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 (1 March 2017)

Fed Up?

“We’re very close to achieving our dual mandate goals. Yet monetary policy essentially still has the pedal to the metal,” Williams said in the text of a speech he’s scheduled to deliver Tuesday in Santa Cruz, California. “We need to gradually ease our foot off the gas in order to avoid a ‘too hot’ economy that in the end isn’t sustainable.” (…)

New York Fed President William Dudley on Tuesday said that “animal spirits have been unleashed a bit” in the wake of the presidential election, pointing to the rise in the stock market.

“It seems to me that most of the data we’ve seen over the last couple months is very much consistent with the economy continuing to grow at an above-trend pace, job gains remain pretty sturdy, inflation has actually drifted up a little bit as energy prices have increased,” Dudley said. (…)

The perennial dove has turned hawkish. And yet:

  • U.S. GDP Advanced 1.9% in Final Quarter of 2016 U.S. consumer spending was stronger than initially thought in the final months of 2016, though the overall economic-growth trajectory remained muted amid downward revisions for business investment and government spending.
  • US economic data remains quite strong, although much of it has been based on “soft” (survey-driven) figures. (The Daily Shot)
Source: Goldman Sachs, @joshdigga

This morning:

  • U.S. consumer spending slows; inflation pushes higher U.S. consumer spending rose less than expected in January as the largest monthly increase in inflation in four years eroded households’ purchasing power, pointing to moderate economic growth in the first quarter.

The Commerce Department said on Wednesday that consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.2 percent after rising 0.5 percent in December. Economists polled by Reuters had forecast consumer spending gaining 0.3 percent in January. (…)

In January the personal consumption expenditures (PCE) price index increased 0.4 percent – the largest gain since February 2013 – after rising 0.2 percent in December.

In the 12 months through January, the PCE price index jumped 1.9 percent. That was the biggest year-on-year gain since October 2012 and followed a 1.6 percent increase in December.

Excluding food and energy, the so-called core PCE price index rose 0.3 percent in January. That was the biggest increase since January 2012 and followed a 0.1 percent gain in December.

The core PCE price index increased 1.7 percent year-on-year after a similar gain in December. The core PCE is the Fed’s preferred inflation measure. (…)

Consumer spending in January was held back by a 0.3 percent drop in purchases of long-lasting manufactured goods such as automobiles. Spending on services was unchanged.

Personal income rose 0.4 percent in January after gaining 0.3 percent in December. Wages and salaries rose 0.4 percent.

Income at the disposal of households after accounting for inflation and taxes, fell 0.2 percent, the first decline since October 2013. Savings increased to $795.7 billion in January from $779.5 billion in December. (…)

The Thomson Reuters/PayNet Small Business Lending Index fell to 123.3 in January from 134 in December, and was the lowest since October, when the index sank to 119.8.

Movements in the index typically correspond with changes in gross domestic product growth a quarter or two ahead. (…)

FEBRUARY PMIs

February data revealed that the U.S. manufacturing sector continued to expand at a robust pace,
although the latest upturn was slightly weaker than seen at the beginning of 2017. This largely reflected a moderation in new order growth from January’s 28-month peak, alongside a slightly softer increase in output volumes. Meanwhile, manufacturers reported a sustained rise in inventory levels, which was linked to greater production schedules and expected improvements in client demand.

The seasonally adjusted Markit final US Manufacturing Purchasing Managers’ Index™
(PMI™) posted 54.2 in February, down only slightly from January’s 22-month peak of 55.0. As a result, the average reading for Q1 to date indicates that the manufacturing sector is on course to register its strongest quarterly improvement in business conditions for two years.

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Manufacturing production has picked up in each month since June 2016, and the latest rise was one
of the fastest recorded over the past two years. A robust pace of output growth was attributed to a
combination of increased client spending and efforts to rebuild finished goods inventories in February. Post-production stocks have now risen for five months in a row, which represents the longest period of inventory building since mid-2015.

Mirroring the trend for production volumes, the rate of new business growth moderated only slightly from the peak seen at the start of 2017. Survey respondents commented on improving domestic
economic conditions and a boost from greater investment spending among energy sector clients.
This helped to offset a near-stagnation in export orders in February. The latest rise in new work from abroad was the weakest since September 2016, reflecting a continued drag on demand from the strong dollar.

