THE CASE FOR CAPEX
The National Association of Business Economists’ poll showed capex plans improving in Q1 to the highest level in 9 years. The recent Duke/CFO outlook on capex jumped to its best level in 4 years. The NFIB expansion plans are also improving. Capacity utilization is now 79.1%
IT spending also seems on the rise as this ChangeWave chart shows:
Student Debt Hampers Home Buyers
Homeownership among Americans under age 35 hit the lowest level on record earlier this year, just as indebtedness among college grads notched a new high. That has stirred debate among economists and policy makers over whether the two forces are related: that high student debt is driving the fall in home buying among the young and harming the U.S. economy.
College students who took out loans will graduate this year with an average of $33,000 in student debt, up an inflation-adjusted 32% from 2007, new research shows. Debt among those who went to grad school is also up sharply.
That, along with a jump in borrowers, has pushed overall student debt to $1.1 trillion, almost double the load in 2007, much of it at relatively high interest rates. The homeownership rate among those under 35, meanwhile, has fallen to 36.2%, from a high in 2004 of 43.6%. (…)
Regular readers have read about the above on June 2 (SHOWTIME!) when I also offered clues to an improving outlook.
Drop in Short Sales Trims House Inventory
Short sales of underwater homes have fallen sharply amid the expiration of a key tax break, a situation that could slow the housing recovery and further limits an already thin supply of houses for sale.
(…) In March, about 5% of home purchases nationwide—some 18,258—were short sales, according to mortgage-technology-and-services firm Black Knight Financial Services. That was down from 6.4% in February and off sharply from the 19.7%, or 51,909, that were short sales in January 2012.
This year’s drop can be traced in part to the December expiration of the Mortgage Forgiveness Debt Relief Act, which Congress originally passed in 2007. Before the act, when a home was sold through a short sale and the lender forgave a portion of the mortgage debt, the seller would typically be required to pay income taxes on the amount forgiven. The act made the forgiven debt tax-free, which paved the way for short sales and helped speed the housing recovery.
“It’s a big concern,” said Veronica Malolos, a real-estate broker in Kissimmee, Fla. Ms. Malolos said some underwater sellers delisted their properties in January and February after learning that the tax provision wouldn’t be extended. (…)
Short sales also have tumbled because of rising home prices, which pushed many homes back above water or closer to it. The median existing-home price nationwide was $201,700 in April, 5.2% higher than in April 2013, according to the National Association of Realtors. In the first quarter, about 19% of homes were worth less than their mortgage, according to the real-estate-information website Zillow, down from 31% a year ago.
With would-be short sellers on the sidelines, the housing market may take longer to work through remaining underwater homes, restricting the already tight home inventory on the market. If some potential short sellers decide to go through a foreclosure instead, that could cause higher losses for mortgage-bond investors, or companies that guarantee payment of mortgages, which tend to recover less in a foreclosure because of the costs of carrying a home. (…)
Economics 101: price = demand vs supply. If supply goes down, will price rise or will demand drop as a result?
Spain Unveils Broad Tax Cuts
Spanish leaders who broke their no-new-taxes pledge after taking office 2½ years ago announced sweeping tax cuts on Friday, saying it was time to compensate a recession-battered populace for its sacrifices and boost a nascent recovery. (…)
Spain’s corporate tax rate would drop from 30% to 25% by 2016. People earning more than €300,000 ($408,000) a year would see their personal income-tax rate fall from 52%, one of the highest in Europe, to 45% in 2016.
Those earning less than €12,450 a year would pay 19% in 2016, compared with 24.75% now.
Some individuals in the middle—those earning between €100,000 and €150,000 a year—would see their tax bills go up, Mr. Montoro said, because the number of tax brackets is being reduced. But overall, he said, income-tax rates will drop by 12.5% over the next two years. (…)
Mr. Montoro said it was now possible to reverse course because Spain’s modest growth is increasing tax revenue. He said tax receipts in the first five months of the year were 5% higher than the same period of 2013. He said Spain’s tax revenue is about 38% of gross domestic product, one of the lowest in the euro zone, but growing.
The cuts announced Friday would by 2016 bring income-tax rates back to their pre-2012 levels for high-income earners and lower them slightly for low-income earners. Sales taxes wouldn’t come down. The plan is subject to modification but is assured of passage because Mr. Rajoy’s party controls parliament.
Meanwhile,
Obama’s Corporate Exodus Shhhh. Please don’t mention tax rates when moving to Ireland.
What kind of country does this to itself? With Medtronic‘s MDT -1.25% planned acquisition of Covidien COV -1.24% and the announcement that the combined company will be domiciled in Ireland, U.S. tax policy has encouraged one more business to spend its money overseas. Medtronic, famous for its high-tech cardiac and spinal devices, will pay $42.9 billion for Dublin-based Covidien, which makes surgical tools and other medical supplies.
