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

THE DAILY EDGE (2 January 2018)

Gift with a bow Here’s how long it will take Americans to pay off their Christmas debt

Shoppers in the U.S. racked up an average of $1,054 of debt this Christmas season — an increase of 5% over last year, according to a survey from MagnifyMoney, a personal finance website. It found 44% of shoppers racked up more than $1,000 in holiday debt, and 5% accumulated more than $5,000 in debt.

Bouncing back from those purchases won’t come quickly. Only half of those surveyed expected to repay the debt within 3 months — others (29%) said they need more than five months to pay it off, often leading to interest on the credit card debt and growing balances. In fact, 10% of people who took on holiday debt said they would only be able make minimum payments on credit cards. (…)

Same chart published Dec. 27 but up-to-date as of Dec. 20:

Wages Finally Start to Grow in Tight Labor Markets In U.S. cities with the tightest labor markets, workers are finding something that’s long been missing from the broader economic expansion: faster-growing paychecks. Businesses are raising pay to attract employees in cities such as Minneapolis and Denver, where unemployment rates stand near or even below 3%.

(…) City-level data “show the relationship between wage growth and a tight labor market still holds,” said Adam Kamins, senior economist at Moody’s Analytics. (…)  Large metro areas including Denver, San Jose, Calif., and Austin, Texas,​ also have unemployment rates below 4% and are experiencing wage growth of at least double the 2% national average. The same trend is happening in smaller areas including Fort Myers, Des Moines, Iowa, and Ogden, Utah. (…)

“As far as positions we struggle with, it’s kind of all of them actually,” he said. About nine months ago, forklift drivers were making between $12 and $13 an hour. Today, hourly pay can go as high as $16 an hour. (…)

Workers in 18 States Get Minimum-Wage Increases

The new year will bring higher minimum wages in 18 states and almost two dozen municipalities, continuing a recent trend of steady pay increases for the lowest-paid workers.

In some cases, the increases represent one of several steps in a multiyear process to slowly raise the minimum wage. Arizona, for instance, will see its pay floor rise 50 cents on Jan. 1, followed by another 50 cents in 2019 and $1 in 2020, part of a four-year process to boost the base salary for workers who don’t work for tips to $12 an hour by 2020. (…)

DECEMBER PMIs

The seasonally adjusted IHS Markit final US Manufacturing Purchasing Managers’ Index™ (PMI™) registered 55.1 in December, up from 53.9 in November. The latest index reading was the highest since March 2015 and signalled a solid improvement in the health of the sector. December data also rounded off the strongest quarterly performance since the start of 2015.

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Output at manufacturers expanded at a steep pace in December, with growth reaching an eleven-month high. Panellists attributed greater production to more favourable demand conditions and increased new order volumes.

New business received by manufacturers continued to rise in December, with the rate of expansion accelerating to a ten-month high. Anecdotal evidence linked increases to greater demand from new and existing clients. Exports sales, however, grew at a marginal pace.

In line with greater production requirements, firms added to their payrolls and at the fastest rate since September 2014. Increased capacity pressures were also reflected in backlog accumulation. The upturn in outstanding business accelerated and was the quickest since October 2015.

Meanwhile, input price pressures intensified with the rate of cost inflation accelerating for the second consecutive month. Furthermore, the marked rate of increase was the second-fastest since December 2013. Panellists linked rises to higher raw material prices, which partly stemmed from supplier delays. Meanwhile, factory gate charges rose solidly, despite the rate of inflation softening since November.

The eurozone manufacturing sector ended 2017 on a high note. Strong rates of expansion in output, new orders and employment pushed the final IHS Markit Eurozone Manufacturing PMI® to 60.6 in December, its best level since the survey began in mid-1997.

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The expansion was led by the investment goods sector, where the pace of growth signalled by the PMI was also a record high. The rate of improvement in the intermediate goods sector remained close to November’s survey-record. Growth was slower in the consumer goods sector by comparison, but remained solid and well above its long-run trend.

National data signalled further broad-based growth, with business conditions improving across all of the countries covered. PMI readings were at survey record highs in Austria, Germany and Ireland, and remained close to November’s series peak in the Netherlands. Rates of expansion in France and Greece were the fastest for over 17 and nine years respectively. Growth also remained robust, albeit slower, in Italy and Spain.

