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

China Inflation

NEW$ & VIEW$ (10 NOVEMBER 2015): China Bottoming; Earnings; Oil.

Ford UAW Workers to Vote on Pact With $30,000 More in Pay, Bonus

Ford Motor Co. employees represented by the United Auto Workers will begin voting on a proposed four-year contract that includes $30,000 in additional wages and bonuses and $9 billion in factory investments expected to create or secure 8,500 jobs, the union said. (…)

Wage increases of $10,633, plus a variety of bonuses guaranteed payouts, will boost the average production worker’s pay by a total of $32,513 over the life of the contract, according to the union. Skilled trade workers’ total compensation will grow an average or $35,098 over four years, the union said. Those calculations don’t include profit sharing. (…)

The Ford deal, though, is richer. Upon approving the contract, workers will get $10,000 in combined bonuses, including the payment for approval and $1,500 in profit sharing that has been pulled forward. They also annually will receive $1,750 in inflation protection and competitiveness payouts. (…)

OECD Sees Growth in Member Countries Expansion will help to offset the impact of a slowdown in emerging economies

The Organization for Economic Cooperation and Development said on Monday that lower oil prices and falling unemployment will bolster economic growth in the 34-nation group of developed economies, helping to offset the impact of a slowdown in emerging economies.

The forecasts underscore how the U.S. in particular is expected to remain an island of stability within the global economy, shrugging off an anemic recovery in Europe, weak growth in Japan and turmoil in China and other developing nations.

In its semiannual economic forecasts, the OECD said that growth in the U.S. would continue to be among the most robust in the group of nations, hitting 2.4% in 2017. It predicted the 19-nation eurozone would continue to lag behind the U.S., with growth at 1.5% this year, 1.8% next year and 1.9% in 2017. (…)

Growth throughout the OECD is forecast to hit 2% this year, 2.2% next and 2.3% in 2017. (…)

Japan, the OECD’s second-largest economy after the U.S., has been hit more significantly by the slowdown in China, the OECD wrote. Growth is expected to hit 1% next year but then slow to 0.5% in 2017, in part because of a consumption tax increase planned for that year. (…)

CHINA ECONOMY HAS BOTTOMED

Beijing has been quietly stimulating using all available tools.

  • House prices have resumed a rising trend.
  • Automobile sales have jumped in the last 2 months.

Now this from CEBM Research:

The CEBM Sales vs. Expectations Composite Index jumped from -30.5% in October to 26.8% in November. The rebound in this month’s index reading was driven by upstream activity in Central China in response to infrastructure project demand, a strong boost in auto sales, and better-than expected container freight export shipments. This month’s survey results display that despite continued weakness in aggregate demand some areas of the economy have begun to respond
positively to continued policy easing and stronger government spending in 3Q15.

Cement demand and pricing has improved noticeably in Central China in response to infrastructure project demand and seasonal factors. Auto sales were a particular bright spot in this month’s survey as sales were boosted by the government’s decision to halve the 10% purchase tax on small automobiles. Container freight export shipment survey respondents reported better-than-anticipated shipment volume and upbeat expectations for shipments November.

Other sectors remain weak but things must begin to turn up somewhere…Slow grind, but grind nonetheless.

China’s Inflation Slows in October

China’s consumer-price index rose 1.3% in October last month from a year earlier, according to the government’s statistics bureau. The pace was slower than the 1.6% year-over-year rise in September and a tick down from the median 1.4% gain forecast by 11 economists in a survey by The Wall Street Journal. Prices of goods at the factory gate fell 5.9% in October from a year earlier, matching September’s decline.

On a monthly basis, consumer prices edged down 0.3%.

Food prices rose 1.9% YoY, from 2.7% in September. Non-food prices climbed 0.9%. Prices of consumer goods increased 1%, while services increased 1.9%. Core CPI (ex-food, ex-energy) are up 1.5% YoY, in line with the last 10 month average.

QUESTIONS

Let’s assume the following environment for the next 12 months:

  • World GDP will grow some 3.0%, China +6.5% and the USA +2.5%.
  • Inflation will be close to zero.
  • Oil prices will decline 40%.
  • The USD will appreciate 20%.
  • U.S. manufacturing will be in recession dragged by weak exports and depressed oil markets.

