Recovery Watch

SHOWTIME! THE FIREWORKS!

Melt up conditions are building rapidly.

We got a clean and overall very strong employment report from the U.S. lifting the outlook for the consumer side of the economy. This was supported by generally more upbeat housing stats for both new and existing houses. We also got the PMIs which showed sustained strong new orders in both manufacturing and services. Even China is looking a little better.

Just as important was that wages showed no real acceleration, keeping both the Fed (short-term rates) and bond investors (longer-term rates) on hold.

And with earnings season starting this week, concerns over high equity valuations may diminish rapidly.

There was no “sell in May”, there is no summer swoon, employment growth is accelerating, new orders flowing in nicely, housing looks a bit better, the Fed is locked in, the bond market is holding up, dividends are surging and M&A is in high gear. What if earnings surprise and guidance is positive?

Nirvana!

…but for how long?

But as many will say: what the heck! Let’s enjoy the moment!

This WSJ piece is the only relatively subdued report I saw during the week-end:

As Jobs Surge, Hurdles Linger The U.S. economic expansion is entering its sixth year with the best stretch of job growth in almost a decade. Beneath the shiny exterior, however, lurk soft patches that worry economists and policy makers.

Employers added 288,000 jobs during the month and unemployment fell to 6.1%, the lowest level since September 2008, the Labor Department said Thursday, pushing the rate closer to what many economists consider full employment.

Yet those gauges don’t capture other weaknesses in the employment spectrum. Nor do those figures explain the mysteries of an economy that has been struggling to gain enough velocity to shake off its many ailments long after the recession ended. (…)

The number of people working part time because they can’t find full-time work rose, and the share of the population either working or looking for work remains around 30-year lows. June’s labor-force participation rate was 62.8%, unchanged from the prior month.

And while U.S. workers’ earnings have been climbing about 2% annually—just enough to cover inflation—wages show few signs of breaking out of that range as an abundance of idled labor allows firms to keep payroll costs contained.(…)

Amid this weakness, hopes for a big second-quarter rebound are now beginning to wither. Forecasting firm Macroeconomic Advisers on Thursday lowered its estimate of second-quarter growth by 0.6 percentage point to an annualized 2.7% after new trade data showed stronger imports than expected, subtracting from domestic output. J.P. Morgan Chase pulled its estimate down to a 2.5% pace from 3%. (…)

The jury is still out on whether an improving job market is leading shoppers to spend more. Wal-Mart Stores Inc. Chief Executive Doug McMillon told analysts during a meeting this past week that the discount retailer wasn’t seeing much of a difference compared with 90 or 180 days ago.

That diverged from remarks made by Kroger Co. in June that its customers are “exhibiting less cautious spending behavior,” according to CEO Rodney McMullen. “More customers perceive the economy to be in recovery,” as shoppers spend more on things like premium pet food and organic products, he said.

Likewise, Molson Coors Brewing Co. CEO Peter Swinburn told investors recently that the past five years were challenging for its core drinkers in North America but that the company is now starting to see the “green shoots” of recovery. (…)

More employment stats:

• Employment growth was above of 200k for the fifth consecutive month, unseen in 15 years.
• First 6 months, employment has risen by 1.385 million, the largest 6-month gain since 2006.
• The participation rate was unchanged at 62.8.
• Household employment surged 407,000 but full-time was -523k vs part-time +799. This after 6 months of strong growth in full time employment totalling 1.8 FT jobs.
• Private sector payrolls rose by 262,000, including a 236,000 rise in services, a 16,000 increase in
  manufacturing and a 6,000 uplift in construction.
• The private diffusion index was strong at 64.8% vs 62.7% in May.
• Hours worked in Q2 increased at a +3.8% Q/Q a.r., the fastest for the expansion.
• Wages growth was +2.3% Y/Y. But the aggregate of wages of production and nonsupervisory workers (hours x hourly rate) jumped at a 6.2% a.r. in Q2. Consumer finances are clearly improving.

More economic news:

PMI signals fastest global economic growth for three years

The global economy ended the second quarter on a high note. Growth rates for output and new orders accelerated to the fastest since February 2011, according to PMI™ survey data. The upturn also broadened out, with growth spurts in the US and the UK being accompanied by signs that Asia is lifting from its recent soft patch.

At 55.4 in June, the JPMorgan Global PMI™, compiled by Markit, has signalled expansion throughout the past 21 months. At 54.1, the average reading over the second quarter as a whole signals that global GDP is now rising at an annual rate approaching 3.0%, up from 2.3% in the first quarter, the best growth outcome since the opening quarter of 2011.

