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: November 2018

THE DAILY EDGE: 30 NOVEMBER 2018: Puts!

Wednesday we got the Powell put, now the Trump put?

U.S., China Explore Deal as Leaders Meet at G-20 Summit Washington could hold off on further tariffs through the spring in exchange for new talks looking at big changes in Chinese economic policy.

The U.S. and China, looking to defuse tensions and boost markets, are exploring a trade deal in which Washington would hold off on further tariffs through the spring in exchange for new talks looking at big changes in Chinese economic policy, said officials on both sides of the Pacific. (…)

One offer, according to Chinese officials: in return for the suspension of U.S. tariffs, Beijing would agree to lift restrictions on China’s purchases of U.S. farm and energy products.

Such a deal would follow the model of partial agreements the U.S. has cut in recent months with the European Union and Japan, U.S. officials said. In those deals, the U.S. agreed not to levy more tariffs—in those cases, tariffs on automobiles—while the two sides negotiated over specific areas. With Japan, for example, Tokyo agreed that any deal would increase automobile production and jobs in the U.S., while Washington agreed not to press Tokyo for more concessions on agriculture than Japan had previously allowed free-trade partners. (…)

The president, before boarding Marine One in Washington to depart for Buenos Aires, said the two sides were “very close” to a trade deal with China, but added: “I don’t know if we want to do it. I’m open to making a deal, but frankly, I like the deal we have now.” Confused smile (…)

(…) The Federal Reserve Bank of Minneapolis recently reported that farm bankruptcies are rising sharply in Wisconsin, Minnesota North Dakota, South Dakota and Montana following declining prices for soybeans, milk, beef and other farm products that face retaliatory tariffs from China, Mexico and other countries hit by Trump tariffs. The Chinese market is now essentially closed to U.S. soybeans, leading many farmers to simply let crops rot in the field.

Dairy farmers are having an even more difficult time, especially as retaliatory tariffs from Mexico close down a critical market for U.S. cheese exports. Mexico has said it will not remove the barriers until Trump removes steel and aluminum tariffs, something he did not do even after agreeing to the new U.S. Mexico Canada Agreement.

“The impact at the farm level is very real and declining prices are the difference between surviving and not surviving,” said Rick Naerebout, CEO of the Idaho Dairymen’s Association. “Dairy farmers are having to sell off their family businesses because they can’t make it. Tariffs are not the sole factor but they are a main factor. We’ve seen drops in cheese exports of up to 20 percent in some of the latest numbers that have come out. Those are big numbers and they are real numbers.” (…)

(…) While the new export-order subindex ticked up to 47.0 from 46.9, the new import subindex fell to 47.1 from 47.6.

Other measures for production and new orders pointed down too. Outside of manufacturing, weakness in construction outweighed strength in services, dragging the official nonmanufacturing purchasing managers index to 53.4 in November, from 53.9 in October—the lowest level in 15 months. (…)

“The market is cooling down a lot,” Ms. Wang said. “Naturally, a lot of loss-making players will exit the market.” (…) Nasdaq-listed Ctrip commands around 62% of the Chinese travel market, according to estimates provided by the company.

(…) According to the people briefed on the preparations, Mr Liu’s December trip would go ahead if Mr Trump agreed to a pause in any further tariff measures in return for the Chinese government’s willingness to negotiate possible changes to its industrial policies. (…)

Fed Minutes Signal Likely December Rate Increase, Less Certain 2019 Path A few officials on the monetary-policy panel expressed uncertainty about timing of further tightening

(…) Officials, however, discussed changing their postmeeting policy statement to emphasize their flexibility to respond to fresh economic developments as they weigh their rate moves next year. (…)

Since January, the statement has said officials expected that “further gradual increases” in short-term rates would be necessary, and the central bank has raised rates by a quarter-percentage point every three months over the past year.

At their recent meeting, officials debated whether they should change that key phrase to stress their next few moves would depend more on the most recent data, a subtle but important shifting of the Fed’s policy-planning gears.

“Such a change would help to convey the committee’s flexible approach in responding to changing economic circumstances,” said the minutes. (…)

Officials placed new attention on developments that might lead the economy to slow more than forecast, a sign of budding caution.

