U.S. Industrial Production Rose 0.2% in November

Industrial production—a measure of output at factories, mines and utilities—rose a seasonally adjusted 0.2% in November from the prior month, the Federal Reserve said Friday. This was slightly below the 0.3% rise forecast by economists.

October industrial production was revised up to a 1.2% gain from an initial estimate of a 0.9% increase. From a year earlier, industrial production rose 3.4% in November. (…)

Friday’s report showed output in the volatile mining sector jumped 2.0% in November, aided by a gain in oil and gas extraction that the Fed said “returned to normal levels after being held down in October by Hurricane Nate.” Without this rebound, industrial production would have remained flat last month, the Fed noted.

Manufacturing output, the biggest component of industrial production, rose 0.2% in November, a sharp slowdown from October’s 1.4% increase. (Charts from Haver Analytics)

  

SENTIMENT WATCH

• Heard: Get Ready for the Big Tax Stimulus GOP tax plan front-loads cuts and should juice an already humming economy

There were several surprises for investors when Republicans unveiled their final tax bill Friday, but the most significant is that they add up to a bigger boost to economic growth next year.

The bigger stimulus could fundamentally change how the market behaves in 2018. Sales and profits will be stronger than most investors expect. But with the unemployment rate low, wage pressures will mount faster, and inflation should pick up more. If the tax plan passes, as seems likely, it could lead the Federal Reserve to raise rates faster, putting the bond market at risk.

(…) The bill unveiled Friday front-loaded more than $200 billion in stimulus for next year. Economists had been penciling in a boost of about a third of a percentage point next year. Now that is looking way low. (…)

The cut in the corporate tax rate to 21% happens right away; the Senate bill had put it off until 2019. It lowers the top rate on individuals to 37%—lower than either the House and Senate plans. It also pushes individual rates down for most other people and increases the child tax credit, which are important because middle-class households are more likely to spend extra income than the rich.

Cornerstone Macro strategist Andy Laperriere estimates that all told, the tax cut for calendar 2018 comes to about 0.9% of GDP. The boost to growth will likely be stronger though. The one-time tax on overseas cash held by companies is technically a drag on growth, but in reality is shouldn’t directly affect U.S. demand. Excluding that, the tax bill could increase GDP by 1.3%. (…)

• Everything You Need to Know About the GOP Tax Bill

• Tax Reform Propels Global Stocks Higher The prospect of U.S. lawmakers passing the most sweeping rewrite of U.S. business and income taxes since the Reagan era continued to propel global stocks higher, fueling gains across U.S. futures, European shares and most Asian markets.

• Can the Tax Cut Boost Stocks?

(…) In a preliminary analysis of the tax plan’s effect, based on the tax plans the House and Senate separately passed last month, Goldman Sachs strategists found that S&P 500 profits would get a 5% boost. The final tax plan doesn’t appear quite so generous—the corporate tax rate is set, for now, at 21% rather than the 20% congressional Republicans initially aimed for—but a ballpark figure of 5% still seems reasonable. (…)

Of course, it is possible that the tax plan boosts economic growth, which would add even more oomph to earnings than is readily apparent. (…)

From the FT:

• Analysts and executives expect corporate earnings to be boosted by an average of about 10 per cent, with some companies set to see significantly higher benefits of up to 30 per cent, thanks to the proposed reduction in the main rate of US federal corporate tax from 35 per cent to 21 per cent.

• Tax Bill a Boon to Commercial Real Estate Owners

• Poll: Voters Increasingly Favor Democrats for Congress Asked which party they prefer to lead Congress after next year’s midterms, 50% said the Democrats and 39% said Republicans, according to a Wall Street Journal/NBC News poll that offers caution signs for the Republican Party.

The bill, which includes deep tax cuts for corporations, reduces the tax rate and provides a steep deduction for some businesses structured as partnerships, limited-liability companies and other so-called pass-through companies, which is how most real estate businesses are set up.

In fact, real estate businesses appeared to fare better than other pass-through businesses, which pay taxes through individual returns. Not only does the proposal drop the top individual marginal tax rate, but the plan also gives a 20% deduction on taxable income to pass-through businesses owned by individuals making less than $157,500 and joint filers making less than $315,000.

In addition, the bill gives some owners of pass-through companies who exceed those income levels another method of qualifying for that deduction that benefits private real estate partnerships with few employees and large real estate holdings, tax lawyers noted.

“If enacted, the commercial real-estate industry will have hit the jackpot,” said Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution. (…)

Amid all this DC activity, we’re 2 weeks away from the end of Q4’17. Positive preannouncements are down somewhat but negative warnings are much lower than last year and than Q3’17 at the same stage.