The upshift in the rate of economic expansion and strong inflows of new business are also translating into meaningful job creation, with June seeing the steepest lift in global payroll numbers for over three years. (Markit)

This is important: vehicle production declined at a -8.0% Q/Q a.r. in Q1. It surged +17.3% in Q2. It is now up 8.2% Y/Y and it is scheduled to increase at a +10.3% a.r. in Q3.

Food for thought:

As Food Prices Rise, Fed Keeps Close Eye The Outlook: U.S. food prices are on the rise, raising a sensitive question: When the cost of a hamburger patty soars, does it count as inflation?

(…) The consumer price of ground beef in May rose 10.4% from a year earlier while pork chop prices climbed 12.7%. The price of fresh fruit rose 7.3% and oranges 17.1%. But prices for cereals and bakery products were up just 0.1% and vegetable prices inched up only 0.5%.

The U.S. Department of Agriculture predicts overall food prices will increase 2.5% to 3.5% this year after rising 1.4% in 2013, as measured by the Labor Department’s consumer-price index.

(…) Drought in Oklahoma and Texas is driving up cattle prices. A disease known as porcine epidemic diarrhea virus has killed millions of piglets and contributed to higher hog prices. A disease known as citrus greening is killing Florida’s orange and grapefruit trees, driving up citrus prices. Most of the shrimp eaten in the U.S. comes from Southeast Asia, where a bacterial infection has devastated stocks. Coffee prices have risen this year due to a drought in Brazil.

These factors suggest recent food inflation springs from special factors constraining supplies in a few areas, as opposed to broad increases in demand, which might propel the kind of across-the-board consumer prices increases that the Fed tries to stem. (…)

The broad PCE index was 1.8% higher in May than a year earlier, its 25th straight month below the Fed’s target. Still, it has accelerated from a 0.8% rise as recently as February. Excluding food and energy the index has picked up to 1.5% from 1.1%, suggesting that broader factors are starting to drive inflation higher.

Ms. Yellen noted in her most recent news conference that inflation readings have been “a bit on the high side” lately, but warned “the data that we’re seeing is noisy.”

But divisions are emerging on this question. “I don’t think the past few months are entirely noise,” Richmond Fed President Jeffrey Lacker retorted after a June 26 speech in Lynchburg, Va. (…)

But here’s the better news:

Brent Oil Falls to Three-Week Low on Libya Supply; WTI Slips

(…) Brent declined 2.3 percent last week, erasing this year’s gains, as rebels seeking self-rule in Libya’s east agreed to surrender the Es Sider and Ras Lanuf ports, the nation’s biggest and third-largest oil-export terminals. The government in Tripoli has instructed National Oil Corp. to start marketing supplies from the two facilities, Mohamed Elharari, a spokesman for the state-run company, said by phone yesterday.

Es Sider holds 4.5 million barrels of crude in storage and Ras Lanuf contains 3 million, Oil Ministry Measurement Director Ibrahim Al-Awami said by phone today. “All the oil in storage at Es Sider and Ras Lanuf is ready for export,” he said. (…)

Hence:

Stocks Are Picking Up Speed The stock market is rolling into the second half of the year in stronger shape than many investors dared to hope in January.

(…) With signs that the U.S. economy is recovering from a winter contraction and the Federal Reserve expected to keep interest rates low for at least another year, many investors are betting the five-year bull market has more room to run. They are reluctant bulls, seeing few alternatives to equities.

“You’re confined to stocks, because money-market instruments don’t pay anything and Treasury yields are so low,” said William Lynch, director of investments at Hinsdale Associates, which manages about $150 million in assets. (…)

The jobs data largely put to rest concerns among investors about the health of the economy, after U.S. gross domestic product fell at a seasonally adjusted annual rate of 2.9% in the first quarter, the fastest rate of decline since the recession. The S&P 500 eked out a 1.3% gain in the first quarter, the smallest quarterly increase by stocks since a decline in the fourth quarter of 2012.

But stocks picked up speed in the past three months as investors anticipated a rebound in the economy, and Thursday’s news seems to have proved them correct.

“Going into this number, I was still concerned: I knew the economy was growing but couldn’t tell if we were making up lost ground from winter,” said Jack Ablin, chief investment officer at BMO Private Bank, which oversees $66 billion. “This confirms that the economy is accelerating, and I will say it vindicates the equity investors’ view.” (…)

For now though, many investors don’t see higher interest rates as an immediate worry with inflation pressures still low. The jobs report bolstered that view by showing wage growth, which in the past has fuelled inflation, remained sluggish, with a 2% rise from a year ago.  (…) 

Investors have been holding back putting new money to work in stocks, with the Dow at records, for fear of buying near a market peak, money managers say. The index has posted 14 record closes this year so far, and it is up nearly 14% from a year ago. But waiting for a significant correction before buying hasn’t worked, as the Dow hasn’t dropped more than 10% in nearly three years.

