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 2018

EMERGING SUBMERGING

I do not invest in emerging markets. Too many moving parts (earnings, accounting, disclosure, forex, politics,…) with unlimited potential grey and black swans from so many corners. It is almost impossible to correctly value emerging markets and adequately measure risk vs reward. Last 15 years: much volatility (risk) with zero overall growth (reward). Only for traders who can be repeatedly smart (lucky?). Key word is repeatedly. Poor odds for me! North American equity markets provide a large enough playground that I can better understand and value. Despite what they say, diversification is not necessarily risk/return positive.

VWO

spy

tsx

From time to time, an emerging markets crisis rocks all other markets for a while. The root causes are generally the same: rapid increases in U.S. interest rates and the U.S. dollar.

Jerome Powell explained the links between U.S. monetary policy, the USD and emerging economies and markets in a speech to the Institute of International Finance in October 2017. That was before he became Fed Chairman.

But in a May 7, 2018 speech to an IMF conference, the new Fed Chairman felt the need to tell the world that U.S. monetary policy isn’t the major cause for EM crisis.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

But Powell added these warnings given that Fed policy was for scheduled rate hikes well into 2019:

I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.

Risk sentiment will bear close watching as normalization proceeds around the world.

Global policy normalization is central banker current wording for scheduled multi-year rate increases. You have been warned.

What Powell is referring to with “risk sentiment” is the highly sensitive risk-on/risk-off trigger on emerging debt and equity markets that effectively dictates capital flows so important for dollar-indebted EM countries and companies.

In previous EM crisis, developed world banks were the lenders to EM countries. This time around, the lenders are mainly bond investors and the borrowers a mix of EM corporates, small to very large, and, to a lesser extent, sovereigns.

In previous crisis, the epicenter was relatively limited to one or a few countries like Mexico in 1982, Thailand and Malaysia in 1997. Redirected capital flows made the crisis global but the economic damages were limited in time and scope. This time around, the visible problems are in Turkey, Argentina and Venezuela but heavily dollar-indebted corporations, spread across the world, are silently suffering the pain of being slowly strangled but rising rates and the strong USD. Eventually, the strangled groundhogs will suddenly emerge from their increasingly uncomfortable undergrounds in need of financial air or simply declare bankruptcy.

In previous crisis, the risk-off trades were in equities and the debt instruments of specific countries and banks. This time around, the risk-off trades will combine both equities and EM bond funds, creating a lot more additional pressures on the weak currencies and further boosting the USD, amplifying the problem in the process. ETF investors will want to rush to the exits, only to find very narrow exit doors with few buyers on the other side? This time around, the next EM crisis will also be a liquidity crisis that will likely impact all asset classes in both emerging and developed markets.

Data from the Institute of International Finance show that EM ex-China debt has almost doubled to $27T since 2007 while China’s has been multiplied 6 times to $36T.

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Corporate borrowings have ballooned across the world while central banks drove interest rates through the floor.

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U.S. interest rates are now going in the wrong way for these unprepared borrowers. The Fed has set the path straight up for short term rates, from nearly zero in 2015 to their current 1.75% on their way to 2.9% at the end of 2019 per the most recent Fed dot plot. Longer term rates are feeling the upward pressure while also lifted by rising inflation and inflation expectations. Ten-year Treasury yields bottomed in 2016 at 1.4% and have since gone up 170 bps even though still offering a historically low 0.6% real yield.

With more than $3T in EM debt maturing between now and the end of 2019, refinancing will necessarily cost between 300 and 500 bps more on fixed rate debt alone, a whopping $120 billion jump in annual interest costs on fixed rate debt. Some 50% will be absorbed by the non-financial corporate sector.

This, without taking into account the damage inflicted by the rising USD.

Foreign investors have increasingly bought domestic-currency bonds, seeking both credit and currency gains. If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves. (Fitch)

Add rising oil prices and you get something close to a perfect storm. It will likely start in the EM world but interest rates and oil prices are rising across the developed world as well where non-financial corporates are also highly indebted.

Groundhog days ahead! Watch your step.

THE DAILY EDGE (21 May 2018): Recession Watch

RECESSION WATCH

Equity markets are pretty good at sniffing recessions 6-12 months early. Whatever the current fundamentals, recessions are bad to terrible for equities. We are clearly late in the economic cycle and signs of potential troubles are mounting. Rising inflation and interest rates are at the top of the list. Rising wages and other costs (e.g. transportation, financial, logistics) can also squeeze profit margins and bring a profit recession. Again, this is a game of probabilities.