(…) The company pledges to continue investing in the U.S.—$10 billion over the next decade. And while its “principal executive offices” will be in Ireland, Medtronic says it will keep its “operational headquarters” in Minneapolis. (…)
But shareholders of all companies—including employees who care about where economic growth will occur in the future—should know that America’s federal corporate tax rate is 35%, which when combined with state and local levies rises to an average of nearly 40%. Ireland, where politicians evidently care about economic growth and as far as we know don’t seek to stifle free speech on the topic, has a corporate tax rate of 12.5%.
Almost alone among civilized nations, Washington also demands to be paid on a company’s world-wide earnings, rather than on money earned in the U.S. This tax is due whenever a company’s overseas earnings are returned to America. Medtronic has about $14 billion overseas and rather than bringing it home and triggering the tax, the company will use the money to fund most of the cash portion of its $42.9 billion purchase.
After Monday’s market close, Medtronic spokesman Rob Clark told us via email that “a benefit of the inversion structure is that it provides us access to the cash of Covidien” and its foreign-generated “free cash flow into the future. Being domiciled as an Irish company puts us into a territorial tax system that provides us the most efficient access to our cash meaning that we achieve tremendous balance sheet flexibility to deploy that cash as necessary. In this case, we made it very clear that one use of this cash is to invest in U.S. based technology and innovation in the form of venture investment, acquisitions, R&D.”
It seems that to have the cash to invest in U.S. businesses—as opposed to being forced to invest in the U.S. government—the company needs to move out of the U.S.
Ireland isn’t the only place with a more competitive tax policy. The near-40% U.S. average rate is almost double the 21% average in the European Union, or the 22% in Asia, according to KPMG.(…)
China Metal Probe Weighs on Copper Outlook Hedge funds and other money managers are building up short positions in the global copper market, according to U.S. data, riding on allegations of fraudulent metal-backed financing in China to amplify pressure on prices of one of the world’s most heavily traded metals.
(…) “There has been an unnatural buyer of copper, which is the bonded warehouses [in China] doing carry trades. Now, a good chunk of [China’s copper imports] will return to end-use which will likely drive down the price sharply,” a New York-based hedge fund manager said in an e-mail to The Wall Street Journal.
Analysts say one-third or more of Chinese copper imports is believed to be used as collateral for loans from Chinese lenders and some foreign banks. There’s so far been no evidence of a mass sell-off among commodity owners as a result of the Qingdao probe, but traders and analysts say a liquidation of copper stocks may pick up speed if the probe widens. (…)
Hedge funds are likely magnifying rather than creating the bearish momentum on the copper market. Prices of the metal had already come down this year as China’s economy slowed, amid a forecast 9% rise over the next two years in global supplies of copper concentrate, the metal’s raw material, coming mostly from Chile and Africa. London Metal Exchange copper on Friday reached $6,765 a ton, down about 8% since the start of the year. (…)
Not all money managers agree with the short-copper positions, as some believe recovering demand from the U.S. could offset the sector’s gloomy outlook. (…)
THE BIG DEBATE
Inflation Is Back on Wall Street Agenda For years, critics have warned that the Fed’s easy-money policies would produce massive inflation. So far, they have been wrong. Now, inflation is showing signs of picking up again and Wall Street is debating what it means for investments.
(…) If inflation returns to more normal levels and stays there, that could signal a stronger economy, which could be good for stocks. But an inflation uptick also could mark the end of the decades long bond rally that has kept bond prices up and yields down since the early 1980s. It would mean higher interest rates, which are bad for home buyers, businesses and holders of existing, low-yielding bonds.
Fed Chairwoman Janet Yellen played down the news last week, saying the data were distorted by statistical “noise.” She reiterated that the Fed intends to keep interest rates exceptionally low for a long time.
All of this is part of a broad and sometimes heated debate about how much investors and policy makers should fear inflation. Some analysts argue that weak global growth and an aging population will for years keep inflation and bond yields lower than many consider possible, potentially changing the way investors view the world. Others still warn that complacency at the Fed will lead to damaging inflation.
How this turns out will have a big impact on where stock, bond and other asset prices go in the months and years to come.
Rick Rieder, who oversees bond investing at BlackRock Inc., says he thinks higher inflation is for real and will continue to show up over the next few months, as the economy strengthens. He said he thinks it will be contained over the longer term, however.
