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

MANUFACTURING

NEW$ & VIEW$ (25 AUGUST 2014)

Today: Did you miss JACKSON WHOLE? Global manufacturing getting reshuffled. Earnings Watch.
Jackson Hole Theme: Labor Markets Can’t Take Higher Rates Global central bankers led by Federal Reserve Chair Janet Yellen said labor markets still have further to heal before their economies can weather higher interest rates.

The focus on jobs suggests the Fed and Bank of England will tighten policy within a year as their economies show signs of strengthening. By contrast, European Central Bank President Mario Draghi and Bank of Japan Governor Haruhiko Kuroda acknowledged they may be forced to deploy fresh stimulus. (…)

Yellen’s message was “there is room for debate over how much slack, as we say, is in the U.S. labor market,” said former Fed Vice ChairmanAlan Blinder, who now teaches at Princeton University in New Jersey. “But in her view, as she looks at all the evidence, the case is close to overwhelming that there is a significant amount left.”

Blinder said there’s a “vigorous debate” among economists and investors about how sluggish the labor market still is. Its surprising strength suggests “we are closer to Fed liftoff than we were a year ago” and rates probably will be increased early next year, he said. (…)

More Economists See Fed Policy As Too Loose Economists overwhelmingly expect the Federal Reserve to hold off raising short-term interest rates until at least 2015. But nearly a third say doing so would mean the central bank waited too long, a new survey found.

The share of economists saying the Fed should raise rates in 2014 has grown from 25% in the organization’s February policy survey.

In a separate Wall Street Journal survey released earlier this month, 91% of economists said the Fed waiting too long to raise rates was a greater risk than lifting rates too soon.

Euro Down on Draghi Comments The euro sank to its lowest level in nearly a year and European stocks climbed, after ECB President Mario Draghi signaled a shift in emphasis.

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Denmark Seen Cutting Growth Outlook as Russia Dispute Weighs
Bank of Canada won’t follow Fed’s lead on interest rates, Poloz says

“The main thing people should understand is that our policy is quite capable of being fully independent, as it has been these past few years,” Mr. Poloz said in an interview at the annual gathering of central bankers and economists at Jackson Hole, Wyo., over the weekend. (…)

While Mr. Poloz insisted he wasn’t making predictions, he offered several reasons to explain why he would feel no pressure to reflexively follow the Fed. For one, the Bank of Canada has a head start. “It’s worth reminding people that we are at 1 per cent,” Mr. Poloz said. “In this world, that’s a high number when everything is starting at zero.”

The Bank of Canada is seeking to return its benchmark interest rate to a setting that neither stokes inflation nor hurts the economy. Before the crisis, the “equilibrium rate” was understood to be about 4 per cent. The central bank now thinks scars from the crisis have lowered that rate. “When you think the equilibrium number is at some lower rate than in the past, which I do, but I don’t know yet what it might be, then at least we know that we are part way there already,” Mr. Poloz said.

The other factor is the relative strength of the two economies. The U.S. has considerable forward momentum, while Canada still is waiting on a revival in exports and business investment. Stronger demand in the U.S. should benefit Canada’s economy. Monetary policy in the two countries is so similar because of their close trade links: When the U.S. economy grows, Canada sells more exports, which boosts economic growth and puts upward pressure on inflation.

Canada’s loss of market share raises questions about whether stronger U.S. growth will boost Canada’s economy to the extent it has in the past. Mr. Poloz says he is counting on new exporters to replace those wiped out by the recession, creating an incentive to leave borrowing costs low to help those entrepreneurs get started. Canada’s job growth this year is almost entirely driven by part-time positions, while U.S. employers are adding jobs at one of the most impressive rates on record.

“The linkage between their recovery and ours is not mechanical … We still have question marks around ours,” Mr. Poloz said. “We ought to be able to strike a fully independent course determined by these other things quite independently of what theirs are.”