Which means that the apparent squeeze on profit margins is not actually hitting profits just yet…

…except in the grocery biz:

• Grocers Absorb Rise in Food Prices to Keep Customers From Straying Retailers hold line on prices, fearing they will lose business to discounters and new rivals online

(…) “Our inflation at cost is still above our inflation at retail,” Mike Schlotman, CFO of grocer Kroger, told investors this month. “We didn’t pass all of it on.” (…)

Trailing S&P 500 EPS are now $128.23 for a Rule of 20 P/E of 22.7, pretty rarely seen historically.

Let’s dare to be forward looking:

• Using full 2017 EPS expected at $131.47 (+11.3%): Rule of 20 P/E: 22.2 = –9.9% decline to “20” fair value.
• Using current 2018 estimate of $146.26 (+11.2%): Rule of 20 P/E: 20.1 = fairly valued one year out.
• Using 2018E + 8% tax reform impact = $158.00 (+20.2%): Rule of 20 P/E: 18.8 = +6.4% upside to fair value one year out.

The above exercise keeps inflation unchanged, a highly heroic assumption if this tax reform meaningfully boosts consumer and corporate demand when the economy is already at 3% speed and unemployment at 4.1%.

Given this tax reform and corporate America’s ability to grow profits, the risk to equities in 2018 comes more from rising inflation and interest rates than from an eventual recession and weak profits, although rising debt levels are adding significant leverage to any adverse economic development.

• Investors Are the Most Bearish Since Great Financial Crisis Big investors are heading into 2018 with the most bearish perspective on stocks since the great financial crisis, according to one closely watched investor survey.

This WSJ article is based on a Boston Consulting Group survey report. Over a two-week period during late October and early November 2017, BCG surveyed 250 investors who oversee approx­imately $500 billion in assets, soliciting their outlook on and expectations for the global macroeconomic environment, equity markets, and the continued ability of companies they invest in or follow to create value.

(…) Nearly half of the survey respondents (46%) are pessimistic about equity markets for the next year, a substantial jump from 32% in 2016 and 19% in 2015. More than a third of investors (36%) are bearish about the market’s potential for the next three years, more than doubling the 2016 survey’s percentage of self-described bears (16%). (…)

The most frequently cited reasons underlying this pessimistic outlook are macro factors such as rising interest rate levels (45% of bears), the US political climate (40%), and unstable geopolitics (31%). (…)

The 3% earnings growth that they expect to see over the next three years is the lowest earnings growth expectation we have seen in the nine-year history of BCG’s investor survey. (…)

Meanwhile, Lowry’s Research remains positive, as its calculated “forces of Supply and Demand continue to suggest a healthy bull market”. Lowry’s technical analysis sees no “significant deterioration in the market conditions” and “a bull market that remains relatively healthy and with months more of new highs ahead.”

FIXED INCOME

• US High Yield Default Rate Approaches Lowest Level Since March 2014

The U.S. high yield default rate is poised to finish 2017 below 2%, its lowest level since the first quarter 2014, according to a new report from Fitch Ratings. The rate stands at 1.5% with just under $19 billion of defaults, a notable decrease from the $59.6 billion (4.7%) tallied last year when energy and metals/mining accounted for 84% of the total. This year, energy and metals/mining together generated only $3.9 billion while telecommunications registered the most defaults for a single sector at $3 billion.

“Retail bond defaults produced just $2 billion of volume, but that amount could double in 2018,” said Eric Rosenthal, Senior Director of Leveraged Finance. “The institutional leveraged loan market has been harder hit by retail defaults than high yield.” (…)

Overall, Fitch forecasts the U.S. high-yield default rate to end 2018 modestly above 2%. Broadcasting/media could generate roughly 40% of the total market default volume and post an 18% sector rate in 2018 (the sector default rate falls to 2% without iHeartCommunications Inc.). Fitch anticipates the energy default rate at just 2% next year, as the sector default cycle is on the wane.

The November TTM 30-day post default average issue bid price is at 59%, up from 27% one-year ago. The par-weighted price is comparable to the benign default periods of 2006-2007 and 2013-2014 when levels finished in the mid 60s. (…)

• Moody’s:

However, the loss of full tax deductibility of interest expense will adversely affect the aftertax earnings of a number of high-yield companies. About 26% of high-yield issuers will be worse off under the House plan and 36% will be worse off under the Senate proposal because of how the House plan allows interest expense to be deductible up to 30% of EBITDA, while the Senate’s version limits the deductibility of interest expense up to 30% of EBIT. (…)

The share of high-yield companies that are worse off because of the loss of the full deductibility of interest expense might become larger in the event benchmark interest rates jump sharply and/or high yield credit spreads widen materially. In addition, the less favorable tax treatment of business interest expense might become most apparent during a credit crunch, which, in all likelihood, would also be accompanied by shrinkages of both EBITDA and EBIT that automatically reduce the amount of interest expense eligible for deductibility.

In general, anything that increases the after-tax cost of debt also increases the risk of more defaults during the next bout of financial stress. Nevertheless, over time, businesses might be expected to adjust to the less favorable tax treatment of interest costs by assuming less debt than otherwise. For now, the market has been largely indifferent to high-yield’s potential loss of financial flexibility in view of how a recent high-yield bond spread of 369 basis points (bp) was thinner than its 2017-to-date average of 384 bp.