S&P 500 EPS in that environment?

Few would have thought flat. Yet, they are flat YoY in Q315 with precisely that environment!

The earnings season is almost over and frankly, these earnings are remarkable:

  • Telecom:                   +14.7%
  • Cons. Discretionary: +14.6%
  • Health Care:              +12.7%
  • Financials:                 +  8.8%
  • Technology:               +  5.3%
  • Industrials:                 +  0.3%
  • Cons. Staples:           –  1.3%
  • Utilities:                      –   2.2%
  • Materials:                   – 15.3%
  • Energy:                       -57.1%

With 2 important sectors down big time, total EPS are essentially unchanged.

With exports down and the USD up 20%, industrial earnings are flat! From RBC Capital global equity team on Industrials’ earnings:

3Q15 earnings results not as bad as feared: We had been braced for a rocky 3Q15 earnings season thanks to the scorched-earth declaration by Fastenal on Oct-13 that the sector had entered an “Industrial Recession” along with negative preannouncements from Colfax and Eaton. That said, results have not played out quite as weak as anticipated, albeit against much lower expectations.

3Q15 earnings scorecard: Of the 24 companies that reported, we had 16 beats, 6 misses, and 2 in-lines. Organic revenue growth has been weaker, declining -2.0% vs. our estimate for -0.8%. Guidance has been broadly weaker with 12 out of 19 companies cutting their 2015 outlooks. In contrast, operating margins have come in better than expected, falling -35 bps YoY vs. our estimate for -70 bps.

Signs of stabilizing oil & gas declines: The most impactful read across from 3Q15 earnings season, in our view, was that oil & gas related cuts to earnings seem to be stabilizing for the first time since oil began its plummet back in Sept-2014. WESCO, Honeywell, Pentair, Roper, and General Electric all largely reiterated their 2015 views, and Dover only modestly tweaked its forecast lower.

Nerd smile Second question:

Assume the USD and Brent are unchanged from their current levels and everything else is trend lined. S&P 500 EPS 12 months out?

Some clues:

  • Ex-Energy, EPS are up 6.5% YoY. And ex-Materials, probably +7.2%. What can Industrials, Materials and Energy contribute without the USD and Oil headwinds?
  • Factset digs deeper:

For companies (ex-Energy) that generate more than 50% of sales inside the U.S., the blended earnings growth rate is 10.1%. For companies (ex-Energy) that generate less than 50% of sales inside the U.S., the blended earnings decline is -2.1%.

The blended sales growth rate for the S&P 500 (ex-Energy) for Q3 2015 is 1.4%. For companies (ex-Energy) that generate more than 50% of sales inside the U.S., the blended sales growth rate is 4.7%. For companies (ex-Energy) that generate less than 50% of sales inside the U.S., the blended sales decline is -4.9%.

So,

  • U.S. centric companies are increasing earnings 10.1% with revenue growth of 4.7% in a zero inflation environment and a 2.5% GDP growth rate.
  • Other non-Energy companies have been able to keep earnings from falling more than 2.1% on a 4.9% sales decline given weak foreign economies, a 20% appreciation of the USD and declining exports.
  • Any which way, margins keep rising! Cost discipline remains strong.

Next 12 months possibilities:

  • U.S. economy improves enough for Fed to raise rates.
  • Draghi keeps pushing.
  • Abe keeps shooting.
  • China keeps stimulating.
  • Brent flat at worst.
  • Copper et al flat at worst.

Current 2016 consensus: +8.6%

image

Doable.

SENTIMENT WATCH
Gundlach Says December Rate Increase a Threat to Stocks, Bonds

A December interest rate increase would threaten U.S. stock and bond markets while potentially driving up the value of the dollar to the point where it weakens the economy, according to Jeffrey Gundlach, chief executive officer of DoubleLine Capital.

“I have a hard time believing a Fed tightening will help the economy,” Gundlach, whose Los Angeles-based company manages about $80 billion, said Monday on a conference call with investors. “I think volatility will increase and the economy will weaken.” (…)

“For the time being,” Gundlach said, the threat of higher rates “will hurt the stock market.”