Like Draghi, Poloz wants (needs) a weaker currency. This is not unrelated:

The Rising—and Falling—Stars of Global Manufacturing

(…) According to a new report from the Boston Consulting Group—which for several years has tracked the competitiveness of global producers—the old assumptions of low cost versus high-cost regions is outdated. (…)

Mexico is now cheaper than China and the U.K. has emerged as a low-cost manufacturer relative to most of its European neighbors, according to the BCG calculations. Brazil, meanwhile, has become one of the world’s priciest places to make things; its cost structure is tied with those of Italy and Belgium in the BCG rankings.

The study used the U.S. as a baseline and found Brazil’s average costs went from 3% lower than in the U.S. in 2004 to 23% higher today. BCG notes Brazilian factory wages more than doubled over the decade, while productivity growth faltered. The cost of buying electricity for factories in that South American country have doubled, while natural gas prices have leapt nearly 60%.

Pointing up The clear winners in this global scramble, according to BCG, are Mexico and the U.S. The two neighbors saw their competitiveness improve more than in any other country studied. “Because of low wage growth, sustained productivity gains, stable exchange rates, and a big energy-cost advantage, these two nations are the current rising stars of global manufacturing,” the report said.

THE U.S. KEEPS ON TRUCKING

American Trucking Associations’ advanced seasonally adjusted For-Hire Truck Tonnage Index rose 1.3% in July, following a decrease of 0.8% the previous month. In July, the index equaled 130.2 (2000=100) versus 128.6 in June. The index is off just 0.6% from the all-time high in November 2013 (131.0). 

Compared with July 2013, the SA index increased 3.6%, up from June’s 2.3% year-over-year gain. The latest year-over-year increase was the largest in three months. Year-to-date, compared with the same period last year, tonnage is up 2.9%.

“After a surprising decrease in June, tonnage really snapped back in July,” said ATA Chief Economist Bob Costello. “This gain fits more with the anecdotal reports we are hearing from motor carriers that freight volumes are good.”

Costello added that tonnage is up 4.9% since hitting a recent low in January.

Trucking serves as a barometer of the U.S. economy, representing 69.1% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

(CalculatedRisk)

MORE ON THE U.K. EMPLOYMENT SURGE

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WEAK COMMODITIES TO KEEP INFLATION IN CHECK

Futures dropped a fifth consecutive week after money managers reduced net-long positions in West Texas Intermediate, the U.S. benchmark grade, by 14 percent in the seven days ended Aug. 19, the Commodity Futures Trading Commission said.

Hedge funds and other speculators cut bullish bets on Brent to the lowest level in two years, data released today by the ICE exchange show. Money managers’ wagers that prices will rise, in futures and options combined, outnumbered wagers that prices will fall by 63,079 contracts in the week ended Aug. 19, the least since July 10, 2012.

Net-longs for WTI slipped by 30,225 to 188,589 futures and options, the lowest level since the seven days ended April 23, 2013. Long positions fell 4.2 percent to 258,246, the least since June 2013. Shorts climbed 37 percent to 69,657, the highest level since December 2012.

Prices sank below $95 on Aug. 19 for the first time in seven months as U.S. air strikes in Iraq helped reverse the advance of Islamic State fighters and the country’s Kurds work to increase oil shipments. Libyan output climbed last week and exports resumed from the port of Es Sider. Refineries in the U.S. typically schedule work for September and October, when demand for gasoline declines after the summer peak, and before consumption of heating fuel picks up during winter. (…)

Iraq’s Kurds are working to quadruple the capacity of their oil-export pipeline within months, an official with knowledge of the situation said, asking not to be named because of policy. The Kurdistan Regional Government, or KRG, more than doubled daily capacity to 300,000 barrels on its link toTurkey as of Aug. 21, and is considering another increase that would allow the line to move 500,000 barrels a day to the Mediterranean port of Ceyhan within as little as three months, he said.

In Libya, production increased to 612,000 barrels a day on Aug. 21, according to Mohamed Elharari, a spokesman for National Oil Corp. Two cargoes have loaded at the reopened port of Es Sider, according to the NOC. The North African country pumped 400,000 barrels a day in July, according to a Bloomberg survey of oil companies, producers and analysts.

