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: August 2016

NEW$ & VIEW$ (29 August 2016): Yellen’s Stronger Case? Look Again.

Note to readers: First, thank you for all the nice comments on HARD HAT ZONE and THE RULE OF 20: THE HISTORICAL RECORD. Second, sorry if I have been late in reading them and, for new commenters, “approving” them for publication on the post. There is a bug somewhere and I cannot find it. I often see comments only when going into the blog’s dashboard which I tend to do infrequently due to time constraints. And even then, I do not always succeed in letting them reach the blog. Sorry about that. But I do appreciate the feedback.

Yellen Sees Stronger Case for Rate Increase

(…) “In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months,” Ms. Yellen said in remarks delivered here Friday. (…)

“Our decisions always depend on the degree to which incoming data continues to confirm the [Fed’s] outlook,” she said. (…)

Officials began the year expecting to raise rates four times in quarter-point increments but have delayed moving them because economic growth disappointed in the first half of the year and because they were uncertain about developments overseas and about the strength of the U.S. job market after some soft reports.

Ms. Yellen said her worries had dissipated, thanks in part to “solid” consumer spending and a job market rebound after a spring slump in hiring.

“While economic growth has not been rapid, it has been sufficient to generate further improvement in the labor market,” Ms. Yellen said. Broad measures of labor-market slack are improving, even though the unemployment rate has been steady most of the year near 5%, she added.

(…) Ms. Yellen highlighted the range of possibilities for rates in the years ahead, noting there is a 70% probability rates could be anywhere between zero and 3.25% at the end of 2017 and between zero and 4.25% at the end of 2018.

“The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted,” she said. (…)

There you go! 70% on 0.0%-3.25%. That’s an almost certain uncertainty.

  • Federal Officials Say No Thanks to Negative Rates Fed officials don’t think negative rates are needed in the U.S. because the economy and job market are improving and they are hoping they will never have to use them in the future given their uncertainty about whether the policy works.

But Ms. Yellen and other FOMC members and staff are looking in the rear-view mirror. Here’s up-to-date data to make you much less certain about the “continued solid performance of the labor market” and the overall economy:

  • Markit’s flash U.S. Services PMI declined from 51.4 to 50.9 in August, its lowest level since February.

imageSofter business activity growth was mainly linked to muted new business gains in August. Reflecting this, latest data signalled that new work expanded at the slowest pace since May and remained much weaker than its post-crisis trend. This contributed to a renewed slowdown in job creation during August, with payroll numbers rising at the least marked rate since December 2014. Some firms reported that subdued demand conditions and the need to cut costs had led to more cautious staff hiring plans and the non-replacement of leavers.

“Subdued demand and the need to cut costs”: as much as I can remember, this is the first time corporate America mentions the need to cut costs in such surveys. Why the need? Because margins are getting squeezed and 2017 budgets call for cost cutting (see HARD HAT ZONE). How to cut costs? Mainly staff.

The seasonally adjusted Markit Flash U.S. Composite PMI Output Index posted 51.5 in August, down slightly from 51.8 in July. As a result, this signalled only a modest expansion of private sector output, with the latest reading in line with the average recorded in 2016 so far.

Commenting on the flash PMI data, Chris Williamson, Chief Business Economist at Markit said:

The ongoing lacklustre economic growth signalled by the flash PMI suggests GDP growth is failing to accelerate in the third quarter from the weak 1.2% pace seen in the second quarter. Historical comparisons indicate that the PMI is signalling an annualised GDP growth rate of just under 1% in the third quarter, based on the data for July and August.

This is the first data set for Q3 with two months in. Markit’s PMI has been a pretty good forecaster on GDP and has rarely been too low.

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This just when about everybody else is boosting his/her Q3 growth estimate as The Daily Shot shows:

While not as dire as the recent analysis by Deutsche Bank which calculated that a recession over the next 12 months is more than likely, with odds rising to 60%, overnight JPM released its latest recession probability analysis, and – somewhat unexpectedly following the last two stellar job reports and a full court political press that the recovery has rarely been stronger going into the election – now sees a 37% chance of a recession in the next 12 months. This is the highest recession probability calculated by Jamie Dimon’s bank during the current economic cycle, and matches the odds first laid out in early July. (…)

But don’t worry, the Fed is prepared:

Yellen Says Fed Could Expand Its Use of Bond Purchases The central bank’s main tool for fighting the next recession could be bond-purchase programs, Federal Reserve Chairwoman Janet Yellen said.

She cautioned however that “with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.”

(…) there was no mention in her comments of negative interest rates, an approach tried by the Bank of Japan, European Central Bank and other central banks in Europe. (…)

Ms. Yellen said the Fed isn’t considering changing its 2% inflation objective. Nor is the Fed considering an economic growth target to set monetary policy (…)

Instead she argued that the main tools in the Fed’s box—bond-buying and statements about the likely path of rates, known as forward guidance—remain adequate. (…)

Ms. Yellen leaned on a recent research paper by Fed senior economist David Reifschneider, which argues that bond purchases and low-rate promises ought to be enough for the Fed to manage even a fairly severe recession. (…)

Hmmm…here’s what ZIRP and $4.3 trillion in bond purchases have done since 2010: +2.1% since the end of the last recession in 2009, down from +2.8% and +3.6% during the previous two recessions respectively. Growth has averaged +1.7% during the last 7 quarters.