Other measures of investor sentiment reflect that lack of conviction in the market. (…)

But with the jobs data showing the economy on good footing, it could provide the kind of confidence in owning stocks that has been lacking.

“From a corporate-profit perspective, this number tells us that there is a good fundamental foundation for where the market is,” said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management, which oversees $242 billion. “Corporate fundamentals are very strong.”

As well, said Michael Purves, chief global strategist for Weeden & Co., good news on the economy “is very important for investors who are late to the party.”

Bloomberg adds:

More than $200 billion was added to U.S. equities during the week as job creation surged beyond expectations in June while central banks in the U.S. and Europe repeated vows to support growth. (…)

“The jobs report was pretty darn good,” Jeff Saut, the St. Petersburg, Florida-based chief investment strategist at Raymond James Financial Inc., said in a phone interview. He helps oversee about $450 billion. “We’re going to get a multiple expansion. Earnings are going to continue to come in better than expected. We’re in a secular market that has years left to run.” (…)

EARNINGS WATCH

S&P reports that of the 20 early reporters (May quarter end), 13 beat (65%) and 6 missed estimates. Q2 EPS are currently estimated at $29.24, down $0.18 from June 12 but nonetheless up 10.9% Y/Y.

If Q2 estimates are met, S&P calculates that margins will rise from 9.51% in Q2’13 to 9.95%, a new record which would alleviate fears of margins mean-reverting.

Trailing 12-m EPS are currently $108.86. After Q2, this might reach $111.92, up 2.8% Q/Q and +12.7% Y/Y.

At 20.2, the Rule of 20 P/E has gone through the “20” level for the first time this cycle. The Rule of 20 current fair value of 1959 would increase to 2015 if Q2 earnings meet estimates.

The fireworks show implies valuations rising above the Rule of 20 fair P/E line of “20”. Over the past 50 years, it has been best to get out of equities above a Rule of 20 P/E of 22, meaning a 20x P/E if inflation is 2%. Using trailing EPS of $112, that brings the S&P 500 Index to 2240, up 13% from current levels. If trailing earnings reach $115-120 after Q3-Q4 (as per current estimates), the fireworks would take us to 2300-2400, up 16-21%.

Remember that the Rule of 20 is not a forecasting tool. Its usefulness is in helping us measure, objectively, potential reward against potential risk. As I see it now, the basic show would return 5-10% over 6 months, solely on earnings growth. The fireworks show would return 16-20%, thanks to rising P/Es as Jeff Saut expects. Downside to the 200-day m.a. (1831) is 7.6% while the debacle scenario is -14%. I still fail to see any signs of a recession in the U.S. so I tend to discount the debacle scenario.

It remains that the risks are:

• Valuation is only fair. This is not a cheap market. A big, sudden shock to confidence could bring the Rule of 20 P/E to 16.5 like in 2010 and 2012. If inflation is 2%, that means a fair P/E of 14.5x $112 = 1625, a 14% debacle.
• Market technicals look positive (100-day m.a. at 1888, 200-day m.a. at 1831, both still rising) but the next four months have traditionally not been the best for equities.
• This is a mid-term election year and equities have yet to perform their usual correction, unless the 6% late January decline counts as a mid-term bust.
• The bear community has thinned considerably in the past 6 months.

S&P’s calculations indicate that Financials’ EPS will only grow 2.7% Y/Y in Q2. They rose 5.6% in Q1. This is a big and important sector.

US banks braced for weak second quarter Fixed-income trade and mortgage lending take blame

Big US banks are expected to report dismal second-quarter earnings, with weakness in fixed-income trading and mortgage banking overshadowing an increase in lending to companies and consumers. (…) Of the six big banks, only Morgan Stanley is forecast to post a rise in net income, according to analyst estimates compiled by Bloomberg.

Banks including Citi and JPMorgan have already warned of another weak quarter for fixed income trading. Citi’s chief financial officer said at the end of May that trading revenue could drop as much as 25 per cent in the second quarter from a year ago. JPMorgan has said trading revenue could decline about 20 per cent. (…)

By contrast, loan growth at large US commercial banks is up 1.5 per cent in the quarter to June 18, reversing a first quarter fall, according to the Federal Reserve. The growth was driven by consumer lending, credit cards and loans to businesses. (…)

Are Markets Underestimating Rate Hike Risks? Investors are seriously underestimating where official interest rates ought to be in a couple of years’ time if the Bank for International Settlements’ calculations are correct.