As we saw last week, the Conference Board’s LEI keeps rising further away from signalling a U.S. recession as per Doug Short’s chart below:

Smoothed LEI

Steve Blumenthal (CMG Wealth Management) closely follows Ned Davis Research’s Global Recession Probability Model (my emphasis)

Here is how you read the chart:

  • The red circle shows the current level and is signaling a 57.54% probability of recession.
  • Note the dotted red line. It marks the “High Recession Risk” zone.  Not there yet.
  • The box in the lower right of the chart shows the time since 1970, based on the level of the probability model, that the global economy was in recession. When the reading is above 70, recession has occurred 90.73% of the time.  Thus, high risk.
  • When between 30 and 70, recession has occurred 51.81% of the time so we are not currently out of the woods.
  • Note too that the line is increasing and the rate of ascent can be fast.
  • The gray areas mark recessions.

(…) The blue line continues to rise.  Note how quickly the line has risen in 2018.  Higher rates are going to be a serious issue.  Call it a 50/50 shot at recession in early 2019. (…)

Steve displays a few other charts showing little recession threat. Then he presents this Gavekal chart:

The private sector may hold the real clues to recession risk.  “While the flattening U.S. yield curve — the difference between short- and longer-dated Treasurys — has been closely watched as a potential indicator of a looming contraction, investors might do better to watch a measure of the cost of private credit, according to Charles Gave of Gavekal Capital Ltd.”  (Source: Bloomberg.)

May 18, 2018 Prime Rate vs. Baa Yield 0.14% from inversion.

  • Current prime rate: 4.75%
  • Baa Corporate Bond Yield: 4.89%

Bottom line: Close to inversion.  To be watched.

Either a U.S. recession has taken place within a year of the private sector yield curve inverting, or a “financial accident” has occurred in other economies with currency links to the U.S. dollar, according to Gave’s data.

Prime rates below the natural rate of corporate credit have allowed banks to generate “artificial” money, kept “zombie” companies alive, and enabled other corporates to engage in “financial engineering” predicated on cheap borrowing costs that risk toppling over if the curve inverts, Gave said.

Based on this measure, “we are entering dangerous territory,” he concluded. If the private sector curve inverts “zombie companies will fail and capital spending will be cut, as firms move to service debt and repay principal. Workers will get laid off and the economy will move into recession.

Source: Bloomberg

I recently discussed these risks in these posts:

Is recession locked in stone on any one of these indicators?  The answer is no.  Investing is a risk/reward game.  There is always risk.  Key is to balance your potential for upside gain with prudent downside risk management.

Finally, here is a look at a collection of early U.S. recession indicators:

Bottom line: A lot of green.  Green is good. No current sign of recession.

Maybe. But probabilities are crawling up. Read on:

(…) According to the Bank for International Settlements, total nonfinancial private and public debt amounts to almost 245% of global gross domestic product, up from 210% before the financial crisis and about 190% at the end of 2001.

General government borrowing in the U.S. might reach 5% of GDP this year, pushing total public debt to about 108% of GDP. In the euro zone, public debt totals about 85% of GDP; in Japan, the debt-to-GDP ratio is close to an eye-popping 240%. Globally, private nonfinancial debt is growing faster than nominal GDP. (…)

One of my main concern is also that of Knowledge Leaders Capital:

Rising oil prices, food prices and interest rates are likely to soon start taking a toll on the US consumer. Over the last year, gasoline prices are up 28%, the price of cornerstone crops like corn, soy and wheat are up between 5-16%, credit card interest rates have moved to an eight year high of 13.6% and the all important mortgage rate has risen to nearly 5%. But the reason price growth in staple items/rates is now so important is because the US household savings rate has moved from 10% to just 3% since 2012. This means that the margin of safety, or households’ ability to absorb tightening of financial conditions, is severely limited relative to even a few years ago. Absent a move higher in wages, commodity and rate inflation are likely to continue to force the savings rate toward the historic lows.

Or force the spending rate lower given the rising cost of credit:

Americans are big spenders and generally seek to maintain their standards of living. This time around, however, there are no savings buffer (rather no borrowing capability). Given the increasing bite that some essentials such as food proteins (+3.5% YoY in April), gas (+25%) and shelter (+3.4%) are taking from weekly earnings (+2.8%) and the decreasing availability of credit, the risk is rising of a sudden buyers strike on the U.S. economy.