They flagged concerns about rising uncertainty related to trade and fiscal policy as well as the lagged effects of their own policy tightening moves over the past, the minutes said. They also cited a possible slowdown in global growth. A couple of officials pointed to softening inflation data.

Some worried over rising levels of corporate debt, which could make the economy more prone to a sharp pullback if slowing growth triggers more defaults and bankruptcies. (…)

U.S. Leveraged Loan Market Is Showing Signs of Sputtering

(…) These debts have weakened with the broader leveraged loan market, which on average is priced at its lowest level since 2016. And there are other signs of cooling in loans too: the percentage of new deals that had to increase pricing spiked earlier this month to the highest of the year, according to data compiled by Bloomberg. Loan offerings are getting pulled at the fastest rate since July. And U.S. leveraged loan funds are seeing some of their biggest outflows in nearly three years. (…)

Whose Line Is It Anyway?

Emerging Markets can be fascinating to many, particularly to those who make a living trying to analyse them. In my Nov. 12 post, I wrote about UBS recommending emerging markets “now trading at 11 times future earnings, a discount to the 30-year average of 13 times, according to UBS”, pointing out that, since 2000, the P/E on the MSCI Emerging Markets has ranged between 8.0 and 13.0.

Yesterday, I came across this chart titled “The Case for Buying EM Stocks” from Alpine Macro which claims to be “A Unique Mind On The Markets”. I like such high-low range charts, especially when they suggest that we are at the very low end of a reasonably stable long-term range. So I glanced at it for 30 seconds before proceeding…

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…to simply redraw the trend lines to see how that might change “The Case”. Not quite as trendy, is it?

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Recall that the composition of the MSCI EM Index is far from stable. For example, just in the last 10 years, China has moved from 14% of the MSCI EM Index to its current 31%. A bunch of “Others” are next in line at 27% from 39% in 2008 while Brazil went from 14% to 6% and Russia from 10% to 3%. Looking at the past may not be a good reflection of the present.

Speaking of EMs:

Commodities Drop Looks Secular, Not Cyclical From slower economic growth to chronic excess capacity, the long-term outlook for raw materials isn’t good.

Gary Shilling has identified 10 forces that explain the weakness and why it will persist.

1. Slowing economic growth globally and a possible recession in the next year.

2. The strengthening dollar is increasing the local currency cost of commodity imports in developing as well as advanced economies

3. Chronic excess capacity exists among commodity producers.

4. Slowing growth in China

5. As economies grow, proportionally less is spent on commodity-intensive goods and more on services.

6. Globalization disrupts economic growth in the West to the detriment of commodities.

7. The escalating trade wars disrupt economic growth and commodity demand as uncertain business people postpone capital outlays.

8. Mounting inventories depress commodity prices. Producers can’t be sure initially whether weakening demand is momentary or serious and don’t want to disrupt production. So inventories climb.

9. The realization that a peak in oil demand, not supply, is in the cards as rising supplies of natural gas and LNG as well as renewables replace oil

10. Real commodity prices, or those after taking inflation into account, fall steadily in the long run as efficiency, substitute and human ingenuity consistently beat temporary shortages.

Point #7 is supported by these charts:

Tax reform was supposed to boost capex in the U.S.. It’s boosting buybacks instead:

New orders are not suggesting that the boost is coming anytime soon:

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Europe looks even worse:

  • CapEx expectations point to slower business investment ahead.

Source: Longview Economics (via The Daily Shot)

Bogle Sounds a Warning on Index Funds The father of the index fund says it’s probably only a matter of time before they own half of all U.S. stocks; ‘I do not believe that such concentration would serve the national interest’

(…) Equity index fund assets now total some $4.6 trillion, while total index fund assets have surpassed $6 trillion. Of this total, about 70% is invested in broad market index funds modeled on the original Vanguard fund.

Yes, U.S. index mutual funds have grown to huge size, with their holdings doubling from 4.5% of total U.S. stock-market value in 2002 to 9% in 2009, and then almost doubling again to more than 17% in 2018. Even that penetration understates the role of mutual fund managers, as they also offer actively managed funds, and their combined assets amount to more than 35% of the shares of U.S. corporations.

