Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: May 2016

NEW$ & VIEW$ (6 MAY 2016): China’s Debt Problem

OF DEMOGRAPHICS AND PRODUCTIVITY

Following up on yesterday’s post dealing with demographics and productivity in which I concluded:

All this to say that we should all modify our mindset away from expectations for a return of rapid growth rates and understand that the economy is set to grow very slowly for many years.

Yesterday, David Rosenberg wrote this following the release of poor U.S. productivity stats:

We have basically a half-point trend in productivity and a half-point trend in the annual growth of the working-age population (…), so if potential supply-side growth is 1%, maybe we should start adjusting our expectations, in Japan-like fashion (okay, maybe more like Europe) to the possibility that 2% GDP growth in today’s sclerotic economy is a virtual boom!

Rosy went on to question why would businesses continue to hire more folks in such an environment and concur with me that we may well be in the early stage of a margin squeeze:

So compensation per hour rose at a 3% annual rate in Q1 while the implicit price deflator slowed to a mere 0.5% annualized pace (look at the pricing pattern over the past four quarters: 2.3%, 1.0%, 0.9%, 0.5%).

That is what is otherwise known as a margin squeeze.

Finally, Rosenberg commented on the negative trade flows to conclude

But net/net, the incoming data flow is not exactly deserving a market multiple two-to-three points above the norm, no matter the level of interest rates.

So, manage your risk accordingly. To help us all, Credit Suisse offers this analysis:

(…) Investor expectations about future revenue growth and profitability both play a key role in driving multiples. Investors obviously prefer high levels of both. But if there’s only one to be had, which combination do investors value more highly? Superior growth and low profitability? Or lower growth and high profitability? Credit Suisse recently analyzed the performance and multiples of companies with market capitalizations of more than $1 billion (excluding financial firms and utilities) between 2004 and 2015, to find out.

Not surprisingly, the bank found that companies with above-median projected growth in revenue and above-median projected profitability traded at an 11.5x EV/EBITDA multiple, compared to just 7.5x for firms with below-median estimates for future revenue growth and profitability. (For reference, the median projected revenue growth was 5.4 percent and the median profitability was 6.5 percent cash flow return on investment.)

But back to the question of revenue growth versus profitability. It turns out that firms with below-median forecasted growth but above-median projected profitability earned higher EV/EBITDA multiples (10.2x) than faster-growing but less profitable companies (8.7x). Furthermore, increases in expected profitability had more of an effect on valuations than did an increase in expected sales. Regardless of whether a company is expected to grow above or below the market median, if it manages to improve profitability above median levels, the effect is dramatic—an additional 2.7 times enterprise value relative to the company’s forward cash flows. That was more than twice the effect that improving revenue growth—an additional 1.2 times EV/EBITDA—awarded to those companies that managed to climb into above-median revenue growth territory. Those that were able to vault over the median in both categories saw multiples rise by 4x EV/EBITDA. In short growth matters more when you combined it with superior return on capital.

Source: Credit Suisse HOLT Corporate Advisory

Source: Credit Suisse HOLT Corporate Advisory

It’s interesting to note that the current preference for profitability over growth is a relatively recent phenomenon. Between 2004 and 2007, companies with above-average revenue growth expectations traded at higher valuations than those with high profit expectations. During the financial crisis, there was no clear pattern to investor preferences, but high-profitability companies began to deliver higher premiums in 2012.

One possible rationale for the shift: Over the past decade, it’s been easier to keep returns on capital up than to produce drastic increases in sales. Fewer than one-third (29 percent) of companies that produced above-average revenue growth between 2004 and 2009 did the same between 2010 and 2015, while nearly two-thirds (64 percent) of companies that were highly profitable in the first five-year period remained so in the second.

Investors, in other words, can be fickle. So how should that affect executive decision-making? For executives making resource allocation decisions, it’s clear that both profitability and growth matter. But understanding exactly what drives investor sentiment about a company is important not only in choosing between competing strategies — those promising faster growth or superior profitability (or, in an ideal world, both) — but also what to buy and how to buy it. Knowing how expectations of future growth and profitability drive valuations can help companies decide on the right price to pay for potential targets as well as secondary decisions, such as whether equity or cash purchases make more sense. In other words, multiples matter for more than just bragging rights.