The increase in crude supply from Libya and Iraq comes as the EIA forecasts U.S. production will reach 9.28 million barrels a day next year, the highest annual average since 1972. (…)image

EARNINGS WATCH

Earnings season effectively over. Factset:

Of the 490 companies that have reported earnings to date for Q2 2014, 74% have reported earnings above the mean estimate and 66% have reported sales above the mean estimate. The blended earnings growth rate for Q2 2014 is 7.7%. On June 30, the estimated earnings growth rate for Q2 2014 was 4.9%. Eight of the ten sectors have higher growth rates today (compared to June 30) due to positive earnings surprises, led by the Health Care sector.

Earnings Guidance: For Q3 2014, 74 companies have issued negative EPS guidance and 27 companies have issued positive EPS guidance.

This 73% negative guidance is below that of May 22 (75%) and March 21 (84%). It is also substantially lower than that of August 22, 2013 (83%).

S&P’s tally puts Q2 EPS at $29.45 (+11.7% Y/Y), rising to $30.11 (+11.8%) in Q3 and $32.39 (+14.7%) in Q4, all only pennies lower than in previous weeks. Trailing 12-m EPS are now $111.94 (+12.8% Y/Y). They are seen rising to $115.13 after Q3 and to $119.27 after Q4, up 2.8% and 6.5% from Q2’s number respectively.

Inflation having stabilized at 2.0%, the fair Rule of 20 P/E is 18 which gives a target of 2015 for the S&P 500 Index, potentially rising to 2072 and 2150 after Q3 and Q4 respectively.

The earnings tailwind is pretty good while inflation seems to have stabilized at 2%. The market keeps bumping against the “20” valuation level without enough impetus or confidence to traverse it like it normally does (see THREE-STARRED EQUITIES). There has been no “sell in May” and no “summer swoon”. There has also been no “mid-term bust”, so far, which would break a pattern perfect since 1962. These may be comforting as we enter the more volatile months of the year…If you missed it Sunday, maybe you should read JACKSON WHOLE.

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Yield-Starved Investors Take Bigger Risks

Companies with lower credit ratings have raised $186 billion in junk loans so far this year, according to Dealogic. The riskiest tranche of that debt—so-called second-lien, or junior, loans—amounts to $3.3 billion, almost double the amount raised at the same stage last year and the most over the same period since 2007. (…)

If a borrower goes bust, junior lenders are only repaid if some other, higher-ranking lenders, get all their money back. Only unsecured creditors and shareholders are further down the queue. Companies also get better terms—junior loans are less restrictive when it comes to taking on additional leverage than senior debt, while borrowers get more flexible repayment options than bonds.

In exchange for the additional risk, investors get a better return. Interest rates on junior loans are typically 3.5 percentage points higher than senior loans, bankers say. (…)

Dealogic data show that more than half the loans that include junior debt have been used for acquisition financing, with a smaller proportion financing dividend payments. (…)

Losses on junior loans can be steep if a company fails. The average recovery rate on defaulted junior loans in Europe between 2003 and 2013 was 36%, according to Standard & Poor’s. That compares with 76% on senior loans, S&P data show.

 High-Yield Spreads Often Narrow During the Early Stages of Fed Tightenings

Ordinarily, monetary tightening is an attempt to contain the inflationary risks arising from above-trend business activity. Because of the latter, high-yield bond spreads tend to narrow at the start of a series of Fed rate hikes. However, spreads often widen considerably once activity has slowed by enough to shrink profits, threaten liquidity, and materially lift recession risk.

Regarding the four episodes of Fed rate hikes since 1993, the high-yield bond spread narrowed by -26 bp, on average, six-months after the start of monetary tightening, but would then widen by 26 bp and 118 bp, on average, 12- and 18-months after the first rate hike. (…)

Beware of averages, even more so if over only 4 cycles which include two huge bubbles. Looking carefully at Moody’s charts, I would take little solace from the “average” narrowing in spreads early on.