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U.S. Corporate Profits Climb as GDP Ticks Down A key measure of corporate profits rose this spring for a second straight quarter alongside modest growth in the overall economy, though U.S. businesses remain under pressure from global weakness and other forces.

Household outlays surged this spring at their strongest pace in a year and a half, but business investment declined for the third straight quarter. The result was a modest 1.1% annualized economic growth rate in the second quarter, according to revised Commerce Department data released Friday.

Company earnings also remain under pressure, potentially restraining investment in the coming months. A key measure of corporate profits rose 4.9% in the second quarter, but gains this year haven’t been enough to offset a drop last year. Second-quarter profits were down 2.2% compared with a year earlier. (…)

Overall economic growth has been tepid since late last year, with GDP advancing at a modest pace of 0.9% in the fourth quarter of 2015 and 0.8% in the first quarter of 2016. But U.S. growth has been poised to accelerate over the summer; forecasting firm Macroeconomic Advisers on Friday predicted GDP would expand at a 3.2% rate in the third quarter, the best performance in two years. (…)

Friday’s report showed slightly weaker second-quarter GDP growth compared with the government’s initial estimate last month of 1.2%. Growth in consumer spending this spring was revised up, offset by larger declines than had been previously estimated for residential construction and government expenditures.

Consumer spending jumped at a 4.4% annual rate in the April-to-June period, the strongest gain since the fourth quarter of 2014. But fixed nonresidential investment, a measure of business spending on equipment and other items, declined at a 0.9% pace following larger drops in the prior two quarters. The slump partly reflects weakness in the domestic energy industry because of low prices for oil and other commodities. (…)

U.S. Durable-Goods Orders Rebounded in July, Jumping 4.4% Demand for long-lasting factory goods rebounded in July—with durable-goods orders leaping 4.4%—in a sign the manufacturing sector could continue to stabilize in the second half of the year.

(…) Much of the uptick was due to civilian aircraft orders, but orders for core capital goods—the kind of business investment that has been conspicuously absent for the past few years——posted their largest gain since January, suggesting firms may finally feel comfortable making the large-scale investments that signal confidence in future demand.

A closely watched proxy for business investment, new orders for nondefense capital goods excluding aircraft, rose for the second-straight month, up 1.6% from June. (…)

The data suggest the manufacturing sector is firming in the second half of the year, coming on the heels of other recent reports suggesting the U.S. manufacturing sector stabilized in July. A Federal Reserve report showed manufacturing output posted its largest monthly advance in a year in July. And the Institute for Supply Management’s gauge showed manufacturing activity expanding in July for the fifth-straight month. (…)

High five Sorry, but the data makes no such suggestion other than to show that June and July were up after the collapse between November 2015 and May 2016.

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YoY, U.S. manufacturing has been in recession for almost 2 years.

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Markit’s flash U.S. manufacturing index declined from 52.9 in July to 52.1 in August:

Although solid growth of output was sustained, total new orders expanded at a slower rate in August. Data indicated that relatively subdued domestic demand was a reason behind softer growth in overall new work, as export sales increased at the fastest pace in 23 months.(…) Manufacturing employment increased only slightly
during August. Furthermore, it was the weakest rate of payroll growth seen for four months. (…) Meanwhile, stocks of finished goods and purchased items both fell as companies generally adopted cautious inventory policies.

This upbeat view was included in the WSJ account of the Q2 GDP report:

“Inventories were a major drag on growth in the second quarter, but now that businesses have better aligned inventories with demand, that should lift and inventories will add to growth in the near term,” PNC Financial Services Group chief economist Stuart Hoffmansaid in a note to clients.

But here are the facts. The first chart is for all businesses. The following 2 charts are for total manufacturing (left) and durable goods manufacturing. Inventories are not even close to be “better aligned with demand”:

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And from the carriers’ mouth:

tonnagejuly16The amount of freight carried in July by the for-hire trucking industry, as measured by ATA’s monthly For-Hire Truck Tonnage Index, dipped 2.1 percent in July from June, ATA reported Aug. 23.

July’s dip follows a 1.6 percent dip in June. Compared to the same month last year, tonnage was up 0.3 percent. Year to date, tonnage is up 3.2 percent, ATA notes.

“On a monthly basis, tonnage has decreased in four of the last five months and stood at the lowest level since October during July,” said ATA Chief Economist Bob Costello. “This prolonged softness is consistent with a supply chain that is clearing out elevated inventories. Looking ahead, expect a softer and uneven truck freight environment until the inventory correction is complete. With moderate economic growth expected, truck freight will improve the further along the inventory cycle we progress.” (…)

So, let’s not bet too heavily that “inventories will add to growth in the near term.” Same is happening in Emerging Markets BTW:

The world economy remains in a funk. Global trade volumes contracted for the second consecutive quarter in Q2, highlighting weak overall demand. Industrial production grew last quarter as higher output in emerging markets more than offset declines in advanced economies. But because sales remained soft, much of that extra output went into inventories. As today’s Hot Charts show, the ratio of industrial production to exports in emerging economies surged to its highest level since the 2009 global recession. That does not bode well for production and hence economic growth in emerging markets in the second half of the year, particularly if exports remain weak. (NBF)

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U.S. Existing Home Sales and Prices Weaken Unexpectedly

Sales of existing homes declined 3.2% (-1.6% y/y) during July to 5.390 million units (AR) after an unrevised June rise to 5.570 million. The decline erased the increases during the prior three months.

