raising fresh equity.
This probably adds up to yet another failed attempt to restore investor faith in Europe’s troubled banks. Without simpler, clearer rules and tests — and clear consequences for failure — there can be little hope of this changing.