OIL
Oil glut to swamp demand until 2020 IEA says cleaner fuels and greater efficiency will depress prices
$80/Bbl Oil By 2020, Says IEA The oil markets should be rebalanced and prices should be in the $80 a barrel range by 2020, according to a new report issued by the International Energy Agency.
OPEC Rift Exposed as Oman Oil Minister Calls Group ‘Irresponsible’

Discontent with the Organization of the Petroleum Exporting Countries spilled into the open Monday, when Oman’s oil minister called current oil production levels “irresponsible” and blamed the group for contributing to low oil prices.

“This is a commodity that if you have one million barrels a day extra in the market, you just destroy the market,” said Mohammed Bin Hamad Al Rumhy, whose country produces oil but isn’t a member of OPEC. “We are hurting, we are feeling the pain and we’re taking it like a God-driven crisis. Sorry I don’t buy this, I think we’ve created it ourselves.”

Mr. Rumhy’s comments came at a conference in Abu Dhabi as he shared a stage with Suhail al Mazrouei, the United Arab Emirate’s top oil official, who is a top advocate of the producer group’s strategy. (…)

Mr. Mazrouei and other Persian Gulf oil officials said low prices are forcing industrywide spending cuts that won’t be sustainable for a prolonged period. That bodes well for prices soon, they said. (…)

In Doha, Prince Abdulaziz bin Salman, Saudi Arabia’s deputy oil minister, rejected the idea that the current period of low prices represents a fundamental lasting shift.

“A prolonged period of low oil prices is…unsustainable, as it will induce large investment cuts and reduce the resilience of the oil industry, undermining the future security of supply and setting the scene for another sharp price rise,” Prince Abdulaziz said.

“Just as the assertions, heard a few years ago—that the oil price would reach $200 a barrel—were proved wrong, so the recent assertion that the oil price has shifted to a new low structural equilibrium—will also turn out to have been wrong,” he added.

Without naming the U.S., Prince Abdulaziz essentially rejected a commonly held theory in the oil industry that production cuts from high-cost producers will “quickly reverse when oil prices start rising again.”

“This is wishful thinking,” he said. “Previous cycles have shown that the impact of low oil prices is long lasting, and that the scars from a sustained period of low oil prices can’t be easily ‘erased.’”

The prince pointed to strong demand for oil in both established and emerging markets as a reason for an eventual rebound in the market.

“Rather than being a commodity in decline, as some would like to portray, supply and demand patterns indicate that the long-term fundamentals of the oil complex remain robust,” he said. (…)

“No one is happy with the current situation,” a Saudi oil industry official said. “The lower oil prices are lasting longer than initially expected and everyone wants the price to bounce back up soon.”

NEW$ & VIEW$ (14 OCTOBER 2015): China, Fed, Earnings.

China Inflation Eases, Pressuring Beijing for More Stimulus

According to National Bureau of Statistics data released Wednesday, China’s consumer-price index rose 1.6% in September from a year earlier, slower than a 2.0% rise in August. (…)

A high-base comparison with year-earlier figures and nearly flat pork prices after a series of sharp monthly increases over the summer helped reduce consumer inflation, official data showed. (…)

Non food prices climbed 1%. Prices of consumer goods increased 1.4%, while services increased 2.1%.

Yu Qiumei, an economist with the statistics agency, said in a statement that food prices declined 0.1% from a month earlier in September while nonfood prices increased 0.2%. (…)

China’s producer-price index dropped 5.9% in September from a year earlier, in line with expectations and matching a drop in August. (…)

According to the People’s Bank of China, loan demand in the manufacturing sector fell to 49.3 in the third quarter, the first time it has been below 50 since the central bank started releasing the data in 2004. This compares with 53.1 in the second quarter of 2015 and 59.3 in the third quarter of 2014.

Rich Nations Lose Emerging-Markets Motor New weakness in China’s economy heightens concerns that developing countries are weighing on rich ones

(…) “It’s clear that the slowdown in emerging markets is having an impact on developed markets,” said Adam Slater, a senior economist at Oxford Economics in London. “Emerging markets have been a very positive force for world growth over most of the last 10 years, and now the big contribution is dropping away.”

New evidence is emerging that developing countries are buying fewer capital goods and higher-end products from richer countries. In addition to China’s announcement that its consumer-price index rose just 1.6% in September from the same period a year earlier, Indonesia, Southeast Asia’s largest economy, imported 16% fewer goods for its factories in the year through August.