Manufacturers responded to greater new business levels by hiring additional staff and increasing their purchasing activity during the latest survey period. The rate of job creation was nonetheless softer than the 18-month peak recorded at the end of 2016. Rising payroll numbers helped to boost operating capacity and contributed to a slower pace of backlog accumulation in February. Meanwhile, strong demand for inputs and efforts to boost preproduction inventories placed pressure on suppliers’  stocks and contributed to longer delivery times for raw materials.

February data pointed to a robust rate of input price inflation across the manufacturing sector. Although slightly slower than in January, the latest rise in average cost burdens was still one of the fastest recorded over the past two-and-a-half years. Rising prices for raw materials in turn led to another moderate increase in average prices charged by manufacturing companies.

February saw the rate of improvement in eurozone manufacturing operating conditions gather further
momentum. At 55.4, up from 55.2 in January, the final Markit Eurozone Manufacturing PMI® rose to its highest level since April 2011 despite posting slightly below its earlier flash estimate of 55.5.

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National PMI data indicated that seven out of the eight nations covered saw operating conditions
improve (the sole exception being Greece). Three countries also registered faster rates of expansion – the Netherlands, Germany and Italy. (…)

imageEuro area manufacturing production and new orders both rose at the quickest rates since April 2011. Companies indicated that domestic demand remained solid in a number of markets, while the weak euro contributed to the fastest growth of new export business for almost six years.

New export orders rose in almost all of the nations covered (Greece was the exception). (… )

Although the weak euro exchange rate was a spur for export competitiveness, it was also a major factor driving up purchase prices. Average input costs rose at the quickest pace since May 2011, with companies reporting that many commodities were higher in price. These pressures filtered through to the factory gate, with average output charges rising to the greatest extent for over five-and-a-half years.

There were also signs that rising demand for raw materials (purchasing activity rose at the second steepest pace in almost six years) led to sellers’ markets developing for a number of inputs. This was highlighted by supplier lead times lengthening to the joint-greatest extent since mid-2011.

Accelerated growth of production and new work received had positive impacts on business optimism
and job creation during February. Confidence levels were only slightly below the series-record high
achieved in January, which companies also linked to improving global economic growth.

Meanwhile, stronger order inflows and an associated rise in backlogs of work encouraged manufacturers to increase employment for the thirtieth month in a row. The rate of job growth eased from January’s high, but remained among the sharpest registered in the survey history. (…)

Chinese manufacturing companies saw a stronger improvement in overall business
conditions in February, with output and total new orders both rising at faster rates than at the
start of the year. The latest upturn in new work was supported by the fastest increase in new
export business since September 2014. At the same time, employment declined at only a
marginal pace that was the slowest seen in two years.

Despite easing since January, the rate of input price inflation remained sharp which prompted firms to raise their prices charged. Looking ahead, manufacturers signalled the strongest degree of optimism towards future output growth since May 2015.

At 51.7, the seasonally adjusted Purchasing Managers’ Index™ (PMI™) picked up from 51.0 in January and signalled an improvement in overall business conditions for the sixth month in a row. Though modest overall, the latest improvement was the joint-second strongest for just over
four years.

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February survey data pointed to a further rise in Chinese manufacturing production, with the rate of expansion picking up from that recorded in January. That said, the rate of growth was moderate overall and below those seen through the final quarter of 2016. Supporting higher production was a further rise in total new business. According to latest data the upturn in new work was partly driven by stronger growth in new export sales. Furthermore, new orders from abroad increased at the quickest pace since September 2014.

Companies continued to report lower staff numbers in February, as has been the case in each month since November 2013. That said, the rate of job shedding was the slowest seen for two years. Higher new orders and lower staffing levels contributed to a modest rise in unfinished business in February.

Improved new order inflows led to a further increase in purchasing activity. Furthermore, the rate of expansion edged up to its strongest since July 2014. As a result, stocks of purchases returned to growth in February, albeit rising at only a marginal pace overall. In contrast, stocks of finished items declined slightly for the second month in a row, which a number of firms linked to the delivery of products to clients.Strong demand for inputs led to a further lengthening of delivery times in February, though at a modest rate.