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S&P 500 companies reduce buybacks Corporate treasurers are wary of high stock prices

Companies in the S&P 500 bought back $120bn of shares in the quarter to June 30, down from $159bn in the first quarter, which was the second-largest amount ever, according to preliminary data from S&P Dow Jones Indices.

Market watchdog issues cyber attack warning Iosco chief says hackers have potential to trigger ‘black swan’ event

Greg Medcraft, chairman of the board of the International Organisation of Securities Commissions (Iosco), predicted that the next major financial shock – or “black swan event” – will come from cyber space, following a succession of attacks on financial players.

He warned that there needed to be a more concerted effort to tackle cyber threats around the world as current approaches varied widely. “The feedback we have had from industry in discussions is that there is not a consistency in approach,” he said.

NEW$ & VIEW$ (18 MARCH 2014)

Food Prices Surge as Drought Exacts a High Toll on Crops Surging prices for food staples from coffee to meat to vegetables are driving up the cost of groceries in the U.S., pinching consumers and companies that are still grappling with a sluggish economic recovery.

imageSurging prices for food staples from coffee to meat to vegetables are driving up the cost of groceries in the U.S., pinching consumers and companies that are still grappling with a sluggish economic recovery.

Federal forecasters estimate retail food prices will rise as much as 3.5% this year, the biggest annual increase in three years, as drought in parts of the U.S. and other producing regions drives up prices for many agricultural goods. (…)

In the U.S., much of the rise in the food cost comes from higher meat and dairy prices, due in part to tight cattle supplies after years of drought in states such as Texas and California and rising milk demand from fast-growing Asian countries. But prices also are higher for fruits, vegetables, sugar and beverages, according to government data. In futures markets, coffee prices have soared so far this year more than 70%, hogs are up 42% on disease concerns and cocoa has climbed 12% on rising demand, particularly from emerging markets. (…)

Inflation also could be tempered if U.S. farmers, as expected, plant large corn and soybean crops this spring and receive favorable weather during the summer. That would hold down feed prices for livestock and poultry, as well as ingredient costs for breakfast cereals and baked goods.

The U.S. Department of Agriculture estimated last month that retail food prices will rise between 2.5% and 3.5% this year, up from 1.4% last year. The inflation comes despite sharp decreases over the past year in the prices of grains, including corn, after a big U.S. harvest. In other years—notably 2008—surging grain prices were a key contributor to higher food costs. (…)

One reason prices are higher now is the lingering effect from the historic 2012 U.S. drought, which sent animal-feed prices surging to record highs and caused livestock and dairy farmers to cull herds, analysts said.

In California, the biggest U.S. producer of agricultural products, about 95% of the state is suffering from drought conditions, according to data from the U.S. Drought Monitor. This has led to water shortages that are hampering crop and livestock production.

imageU.S. fresh-vegetable prices that jumped 4.7% last year are forecast to rise as much as 3% this year, while fruit that gained 2% last year will rise up to 3.5% in 2014, according to the USDA.

Dry weather in Brazil has contributed to a dramatic increase this year in prices for arabica coffee, the world’s most widely produced variety. Arabica-coffee futures, which were at a seven-year low last year, settled at a two-year high of $2.0505 a pound on March 13.

In each of the past two years, global food prices on average declined from the previous year, as farmers ramped up production of wheat, sugar and other commodities, according to the United Nations Food and Agriculture Organization, which publishes a monthly food-price index. But that index rose 5.2 points to 208.1 last month compared with January, the sharpest jump since mid-2012.

Food-price increases are a particularly touchy issue for emerging markets, where spending on food accounts for a higher share of monthly budgets than in wealthier countries. (…)

In last week’s post on rising food prices, I also warned of the coming El Niño which we last saw in 2009:

Commodities investors and farmers are on alert after the third official warning in a week of an El Niño weather phenomenon emerging that could affect food and energy markets already reeling from extreme weather in many parts of the world.