Such grim data is reflected in the eurozone, which on Wednesday blamed a fall in industrial output in August on large developing economies such as China; in Germany, which this month announced a surprise fall in manufacturing orders in August and the lowest exports in seven years; in Japan, whose factory output was weaker than expected in the same period; and in the U.S., where exports for that month were their smallest since 2011. (…)

Emerging markets increased their share of manufacturing and exports to 52% of global gross domestic product compared with 38.3% just 15 years ago, according to Oxford Economics.(…) Minutes from the European Central Bank’s governing council meeting in September reveal lower GDP growth forecasts for the euro area: to 1.4% this year and 1.7% in 2016 from 1.5% and 1.9% three months ago. The bank said the revised outlook in part “reflected lower external demand owing to weaker growth in emerging markets.” (…)

While China accounted for 10% of world trade from 2000 to 2014, it contributed 15% to global growth, according to Oxford Economics. In that time, Brazil, India and Russia combined accounted for 15% of world trade and contributed 23% of its growth. (…)

Punch It’s all relative. From a U.S. perspective, exports, and exports to China, remain relatively less consequential:

The Russian government is debating whether to place limits on how much the rouble is allowed to strengthen against the US dollar in order to reduce the economy’s reliance on oil, gas and metals, according to a senior government official.

The proposal is part of a broader discussion among Moscow’s economic policymakers over how to use the pressures of the extended economic slump brought on by low oil prices and western sanctions to force through long-delayed structural reforms and boost export competitiveness.

“In case the economy weakens, the rouble can fall freely and we will not intervene. But in the course of at least two to three years, it cannot strengthen more than, for example, 55 or 50 to the [US] dollar,” said a senior official. (…)

Most Fed Regional Boards Favored Discount-Rate Rise in September The boards of directors at eight of the 12 regional banks in the Federal Reserve system voted last month in favor of increasing the rate for direct loans from the Fed to 1 percent from 0.75 percent, according to details released by the U.S. central bank on Tuesday.

Divisions have burst into the open at the top of the Federal Reserve over when to lift interest rates, casting a fresh cloud of uncertainty over the US central bank’s strategy for withdrawing its monetary stimulus.

In the past two days, two members of the US Federal Reserve board have signalled they are opposed to a near-term increase in interest rates, questioning the approach adopted by chair Janet Yellen amid divisions over the outlook for inflation.

Daniel Tarullo said in a CNBC interview on Tuesday that his current expectation was that it was not appropriate to raise rates this year, joining fellow governor Lael Brainard in favouring a wait-and-see approach. (…)

The interventions further cloud muddy communications from the Fed about the policy outlook, at a time when investors have been calling for a sense of where the Fed is heading. Given the divisions in the central bank, however, there is a risk of further confusion in the weeks ahead.

  • Fed officials universally accepting slowing payroll growth

While views on the appropriate path of policy have varied, Fed officials seem to be in the process of providing reassurances to the market that even if payroll growth slows from here it will not be a cause for concern. On Friday, Dudley and Lockhart promoted the narrative that even if jobs ease back a bit (to something resembling the more recent NFP prints) it is still more than enough to absorb the growth in the labor force. Even the uber-dovish Evans noted employment is not worrying him and the long-run sustainable payroll growth rate is south of 100k. Vice Chair Fischer chimed in over the weekend, and Williams and Bullard have made similar comments in recent days.

So what that means is this view seems to be held across the full dove/hawk spectrum. In our view, this is likely part of an effort to lift expectations regarding a December liftoff. This all goes back to the idea that if they truly want to start the tightening process at yearend— keep in mind we think by then they will already be 6 months late to the tightening party—they are going to have to sell the idea very hard. (RBC Capital)