Keep in mind that companies that have achieved high margins thanks to ample labor availability and low wages will find it tougher from now on. In this slow growth/rising wages environment, good and rising dividends and above average earnings visibility will attract higher valuations.

CHINA’S DEBT PROBLEM

Goldman Sachs sets the stage (via BI):

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The combination of rising indebtedness with slower growth can be lethal.

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Now read this:

Ghost CLSA Sees China Bad-Loan Epidemic With $1 Trillion of Losses

Chinese banks’ bad loans are at least nine times bigger than official numbers indicate, an “epidemic” that points to potential losses of more than $1 trillion, according to an assessment by brokerage CLSA Ltd.

Nonperforming loans stood at 15 percent to 19 percent of outstanding credit last year, Francis Cheung, the firm’s head of China and Hong Kong strategy, said in Hong Kong on Friday. That compares with the official 1.67 percent.

Potential losses could range from 6.9 trillion yuan ($1.1 trillion) to 9.1 trillion yuan, according to a report by the brokerage. The estimates are based on public data on listed companies’ debt-servicing abilities and make assumptions about potential recovery rates for bad loans.

Cheung’s assessment adds to warnings from hedge-fund manager Kyle Bass, Autonomous Research analyst Charlene Chu and the International Monetary Fund on Chi na’s likely levels of troubled credit. The IMF said last month that the nation may have $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of gross domestic product.(…)

Byron Wien: What Investors Need to Know About China

(…) I have just returned from a trip to Singapore, Hong Kong, Beijing, Shanghai and Tokyo, meeting with sovereign wealth funds, other clients, policy officials and business people. While everyone is aware of the slowdown in China, very few expect a hard landing caused by a real estate bubble, a banking collapse related to non-performing loans or other factors. (…)

Because the banking system is integrated into the People’s Bank of China, the assumption is that there won’t be a banking meltdown, but that may not be right. (…)

Banks also need to become more profit-oriented. One of the reasons there are so many non-performing loans on their books is that the managers know that big or small, they can’t fail: the government will bail them out. (…)

The key government objective is to maintain stability, not profitability. and the Chinese seem to accept that. One official told me that Xi is highly focused on the need to retain the approval of the people. Civil unrest is to be avoided at almost any cost. (…)

(Hint to access the Barron’s article: copy/paste the headline in your browser and click on it. Google will then display related links. Click on the link to Barron’s. It generally works fine.)

OIL
Americas, Asia do what OPEC wouldn’t: cut oil production Wildfires in Canada. Instability in Venezuela. Stalling U.S. frackers. Drops in oil output are happening so fast that it looks as if the Americas alone could resolve global oversupply.

(…) Output from the Americas dropped over 1.5 million bpd last quarter, while producers in Asia and Australia cut some 250,000 bpd, eating away large chunks of the world’s oversupply, government, industry and consultancy data shows. (…)

A raging wildfire in Fort McMurray, at the heart of Canada’s oil sands region, has forced more than 690,000 bpd out of production, according to Reuters estimates, with more disruptions possible. (…)

U.S. output, down by 410,000 bpd this year and 800,000 bpd since mid-2015, is expected to slide another 800,000 bpd in the next five months, according to the Energy Information Administration.

Latin America’s crude oil production, suffering from under-investment, fell 4.6 percent in the first quarter to 9.13 million bpd, a loss of 441,000 bpd from the same period a year ago, according to data from individual countries and OPEC.

The largest decline was in Venezuela, which lost 188,000 bpd in the first quarter as President Nicolas Maduro’s government wrestles a deep economic crisis.

Production is also on the wane across Asia Pacific.

China, the region’s biggest producer and consumer of oil, is expected to see a 6 percent drop in crude output in 2016 due to ageing fields and poor economics, Standard Chartered bank said. (…)

CEBM says China’s domestic oil output declined 4% YoY in March and 2% in Q1’16.