Smile U.S. inflation muted despite food price increases

The Labor Department said its Consumer Price Index nudged up 0.1 percent as a decline in gasoline prices offset an increase in the cost of food. It had ticked up 0.1 percent in January and last month’s gain was in line with economists’ expectations.

In the 12 months through February, consumer prices increased 1.1 percent, slowing from a 1.6 percent rise in January. The February increase was the smallest rise since October last year.

Last month, food prices rose 0.4 percent, the largest increase since September 2011. That accounted for more than half of the increase in the CPI last month.

Stripping out the volatile energy and food components, the so-called core CPI also rose 0.1 percent for a third straight month. In the 12 months through February, core CPI rose 1.6 percent after advancing by the same margin in January.

Has Food Stamp Enrollment Finally Peaked? After years of increases that defied the roaring stock market of 2013 and the slowly falling unemployment rate, the number of Americans receiving food stamps appears to be easing. Somewhat. Very, very slowly.

The U.S. Department of Agriculture, which administers the Supplemental Nutrition Assistance Program, reported that 46.8 million Americans received SNAP benefits in December. That is a lot of people, but it’s also the lowest number of Americans to receive benefits since June 2012. The December 2013 figure was down 1 million people from December 2012.

The USDA also reported that 22.8 million households received SNAP benefits in December, which is the lowest number since August 2012. And the $5.8 billion in SNAP benefits that was paid out in December was the lowest number since November 2010.

SNAP data can bounce around, and it’s unclear whether the number of people receiving benefits will continue to fall. The December figures don’t take into account changes that were made in February when Congress passed a farm bill that included new limits on who can receive food stamps. Also, as more and more Americans return to work and earn more money, the number of people receiving these benefits is expected to fall, though many thought total enrollment would fall more quickly than it has.

U.S. Factories Rev Up

Industrial production increased a seasonally adjusted 0.6% in February from the prior month, the Federal Reserve said Monday. Capacity utilization, a gauge of slack across industries, was up 0.3 percentage point to a 78.8% rate.

In one positive sign, manufacturing output—the largest component of industrial production—jumped 0.8% in February. That was the biggest gain since August and nearly retraced a 0.9% January drop. (…)

Manufacturing output had tumbled 0.9% in January. “Much of the swing in the rates of change for production in January and February reflected the depressing effects on output of the severe weather in January and the subsequent return to more normal levels of production in February,” the Fed said. (…) (Chart from Haver Analytics)

Confused smile I thought severe weather hit much of February.

February ended with its coldest final week since 2003, according to Berwyn, Pennsylvania-based weather data provider Planaytics Inc., The second week of the month was the snowiest such period since 2007.

It will all be clearer in April Fingers crossed.

And while the weather effect may be fading, manufacturers still have to cope with inventory backlogs. Factory stockpiles rose steadily last year as production outstripped demand. Inventories of durable goods—products designed to last at least three years—hit a record level in January. When too many goods pile up on shelves, companies typically slow output.

New York manufacturers said business conditions improved this month, although new demand remains sluggish, according to the Federal Reserve Bank of New York’s Empire State Manufacturing Survey released Monday. The Empire State’s business conditions index increased to 5.61 in March after it fell to 4.48 in February from 12.51 in January, which had been the highest reading since May 2012.

FINAL WEATHER SCORES

Assuming there are no revisions (Winking smile), here’s the final tally via Mother Jones:

This winter has been a tale of two Americas: The Midwest is just beginning to thaw out from a battery of epic cold snaps, while Californians might feel that they pretty much skipped winter altogether. In fact, new NOAA data reveal that California’s winter (December through February) was the warmest in the 119-year record, 4.4 degrees Fahrenheit above the 20th century average. temperature map

U.S. Home Builders Remain Cautious U.S. home builders remained cautious about the housing market in March, suggesting a driver of the recovery might be sputtering for reasons beyond the severe winter weather.