  • BULLARD: SUB-200K PAYROLL GAINS MAY BECOME THE NORM IN NEXT FEW YRS
  • DUDLEY: 120-150K JOBS/MONTH ENOUGH TO PUSH U/E RATE DOWN
  • EVANS: LONG-RUN SUSTAINABLE JOBS GROWTH TO BE SUB-100K/MONTH
  • FISCHER: SLOWER RECENT JOBS GROWTH STILL ENOUGH TO ERODE SLACK
  • LOCKHART: RECENT JOB GAINS STILL MORE THAN ENOUGH TO ACCOMMODATE TREND GROWTH IN LABOR FORCE
  • WILLIAMS: JOB GAINS STILL SIGN ECONOMY IMPROVING, 100-150K “WOULD BE GOOD TO ME”
    Source: RBC Capital Markets US Economics, Bloomberg, MNS
Mounting Full-Time Employment Shows Less Slack for Yellen’s Fed

(…) The number of Americans working part-time for reasons related to the economy dropped by 447,000 in September from the prior month to 6.04 million, the fewest since August 2008, according to figures from the Labor Department. The level has dropped by a little more than 1 million over the past 12 months. (…)

The Federal Reserve Bank of Atlanta has put together a gauge that attempts to better estimate sluggishness in the labor market. The so-called Z-Pop ratio measures the share of the working-age population putting in full-time hours, working less than a full week by choice or not wanting to work at all.

The share of people who are content with their labor market status is on the rise, in part because of the decline in involuntary part-time work. About 92 percent were fully utilized or satisfied with their employment status in September. The remaining 8 percent were counted as under-utilized.

The ratio is “consistent with a tightening labor market,” John Robertson, an Atlanta Fed economist who’s worked on the project, said in an e-mail.

The Z-Pop ratio is closer to pre-recession levels than other measures, including the share of the working-age population with jobs, and also shows more marked improvement in recent months.

Gauges such as the employment-population ratio are being damped by the exodus from the workforce of retiring baby boomers, which is less related to the state of the economy. (…)

EARNINGS WATCH
  • 30 companies (9.0% of the S&P 500’s market cap) have reported. Earnings are beating by 2.9% while revenues have missed by -0.9%.
  • The beat rate so far is 70% on EPS and 40% on revenues.
  • Expectations are for a decline in revenue, earnings, and EPS of -3.6%, -5.3%, and -4.2%. Ex-Energy, these would be +1.8%, +1.9%, and +3.1%. This excludes the likelihood of beats, which have been above 4% over the past three years.
  • Yesterday JP Morgan reported a $1.0 billion litigation cost, a 40 bps drag on S&P 500 earnings growth. (RBC Capital)
CLSA Just Stumbled On The Neutron Bomb In China’s Banking System

(…) According to CLSA estimates, Chinese banks’ bad debts ratio could be as high 8.1% a whopping 6 times higher than the official 1.5% NPL level reported by China’s banking regulator!

As Reuters reports, the estimate is based on analysis of outstanding debts for more than 2700 A-share companies (ex-financials) and their ability to repay loans. Or in other words, if one backs into the true bad debt, not the number given for window dressing purposes by Chinese “regulators”, based on collapsing cash flows, what one gets is a NPL that is nearly 10% of all outstanding Chinese debt.

Reuters has some more details on the methodology:

  • Two consecutive years of a co’s interest coverage (EBITDA/interest expense) below 1x or losses for two successive years qualifies for debts to be treated as “bad” in CLSA’s analysis.
  • By these measures, wholesale & retail and manufacturing sectors boast the highest implied NPLs at 21.1% and 15.8% respectively, taking into account total debt
  • While China’s real estate sector has been the most aggressive in adding debt, profitability at developers in tier-1 cities has held up well, muting the overall NPLs for the sector
  • Developers in tier-2 and tier-3 cities, however, show high implied NPLs
  • As bad debts rise, burden falls on PBOC to ensure sufficient liquidity so that Chinese banks can gradually absorb the credit costs, CLSA says.

Yes, the PBOC’s burden most certainly rises, and what a burden it is: here’s why.

The chart below shows the history of total Chinese bank assets: as of the latest official data, the number is roughly $30 trillion.

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 8% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $1 trillion.

In other words, while China has been injecting incremental liquidity into the system and stubbornly getting no results for it leading experts everywhere to wonder just where all this money is going, the real reason for the lack of a credit impulse is that banks have been quietly soaking up the funds not to lend them out, but to plug a gargantuan, $1 trillion, solvency shortfall which amounts to 10% of China’s GDP!

Omega Advisors’ Leon Cooperman: 7 Thoughts About the Markets