• Fitch: $9.7T of Neg Yielding Debt Despite Monetary Normalization

The total amount of global negative-yielding sovereign debt remains at elevated levels despite the European Central Bank’s (ECB) plan to reduce monthly asset purchases amid improving economic fundamentals in the Eurozone, according to Fitch Ratings. As of Dec. 4, 2017, there was $9.7 trillion of negative-yielding sovereign debt outstanding, up from $9.5 trillion on May 31, 2017 and $9.3 trillion one year ago. (…) Improving growth has led the ECB to plan to slow the pace of asset purchases to EUR30 billion per month beginning in January 2018.(…)

ECB net purchases of public-sector debt securities have been roughly 3.5x the volume of net issuance on average in 2016 and 2017, forcing holders of Eurozone debt to purchase other assets, such as US treasury securities.

(…) In Germany, a bond originally with 10 years to maturity will come due in January 2018 with a coupon of 4%. If reissued, with a coupon at current market rates, the German bond will have a coupon of around 30bps. (…)

BTW, European speculative-grade bonds are now trading below 2.0% (e.g.: Volvo BB+ 1.8%, Energias de Portugal BB 1.6% and Leonardo S.p.A. BB+ 1.3%).

Trump to label China as a strategic ‘competitor’ Beijing accused of pursuing policies of economic aggression to weaken US

(…) While the national security strategy outlines a range of threats, most of the criticism is reserved for China and Russia, which are described as “revisionist” powers that are trying to “shape a world antithetical to US values and interests”. “China and Russia challenge American power, influence, and interests, attempting to erode American security and prosperity,” the document warns. (…)

• Drawbridge up: Trump’s foreign policy

In 2006 George W. Bush unveiled a National Security Strategy (NSS), a 54-page statement of his worldview, linking America’s security to the global spread of democracy and economic freedoms. “We choose leadership over isolationism, and the pursuit of free and fair trade and open markets over protectionism,” he wrote. Donald Trump will today unveil an “America First” NSS trashing that optimistic creed. The Trump strategy is expected to accuse China of “economic aggression”, and to blame predecessors for admitting rising powers into a liberal trading order in hopes of promoting reform, only to see rivals cheat and hurt America. Expect talk of “competitive engagement” (raising fears of trade wars) and praise for strong, sovereign nations that fight Islamic terrorism, not warm words about furthering democracy. Supporters call Mr Trump a new Reagan, promoting “peace through strength”. But this angry, defensive new America is no shining city on a hill. (The Economist)

Mr. Trump’s Trade War The president is right to emphasize reciprocity. His mistake is to focus on the balance of trade with individual countries rather than on the rules of market access

(…) The focus on the trade balance in trade negotiations is misguided. Trade is not like a ledger, where imports are the cost and exports are the benefit, and trade surpluses and deficits do not indicate that one country is “winning” and the other “losing.”

The trade deficit is driven by macroeconomic factors, not by trade barriers or trade agreements. (…)

In some circumstances, it may make sense to care about the overall balance of trade. If the trade deficit is viewed as a problem, the solution is for the U.S. to save more and spend less, like countries with trade surpluses, such as China, Germany and Japan. One component of America’s poor savings record is the federal budget deficit: When it grows as a share of GDP (due to a decline in revenues or an increase in expenditures), it contributes to the trade deficit.

But it makes no sense to care about balancing trade bilaterally with individual countries. A household may care about whether its overall spending exceeds its income, but it doesn’t care about balancing each component in its budget. Everyone runs a trade surplus with his or her employer. Everyone runs a trade deficit with the grocery store, except for the people who work there. It is nonsensical to balance your checkbook bilaterally; just try doing that with Amazon or Costco. (…)

With Canada, the U.S. does indeed have a trade deficit in goods, but it has an even larger trade surplus in services. Is this “very unfair” to Canada? Are we “taking advantage” of our longtime ally? What would Mr. Trump say if Canada said that we are obligated to intervene to reduce our surplus? (…)

Emphasizing deficits and surpluses has made our trading partners less willing to negotiate and to make concessions on issues of market access. And Mr. Trump’s precipitous decision to pull out of the TPP and his threats to withdraw from Nafta mean that the U.S. is now viewed as an unreliable partner. (…)

Commerce Secretary Wilbur Ross complains that cars assembled in Mexico receive better treatment in the EU than those produced in the U.S. The reason is simple: Mexico has a free-trade agreement with the EU, and the U.S. does not. Canada also just recently concluded a comprehensive trade agreement with the EU. Both countries now have a leg up over the U.S. in exporting to the EU. (…)

The more the U.S. stands apart from these trade negotiations, the more U.S. exporters will face discrimination in foreign markets. (…)