Builder confidence in the market for single-family homes rose just one point from a month earlier to a seasonally adjusted 47 in March, the National Association of Home Builders said Monday. Readings below 50 indicate more builders view conditions as poor than good.

The increase, which was smaller than expected, comes after a drop of 10 points in February, the biggest one-month decline on record. Builders reported they were slowed by poor weather, but also said they were also hampered by difficulties finding labor and land. (…)

Monday’s report showed sales and traffic increased slightly in March, but sales expectations over the next six months declined. (Chart from Haver Analytics)

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image Housing Starts in U.S. Little Changed From Stronger January

The 0.2 percent decrease to 907,000 homes at an annualized rate last month followed a revised 909,000 pace in January, figures from the Commerce Department in Washington showed today. The median estimate in a Bloomberg survey called for a 910,000 rate after a previously reported 880,000 in January.

Permits filed for future projects increased 7.7 percent to a 1.02 million pace in February, the most since October and reflecting a surge in applications for apartment-building construction. One-family home-building permits dropped for a third straight month to the lowest level in a year. (Chart from CalculatedRisk)

CONTAINER IMPORTS DECLINE FOR SECOND STRAIGHT MONTH

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U.S. ocean container export volumes fell 4.7 percent from January, following two months of modest increases. Exports to China, one of our largest trading partners, have fallen for the last two months. Recently the Chinese economy has slowed, with factories closing and wages falling. Exports to many of our other major trading partners decreased in February as well. This was the worst February for container exports in the last five years. Compared to February 2013, exports were down 16.8 percent. (Cass)

Must be the weather, somewhere…

EU Auto Demand Revs Up

New car registrations, which closely track actual sales, rose 8% in February from the same month a year earlier to 861,058 vehicles, the European Association of Automobile Manufacturers, known as ACEA, said. Car sales in February rose for the sixth consecutive month after six years of falling demand. Car sales in January and February combined were up 6.6%.

Car sales fell 1.4% in France last month, while sales in Germany, the EU’s biggest car market, rose 4.3% and are up 5.7% so far this year. Car sales rose 3% in the United Kingdom and were up 8.6% in Italy and 17.8% in Spain.

German Court Clears Bailout Fund Germany’s highest court ruled that the euro zone’s permanent bailout mechanism is in line with the country’s constitution, confirming a ruling that had been crucial to put an anticrisis firewall in place.
imageRussian Sanctions vs. Russian Debt Exposure

(…) Russia clearly does not have a public foreign debt problem, but it does have a private foreign debt problem. Its corporates have issued FX-denominated bonds now worth 10% of its GDP (see the chart “Russian External Bonds”). That issuance has grown further and faster than for emerging markets as a whole, as well as commodity-exporting EM economies which tend to be the perennial bad boys of debt.

Who owns this foreign debt? Bonds are bearer instruments so we don’t know. But we do know something about bank exposure to Russia, and it is European banks that are exposed to the lion’s share of the problem. European banks’ exposure to Russia totals $272bn, which is about a fifth of their exposure to the GIIPS economies. In and of itself, that doesn’t sound like the makings of a crisis, but it is clearly an additional deleveraging headwind that will buffet a banking sector that has barely recovered from its 2011-12 “near-death” experience.

The circumstances under which this exposure could turn into a crisis are where a weakening ruble makes the foreign debt burden difficult for Russian banks and non-financial corporations to service, especially at a time when weakening domestic growth threatens their earnings momentum. Those circumstances are neither distant nor unlikely.

CHINA
China FDI data indicates sharp slowdown in February  China drew $19.3 billion in foreign direct investment (FDI) in the first two months of 2014, up 10.4 percent from a year earlier, the Commerce Ministry said on Tuesday, indicating a sharp slowdown in February due to the Lunar New Year holidays.

China drew $19.3 billion in foreign direct investment (FDI) in the first two months of 2014, up 10.4 percent from a year earlier, the Commerce Ministry said on Tuesday, indicating a sharp slowdown in February due to the Lunar New Year holidays.