Underpinning the strong headline PMI were near record increases in euro area manufacturing output and new orders, both of which rose to the greatest extents since April 2000. Domestic market conditions remained robust, while growth of new export business was only a tick below November’s survey high. New export orders rose at, or close to, record rates in Austria, Germany and the Netherlands and remained solid in of the all other nations covered. (…)

Robust intakes of new business tested capacity, leading to a further marked increase in backlogs of work. Outstanding business increased at the sharpest pace in the series history, led by marked gains in Germany, France and Austria. This in turn supported a joint-survey record increase in euro area manufacturing employment. (… )

December saw rates of inflation in output prices and input costs remain elevated, despite slowing slightly since November. Part of the increase in purchase prices reflected ongoing supply chain pressures, with average vendor lead times lengthening to one of the greatest extents on record. (…)

The headline PMI pointed to a stronger improvement in Chinese manufacturing operating conditions at the end of 2017. Latest data highlighted faster growth of output, total new work and export sales. Greater production led to a further rise in buying activity, with the rate of growth quickening to a four-month high. At the same time, capacity pressures continued to build, with backlogs rising amid a further decline in workforce numbers (albeit marginal).

Inflationary pressures remained elevated, with input costs rising sharply and prices charged increasing at a solid pace.

The seasonally adjusted Purchasing Managers’ Index™ (PMI™) posted 51.5 in December, up from 50.8 in November, to signal a further improvement in the health of the sector. Though modest, the rate of strengthening was the highest seen for four months.

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Manufacturing production continued to increase across China at the end of 2017. Notably, the rate of expansion quickened to a three-month record. Improved sales and stronger underlying market demand were cited as key sources of growth in December. Furthermore, total new orders expanded at the steepest pace since August, with export sales also rising at a faster pace at the end of the year.

Despite stronger increases in output and new work, manufacturers continued to shed staff in December. That said, the rate of job losses was the weakest seen for nine months and marginal. Nonetheless, lower staff numbers contributed to another rise in outstanding business, with the rate of accumulation quickening slightly since November.

Higher production prompted firms to raise their buying activity for the seventh month running. Moreover, the rate of growth was the fastest seen since August. However, stock shortages at suppliers and delays linked to environmental inspections led to a further lengthening of average delivery times. (…)

Average input costs continued to rise sharply, despite the rate of inflation softening to a four-month low. Anecdotal evidence indicated that higher costs for a variety of raw materials drove up cost burdens. Consequently, firms increased their selling prices solidly. (…)

EARNINGS WATCH

Thomson Reuters/IBES:

  • The estimated earnings growth rate for the S&P 500 for Q4 2017 is 12.0%. If the Energy sector is excluded, the growth rate declines to 9.5%.
  • In the S&P 500, there have been 69 negative EPS preannouncements issued by corporations for Q4 2017 compared to 42 positive EPS preannouncements. By dividing 69 by 42 one arrives at an N/P ratio of 1.6 for the S&P 500 Index. This 1.6 ratio is below the N/P ratio at the same point in time in Q4 2016 (2.0), and below the long-term aggregate (since 1995) N/P ratio for the S&P 500 (2.8).

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The first few weeks of 2018 will be important as we watch the earnings releases and the guidance for 2018 including the effects of the tax reform. So far, sell side analysts have not done much work on the new U.S. tax regime.

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EUROPE?

European companies are slow reporters, possibly in no rush to disappoint, even when the economy is accelerating:

  • Thomson Reuters reports that 275 companies in the STOXX 600 have reported earnings to date for Q3 2017. Of these, 48.5% reported results exceeding analyst estimates. In a typical quarter 50% beat analyst EPS estimates.
  • In aggregate, companies are reporting earnings that are 4.6% below estimates, which is below the 4% long term (since 2011) average surprise factor. Now that is 4.6% below the estimate at the end of the quarter; it is some 8% below the estimates at mid-year.
  • 307 companies in the STOXX 600 have reported revenue to date for Q3 2017. Of these, 45.6% reported revenue exceeding analyst estimates. In a typical quarter 54% beat analyst revenue estimates.
  • In aggregate, companies are reporting revenues that are 1.9% above estimates.
  • Third quarter earnings are expected to increase 1.3% from Q3 2016. Excluding the Energy sector, earnings are expected to decrease 2.6%. Third quarter revenue is expected to increase 3.8% from Q3 2016. Excluding the Energy sector, earnings are expected to increase 2.0%.

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What Inflation Could Mean for the Market Even a small uptick in inflation in 2018 could catch markets off-guard. How to prepare.