EARNINGS WATCH

The Q1’16 earnings season is almost over with essentially traditional retailers remaining to report over the next 2 weeks. RBC says that their earnings are projected to decline -1.5%. Early reporters have beaten by 2.3%, half the pace of other S&P 500 companies.

  • 431 companies (87.9% of the S&P 500’s market cap) have reported. Earnings are beating by 4.5% while revenues have missed by -0.4%.
  • Expectations are for a decline in revenue, earnings, and EPS of -1.9%, -7.0%, and -4.8%.
  • EPS is on pace for -4.3%, assuming the current beat rate for the remainder of the season. This would be +0.8% excluding Energy.
US stock funds suffer $11bn of outflows Redemptions since the beginning of the year top $60bn

chart: US stock funds hit by $11.2bn of withdrawals(…) Portfolios invested in US equities recorded $11.2bn of outflows in the week to May 4, accelerating redemptions from the asset class since January to more than $60bn, according to Lipper. (…)

Investors also continued to pull money out of equity funds for Japan, the UK and Europe, according to the latest weekly EPFR data.

European stock funds extended the longest streak of redemptions in nearly six years, with investors withdrawing $4bn from German equity funds since February.

UK stock funds suffered the biggest weekly redemption since mid-December. Japan extended its current outflow streak to six straight weeks, the longest since the third quarter of 2014. (…)

US investors have turned to money market funds — often seen as a proxy for cash — adding $6.5bn in the past week. Funds invested in US Treasuries recorded $44m in new investments. (…)

Trump raises prospect of replacing Yellen Likely GOP nominee says he could change ‘very capable’ Fed chair

NEW$ & VIEW$ (5 MAY 2016): Of Demographics and Productivity

Freight Rail Traffic Plunges: Haunting Pictures of Transportation Recession

Total US rail traffic in April plunged 11.8% from a year ago, the Association of American Railroads reported today. Carloads of bulk commodities such as coal, oil, grains, and chemicals plummeted 16.1% to 944,339 units. (…)

Only five of the 20 commodity categories saw gains. Of the decliners, coal was the biggest. But petroleum products also plunged 25%, and grain mill products dropped 7%. Even without coal, carloads were down 3% year-over-year.

But it’s not just coal. In April, loads of containers and trailers fell 7.5% year-over-year to 1,028,460 intermodal units. They transport goods for retailers and wholesalers. They haul parts, components, and assemblies for manufacturers. They haul imported goods from ports and borders to different destinations across the country, and they haul goods to be exported to the ports and borders. They’re a measure of the real economy.

For the first 17 weeks of the year, total rail freight fell 7.8% from the same period a year ago, with carload traffic down 14.3% and intermodal down 0.8%. (…)

It didn’t get any better at the end of April: for the week ending April 30, carloads plunged 14.1% and intermodal traffic dropped 8.6% from the same week a year ago. (…)

Insurers Seek Rate Hikes to Cover Obamacare Costs Insurers have begun to propose big premium increases for coverage next year under the 2010 health law, as some struggle to make money in a market where their costs have soared.

(…) Still, the analysts said, a number of insurers are likely to seek significant hikes as they aim to cover costs that have continued to outstrip their estimates—in some cases coming after earlier premium increases.

The increases, along with the continued lagging results for insurers, are a sign that the exchange business hasn’t stabilized for insurers in the first few years of the health law’s full implementation, prompting health plans to continue to push for more changes to the law. (…)

In Oregon and Virginia, the first two states to make insurers’ premium proposals for 2017 public, several big insurers are showing how those projections bear out.

Providence Health Plan, currently the largest insurer for people buying coverage through the Oregon health exchange, is seeking an average increase of 29.6%.