Chinese Companies Caught in Yuan Riptide China’s decision to squeeze speculators out of its currency is causing pain for local companies and individual investors.

(…) paper losses on one popular way companies hedge their yuan exposure and individual investors bet on the yuan, through what is known as target redemption-forward products, have hit $2.3 billion, on contracts valued at $150 billion. (…)

For now, most of the losses remain on paper because investors and companies haven’t yet sold their positions. However, banks are asking both corporate and individual clients with losing bets to pony up more collateral, traders in Hong Kong say. Banks also are advising companies to restructure their investments around weaker levels for the yuan, a cheaper alternative than completely unwinding millions of dollars of the products, which were originally designed to help companies hedge against gains in the yuan.

While the recent declines likely aren’t big enough to trigger a stampede out of the yuan, the added volatility in the exchange rate may give some investors pause. (…)

CHINA’S REAL ESTATE CRISIS

This potential risk is now widely known (WATSA ON CHINA). Stratfor just wrote a piece on China housing (Tks Maurice). Some excerpts from A Difficult Year Looms for China’s Real Estate Market:

(…) At the moment, the price cuts are confined to a few complexes and areas associated with specific developers. Nevertheless, falling prices have given way to growing pressure to sell in local property markets across the country, posing a serious threat to the stability of the national real estate market and the economy as a whole. (…)

There is massive oversupply and rampant speculation, and local governments are highly dependent on property-related revenues. (…)

The real estate market has become the linchpin of economic growth and local government financing. The real estate sector boomed behind fast-paced urbanization and skyrocketing demand from the rising middle class, but equally important was the political incentive to offer unrestrained credit in order to turn the market into a driver of economic development. Now that Beijing is focused on the structural problems of the country’s economy and its impending slowdown, the government is no longer able to keep prices high. (…)

According to official estimates, property loans by 2013 accounted for about 38 percent of total loans, compared to about 28 percent in 2007. This included 13 percent from mortgages for individuals (down from about 20 percent in 2007), 10 percent for real estate developers and approximately 15 percent for local government financing vehicles (entities created by local governments to raise money for mostly infrastructure and property development projects). In 2014, approximately 2.39 trillion yuan in local debt will mature, most of which is highly dependent on land transfer fees and thus land and property prices for financing and repayment. Cities and provinces that have a high dependence on real estate finances and with declining local economies will be exposed to higher risk, including
Zhejiang, Fujian and Sichuan. Additionally, real estate is the primary source of collateral for about three-fourths of bank loans for many sectors, including manufacturing, steel and shipbuilding. A downturn in real estate prices could undermine the banks’ ability to recover loans for many of these already strained sectors.

Bank exposure to the real estate sector is increasingly off the books – in the form of wealth management products, which have become central features of China’s “shadow” lending sector in recent years, or trust funds — since the credit line was tightened in 2011. In 2014 alone, approximately 4 trillion to 4.5 trillion yuan in high-rate trust funds will mature, about 633.5 billion yuan of which is tied to real estate. Sporadic defaults in small and regional banks associated with industries such as
coal and steel have already occurred. A sharp decline in property prices would add significantly to the risk of bank defaults.

Beijing still has a handful of policy tools to prevent the real estate crisis from spreading nationwide, including loosening restrictive policies on developers and individuals or adding liquidity to the market as it did during the 2008-09 financial crisis. But the central government is also under pressure to refrain from generating greater systemic risk and putting into question its ability to maintain economic and financial stability. With local industries such as coal and manufacturing slowing and an inevitable correction of state-driven investment, a wider adjustment of the local real estate market is unavoidable — and perhaps even necessary in the short
term. The risk of contagion will inevitably grow and could turn the once-booming sector into a liability.

Right on cue, this morning:

China Property Developer Can’t Repay Loans Zhejiang Xingrun’s Default Is Unusually Large for Developer in Affluent Region of Country

Government officials rushed to deal with the collapse of a property developer unable to repay almost $600 million of loans in a large default for a real-estate firm and the latest sign of stress in a slowing Chinese economy.