What Inflation Could Mean for the Market(…) Such a jolt could reshuffle the market. Since 1950, stocks have traded at an average multiple of 18.1 times earnings when inflation has ranged between zero and 2%—the “sweet spot,” says SunTrust Chief Market Strategist Keith Lerner. At 2% to 4%, the multiple slips to 17.2. (…)

The producer price index, which measures the prices that goods and services producers get, rose 3.1% on a year-over-year basis in November, the fastest rate since January 2012. Lumber prices have risen this year and are expected to continue trending higher next year, potentially forcing home prices higher, too. The Federal Reserve Bank of New York introduced an inflation measure this year, the Underlying Inflation Gauge, which tracks consumer and producer prices, commodity prices, and real and financial asset prices. Based on prior data, it is at an 11-year high, near 3%. (…)

Sure looks like the Rule of 20 to me! Yet, no mention of it.

Here’s how the S&P 500 trailing P/E behaves during various inflation periods:

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And here’s the Rule of 20 P/E with its stable, dependable range under all conditions:image

Not only do you know what inflation can mean for the market, you can also calculate and measure the valuation risk around the “20 fair value” level. This bull is pretty normal so far having gone from deep undervaluation in 2009-10-12 to nearly full value. Since this is on trailing EPS, it would not be surprising to see valuations exceed previous highs of 23-24 if investors fully buy the profit boosts from the tax reform. That said, we know this is pretty late at the party. Three risk factors here:

  • profit risk: mainly tied to recession risk given current trends and tax reform. Low risk level currently.
  • inflation risk: the Fed is totally focused on 2.0%+ inflation and openly willing to allow some overshooting. Inflation going from 1.8% to 2.5% reduces the Rule of 20 “fair P/E from 18.2 to 17.5, increasing the potential downside to fair value from 13.0% to 16.5%.
  • confidence risk: this risk is now at its maximum given current confidence readings and rising interest rates. A confidence shake up could be nasty given that TINA is no longer in everyone’s mind as 2Y Treasuries flirt with 2.0% yields. Buying the dips may not be as “automatic”.

If you’re wondering,

  • here’s the P/E on forward earnings:

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  • And the Shiller P/E for the same period. Scary but not terribly credible nor useful.

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The price of a digital currency called Ripple surged 50% on Friday, pushing its market valuation to a record $85 billion, second only to bitcoin among crypto-assets.

(…) Friday’s move puts it ahead of Ethereum’s $72 billion valuation, and is second to only bitcoin, currently at $244 billion. (…)

For XRP, the gains come after the latest signs that the company behind the currency, also called Ripple, has shown more progress in signing up banks to its closed-loop network, called RippleNet.

Earlier this month, the currency got a boost after a consortium of Japanese banks signed up to test its network. The company has more than 100 banks, mostly outside the U.S., signed onto its platform. It has not disclosed amounts, but has said that some of those banks have been using it in a live environment to move money, rather than just testing it as a concept.

XRP is different from other digital currencies in that its development is being guided and controlled by a single, for-profit company. Ripple the company launched its currency in 2012, as part of a plan to use the concepts behind bitcoin to build a cross-border, interbank payments and settlement network. (…)

When Ripple launched the network in 2012, it created 99 billion XRP. About 38 billion have been distributed; the company holds with rest, with plans to release them publicly over time. (…)

Happy and Healthy New Year!

THE DAILY EDGE (28 December 2017)

U.S. Pending Home Sales Edge Higher in November

The National Association of Realtors (NAR) reported that pending home sales increased 0.2% (0.8% y/y) during November to an index level of 109.5 (2001=100). This followed their 3.5% jump in October. Sales were 3.6% below their recent peak in April 2016.

Sales changes were mixed by region in November. Those in the Northeast rose 4.1% (1.1% y/y) to an index level of 98.9, after edging up 0.5% in October. In the Midwest, they were up 0.4% (0.8% y/y) to 105.8, following October’s 2.4% advance. In contrast, sales slowed in the South by 0.4% (2.5% y/y) to 123.1, thus pausing after October’s 7.4% surge. And in the West, sales were down 1.8% (-2.3% y/y) to 100.4 after inching down 0.1% in October. The widely varying index levels themselves indicate that home sales trends are hardly standard across the country; sales in the South have historically been more vigorous than elsewhere, but relative strength otherwise shifts back and forth among the other regions.

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WHAT COULD GO WRONG?

Robert Eisenbeis, Ph.D., Vice Chairman & Chief Monetary Economist, Cumberland Advisors

(…) What could go wrong?  There are clearly plenty of possibilities. First, we are in uncharted waters when it comes to international central bank policy. A flood of liquidity has been created by that policy, and some assert that this liquidity has contributed to dampening volatility in virtually all key financial markets to historic lows. What the policy exit looks like is uncertain, and right now the Fed is rowing against the tide.