In Virginia, where premium increases had been relatively modest to date, Anthem Inc. is asking for an average increase of 15.8%. (…)

Increases can be blunted for many lower-income consumers by federal subsidies that flow directly to the insurer, offsetting the consumer’s premium bill. (…)

U.S. Trade Deficit Narrows as Exports & Imports Both Fall

The U.S. foreign trade deficit decreased to $40.4 billion in March from $47.0 billion in February, marginally revised from $47.1 billion. Exports of goods & services fell 0.9% (-5.4% y/y) as imports dropped 3.6% (-9.1% y/y).

The trade deficit in goods was $58.5 billion in March, following February’s $64.5 billion. Goods exports decreased 1.6% (-8.1% y/y). Four of the five major categories fell, with nonauto consumer goods exports down 9.3% (-4.1% y/y). Autos & parts were down 5.6% (-3.3% y/y), foods, feeds & beverages 3.7% (-15.0% y/y) and industrial materials & supplies 2.5% (-15.7% y/y). Capital goods exports rose 2.4% (-3.7% y/y) and “other” goods were up 15.0% (8.4% y/y).

Imports of goods were also down in March, by 4.3% (-11.2% y/y). Every major end-use category declined, with non-auto consumer goods down 9.9% (-13.8% y/y), food, feed & beverages down 5.9% (3.7% y/y) and capital goods down 3.2% (-9.1% y/y). Imports of industrial materials & supplies were off 2.9% in March (-22.8% y/y) and autos & parts 2.6% (-3.3% y/y). “Other” goods imports did increase, by 16.4% in the month (13.8% y/y).

The dollar value of energy-related imports rose in March by 11.2% (-38.1% y/y) after a sizable decrease in February. Quantity, measured in thousands of barrels, increased 9.4% (+4.9% y/y). The dollar value of crude petroleum imports rebounded 13.7%% (-36.2% y/y) as the per barrel cost of crude edged up to $27.68 (-40.4% y/y).

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Pointing up New U.S. Rules Make Foreign Goods Better Deal for E-Shoppers A change in trade rules is making it cheaper and easier for American consumers to buy overseas goods online, heartening merchants abroad but threatening stiffer competition for U.S. retailers.

A change in trade rules is making it cheaper and easier for American consumers to buy overseas goods online, heartening merchants abroad but threatening stiffer competition for U.S. retailers.

Since about a month ago, the government has allowed Americans to import up to $800 at a time of most foreign goods without having to pay import duties or tax. That’s quadruple the previous exemption of $200. (…)

Until the new rules took effect March 10, duties averaged 33% on the top 50 products brought into the U.S. when purchases exceeded $200, according to United Parcel ServiceInc. On a $201 purchase of costume jewelry, U.S. customs would collect a duty of 110%, more than doubling the price.

Now, those duties are zero, providing the price totals less than $800. (…)

By 2020, however, about 943 million people world-wide are expected to buy online from abroad, spending an estimated $994 billion—nearly quadruple the sum 309 million such people spent in 2013, according to a study by Accenture and AliResearch, an arm of e-commerce company Alibaba. Already, 5 4% of U.S. online shoppers have made a purchase overseas, according to a survey by comScore and UPS, as consumers increasingly shop on their phones and look for unique products. (…)

SOMETHING HAS TO GIVE

Friday’s employment number could change things but as of this morning US and global growth look tepid and slowing.

This is from ISI’s Ed Hyman yesterday. He was dismayed by their important airlines and trucking surveys which have been falling abruptly in recent weeks. Also, the ADP report for April made him revise his April employment forecast to 175k from 200k. Later in the day, Markit’s Composite PMI was suggesting 160k jobs in April.

Corporate executives must be busy trying to maintain profits this year given the very weak revenue growth rates:

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Subpar business sales have already triggered a pullback by planned capital spending. A more reserved approach to business outlays on staff may be forthcoming. (Moody’s)

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Three weeks ago, NBF Economics and Strategy warned:

While hiring has yet to respond to slower economic growth and lower labour productivity, corporate profits already have. Profits are falling at the fastest pace in years and it’s a matter of time before corporations adjust headcount accordingly. As today’s Hot Charts show, human resources departments tend to react to corporate profits with a one to two quarter lag, which suggests a soft Q2 for employment creation.