That scenario would push bond prices lower and yields higher, and lead the Fed to begin raising its benchmark overnight interest rate as soon as the first quarter of 2015, earlier than most people expect, Mr. Rieder said. Markets currently expect the increases to start in the second half of 2015. (…)
BlackRock has forecast that stocks can keep rising, possibly in a volatile market. (…)
Stock investors hope higher inflation means rebounding economic growth, which would help corporate earnings. (…)
The bond market is pricing in 2.28% annual inflation, according to a calculation based on the relative yields of the 10-year Treasury note and the inflation-protected Treasury bond. That is the highest since January and is up from 2.10% in April, according to data from Ryan ALM and the Treasury Department. The Fed’s target inflation rate is 2%, although that is based on a different measure that is even lower than consumer-price inflation. (…)
And yet, even many economists who expect more inflation gains say the consequences should be mild because inflation still is quite low. (…)
Inflation Is Nothing for Investors to Fear…for Now
(…) In the meantime, inflation isn’t yet high enough to cause much damage to the stock market, says Ned Davis of Ned Davis Research. He notes that since 1925, the S&P 500 has dropped 5% a year, on average, when the inflation rate has exceeded the S&P 500’s yield by more than 2.1 percentage points. No worries, yet: While May’s 2.1% inflation rate is still higher than the S&P’s 1.9% dividend yield, it’s in a range in which shares historically have returned 6%. “To put the stock market on the defensive, you have to feel like the Fed is on the defensive,” Davis says.
That could mean rate hikes. But even then, stocks won’t necessarily suffer as long as the economy continues to grow, says UBS strategist Julian Emanuel. Since 1998, there have been three periods where inflation rose along with growth, and the market averaged an annual return of 17% in them until growth petered out. “Inflation that’s driven by wage gains and a positive employment picture has traditionally been bullish for stocks,” Emanuel observes. (…)
“Since 1998”! Yeah, sure. He probably means 1998-2000 and 2006-2008 and, seemingly, 2011-2012. How reassuring!
What matters is whether the rise in inflation is outpaced by a rise in profits which would more than offset the decline in P/Es stemming from rising inflation. I went back to 1956 and identified 7 periods of meaningful acceleration in inflation.
Profits rose In 5 of these 7 periods but equities gained in only 3 periods, including one during which profits actually declined. The only two big winning periods were 1986-1990 and 1998-2000. In the first instance, investors had to survive the 1987 crash. In the second instance, well, we all remember how it ended.
On average, profits rose 20% but equities averaged only a 1% gain over all 7 periods demonstrating the negative impact rising inflation has on P/E multiples. Excluding the 1998-2000 period (irrational technology stocks valuations), P/E multiples dropped 2 full points on average while inflation rose 6%.
Trailing P/Es fluctuated wildly showing no useful patterns. However, the Rule of 20 P/Es are more stable and much more informative. The Rule of 20 says that fair P/E is 20 minus inflation. In effect, we find that trailing P/E plus inflation (CPI) generally fluctuates within a range of 17 to 23 (black line below). So, a 1% change in inflation should translate into a 1 point opposite change in the P/E ratio. Depending on the starting P/E, each 1% increase in inflation must be accompanied by a 5-10% gain in profits for investors just to break even.
It is instructive to note that, excluding 1998-2000, the ending Rule of 20 P/E averaged 20.9 and in 5 of the 7 periods, it ended pretty close to its theoretical 20 fair value. Given the current Rule of 20 reading of 20 there is little room to offset any meaningful rise in inflation if profits do not accelerate commensurably.
This is why I wrote SHOWTIME! in early June.
It is thus showtime for earnings and margins, showtime for the economy and showtime for P/E multiples.
The earnings show is actually underway and getting better, drawing a larger crowd. If margins actually break out and enter the show, the crowd should keep growing, especially if the economy also gets in the act.
But the big show, the one with fireworks, is the powerful spectacle of rising earnings, rising margins and rising confidence (P/Es), a combination not sighted for over a decade but which is typical of end-of-cycle shows.
Or, we may be in for an early sixties performance in which rising earnings and stable inflation steal the show to the economy and geopolitical risks and carry equities higher on multiples stabilized around fair value.
The worst case would be hints of a sustained economic slowdown potentially generating weaker revenue growth and declining margins. This is actually the bear narrative that has refused to materialize so far in this cycle.
But don’t worry. In such a case, ladies and gentlemen, you shall be completely awed by the new and improved Yellen & Draghi show where Janet Yellen will offer an even better version of the highly successful Bernanke act and Mario Draghi will, for the first time ever, take real action rather than merely talk.
This powerful combination of lowest ever interest rates, potentially even going negative, and an almost world-wide showering of liquidity, could do the ultimate trick: boost the economy and take equity multiples well into the twenties, something last seen more than a decade ago.
But inflation needs to behave…