Average input costs rose sharply in the latest survey period, despite the rate of inflation easing to a four-month low. According to respondents, higher raw material costs were the key driver of inflationary pressures. As part of efforts to protect their margins, firms increased their output charges again in February and at a solid pace.

Optimism towards the one-year business outlook reached a 21-month peak in February. Confidence was generally linked by respondents to new product developments and improving market conditions.

The headline Japan Manufacturing Purchasing Managers’ IndexTM (PMI)TM rose from 52.7 in the opening month of 2017 to hit a 35-month high of 53.3 in February. The improvement in the health of the sector was reflected in all five PMI sub-components.

February survey data pointed to the fastest increase in new business wins for 14 months. In fact, the rate of growth strengthened for the fourth month straight and continued to outstrip the historical average. The rise in total new work was broad-based, as new export orders also grew and
at the quickest extent for 38 months.

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Amid reports of stronger demand, Japan’s goods producers raised output further in February. The latest increase extended the current sequence of growth which started in August 2016, and was the sharpest for 35 months.

Job creation was evident in Japan’s manufacturing sector in February. Moreover, firms added to their workforce numbers at the quickest extent since April 2014, with panel members citing greater production requirements.

Meanwhile, manufacturing companies recorded the first accumulation of backlogs of work for 14 months and at a pace which was strong in the context of historical data. In line with the trend for output, Japanese goods producers increased their purchasing activity at a pace broadly similar with January’s one-year high. Anecdotal evidence suggested the increase reflected an uptick in output in the sector.

Post-production inventories rose for the second month in a row at Japanese manufacturers in February. That said, the rate of increase was only slight. Stocks of raw materials and semi-finished goods also increased, albeit at a relatively subdued rate.

Japanese manufacturers signalled the quickest rise in average cost burdens for two years during
February, with panel members linking this to higher prices for machinery, iron, zinc, oil, steel and
copper. However, output charges remained broadly unchanged during the month.

Business confidence amongst Japan’s manufacturers was the second-strongest recorded in the 56-month series history in February. New factory openings and forecasted increases in new business led goods producers to feel more optimistic towards their 12-month outlook on growth.

Finally, average lead times faced by Japanese manufacturers lengthened further in February. However, the rate of increase was only moderate.

U.S. Housing Market Roars Into 2017, Case-Shiller Says Home prices jumped in December to their fastest full-year growth since 2013, as buyers shrugged off the effects of higher interest rates.

The S&P CoreLogic Case-Shiller Indices, covering the entire nation, rose 5.8% in the 12 months ended in December, compared with a 5.6% year-over-year increase reported in November.

The 10-city index gained 4.9% over the year, up from 4.4% the previous month, while the 20-city index gained 5.6% year-over-year, versus a 5.2% increase in November. (…)

Housing inventory in December hit its lowest level since 1999, when the National Association of Realtors started tracking the data. The number of homes for sale was down 7.1% in January compared with a year earlier, the Realtors said. (…)

How effective is defense spending?

If latest signals from Washington are any guide, the much-awaited fiscal stimulus ─ which is largely responsible for the stock market surge since the elections ─ may not live up to the hype. The Trump administration reportedly aims to boost defense spending by US$54 bn this year, which would take the latter back near pre-sequestration levels. But the bad news is that it’s also seeking compensating cuts in non-defense spending. It’s hard to see how such a measure will boost
economic growth.

As today’s Hot Charts show, fiscal multipliers for defense spending have typically been estimated at
less than 1, meaning that such outlays are likely to crowd out private spending, restraining growth as a result. One can only hope compensating cuts to non-defense spending does not include infrastructure whose fiscal multiplier is well above 1 according to the Congressional Budget Office.

The benefits of upcoming tax policy are also unclear ─ the CBO suggests fiscal multipliers are much lower than 1 when there are tax cuts for corporations and wealthy individuals.Multipliers are also the smallest when the economy is close to potential, as is currently the case. All told, we won’t be holding our breath for the 4% U.S. GDP growth that was promised during the election campaign. (NBF)

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It is also generally accepted that high indebtedness results in lower multipliers (see ECB working paper Fiscal Stimulus in Times of High Debt- Reconsidering Multipliers. The U.S. NBER came to similar conclusions in HOW BIG (SMALL?) ARE FISCAL MULTIPLIERS?)