Sales of existing single-family homes fell 2.0% last month (-0.8% y/y) to 4.820 million. Sales of condos & co-ops dropped 12.3% (-8.1% y/y) to 570,000, the lowest level since February.

Weakness in sales occurred in most regions of the country.

The number of existing homes on the market declined 5.8% y/y to 2.130 million.

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Millenials not looking to work are obviously not thinking of buying a house just yet (chart via The Daily Shot):

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EARNINGS WATCH

Factset’s weekly summary:

  • Earnings Growth: For Q2 2016, the blended earnings decline for the S&P 500 is -3.2%. The second quarter marks the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.
  • Earnings Revisions: On June 30, the estimated earnings decline for Q2 2016 was -5.5%. Seven sectors have higher growth rates today (compared to June 30) due to upside earnings surprises, led by the Information Technology and Consumer Discretionary sectors.
  • Earnings Guidance: For Q3 2016, 77 (72 last week) S&P 500 companies have issued negative EPS guidance and 33 (30) S&P 500 companies have issued positive EPS guidance.

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For Q3, Factset sees EPS down 2.1% from +0.4% last June 30th. Thomson Reuters is at –0.5% from +2.0%. Revisions are similar from a different base. For 2016 as a whole, Factset sees $118.50 and TR $117.97.

But trailing EPS are now $115.20 and the rule of 20 P/E is 21.1. Did you miss THE RULE OF 20: THE HISTORICAL RECORD last week?

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Digging Into China’s Growing Mountain of Debt

(…) Bloomberg Intelligence breaks China’s total debt into four components: bank, corporate, government, and household. Bank debt has decreased slightly in relation to the size of the country’s economy over the past 10 years, to 19 percent of GDP in 2015. Corporate debt, meanwhile, jumped to 165 percent of GDP from 105 percent. Government debt rose to 22 percent of GDP. Household debt has increased to more than 40 percent of GDP, a rise of 23 percentage points.

Despite that rapid growth, household debt in China is far below levels in the U.S. before the subprime crisis. At its 2007 peak in the U.S., household debt reached almost 100 percent of GDP. What’s more, in China household savings are twice as large as debt. (…)

Another big difference between China today and the U.S. during the subprime bubble is that Chinese residential properties are typically purchased with significant down payments. According to the China Household Finance Survey, the average household debt in urban areas amounted to only 11 percent of home value in 2012. Mortgage debt remains comparatively rare. That showed up in the survey data: The median household debt was zero percent. The same survey also found that if housing prices were to decline 50 percent, less than 14 percent of mortgages would exceed the value of the properties. Given China’s high savings rate and low leverage, it seems unlikely that households would cause a financial crisis. (…)

While certain industries and enterprises have a lot of debt, Chinese companies’ average leverage isn’t high, according to a recent International Monetary Fund working paper. Since 2006, listed companies that aren’t state-owned have reduced median liabilities to 55 percent of common equity. At state-owned enterprises, however, median leverage has been unchanged at about 110 percent. Leverage has increased at the tail end of the distribution, driven by rising debt at companies in construction, mining, real estate, and utilities. An increasing share of debt is attributed to a few companies with high leverage ratios.

China is different from other markets in an important way. Many large corporations and nearly all the major banks are state-owned. In other words, the debtors and creditors are ultimately owned by the same entity. (…)

Fortunately for the rest of the world, China has a high savings rate. Capital controls aren’t fully lifted, making capital flight difficult. The government has almost complete control of the banking industry. In addition, China’s listed banks get about 70 percent of their funds from deposits. In comparison, U.S. investment banks in 2008 relied heavily on short-term money-market funding.

Such circumstances make it unlikely that China’s debt will spark a global crisis in the near future.

SENTIMENT WATCH

(…) Overall, assets in mutual funds and exchange-traded funds focused on dividend-paying shares have swelled to $672.6 billion, nearly double the $367.3 billion in assets those funds held at the end of 2011, according to Morningstar. (…)

(…) Government bonds, dividend-paying stocks and emerging-market securities have been bid up in the global search for yield. In an unusually quiet market, any shift in sentiment could send investors who have piled into similar positions all heading to the exits at the same time. (…)

Ghost BTW:

September is typically the weakest month of the year; since 1928, the S&P 500 has dropped in September 56% of the time.

Will Canadian banks’ blowout profits silence skeptics?

(…) In the first week of the fiscal third-quarter reporting season, Bank of Montreal, Royal Bank of Canada, Canadian Imperial Bank of Commerce and Toronto-Dominion Bank all surpassed expectations with their quarterly profits. (Bank of Nova Scotia and National Bank of Canada conclude the reporting season for the big banks next week.)

Combined, they reported profits totalling more than $7.9-billion, or $7.4-billion after adjusting for one-time gains such as asset sales. This adjusted figure, which illustrates the banks’ underlying operating performance, was up 6.6 per cent from last year – a strong showing at the best of times, but remarkably strong given the low expectations.