If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.

Three index fund managers dominate the field with a collective 81% share of index fund assets: Vanguard has a 51% share; BlackRock, 21%; and State Street Global, 9%. (…)

It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest. (…)

Even if present trends continue (sometimes they don’t), the enormous value of index funds should not be ignored. First, index funds provide investors with the most effective stock-market strategy of all time: buy American business and hold it forever, and do so at rock-bottom cost. Second, index funds are among the few truly long-term owners of stocks—for all practical purposes, permanent owners of capital—an enormously valuable asset to society. The long-term focus of index funds is a much needed counterweight to the short-termism favored by so many market participants. (…)

THE DAILY EDGE: 29 NOVEMBER 2018: Two Powell Puts

Fed’s Powell Says Rates Are Just Below Neutral Range

(…) Investors welcomed his remarks because they appeared to retreat from a comment he made in early October describing the Fed’s benchmark rate as a “long way” from a neutral level—which implied to some listeners that Mr. Powell planned to keep raising rates for a while. His remarks Wednesday appeared to suggest to this audience that he might stop sooner or move more slowly. (…)

On Wednesday, Mr. Powell pointed to the range of neutral-rate projections submitted by 15 Fed officials at their policy meeting in September, varying from 2.5% to 3.5%. The Fed’s benchmark federal-funds rate since then has been between 2% and 2.25%—or just below the lowest estimate. (…)

“There is no preset policy,” he said. “We will be paying very close attention to what incoming economic and financial data are telling us.” (…)

“It removes concerns of a Fed dead set on tightening up to a point where rates would intentionally slow down the economy,” said Roberto Perli, an analyst at Cornerstone Macro, in a report Wednesday. (…)

“We know that moving too fast would risk shortening the expansion,” Mr. Powell said. “We also know that moving too slowly—keeping interest rates too low for too long—could risk other distortions in the form of higher inflation or destabilizing financial imbalances.” (…)

Compared with his recent predecessors, Mr. Powell, who became Fed chairman in February, has more regularly noted that the past few expansions ended with bursting financial bubbles rather than surging inflation.

Two Powell puts: Mr. Market is seeing an eventual Powell put in this move from “long way” to “just below” and “economic and financial date dependence”. At the same time, Powell puts Trump on notice that the Fed is not really the problem for Mr. Market.

‘Bring Me Tariffs’—How Trump and Xi Drove Their Countries to the Brink of a Trade War In the corridors of power, officials from the U.S. and China maneuvered and often miscalculated

Long but interesting article in the WSJ covering the very difficult trade talks between confused Chinese and divided American negotiators. The last sentence sets the stage for the next few days:

The Chinese still aren’t sure which Trump will show up when the two leaders get together—the leader who surprised China with his determination to see tariffs through, or the deal maker Chinese leaders thought they knew.

(…) Xi knows China’s debt-addicted economy needs to upgrade from thin-margin exports of basic consumer goods and industrial commodities to high-tech sectors that can create new markets and higher incomes.

(…) Xi can only conclude that relying on the West is too dangerous and his country must develop and control its own key technologies. (…)

But the trade war is spiraling into something much bigger — a clash of perceived national interests. Xi won’t sacrifice what he believes is mission critical for China’s future to appease a wounded, erratic and unpopular U.S. president. Only when Trump wakes to that reality can the trade war be brought to an end.

(…) With neither side willing to compromise, the dispute runs the risk of causing a complete breakdown in U.S.-China relations, and poses the single biggest threat to global peace and stability. (…)

Big American retailers are getting tough with Chinese suppliers as import tariffs bite, cutting orders, negotiating down prices and demanding faster turnarounds. (…) In China, manufacturers of handbags, lighting, footwear and other products say they are feeling the strain. Many are trying to find new customers outside the U.S., and some have resorted to offering discounts in a bid to halt a slide in orders. (…)

In interviews, dozens of Chinese manufacturers reported constricted sales. Sunshine Leisure Products, a maker of camping chairs in the eastern province of Zhejiang, said orders are down about 30% even as it lowered prices by as much as 7%. A supplier of LED decoration lights in the eastern province of Shandong said orders for next year—typically settled by November—were still in abeyance, as American customers have been asking it to bear the 10% tariff. In the southern city of Shenzhen, a sales manager for furniture maker Homegard International said orders have fallen by half. (…)

At a recent trade fair in Guangzhou, exhibitors reported fewer American buyers. That is spurring Chinese suppliers to look for other sources of revenue, they said, such as more aggressively targeting European customers. (…)

Home Depot anticipates price rises if additional tariffs of 25% go in place as planned, adding in a conference call with analysts that washing-machine prices rose when tariffs were applied earlier in the year.