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Two more risks to closely monitor:

  • A financial accident. The more interest rates, oil prices and the USD keep rising, the higher the risk of a financial accident, particularly from emerging markets.
  • The risk of a profit recession is also slowly creeping up. More companies are complaining about rising costs for raw materials, labor, fuel, transportation. We will soon see many more companies with ballooning financial costs.

Another busy auction calendar is set to put more pressure on Treasuries—the 10-year yield is consolidating above 3 percent. The Treasury will sell a combined $99 billion of fixed-rate notes this week, in some of its largest offerings since 2010.

If you enjoy economic Armageddon scenarios, John Mauldin has a treat for you: Train Crash Preview

EARNINGS WATCH

Facstet’s weekly summary:

Overall, 93% of the companies in the S&P 500 have reported earnings to date for the first quarter. Of these companies, 78% have reported actual EPS above the mean EPS estimate, 6% 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 (74%) average and above the 5-year (70%) average.

If 78% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting actual EPS above estimates since FactSet began tracking this metric in Q3 2008.

In aggregate, companies are reporting earnings that are 7.5% above expectations. This surprise percentage is above the 1-year (+5.1%) average and above the 5-year (+4.3%) average.

If 7.5% is the final percentage for the quarter, it will mark the highest earnings surprise percentage since Q4 2010 (10.4%).

The blended (year-over-year) earnings growth rate for Q1 2018 is 24.5%. If 24.5% is the final growth rate for the quarter, it will mark the highest earnings growth reported by the index since Q3 2010 (34.0%).

In terms of revenues, 77% of companies have reported actual sales above estimated sales and 23% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is above the 1-year average (70%) and well above the 5-year average (57%).

In aggregate, companies are reporting sales that are 1.0% above expectations. This surprise percentage is below the 1-year (+1.1%) average but above the 5-year (+0.6%) average.

The blended (year-over-year) revenue growth rate for Q1 2018 is 8.3%. If 8.3% is the final growth rate for the quarter, it will mark the highest revenue growth reported by the index since Q3 2011 (12.5%).

At this point in time, 89 companies in the index have issued EPS guidance for Q2 2018. Of these 89 companies, 51 have issued negative EPS guidance and 38 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 57%, which is well below the 5-year average of 72%.

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Thomson Reuters’ tally shows Q1 EPS up 26.2% (24.2% ex-Energy) on a 8.2% revenue growth rate (+7.8% ex-Energy).

Trailing EPS are now $140.38. Pro forma the tax reform, assuming a 7% average accretion, trailing EPS are $146.75, on their way to $151.60 if Q2 estimates are met and $161.33 for all of 2018.

The Rule of 20 P/E is now 20.6 using trailing pro forma earnings, down from 23.5 in January. It is exactly 20.0 post Q2 results and 18.9 based on full 2018 estimates. It is generally best not to use forward earnings but the growth this year is so extraordinary that it is instructive to see how valuations can change in such an earnings environment.

The S&P 500 was clearly overvalued in January but, 5.3% lower and 11% higher trailing earnings, the reality is that valuations are not as stretched.

The other reality is that the effects of the tax reform are there to stay. This is not a one-off event that will revert in 2019.

Another myth that needs to be corrected is the effect of buybacks. Share buybacks only added 1.3% to the EPS growth rate in Q1 per Thomson Reuters data. TR calculates that the buyback impact will rise to +2.2% in Q2 and peak at +2.9% in Q1’19 (recent peak impact: +3.4% in Q1’17).

The Mystery of the Small-Cap Rally

It has been a good year for small-caps. The Russell 2000 is up 5.9% so far and the S&P Small Cap 600 is up 7%. In contrast, the large-cap benchmark S&P 500 is up all of 1.5%.

Coming up with reasons for the small-cap outperformance isn’t hard. Small-caps are more domestically focused, and as a result are receiving even more of a benefit from the corporate tax cut than their larger peers are. By the same token, they stand to benefit more from the recent pickup in the U.S. dollar, which lowers the dollar value of multinationals’ overseas earnings, but reduces import costs for U.S. operators. Recent U.S. economic reports have looked better relative to what has been coming out overseas. (…)

Within the S&P 600, for example, the health-care sector is up nearly 27% so far this year. Health-care stocks in the S&P 500 are up less than 1%.