In the case of CIBC, a standout, profit rose more than 8 per cent from last year after subtracting a gain from the sale of its stake in American Century Investments. Its profit on a per-share basis was nearly 14 per cent above the consensus estimate from analysts.

“It’s nice when everything comes together,” said Kevin Glass, CIBC’s chief financial officer. “All businesses performed well.”

To be sure, some of the profit drivers this quarter might not repeat next quarter. For example, the capital markets divisions of all four banks that reported results this week produced double-digit growth due to a pickup in corporate financing activity. Profits from this area, though, are notoriously lumpy.

The banks also benefited from ongoing efforts to cut costs, which are making them more efficient. BMO, which kicked off the reporting season on Tuesday, said its expenses during the quarter had risen just 2 per cent from last year, excluding the impact of the U.S. dollar. (…)

The two-year slump in crude oil prices is affecting the ability of energy companies to repay their loans. Earlier this year, many observers were concerned that the banks could be on the hook for huge loan losses. These concerns are now subsiding. BMO, RBC, CIBC and TD set aside a total of $1.3-billion to cover bad loans in the third quarter. While these provisions for credit losses are up substantially from last year, and the banks are reluctant to declare that the worst is over, things are moving in the right direction.

Provisions declined by nearly 10 per cent from the previous quarter, partly because of stabilizing oil prices. As well, bad loans represent, on average, less than 0.3 per cent of the banks’ total loans, which is at the low end of the historical average. (…)

Meanwhile, the banks remain confident that their exposure to Canada’s housing market is on solid ground.

“We continue to feel good about the quality of our portfolio, about our standards, about the quality of our [loan] originations,” Teri Currie, group head of TD’s Canadian personal banking, said during a conference call.

Laura Dottori-Attanasio, CIBC’s chief risk officer, put the downside risk into perspective. She said that under a particularly bleak scenario where house prices tumbled 30 per cent and the Canadian unemployment rate soared to 11 per cent, the bank would face less than $100-million in additional losses on a residential mortgage portfolio of $172-billion. Within that portfolio, 57 per cent of mortgages are insured, down from 65 per cent last year. The uninsured portion of the mortgage book would be largely unaffected. (…)

But the outlook remains skeptical among many others. Short sellers haven’t eased up on their bearish bets, given that the level of short interest on bank stocks remains high. And while analysts have been raising their target prices on bank stocks in response to the upbeat quarterly results – they’ve boosted their targets by an average of more than 3 per cent – most haven’t altered their tone.

Of course, the skeptics on Canadian banks have a point: The economy is struggling, tapped-out consumers don’t have a lot of room to expand credit card debt and regulators are determined to cool an overheating housing market that has served the banks well in recent years.

But as this week’s results demonstrate, the banks are very good at navigating these obstacles. The burden of proof, it seems, has shifted to the skeptics. (…)

HARD HAT ZONE

In December 2015, I downgraded equities to 2 stars at 2085 on the S&P 500 Index, arguing in YIELDING TO HIGH YIELD that equity markets needed to adjust valuations to take into account the higher risk environment that was then explicit in the high yield market and that

downside to the 17.5 range on the Rule of 20 is quite possible as a result. At current earnings and inflation levels, this would take the S&P 500 Index down to 1825, 9% below current levels.

Two months later, after the Index troughed at 1811, I went back to 3 stars (at 1866), arguing that:

  • Equities were undervalued and a change in investor psychology could result in a good rally given that the S&P 500 Index was then nearly 10% below its 200-day moving average of 2035.
  • Investors could again be reassured in the following weeks/months if:
    • U.S. recession fears abate;
    • oil prices strengthen;
    • China does not implode and stabilizes growth.
  • Such events would likely more than offset the weak earnings trends in the first half of the year, building expectations for a better second half.

On March 28, I uncharacteristically reverted back to 2 stars at 2050 as valuations had again reached elevated levels without any apparent renewed support from earnings nor  the economy. Equities went sideways for 3 months, only to jump 10% after Brexit. Why?

Everything seems to have changed on June 24. While equity markets initially got scared, fixed income markets jumped as yields collapsed across the world.

Then we started to hear the talking heads explain how equities were cheap compared with everything else boasting a yield across the world. And, by the way, the economy has begun to surprise positively which is why oil was back to $50 and copper was recovering, yaddi yaddi yadda…

No doubt central bankers would become even more benevolent post Brexit, keeping money cheaper than ever and buying bonds almost indiscriminately.

Since the Brexit vote, 9 central banks have cut rates globally, culminating in the BoE’s dramatic move on August 4. So encouraged, investors have accepted the new buzzwords “lower for longer” and even “longer forever”. And so equities yielded as well.

Meanwhile, the yield hunters discovered emerging markets bonds…

…and are feverishly pouncing on their ETFs. This is mad!

The hunt for yield is also reaching deeper into the quality spectrum…

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…even as fundamentals are deteriorating as Moody’s demonstrates:

(…) The now chronically faster growth of corporate debt relative to net revenues has hoisted nonfinancial-corporate debt up from Q2-2012’s cycle bottom of 81.0% to Q2-2016’s estimated 93.0% of net revenues. The latter far exceeds where the ratio stood immediately prior to the starts of the three latest recessions. Corporate debt approximated 87.4% of net revenues in Q4-2007, 84.1% in Q4-2000, and 80.5% in Q2-1990.