Walmart’s merchants are combing through a list of items affected by tariffs, working with suppliers to bring costs down, Walmart finance chief Brett Biggs said in an interview.

“If we get tariffs as discussed in January prices are going to go up,” he said.

(…) In his tweets, Mr. Trump noted that pickup trucks and work vans have long been protected by 25% tariffs, compared with a 2.5% tariff on cars. He suggested that a higher rate on more vehicles could help U.S. companies preserve production in those segments as well.

“The reason that the small truck business in the U.S. is such a go to favorite is that, for many years, Tariffs of 25% have been put on small trucks coming into our country,” the president tweeted.

“If we did that with cars coming in, many more cars would be built here….. and G.M. would not be closing their plants in Ohio, Michigan & Maryland,” he added. (…)

Mr. Trump didn’t say how long he would be willing to wait before pulling the trigger on car duties. US-EU trade talks are scheduled to resume early next year, as are similar negotiations with Japan, which also faces the threat of the new vehicle export restrictions. (…)

Lighthizer said in a statement criticizing China’s “egregious” tariffs on U.S. autos that he was taking such action at the direction of President Donald Trump. (…)

Automotive duties on both sides have been increased by tit-for-tat tariffs. The United States imposed a 25 percent tariff on Chinese vehicles on top of the 2.5 percent it normally charges.

China had lowered tariffs for all other countries to 15 percent, but imposed an additional 25 percent retaliatory tariff on U.S. vehicles.

Chinese auto exports to the United States are relatively small. It exported 53,300 vehicles to the U.S. market last year and imported 280,208 U.S. manufactured vehicles, according to data from the China Automotive Technology and Research Center (CATARC), a government-affiliated think-tank. (…)

Volvo, which is owned by Chinese carmaker Geely, plans to move most of the production of its best-selling XC60 SUV for export to the U.S. market away from its Chengdu plant in China to Torslanda in Sweden. (…)

Volkswagen planning new North America factory for electric vehicles Volkswagen is deciding where to locate a new factory in North America to build electric vehicles for the U.S. market, the German automaker’s new head for the Americas said on Wednesday.
Personal Income and Outlays, October 2018

The consumer stats remain strong with both disposable income and spending up in the 4.5-5.0% range and core inflation slowing below 2.0% YoY and below 1.5% at annualized rates over the last 3 and 5 months:image

U.S. New Home Sales and Prices Remain Sluggish

New single-family home sales fell 8.9% (-12.0% y/y) in October to 544,000 (SAAR). It was the fourth decrease in the last five months and carried sales down to their lowest since March 2016. Revisions to previous months’ sales were positive, however: those in September, originally reported at 553,000, were revised to 597,000, and those in August, which had been reported last month at 585,000, were revised to 591,000. The October result did undershoot the expectations in the Action Economics Forecast Survey, which had estimated 585,000 sales. These sales transactions are recorded when sales contracts are signed or deposits are made.

The median price of a new home fell 3.6% (-3.1% y/y) in October to $309,700 from $321,300 in September. The average price of a new home rose, however, to $395,000 (+0.3% y/y) from $379.000 in September.

By region, the largest percentage decline last month was in the Midwest, where sales fell 22.1% (-16.7% y/y) to 60,000. Those in the Northeast dropped 18.5% m/m (-46.3% y/y) to 22,000. In the South, sales were off 7.7% in October (-11.6% y/y) to 313,000, while those in the West eased 3.2% (-6.3% y/y) to 149,000. (…)

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Evergrande: China’s biggest property developer faces debt crunch Investors wonder if company will be left out in cold from ‘frigid winter’ forecast for market

Housing is China’s Achille’s heel and Evergrande is the mother of risk there. As the FT points out, Evergrande had $208B in total liabilities at the end of June, the most of any Chinese developer, with $43B maturing over the next year which represents 61% of all Chinese developers maturities combined next year. “Ratings agency Standard and Poor’s named Evergrande in a list of 11 developers with “weak” or “less-than-adequate” liquidity profiles. But Evergrande was the strongest among this list with a rating of B plus and a positive outlook.”