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Maybe, we are there now.

The ROW is not in better shape as the JP Morgan Global Manufacturing survey revealed yesterday:

The growth rate of the global manufacturing sector ground to a near-standstill at the start of the second quarter. At 50.1 in April, the J.P.Morgan Global Manufacturing PMI™ posted a reading barely above its no-change level of 50.0 and the second weakest during the past forty months.

Rates of expansion in output and new orders also decelerated back towards the broadly stagnant outcomes registered in February. Conditions remained muted in
many domestic markets, while international trade flows continued to deteriorate. The level of new export business fell for the third straight month and to the greatest extent since September of last year.

The performances of the main industry groups covered by the survey all remained lacklustre during April. Output growth slowed to marginal rates at both consumer and intermediate goods producers, while the investment goods sector stagnated.

Developed and emerging markets both exhibited a degree of weakness during the latest survey month. Developed nations (on average) saw their combined pace of output expansion slow to a three-year low. Production growth slipped to a 16-month low in the European Union, to a (Markit) survey low in the US and declined at the fastest pace in two years in Japan.

April saw output fall back into contraction territory in the emerging markets, the tenth time in the past 12 months that a decrease has been registered. China stagnated, growth slowed in India and Indonesia, while Brazil, Russia and Malaysia recorded substantial downturns in production.

In effect, we are in a synchronized lull in manufacturing:

In spite of all the QEs and other currency manipulations, world exports (i.e. demand) have stalled as this Gavekal slide illustrates.

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(…) More than a dozen factory executives interviewed at the twice-yearly Canton Fair in Guangzhou all warned of difficult trading conditions, particularly in Europe. A few said they had seen a modest improvement in US demand this year but not enough to offset the weakness elsewhere.

With buyers coming from all over the world and thousands of manufacturers offering everything from buttons and zips to food products and electronics, the Canton Fair is a barometer of the state of global demand and of China’s important manufacturing industry. (…)

Exporters say they remain under pressure to cut prices and minimum order sizes to secure contracts. (…)

  • SLOW AND SLOWER

The top chart is USA, the lower chart is G7 ex-USA (RBC):

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John Mauldin reminds us that ΔGDP = ΔWorking Age Population + ΔProductivity and that the trends are not our friends:

Of course, nowadays the working age does not stop at 65, but the trends are generally not much different, especially since older workers tend to work in services where pay and productivity is lower. In any event, when the labor force is not growing, it must become more productive to provide economic growth, which is no longer happening as RBC illustrates:

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In all, the basic economic fundamentals are a strong and stronger headwind for global economies, explaining why central banks seem to be pushing on strings with all their QEs and negative rates experiments while fiscal policies remain neutral at best. Mix politics and social tensions with this and no wonder there is no traction anywhere.

(…) Since the economic recovery began in mid-2009, output per hour worked has expanded at an average annual rate of 1.3%. That was the worst performance over a seven-year stretch since the late-1970s to mid-1980s, which were marked by back-to-back recessions.

In the first quarter, the picture worsened: Productivity in the nonfarm business sector declined at a 1% seasonally adjusted annual rate, the Labor Department said Wednesday. From a year earlier, productivity was up just 0.6%. The quarterly drop marked the fourth decline in the past six quarters. (…)

firms struggling to produce goods and services efficiently are boosting headcount to compensate, though the added workers are having a limited impact on output. In the first three months of this year, workers toiled for longer hours—and for higher wages—but their output barely nudged up.

Unit labor costs, a key gauge of compensation costs, increased at a 4.1% annual rate in the first three months of the year from the prior quarter. That was the sharpest jump in more than a year. Labor costs climbed 2.3% from a year earlier, well above recent inflation reading.