INFLATION WATCH

 
Trump’s Congress Speech Marks a Shift in Tone Although there were no major policy changes, the edges of President Donald Trump’s most incendiary rhetoric were sanded off. It was the Trump doctrine with aspirational overtones.

President Donald Trump, after reaching the White House with fiery rhetorical attacks and a combative message, pitched his agenda to voters and Congress with language that was much more presidential and traditional in tone. He also issued a call for American renewal in stark contrast to the aggressively nationalist posture he outlined at his inauguration just over a month ago. (…)

But despite the more unifying tone, the speech isn’t likely to do much to help Mr. Trump get his stalled legislative agenda off the starting block. To move a tax overhaul through Congress, and a replacement for the Affordable Care Act, he needs a united GOP and support from at least some Senate Democrats. Right now he has neither. His long speech isn’t likely to change that. (…)

BofA Throws In The Cautionary Towel: Raises S&P Price Target From 2,300 To 2,450

(…)to “reflect an increasing likelihood that we are entering the typical later stages of a bull market, during which fundamentals typically take a back seat to sentiment and technicals.”

Nonetheless, she does attempt to and adds that “typically, in the later stages of a bull market, corporate earnings are cyclically elevated and the multiple that the market assigns to those earnings is often elevated as well. As a result, market prices can become significantly overvalued relative to their intrinsic fair value, and this divergence can last for years. Thus, we would highlight the distinction between our year-end target of 2450 (driven largely by sentiment and technicals) and our estimated intrinsic fair value of 2230.” (…)

THE DAILY EDGE (28 February 2017)

Aircraft Sales Boosted U.S. Durable-Goods Orders in January Orders for long-lasting factory goods climbed last month due to purchases of military and civilian aircraft, overshadowing a weak start to 2017 for business investment in new equipment.

Orders for durable goods—products, like airplanes and dishwashing machines, that are designed to last at least three years—increased 1.8% in January from the prior month to a seasonally adjusted $230.35 billion, the Commerce Department said Monday. Economists surveyed by The Wall Street Journal had expected a 2.0% increase in total orders last month.

(…) Excluding the transportation segment, orders fell 0.2% from December.

A closely watched proxy for business investment in new equipment, new orders for nondefense capital goods excluding aircraft, fell 0.4% in January from the prior month. That was the sharpest one-month drop in the category since September.

Still, the broader trend remained positive. Total durable-goods orders were up 1.4% in January from a year earlier and orders for nondefense capital goods excluding aircraft rose 2.6% compared with January 2016. (…)

We will see if the expected tax reform which would allow businesses to totally expense capex in the first year will incite companies to defer some plans until the reform is effective.

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U.S. Pending Home Sales Slip

Pending home sales, which measure how many homes went under contract, fell 2.8% from a month earlier to an index of 106.4 in January, the National Association of Realtors said.

Sales rose 0.4% from a year earlier.

Haver adds that

(…) the pending sales figures were mixed across regions, suggesting the series also may have been affected by weather. For example, the index in the West declined by 9.8% to 94.6, the lowest reading since June 2014, possibly reflecting the heavy rains in California. Meanwhile, pending sales in the Northeast hit a new cycle high of 98.7, amid unseasonably mild winter weather.

But Haver’s own charts reveal a trend beyond the weather, whether one looks at regional or nationwide trends:

 large image large image

Confused smile Could it possibly be higher house prices and rising mortgage rates?

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In all, housing sure does not look like wanting to lead the economy here, does it:

Source: @IIF, @DeanDijour (via The Daily Shot)

And yet, US homebuilder shares are outperforming again on tight housing inventories.