Officials in the eastern city of Fenghua have been meeting in recent days to determine how to deal with Zhejiang Xingrun Real Estate Co.’s outstanding debt and dispose of its remaining land assets, according to a person in the city’s financial affairs office, who declined to give her name. The company owes banks 2.4 billion yuan ($390 million) and a further 1.1 billion yuan to other creditors, according to a statement on the local government’s website.

Zhejiang Xingrun’s chairman, Shen Caixing, and his son, Shen Mingchong, have been detained by local police after being charged with illegal fundraising, the government statement said. The charge is a broadly defined economic crime often leveled against private businesspeople when their companies collapse. (…)

Earlier this month, solar components maker Shanghai Chaori Solar Energy Science & Technology Co. became the first Chinese company to default on a domestically issued bond. A number of trust companies have signaled that their borrowers are unlikely to be able to repay their debts. (…)

Government records show that at the beginning of 2010, Zhejiang Xingrun paid 660 million yuan, or 4,700 yuan per square meter for what at the time was the largest piece of land the local government had sold in two years. At the end of 2013, the local government sold three adjoining lots for about 3,500 yuan per square meter, undercutting the value of the land the company was using as collateral. (…)

SMALL IS BEAUTIFUL? Hmmm…

Small caps continue to outperform large caps. Citigroup analysts try to explain (via ValueWalk):

(…) there is a view that the more domestic focus of smaller cap Russell 2000 stocks may be part of the reason given unanticipated international developments for the relative strength. Moreover, new growth concerns in China and other emerging economies likely have affected more of the bigger multinational entities than their smaller counterparts, yet many indicators suggest a swap back toward large caps make eminent investment sense.  image

Small cap valuations are getting more and more stretched, defying nearly 40 years of history:image

Citi’s analysts have done the leg work for us:

When reviewing 360 (!) economic indicators and finding the 10 most highly correlated to subsequent 12-month stock price trends, it is signaling that a large cap bias is appropriate. Notably, the spread between junk bond and 10-year Treasury yields are near historical lows and there has been a relative price performance relationship tied to that spread as well. Accordingly, it seems wise to take on the large cap relative trade at this juncture.It’s amazing the relationships one can find when one digs through 360 indicators: how the capacity utilization of electric and gas utes can help understand the Russell 200/S&P 500 relationship is well beyond me but what else is new? On the other hand, Citi’s model on that same relationship has been pretty good.

Figure 3 highlights the lead indicator model that we have constructed by reviewing the correlations of 360 economic series and subsequent relative stock price performance of large and small cap indices and finding the 10 most correlated factors. While we do not disclose all of the factors in this proprietary approach, Figure 4 does address one to give investors some glimpse of underlying data sources and its unique R-squared relationship. Accordingly the data argues for smaller cap relative caution.

TheTradersWire.com is also alarmed by the apparent froth in small caps:

(…) Another sign of disproportionate risk in small-caps is so many of the past year’s leaders in the Russell have no earnings.

Shockingly, among the index’s top 10 performers during the past 12 months, only the beleaguered retail pharmacy chain Rite Aid (NYSE: RAD) has positive earnings. The rest are losing money.

This suggests investors who favor small stocks are resorting to heavy speculation in their pursuit of attractive returns because so few good values are left in the smaller-cap space. (In fact, only about 10% of Russell 2000 stocks currently trade for 10 times earnings or less.) And based on the names in the Russell top 10, the speculation involves the riskiest types of stocks — biotechnology, alternative energy, and technology companies that have rarely, if ever, turned a profit. (…)

Steaming mad One-Fifth of U.S. Teens Say Designated Driver OK to Drink

About one in five adolescents say it’s fine for their driver to have some alcohol or use drugs, as long as that person isn’t too impaired to drive. Four percent just pick the least inebriated person to take them home, Liberty Mutual Holding Co. and a safety group found in a survey released today. (…)

A separate study of bar patrons last year found that about 40 percent of designated drivers consumed some booze. Confused smile

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