Indeed, wage growth showed some progress. Hourly compensation increased at a 3.0% annual rate compared with the prior quarter. That comes after hourly compensation grew at a 0.9% annual rate in the fourth quarter, and could be a signal that a tightening job market may be putting pressure on employers to better pay packages. (…)

Nerd smile All this to say that we should all modify our mindset away from expectations for a return of rapid growth rates and understand that the economy is set to grow very slowly for many years. Investors will be walking on a tight rope, always worried to tilt towards recession and deflation. We should abandon the hope that our central bankers will bail us out, rather hoping that they will merely keep us straight. More than ever, investing will need to focus on risk management as the downfall would be much more painful than the upside reward.

Oil Rallies as Investors Shrug Off Rise in U.S. Stockpiles Crude and WTI prices bounced back, with investors focusing on tightening supply in Canada and Libya.

(…) Analysts at JBC Energy estimate that some 500,000 barrels a day of capacity is currently offline due to the wildfires. (…)

The authorities that control the eastern half of Libya moved this week to block oil exports, including from the Marsa El-Hariga terminal, which represents the bulk of Libya’s exports—more than 150,000 barrels a day. (…)

A U.S. government report on Wednesday showed another hefty increase in domestic crude-oil inventories. Last week, U.S. oil stockpiles rose by 2.8 million barrels, more than double the rise forecast by analysts in a survey by The Wall Street Journal. Gasoline stockpiles also rose unexpectedly, sending combined oil and fuel stockpiles to a record high of 1.37 billion barrels, according to the U.S. Energy Information Administration. (…)

Stanley Druckenmiller Cites Similarities to 2008 Crisis

(…) The Federal Reserve, he said, is to blame. By keeping interest rates so low, the Fed is “raising the odds of the economic tail risk they are trying to avoid.” It is an “ephemeral sugar high.”

Is The Emerging Markets Rally Built on Flimsy Foundations?

(…) From its January low, MSCI’s Emerging Markets stock index has risen 18.2%. So far this year, the Brazilian real is up 11.6%, the Russian ruble 10.7% and the South African rand 4.2% against the dollar. Local-currency bond returns have been turbocharged by those moves. (…)

Investors put around $63 billion to work in emerging markets in March and April, the Institute of International Finance estimates.

There are three big factors behind this shift. The first is the apparent stabilization of China, an outsize contributor to emerging-market growth and a clear influence on commodities prices that matter for many countries. The second is looser financial conditions sparked by the gradual approach by the U.S. Federal Reserve to raising rates and the resulting softer dollar.

And the third is that emerging-market pessimism had become so widespread that it only took a small turn in sentiment to push prices sharply higher. (…)

There is even hope that emerging-market growth may be turning up. Citigroup’s economic surprise index has moved into positive territory, although the bank’s economists note China has had a big influence on this swing. After five years of a narrowing gap between emerging-market and advanced-economy growth, the International Monetary Fund forecasts that growth in emerging nations will accelerate again in the coming years.

But it is too early to be really confident that the turn is sustainable: May’s market wobbles, which have dented returns, are testament to that. (…)

(…) Demographic analysis by Standard & Poor’s has found that ageing populations across emerging markets are forcing governments to increase access to healthcare while relying on a shrinking workforce to pay for social programmes, leading to a deterioration in public finances and a rise in government borrowing.

By 2050, S&P expects average debt in emerging markets to rise from 42 per cent of GDP to 136 per cent, compared with 134 per cent in advanced economies, unless policy changes are made.

The shift would result in a drop in the number of countries with “investment-grade” sovereign ratings, according to S&P, putting pressure on investors searching for the highest quality assets.

(…) emerging markets such as Brazil, India and Turkey are expected to sharply increase spending on healthcare in the next few years.

Increases in the ratio of old individuals to young workers are predicted to be felt more keenly in emerging markets than developed economies in the next few decades, with Brazil’s old-age dependency ratio forecast to triple by 2050, while those in the US and UK grow at a steadier pace.

In March, the International Monetary Fund announced that the consequences of shrinking and ageing populations would be large and growing fiscal burdens with age-related spending as a percentage of GDP would reach unmanageable levels unless steps were taken to deal with the issue. (…)

Chart: Old-age dependency

China fertiliser maker defaults on bond Cash-strapped local governments lose appetite for bailouts