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Lenders must be betting that operating margins will remain elevated and that interest rates will remain depressed. Yet, margins (ex-Energy) peaked 18 months ago and have declined back to their 2011-13 level which was also the peak in 2007.

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Yet again, the Fed has clearly indicated its intention to normalize (i.e. raise) interest rates ASAP so the cost of debt will likely increase at least in sync with economic activity (i.e. revenue growth).

Corporate America is highly levered at this late stage of the cycle when margins generally begin to decline and interest rates start their ascent, a recipe for lower profits and deteriorating credit quality. No doubt that financial markets are pricing in these obvious risks. Well, think again as Moody’s explains:

The once fairly tight relationship between the high-yield bond spread and the ratio of corporate debt to net revenues has broken down. For one thing, the high-yield spread has been narrower at each ratio of debt to net revenues when compared to the past. Moreover, the high-yield spread recently defied convention and narrowed despite a higher ratio of debt to revenues.

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What might explain the break from trend? For starters, markets may be convinced that a powerful rejuvenation of business sales impends. However, such an explanation presupposes a great deal of naivety on the part of market participants.

Even more so when considering that “lower for longer” does not rhyme with accelerating economic growth.

Another possibility centers on a higher ratio of corporate debt carrying an investment-grade rating. However, investment-grade’s share of the dollar amount of US corporate bonds has eased from the 81% of 2002-2007’s upturn to the 79% of the current recovery. (…)

The suppression of net interest expense by the current recovery’s extraordinarily low benchmark borrowing costs has diminished debt servicing risks at all levels of indebtedness. Nevertheless, this argument assumes the ease of refinancing maturing debt and, thus, downplays the historical reality of those occasional episodes where systemic liquidity is severely diminished.

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The last argument also eludes the dynamic nature of the corporate P&L. When rates get normalized, margins will also normalize. The interest expense ratio troughed at 2.7% of revenues in the previous 2 cycles but debt was then 74-77% of revenues. It’s now 93%! If interest expense is near 3.5% of revenues with rates near zero, where will it be after the Fed has its way given current indebtedness. A 75-100 bps negative swing in margins looks like a minimum. This would reduce aggregate net after tax corporate profits by some 5-8% minimum, solely from the rate normalization process, let alone its impact on the economy.

For companies with a high debt leverage, the impact will be much larger than average, both on profits and debt ratings.

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But in their blind rush for yield, investors won’t consider adverse scenarios at this time, even though history is not friendly.

Real GDP’s yearly increase slowed from Q1-2016’s 1.6% to Q2-2016’s 1.2%. The latter was the smallest such gain since the 1.0% yearly increase of Q2-2013. All else remaining the same, even if real GDP’s annualized quarterly increase averages 3% in 2016’s second half, the real GDP’s annual increase would still slow from 2015’s 2.6% to 1.6% for 2016.

According to the long-term statistical relationship, yearlong real GDP growth of 1.6% has been associated with a yearlong average of 635 bp for the high-yield bond spread, which is wider than the recent high-yield spread of 584 bp. Unless real GDP accelerates considerably, not only will any narrowing by the high-yield spread be limited, but a wider spread may be unavoidable.

The high-yield market now bets on faster economic growth for 2017. The latest consensus forecast expects 2017’s real GDP to grow by 2.2% annually, where the latter has been statistically associated with a 580 bp midpoint for the high-yield bond spread.

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But we can’t have our cake and eat it, too. Faster economic growth could help the top line but what about inflation? Higher inflation should push nominal yields up, making debt more expensive. But who cares about inflation nowadays? Even though…

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image(For more on the Sticky-Price CPI, click here)

The Atlanta Fed has an Inflation Dashboard to help visualize recent inflation measures in the context of longer-term trends. Notice how expectations remain low even if trends point clearly upwards.image

Hmmm…Hot smile Every man can see things far off but is blind to what is near (Sophocles).

Back to our discussion on leverage and credit, companies are also trying to offset slow growth with M&A and share buybacks.

The impact of M&A on US credit rating revisions varies with the stage of the M&A cycle and the importance of debt or cash to the funding of M&A. Early in the cycle, M&A tends to supply more upgrades than downgrades as weaker credits benefit from being acquired by stronger credits, where the credit standing of the latter is still solid enough to withstand the funding of an acquisition. Also, lower quality credits tend to pay down debt with funds raised via divestments earlier in the cycle.

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(…) since the end of September 2013, M&A has entered into far more downgrades (288) than upgrades (188), where the biggest deterioration applied to high-yield, whose 197 M&A-related downgrades since September 2013 exceeded the 153 upgrades. Meanwhile, the M&A-linked revisions of investment-grade ratings revealed a wider gap between 91 downgrades and 35 upgrades.

For the year-ended June 2016, 60 net US downgrades stemmed from M&A, that is, 124 M&A-linked downgrades less 64 upgrades. The 60 net downgrades at least partly ascribed to M&A were the most of any yearlong span since the 75 of calendar-year 2002. An extended slide by the dollar value of M&A would eventually help to form a peak for the number of net downgrades linked to M&A.

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Lastly, share buybacks also tend to cut into corporate credit ratings:

The moving yearlong sum of US credit rating downgrades at least partly attributed to shareholder compensation rose from March 2015’s 32 and December 2015’s 48 to 61 for the span-ended March 2016. The yearlong sum of downgrades ascribed to either equity buybacks or dividends last climbed to 61 in early 2007.