Uncertainty in the classical Frank Knight sense is the major concern. There is economic and central bank policy uncertainty and we simply have no way of assessing the probabilities of major shocks that loom on the horizon from a variety of sources. Positive economic growth in Europe and selected parts of Asia continues, but turmoil plagues Latin America including Argentina, Brazil and Venezuela.  As for Africa, political unrest and civil wars are destroying more wealth than is being created. Unrest and war continue in the Arab Middle East, and the outcome of the Palestinian and Israeli situation is still far from clear. Then there is North Korea.

All of these uncertainties suggest that investment opportunities with lower risk remain centered on the US and Europe. However, there is an interesting dynamic at play even here when it comes to interest rates. With negative rates still in effect in Europe and the Fed’s continuing on its current path of gradually raising rates, it makes perfect sense for European banks to continue to hold reserves at the Fed at a continuingly widening spread to take advantage of the risk-free arbitrage that currently exists. This practice will put upward pressure on US exchange rates and also bid up Treasury prices on the margin to the extent that foreign banks buy Treasuries. When the ECB and Bank of Japan reverse course, much of this activity will unwind and act to tighten policy here in the US with no action taken by the Fed.

So, while there is room for optimism with respect to the US, cautious is the watchword going into 2018.

The yield curve is rapidly flattening as 2Y and 5Y rates jumped by 40-50% in the last 4 months. For the first time since 2011, TINA is not as powerful against uncertainty: investors have alternatives with both maturities now offering yields in the 2% range.

TINA is also losing strength considering that equity dividend yields, 1.8% on the S&P 500 Index, are now lower than the 1.9% yield on 2Y Treasuries, unseen since the Financial Crisis.

While U.S. interest rates are quickly rising, Moody’s observes that

Markets are fairly confident that nonfinancial-corporate leverage is about to peak and then move lower. Otherwise, how else can one justify expectations of a flat to lower default rate going forward? In terms of moving yearlong observations, the ratio of nonfinancial-corporate debt to pretax operating profits edged up to 696% in Q3-2017. Nevertheless, Moody’s Default Research Group expects a decline by the default rate from Q3-2017’s 3.5% to 2.4% by Q3-2018.

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In previous cycles, the ratio of debt to operating profits kept rising after reaching current levels, in part because rates rose and/or profits peaked and dropped with subsequent recessions.

Thus, today’s seeming indifference to an elevated ratio of debt to operating earnings might be ascribed to expectations of an impending peak for the ratio of debt to core profits. The jumps by nonfinancial corporate leverage of 2000 and 2008 were largely the consequence of substantial contractions by corporate earnings. (…)

Moody’s net US High Yield Downgrades spiked during the 2015-2016’s bout of industrial commodity price deflation and subsequently declined to its current 2%, a level whihc has often been the cyclical low.

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(…) Not only is the net high-yield downgrade ratio a useful leading indicator of the default rate, it is also a helpful coincident indicator of the high-yield bond spread. The net high-yield downgrade ratio now favors a 419 bp midpoint for a composite high-yield bond spread, which exceeds the recent actual high-yield spread of 365 bp. This difference of opinion implies that the high-yield spread predicts a lower default rate than do net high-yield downgrades.

It’s very much worth keeping an eye on high-yield credit rating changes, especially downgrades to the lowest rungs of the high-yield ratings’ ladder, or Caa3 or lower. Because the lowest high-yield credit ratings often accompany defaults, the relative incidence of downgrades to “Caa3 or lower” shows a very high correlation with the default rate.

More specifically, the moving yearlong ratio of the number of credit rating downgrades to “Caa3-or lower” to the number of high-yield issuers shows a very high correlation of 0.92 with the percent of high yield issuers defaulting during the past year, where the latter is commonly referred to as the high-yield default rate.

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(…) For now, the latest thinning of Caa-grade bond spreads suggests that the market believes the latest increase in default-prone downgrades will be short-lived. (…)

Making the recent narrowing by Caa spreads all the more remarkable is how recent tax reform legislation weighs most heavily on Caa-rated issuers. According to Moody’s Investors Services, the combined benefits of a lower corporate income tax rate and the full and immediate deductibility of capital spending will exceed the costs of less than full deductibility of business interest expense “for all but a handful of U.S. investment-grade nonfinancial companies”.