In its latest annual report, the BIS–the global central bankers’ club–estimated the path of where key central bank interest rates ought to be over the next couple of years according to Taylor Rule calculations. The Taylor Rule is a simple but, in the past, effective way of calculating the level of interest rates consistent with trend growth and stable inflation long run inflation.

According to the BIS’s calculations, the U.S. Federal Funds rate ought to be 2.7% by the end of 2015, according to median Taylor rule estimates, against market expectations of 1.68% and the current target range of 0% to 0.25%. For the U.K., the market is undershooting the central Taylor rule estimate for the end of 2015 by more than two percentage points. That underestimate is about 0.7 percentage points for the euro zone and 1.8 percentage points in Japan.

In other words, if the market is to be believed, the rule of thumb estimate suggests all the major economies will be suffering an inflation problem by the end of next year.Is this likely?

First the caveats. The Taylor Rule depends on estimates of potential output and equilibrium interest rates, both of which are subject to considerable debate. This leads to a significant range in Taylor Rule outcomes. The BIS gives a range of plus and minus one percentage point on its Taylor rule estimates, while economists elsewhere would undoubtedly come up with different estimates altogether.

What’s more, although it seemed to hold in the years before the financial crisis, there are plenty of arguments about why it might not now. There are still banking sector blockages related to the crisis preventing the transmission of central bank policy to the wider economy. Hence the need for central bank asset purchases.

A number of these economic headwinds make central banks reluctant to reverse policy too soon for fear of stifling a recovery that’s only just getting into swing. Indeed, central bankers have gone out of their way to reassure investors and markets that rates will stay low for a long time yet and will level off at lower levels than in the past. Federal Reserve chairwoman Janet Yellen argued against BIS arguments favoring tighter monetary policy to prevent inflating asset bubbles. The general feeling has been that deflation is more of a risk and that there will be plenty of time for central banks to react to any build-up of inflationary pressures.

It’s a view incorporated by the markets. Equity prices and bond yields reflect this lower for longer, inflation’s no worry outcome. Which is where the potential problems come in.

Recent strong employment data in the U.S. and U.K. have caught the central banks of both countries on the hop. Yes, so far, there’s little evidence jobs growth filtering through to rising wages. But it seems likely that the remaining economic slack is quickly being used up. Meanwhile, in Japan there are also signs of a tightening labor market.

If those headwinds disappear, central bankers could find their economies have normalized during a time of extremely abnormal monetary policy. The choice then will be to allow inflation to overshoot as interest rates are slowly brought into line or to move fast on rates and risk collapsing asset markets.

It could be that central banks get lucky. Inflation could remain subdued in the face of exceptionally easy monetary policy–as it did in the years before the financial crisis. There could still be plenty of hidden slack in the economy, in the form of underemployment. Productivity could rebound with the banking sector’s return to health. Asset markets could be well behaved as the slow and steady policy tightening is put in place, whatever weakness helping to do central bankers’ jobs for them and thus further limiting how high rates might need to climb.

But the risks things don’t turn out perfectly are considerable. And investors don’t seem to be pricing them in.

A good example of leverage over low financing costs:

As just one example of many, Cliff Noreen, president of Babson Capital Management, points to Monsanto (ticker: MON). The agribusiness giant announced plans the week before last for a $10 billion share-repurchase plan, funded in part by a $4.5 billion debt offering. That produced a quick 5% pop in the stock. After taxes, Noreen figures the borrowing cost—with seven maturities ranging from three years all the way out to 50 years—was less than 3% for Monsanto, a solidly investment-grade company.

“With debt capital this cheap, and the equity market’s positive reaction to Monsanto, many more companies will certainly be considering similar aggressive actions. [It is] financial engineering 101 at its best to improve return on equity as we are at or near record stock-buyback levels,” he says. (Barron’s)

ECB’s Coeure: rates to stay low, Europe needs more investment

(…) “The ECB is taking care of monetary stability. We’ve said clearly that interest rates will remain very low, very close to zero, for a very long time, whatever the developments in the rest of the world,” Coeure said.

“One should expect a divergence of monetary conditions between the euro zone and the United States and Britain – where interest rates will at some point be lifted.”

ELSEWHERE: 

Philippine Central Bank Could Raise Rates Despite Easing Inflation Though Philippine inflation eased in June, its central bank could still feel pressure to further tighten monetary policy, with a growing expectation of an increase in overnight rates, which have been left untouched since October 2012.