The difference? The S&P 600 health-care sector is chock-full of biotech stocks (as is the Russell 2000), and biotech stocks have been bid higher this year on expectations more of them will be acquisition targets. The S&P 500 health-care sector is dominated by major pharmaceutical companies—the ones struggling with sluggish growth that are presumably shopping for biotechs. (…)

The Russell 2000 is currently trading at 32.1x trailing EPS which are forecast to jump 39% over the next 12 months.

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I suspect there is an oil price effect in forward earnings. Ed Yardeni tracks the S&P 600 index. These charts tend to support the oil price effect assumption given that oil prices cratered in the second half of 2014.

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Analysts also tend to prove very optimistic on small caps margins.

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It looks like analysts are already having second thoughts on 2018 estimates for small cap companies as this Hedgopia chart shows:

As discussed in TOPSY CURVY: SMALL IS NOT THAT BEAUTIFUL

  • David Hay, CIO at Evergreen/Gavekal says that 20% of the Russell 2000 companies can’t cover interest with EBIT. That’s 400 companies. And yet, according to David, the Russell 2000 index is trading at 26x forward earnings, excluding the 1/3 or so that lose money.
  • This is a scary alligator chart from David’s latest webinar:

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On the other hand, Lowry’s Research argues that since “small caps have, historically, been among the first stocks to show developing weakness as a bull market enters its final stages, these new highs in both the small cap price indexes and Adv-Dec Lines suggest a healthy primary uptrend showing few signs of age.”

U.S. Sends Mixed Messages on China The Treasury secretary and the administration’s top trade official took markedly different positions over whether the U.S. will move forward with tariffs on Chinese imports.
  • The trade war is on hold. The U.S. won’t impose tariffs on Chinese products for now, after progress during two days of negotiations, Treasury Secretary Steven Mnuchin said. China promised to buy “significantly” more U.S. goods, without specifying how much. Investors cheered the news, despite lingering skepticism about whether the truce will last.
  • The U.S. remains far apart from Mexico and Canada on a revised Nafta accord, and President Trump is more focused on reaching a good deal rather than an immediate one, Mnuchin said. The parties have roughly two weeks left to reach an accord that could pass Congress, which had been U.S. Trade Representative Robert Lighthizer’s goal.

Canada’s Inflation dips to 2.2% in April; core measure above 2% for first time in 6 years

Statistics Canada reported that the consumer price index (CPI) rose 0.3 per cent month over month in April, in a broadly based increase that was highlighted by a nearly 7-per-cent jump in gasoline prices. That left the year-over-year CPI inflation rate at 2.2 per cent, down slightly from the three-and-a-half-year high of 2.3 per cent posted in March. Despite the slight pullback, it’s the third consecutive month that the annual inflation rate has run above the Bank of Canada’s target of 2 per cent, the central bank’s key guide for setting interest rate policy.

Meanwhile, two of the Bank of Canada’s three preferred measures for core inflation – designed to filter out short-term volatility and temporary fluctuations – posted year-over-year gains, while the third held steady. That edged the average of the three measures above 2 per cent for the first time in more than six years.

Three charts from The Daily Shot to make our minds spin:

Source: @lisaabramowicz1, @queenofchartz

  • When taking shadow rates into account, the current Fed’s rate-hike cycle (from the lows) is setting records.

Source: Bianco Research

Money 5 Smart Places to Park Cash Short-term bond ETFs are now yielding more than 2%, thanks to the Fed’s interest-rate hikes. Our guide to some of the best.

5 Smart Places to Park Cash

Red heart Kate Raworth: A healthy economy should be designed to thrive, not grow

15:53 minutes · Filmed Apr 2018 · Posted May 2018 · TED2018

Why must economic progress always mean unchecked, unequal, unsustainable growth? Economist Kate Raworth asks instead: What would a sustainable, thriving, regenerating economy look like? “Like a doughnut,” she says. In this eye-opening talk, she explains how we can move countries out of the hole — where people are falling short on life’s essentials — and create thriving economies that work within the planet’s ecological limits.

Watch now »

DEMOCRACY IN CRISIS

(…) what we hope to accomplish in this week’s missive is to share a key finding we believe is worth considering at an ideological level: that democracies around the globe are in, many cases, under siege. (…)

Mug The 50 best IPAs in America (h/t Steve Blumenthal)

Contact: edgeandodds [at] gmail.com