Meanwhile, the yearlong sum of upgrades stemming from infusions of common equity capital (including IPOs) sank from the current cycle’s peak of 48 for the span-ended September 2010 to the 14 of the span ended March 2016, where the latter matched its current cycle low from the 12-months-ended September 2012 and December 2012. Regarding the previous upturn, the moving yearlong sum of equity-infusion upgrades sank from a June 2005 high of 57 to the 31 of December 2007.

The climb by shareholder compensation downgrades suggests corporations are increasingly compelled to take extraordinary measures in order to support equity prices. When companies are willing to return capital to shareholders even at the cost of a credit rating downgrade, managements implicitly admit to the difficulty of achieving a satisfactory return from business assets. (Moody’s)

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Not only are corporations taking “extraordinary measures in order to support equity prices”, they are doing so using extraordinary ways, i.e. debt, as Bloomberg reveals:

As earnings fail to rebound, companies looking to charge up their stock returns with repurchases are turning to debt markets like no time since the Internet bubble. The proportion of buybacks funded by debt rose above 30 percent in June for the first time since 2001, data compiled by JPMorgan Chase & Co. and Bloomberg show.

And while all these M&A and debt-funded buyback activities are going on amid a profit recession, insiders are busy selling their company stock:

The number of officers and directors of companies purchasing their own stock tumbled 44 percent from a year ago to 316 in July, the lowest monthly total ever, according to data compiled by The Washington Service and Bloomberg that goes back to 1988. With 1,399 executives unloading stock, sellers outnumbered buyers at a rate that was exceeded only two other times. (…)

With equities setting records, insider purchases are dwindling, with two buying for every nine that sold. At 0.23, the buy/sell ratio is about one-third of what it was in February and last August, and compares with an average of 0.69 over almost three decades. (…) (Bloomberg)

Meanwhile, these trends are not friendly to credit ratings and bank profits:

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In all, everything is converging towards higher credit spreads. Keep in mind that credit ratings don’t care about trends in earnings per share which contribute nothing to interest coverage and capital repayment. The reality is that S&P 500 companies’ aggregate operating profits have declined 14.5% from their Q3’14 peak while GAAP earnings have dropped 18.7% per S&P IQ data.

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This corporate squeeze is confirmed by this chart from the U.S. national accounts showing corporate profits per unit of revenues (also called profit margins) which have dropped precipitously from 12.5% at their peak in Q4’14 to 10.6% in Q1’16.

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By Q4’15, profit margins had collapsed 19.2% YoY. The good news is that this has historically been the bottom of the range. The bad news is that such bottom has generally been reached just before recessions, suggesting that corporations tend not to tolerate larger deteriorations in margins and aggressively cut costs to stabilize profits.

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Margins did recover somewhat in Q1’16 but Moody’s is cautious going forward:

(…) the difference between the annual growth rates of the yearlong averages of corporate gross-value-added less unit labor costs offer insight regarding the state of the business cycle. The record shows that economic recoveries are better served the faster corporate gross-value-added grows vis-a-vis unit labor costs. To the contrary, recessions have been near, if not actually present, each time unit labor costs outpaced corporate gross-value-added over a year-long span.

Thus, the recent equality between the 2.5% annual growth rates for both corporate gross-value-added and unit labor costs during the year-ended March 2016 weighs against being too confident about the longevity of the current recovery. Nevertheless, if the ongoing slowdown by corporate gross-value-added, or the net revenue proxy, is mostly the offshoot of the energy recession, the faster growth of unit labor costs relative to the net revenue proxy may overstate the risks of a cyclical downturn. Still, the longer unit labor costs outrun net revenues, the greater is the risk of a recession.

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Autumn brings changing climates. It also brings the annual corporate budget exercise when CEOs and CFOs call on their executives to adjust their business plans according to specific company parameters and objectives for the following year. This year, the message is likely to be: “Folks, we have a margins problem and neither increased demand nor higher prices will bail us out in 2017. Accordingly, costs must be reduced in order to protect profits.”

The surprise is likely to be that employment growth slows down considerably since labor is the largest cost item in just about every business. The other surprise is that this drive to cut costs will reverberate throughout the economy since one’s cost saving is someone else’s revenue loss.

Based on the payroll survey, employment growth has levelled off below 2%, actually slowing down in recent months:

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Corporate hires (JOLTS) have also levelled off in the past year…

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…and are down YoY:image

Mrs. Yellen’s own LMCI Index, derived from 19 labor market indicators, has been pretty weak recently, even with strong payrolls in June and July:

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In the real world of small business owners, traditionally the most important job creators in the U.S., margins are getting seriously squeezed as worker compensation keeps rising faster than revenues. Overall profits have only been saved by the gigantic decline in energy prices but this is no longer contributing. Yet, demand is so weak that they can’t even think about raising prices. So they must revert to cost cutting. The latest NFIB survey reveals that 15% of biz owners planned to increase employment in July, down from 18% in June and 22% in May. image

Another sign that corporations are already into cost control mode comes from the corporate travel industry, often among the first cost items to get axed by CFOs. Hotel management comments on earnings conference calls after Q2’16 uniformly complained about the softness in corporate demand. Occupancy is down 0.3% YtD (Smith Travel Research) and -2.0% during the first half of Q3. Raymond James calculates that U.S. hotel demand slowed from +2.9% in 2015 to +1.5% during the last 3 months and +0.6% in July. Airlines are also feeling the pinch with business travel down and getting worse as the year progresses.