However, the loss of the full deductibility of interest expense leaves an estimated 26% of U.S. high-yield issuers worse off despite both a lower corporate income tax rate and the more favorable tax treatment of capital expenditures. In addition, the share of high-yield companies that are worse off soars as the high yield credit rating moves lower.

For example, the percent of issuers made worse off jumps from 7% at the Ba rating to 27% for B2-rated issuers and, then, to 50% for B3-grade issuers. Finally, more than 75% of issuers rated Caa1 or lower will be worse off because of the loss of the full deductibility of interest expense. The high-yield market must be careful not to underestimate the risks now implicit to any unexpected broad-based contraction of operating profits.

And interest rates have just begun their upward journey…

But, the optimists say, tax reform will boost the economy and profits. David Rosenberg did the math, calculating that the $80B of expected incremental gain to nominal GDP and the $140B in additional profits dwarf against the $420B withdrawal of monetary support from the Fed in 2018. And if the Fed just raises rates twice (most economists expect 3-4 hikes), this would add an additional $100B drag out of nominal GDP.

Goldman expects $5 billion hit to quarterly earnings due to new tax law

Around two-thirds of the $5 billion decrease is due to repatriation tax, Goldman said in a statement with the U.S. Securities and Exchange Commission.

The remainder includes the effects of the implementation of the territorial tax system and the re-measurement of U.S. deferred tax assets at lower enacted corporate tax rates. Expect a tsunami of such announcements in January. Also expect chaos in earnings data as each aggregator applies its own approach in the treatment of “non-operating” and “non-recurring” items.

U.S. Investor Optimism Still Riding High

U.S. investor optimism has remained strong in the fourth quarter, with investors mostly upbeat about the 12-month outlook for the economy, the stock market, unemployment and their personal finances. This is reflected in the Wells Fargo/Gallup Investor and Retirement Optimism Index, which hit +140 in the fourth-quarter poll. While similar to the +138 recorded in the third quarter, it is up from +96 a year ago and is technically the highest since September 2000, when it was +147.

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But the average hides the great American divide:

Republicans’ score on the index jumped from -9 in the third quarter of 2016 to +145 in the fourth quarter of that same year — a three-month period spanning the 2016 election. It has since edged up further to +220. Meanwhile, Democrats’ index score plummeted from +166 to +32 a year ago — but has since improved, now registering +56.

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Bullish Sentiment: Start of a New Streak?

(Bespoke)

SoftBank-led group to acquire $9bn stake in Uber Shareholders agree to sell 17% of car-booking company at a discount

(…) The investment by the SoftBank-led consortium is comprised of two tranches. The consortium will buy about $1.25bn of new Uber shares at the same price as the company’s most recent fundraising round, which valued it at $70bn. The group will also buy a second, larger tranche of discounted shares from Uber’s existing shareholders, at price of $32.93 per share, which is a 30 per cent discount to Uber’s previous fundraising. (…) About 15 per cent of Uber’s shares will change hands in the tender offer, which was oversubscribed, said people familiar with the process. (…)

In effect, SoftBank is buying a 17.5% stake in Uber, with 2 board seats, for $9B, valuing Uber at $51.4B, nearly 27% below the most recent valuation. As a reminder, on August 23, 2017:

(…) Three of the investors, Vanguard Group, Principal Funds and Hartford Funds, all marked down their shares by 15 percent to $41.46 a share for the quarter ended June 30, according to the fund companies’ latest disclosure documents, the Journal reported.

A fourth investor, T. Rowe Price Group, cut the estimated price of its Uber shares by about 12 percent to $42.70. Another investor, Fidelity Investments, maintained its estimate of $48.77 as of June 30, WSJ said. (…)

Surprised smile Looks like markdowns between 20% and 32% should be necessary at year-end.

High five But wait! SoftBank’s direct $1.25B investment could be used to keep the valuation at $69B since this is the latest value from fund raising. Ninja

FYI:

Uber Technologies Inc.’s net loss widened to $1.46 billion in the third quarter, according to people with knowledge of the matter, as the ride-hailing leader struggled to fend off competition, legal challenges and regulatory scrutiny. (…)

Uber told stockholders that gross bookings, the key yardstick of demand for ride services, rose 11 percent to $9.71 billion in the period that ended in September, compared with $8.74 billion in the second quarter, said the people. Net revenue grew 21 percent to $2.01 billion in the third quarter from $1.66 billion.

But losses, which had been narrowing in previous quarters, reversed course. The net loss increased 38 percent from the second quarter, when it was $1.06 billion. (…)

U.S. Is Becoming the World’s New Tax Haven