On Friday, the Philippine Statistics Authority announced that June inflation decelerated to 4.4% after rising to a 30-month high of 4.5% in May. June’s reading brought the average for the first half of the year to 4.2%, at the upper bounds of the central bank’s 3% to 5% target range for this year.

German Industrial Output Falls in Sign of Slower Growth

Production, adjusted for seasonal swings, fell 1.8 percent from April, when it declined a revised 0.3 percent, the Economy Ministry in Berlin said today. Production rose 1.3 percent in May from the previous year when adjusted for working days.

Germany Halts Shale-Gas Drilling

Germany plans to halt shale-gas drilling for the next seven years over concerns that exploration techniques could pollute groundwater.

“There won’t be [shale-gas] fracking in Germany for the foreseeable future,” Environment Minister Barbara Hendricks said Friday.

The planned regulations come amid a political standoff with Russia, Germany’s main natural gas supplier, and following intensive lobbying from environmentalists and brewers concerned about possible drinking-water contamination. (…)

The government will reassess the ban in 2021.

Germany arrests ‘US double agent’ Apprehension likely to inflame tensions

German authorities have arrested a suspected double agent working for the US who is thought to have spied on the Bundestag’s inquiry into claims of US surveillance, according to local media reports.

The incident risks becoming the biggest problem to hit US-German relations since it emerged in October last year that the US National Security Agency monitored the mobile phone of German chancellor Angela Merkel. (…)

In an interview with German state broadcaster ZDF in January, Mr Obama emphasised his “relationship of friendship and trust” with the German leader. (…) 

Hong Kong: Change in the air As Beijing seeks to ‘clarify’ the level of autonomy in the former British colony, a mood of rebellion is growing

(…) Hong Kong is facing arguably its worst political crisis since the handover, as pro-democracy activists and the Communist party in Beijing come into conflict over how the former colony should be run. (…)

The mood of rebellion in the city has intensified since Beijing last month issued a “white paper” clarifying the extent of Hong Kong’s autonomy. “One country, two systems” did not exist because of any integral right or piece of paper signed with a faded colonial power. It existed, it said, because Beijing allowed it. (…)

Global Times, a tabloid mouthpiece for the Communist party, warned this week that Hong Kong could face unrest similar to Thailand and Ukraine because of the pro-democracy demonstrations.

Beijing’s tussle with Hong Kong is not an isolated event. Throughout the region, a more assertive China has become embroiled in disputes with neighbouring countries over territory in the East and South China seas. In Taiwan, a self-ruled island that Beijing considers a mere province, people are watching events in Hong Kong with apprehension. (…)

In Hong Kong, the debate centres on the question of who should be able to stand in elections for chief executive. Beijing insists that, in accordance with the Basic Law, candidates must be screened by a nominating committee. It also says that any candidate must “love China”, a requirement that many interpret as meaning loyalty to the Communist party. Pro-democracy activists want a form of civic nomination that would allow less pro-establishment figures a shot at office.

Beyond the technical arguments about precisely how the chief executive – and eventually the legislative council – are to be elected lie much deeper misgivings about Hong Kong’s way of life.

Many residents feel the economic spoils have been carved up by an establishment that has swiftly transferred its loyalties from colonialists in London to communists in Beijing. Income disparity in Hong Kong is among the widest in Asia. Many poorer people have given up on the idea of ever buying a flat, as prices have been driven to astronomical levels by a wall of mainland money.

Apart from a sense of social and economic injustice, there is resentment against what is perceived to be an “invasion” by mainlanders. Ugly confrontations have broken out, with Hongkongers accusing mainlanders of sundry affronts, including buying up all the baby formula (because of a fear that mainland milk is contaminated) to eating food on the impeccably clean subway. The Hong Kong government is considering imposing a cap on tourists to assuage public resentment. (…)

For Hong Kong, the battle is not just about democracy. The territory has enjoyed a business-friendly reputation precisely because it is seen as the one place in China where the rule of law is upheld. Even the four big international accountancy firms, nervous about the impact that unrest could have on business, took out an advertisement declaring they were against the pro-democracy movement.

Thus Hong Kong’s reputation as a business centre could receive a double blow. On the one hand, the institutions that underpin it could be weakened as Beijing asserts more authority. On the other, the backlash against such perceived threats could create an instability that makes international companies think twice about basing operations there.

The stakes over the next few months are thus extremely high. If the government does not put forward a proposal on universal suffrage deemed acceptable, “Occupy Central” protesters have threatened to carry out their plan to bring a vital Hong Kong business district to a halt. They would, in effect, be calling China’s bluff. How Beijing responds will help to shape the next 17 years and beyond.