The restaurant industry may also be starting to feel the corporate controller pinch with real sales growing 2.5% YoY in the 3 months to July, down from +4.7% in Q1’16 and +3.5% in Q2. The National Restaurant Association Performance Index has been weakening all year and went negative in June.

Back to declining margins on the S&P 500 Index, many think this is all energy related but Moody’s is says otherwise:

Extracting energy sales, broad estimates of business revenues still show sluggish growth. Take an estimate of core business revenues set equal to the sum of the sales of manufacturers, retailers, plus wholesalers less sales of identifiable energy products: Despite advancing by 0.7% from May 2016, June’s core business sales rose by only 1.4% from June 2015. Core business revenues slowed from H1-2015’s annual gain of 3.0% to the 1.5% of H1-2016.

This is at a time when unit labor costs are growing 2.5% annually. Factset calculates that the blended earnings decline for the S&P 500 in Q2’16 is –3.2% in total and +0.4% ex-Energy. The blended sales decline for Q2 2016 is -0.2%, +2.5% ex-Energy. With and without Energy, quarterly profit margins declined again in Q2 after having peaked in Q2’15.

Moody’s points out that such margin squeeze usually results in a widening in high yield bond spreads, contrary to what is currently happening:

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There is a lot more on deteriorating margins here (near the end) and here.

Meanwhile, the recent drop in profits has boosted the dividend payout ratio to 45%, a level previously reached only during recessions. The hunt for yield is thus likely to get more challenging as fewer companies can justify raising their dividend rate.

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This just when higher dividend payers are the darlings of investors. YTD, the S&P 500 Index boasts a total return on +7.8%, boosted by the +18.3% total return by high-dividend shares (SDY). The 720Global blog sums up how the hunt for yield has impacted U.S. equities YTD:

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Bernstein Research has this P/E chart (via The Daily Shot):

Let’s focus on the Utility sector to see if we can find some fundamental support to its current valuation of 21x EPS (charts from CPMS/Morningstar).

  • The dividend yield is at the bottom of the range with a 16-year high payout ratio:

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  • Debt/assets is at an historical high with return on assets reaching new lows at 2.9%.

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  • Cashflow has grown along with debt but CF/Debt has been trending down and is now near historical lows. What will happen if CF declines or interest rates rise? Or both?

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  • Admittedly, electric utilities’ margins have expanded tremendously in the past 2 years as coal and natural gas prices have collapsed. But this is a regulated sector, isn’t it?

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  • Yield hunters are thus chasing stocks of utility companies which collectively are achieving historically low returns on their highly levered assets even though the operating and financing conditions are near optimum. The cashflow coverage of their debt is historically low and their dividend payout ratio very high. God forbids a significant rise in coal or gas prices, let alone interest rates. What if regulators wake up and order lower electricity prices for their constituents? Or if solar panels become much more affordable and popular?

The Utility sector currently sells at 2.4x book value. Since 1993, its PB has ranged from 1.4x to 2.5x (excluding the flare ups to 3.0x in 2000 and 2.7x in 2007-08). A high PB ratio could be acceptable if ROE is also high. But the Utility sector’s ROE currently stands at 11.0%, a historical low. It had reached the 16% level during the bubble years of 2000 and 2007-08. One can also wonder if regulators will continue to allow  current rates of returns if interest rates are really lower for longer.

All in, there is no better example of the high level of risk currently blindly taken by yield hunters.

One more thing: 39% of Utility companies missed their Q2 EPS estimate, worse than any other sector and twice the S&P 500 average. The miss on revenues was a huge 89%! These are utility companies…yet, their revenues declined 2.4% YoY on a –6.7% surprise factor. And this has been the best S&P 500 sector YTD with a 17.2% return.

The yield hunt has become very crowded and now has a very narrow exit door, unbeknown to most investors. CLSA’s Greed & Fear points out the extraordinary liquidity risk facing fixed income investors:

Remember that the ratio of corporate bonds owned by US mutual funds and ETFs, relative to brokers and dealers, has surged from 1.7x to 31x since 2007. This
liquidity issue will also be made worse by the extent to which emerging market debt is owned by open-ended mutual funds. Net assets in global emerging market bond funds and ETFs totalled US$401bn at the end of June, according to EPFR Global.

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When money starts to flow out, as it inevitably will, selling through the narrow door will be painful.

To sum up,

  • The worldwide hunt for yield since the Brexit vote has boosted valuations of most higher yielding securities and narrowed spreads across the board even though most recent economic and financial trends would normally dictate higher spreads.
  • Corporate Indebtedness as a percent of revenues has risen to the point where it now exceeds its level at the start of the last three recessions.
  • This is happening while revenue growth is slowing and profit margins are declining.
  • Mergers and acquisitions, as well as share buybacks are adding to corporate leverage and causing accelerating credit ratings downgrades.
  • Aggregate profits have declined 14.5% for operating profits and 18.7% for GAAP earnings since Q3’14, compounding the leverage problem.
  • Corporations have already begun to reign in their expenses but the trend will likely accelerate in coming quarters as annual budgets need to take account of the increasingly challenging environment.
  • Four consecutive declines in quarterly earnings have brought dividend payout ratios to 45%, a level normally seen only during recessions.
  • This while higher dividend stocks are pulling equity markets higher into overvalued territory, even though corporate fundamentals are deteriorating.