Evergrande needed to accept 11% for 2Y dollar bonds last week, up from 8.75% on 8Y bonds last June, now trading on a yield-to-worst basis of 13.35% according to Grant’s.

This is not only China’s risk as J Capital’s Anne Stevenson-Yang explains:

Once the debt crisis comes, it will likely to be deflationary for the world. China will have little choice but to depreciate the currency in the face of demand for dollars, and that will force prices lower across the world. It is clear from recent weeks that the exchange value of the renminbi is now in the eye of a fiscal hurricane as it has not been for years.

Cash-Strapped Millennials Are Turning to Installment Plans to Pay for T-Shirts and Jeans Finance apps Afterpay and Affirm approve applicants in seconds and say their algorithms minimize default risk.

(…) Affirm and Afterpay say they’re targeting millennial shoppers by filling a gap between credit cards and store credit, which require lots of paperwork and a strong credit rating. (…)

Consumers apply online or via app and learn whether they’ve been approved in seconds. They click a button at checkout on the websites of participating retailers if they want to pay by installment. Cotton On, which sells inexpensive apparel, began offering U.S. installments through Afterpay in August. E-commerce chief Brendan Sweeney says 20 percent of buyers are already using the feature, which breaks up bills into four equal parts spread over six weeks and charges no interest.

“I was kind of skeptical that there would be a market for people interested in installments, but there clearly is,” he says. “We’ve seen a remarkable uptake from millennial customers.” Sweeney says shoppers spend $50 on average per order. (…)

The company charges no interest, instead collecting a fee of as much as 6 percent of a sale from the retailer. Afterpay works with 20,000 merchants globally—including 1,000 now online in the U.S. where the company has signed up Urban Outfitters, Anthropologie and Free People. Based on its recent monthly performance, Afterpay says it has a global sales run rate of more than $3 billion a year.

Afterpay is betting American millennials will be just as keen on its service as their Australian counterparts. The company says 65 percent of the U.S. cohort don’t have a credit card, are 30 on average and are intrigued by using installments to pay for merchandise. Leslie Parrish, a senior analyst at researcher Aite Group, says the simplicity of installments is at the heart of the appeal. “You know precisely when you’ll pay off that loan,” she says. “That gives you more discipline.” (…)

Affirm charges retailers a fee or consumers interest, which can be as much as 20 percent. Repeat customers, who have shown they can repay loans, typically pay lower interest. Those who default may be turned away next time. (…)

Affirm and Afterpay typically approve more than 80 percent of applicants, compared with about 50 percent for store credit. (…)

Afterpay and Affirm brush off such concerns, arguing that their technology analyzes hundreds of variables, even how fast a person is typing Confused smile, to determine credit-worthiness. (…)

There will be blood!

Bond Indexes Bend Under Weight of Treasury Debt The surge in government borrowing is beginning to warp bond indexes, posing a challenge for investors looking for the best returns amid rising interest rates.

(…) as the government steps up borrowing to fund last year’s tax cuts, index funds end up holding more Treasurys, squeezing out the securities that pay higher rates of interest.

The U.S. government is borrowing $129 billion this week, up 28% from the same series of note auctions a year ago. The increased borrowing means Treasurys now amount to almost 40% of the value in the leading bond market investment benchmark—the Bloomberg Barclays U.S. aggregate index—which fund managers use to gauge their success. That is up from around 20% in 2006, before the start of the financial crisis. (…)

As issuance increases, funds that use the Bloomberg Barclays aggregate index as a guidepost for portfolio composition will wind up owning increasingly large amounts of Treasury debt. Independent bond analyst David Ader predicts Treasurys will make up half of the U.S. bond market and the indexes that track it by 2028. (…)