SIRP (Safety and Income at a Reasonable Price) investing because of TINA (There Is No Alternative) has now reached a point where TINROS (There is Nothing Reasonable Or Safe). TWEB (This Will End Badly) and, once again, investors, including the little guy, will be severely hurt by central bank experiments.

When and how will “adverse consequences” happen? Dunno! It could be a black swan erupting from the very slow economies as often happens. It could be pain from rising interest rates (e.g. LIBOR). It could be poor earnings. It really does not matter. Remember what Forrest Gump said!

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What is important is to understand that investors are currently accepting not being paid to carry a rising level of risk. This is the time to go on a long trip, start intensive golf lessons, get seriously into painting. Importantly, raise cash, reduce beta and forget about the market for a while.

The caveats?

  • A baby boomers’ yield bubble! Demographics can be a powerful force behind financial markets. There are about 75 million baby boomers in the U.S. only and these people must be getting pretty worried just looking at two tables side by side: the mortality tables and the yield tables. Turning 65 and contemplating living through 90 with “safe” interest rates below 1% can be terrifying. For them, “lower for longer” means “poorer forever”. Many will keep working longer, even a few hours a week greeting people at Wal-Mart, but many others are now reaching for yield to boost their monthly revenue streams. The Fed is well aware of that as expressed in the July FOMC minutes:

Several [members] expressed concern that an extended period of low interest rates risked intensifying incentives for investors to reach for yield and could lead to the misallocation of capital and mispricing of risk, with possible adverse consequences for financial stability.

After having created the problem, the Fed thinks it can absolve itself simply issuing the warning.

Investors must be very careful. Losing money on a house when you are 30, 40 or even 50 is painful but leaves many years to hope to make it up. Losing capital at 65, 70 or 75 is downright ruinous. At such age, return of capital is much preferable than return on capital.

  • A stabilization of high-yield credits thanks to a continued bull run:

Equity market performance matters greatly to corporate bonds, especially those rated less than high-grade. The strong performance by US equities since early 2016 has facilitated a notable stabilization of many high-yield credits and has helped to trigger credit rating upgrades.

Regarding the latter, the high-yield credit ratings of seven issuers from the hard-hit oil & gas industry have been upgraded thus far in the third quarter because of infusions of common equity capital, mergers, or asset divestments. These financially-driven upgrades received considerable support from a firmer equity market regardless of whether market valuations are fundamentally sound. (Moody’s)

Higher oil prices would help energy companies but would have adverse effects on all other sectors, either directly through higher operating costs or indirectly through reduced revenues as consumer disposable income would be diminished.

SHOULD WE BAIL OUT?

What is the downside risk?

  • -6.0% to the 200-day moving average (2050 on the S&P 500 Index). Simple mean-reversion. The 2050 level also happens to be “fair value” on the Rule of 20 scale.
  • -11% to 1940 at 19 on the Rule of 20, a level which has held on several corrective occasions since 2014.
  • -19% to 1770 or 17.5 on the Rule of 20, the low touched in January 20, 2016 and again on February 11, 2016. While inflation is unchanged since, trailing EPS are 1.8% lower.

So, unless the earnings fundamentals deteriorate further, no bear market risk at this time.

Upside?

  • Since 1960, in all 7 instances when the Rule of 20 P/E crossed above 20, markets have gone on to reach at least 22.2 on the Rule of 20 scale. With current data on inflation (2.2%) and trailing EPS ($115.20), that gets the S&P 500 Index up 5.5% to 2300.
  • In all but one, equities reached 23.1: +10.4% to 2400.
  • Four out of 7 touched 24: +15.2% to 2510.

These assume that core inflation and trailing EPS are stable from here, two conditions that will likely not happen.

Inflation has ranged between 1.6% and 2.3% since 2012. Going back towards the lower end of the range would be positive for valuations but could also mean a weaker economy.

Profits are forecast down a little in Q3 but a normal beat could keep them stable. Current Q4 estimates are +8.3% on higher margins AND an acceleration of revenue growth from +1.5% in Q2 to +2.4% in Q3 and a heroic +4.8% in Q4. Unlikely in my view.

On balance, slightly more downside than upside

Market fundamentals (inflation + EPS) are not providing much tail wind, if any, over the next 3-6 months. Central banks are the only major supports for equities nowadays but do they really know what they are doing? Given the large number of potentially adverse factors, I would not place many chips on the upside table at this point in time.

Further tilting me towards the downside table are these facts:

  • Economic surprises seem to be reverting to negative.
  • Investors are pretty positive.
  • Insiders are not acting positive.
  • Brexit? Dunno. China? Dunno. Libor? Dunno.
  • Elections? How bad would a surprise be? How bad would a non-surprise be? Dunno.

I anm staying negatively tilted with 2 stars. Not bailing out entirely because recession not in sight, yet, and a bear market seems unlikely, for now.

Contact: edgeandodds [at] gmail.com