Auto Car Dealer’s First Overflow Lot in 37 Years Exposes U.S. Pileup

(…) Dealers had about 85 days worth of cars and trucks on hand at the beginning of February — about 22 days more than at the beginning of 2017 and eight days more than a year earlier, according to Automotive News Data Center. (…)

Production cutbacks also have already begun. GM and Fiat Chrysler have eliminated shifts, laid off employees or scheduled days off early this year at plants making slower selling models including the Chevrolet Cruze compacts, Chrysler Pacifica minivans and Buick Lacrosse sedans. (…)

INFLATION WATCH

With businesses split on U.S. border tax, wider reform looks shaky
U.S. economy slows in the fourth-quarter; consumer spending remains bright spot
Evercore ISI: “Trump Budget Not Happening” 
A New Way to Look at Crazy Stock Valuations Valuations have been inflated by a collapse in profits for oil companies

(…) The energy sector stands at more than 30 times Thomson Reuters IBES’s estimate of operating earnings over the next 12 months, higher than any time from when the sector data started in 1995 up to last year—when it briefly reached an extreme of almost 60 times.

(…) investors who rely on the overall valuation of the index as a signal for future returns would be misled if they ignored the collapse in oil-sector profits.

Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, puts the overall market at 18.1 times this year’s estimated operating earnings. When the energy sector—containing six of the seven S&P companies forecast to lose money this year—is excluded, the forward PE stands at 16.6, a much less frightening figure. (…)

There are both conceptual and practical objections to taking this as a signal that stocks are at a reasonable level. The conceptual problem is that it looks like manipulation of the figures to justify buying shares, a practice with a long and dishonorable history on Wall Street. (…)

The practical issue is more worrying. Even without energy, valuations are pretty high. (…)

I used that same argument one year ago at 1866 on the S&P 500 Index (UPGRADING EQUITIES TO 3 STARS) but the numbers were very different:

(…) But equity markets are even cheaper than they appear. The absolute P/E on trailing EPS is now 15.9, down from a recent peak of 18.2 in December 2014. This compares with a long term average of 13.7 (since 1927 and 1953, 18.5 since 1993). However, the Energy sector P/E is currently 40x because of depressed EPS when it normally is around 12x. This abnormally high multiple artificially inflates the overall S&P 500 Index P/E by about 2 full P/E points meaning that normalizing Energy, equities are actually selling at 13.9x EPS, right on their LT average and very low considering current low inflation and interest rates.

Applied on the Rule of 20, its current 18.0 reading drops to 16.0 with Energy normalized, meaning that fears about a U.S. recession, the oil rout, another banking crisis and the China syndrome have largely been factored in. (…)

Regular readers understand that the Rule of 20 is not a forecasting tool but rather an objective measure of risk and reward. In the current circumstances, the upside is between +13% and +25% while the downside seems limited in a no recession environment.

imageBut that was when Energy earnings were totally depressed, not quite the case anymore (chart on right) unless one sees a much higher oil price ahead.

Ed Yardeni has these P/E charts (on forward EPS) which show that other sectors’ P/E are not low contrary to early 2016:

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If we normalize the S&P P/E using a P/E of 12 for Energy shares, the S&P 500 trailing P/E drops from 20 to 18.4 and the Rule of 20 P/E drops from 22.3 to 20.7, far from bargain levels in both cases.

(…) the ironclad law of economic growth is actually quite pliable. Real GDP annual growth of 3.5 percent would occur with 2.5 percent yearly growth in productivity and 1 percent rises in employment, the historic numbers. True, with low fertility rates, the Census Bureau sees the U.S. population rising just 0.2 percent a year by 2026, even with net immigration of 1.3 million annually over the next decade.

Nevertheless, the labor participation rate — the percentage of the population over 16 that is employed or actively looking for work — had plummeted to 62.9 percent in January from the 67.3 percent peak 17 years earlier. So 4.4 percent of the potential workforce, or 11.3 million people, have departed. About 60 percent were retiring postwar babies, but many are returning or staying in jobs past normal retirement ages because their health is better than their predecessors’ and because they need the income. Postwar babies have been notoriously poor savers throughout their lives. The participation rates of those over 65 are actually rising, not falling, as is normally true for seniors.

Also increasingly looking for work are youths who stayed in school during the dark Great Recession years and are now better educated and attracted by expanding job openings. In addition, skills to meet available jobs are being provided by apprenticeship programs that combine two-year college degrees with on-the-job training. German manufacturers brought this system with them to their factories in the U.S. Southwest, and it is increasingly being emulated by U.S. firms.

Trump’s threats of mass deportation of undocumented immigrants have been scaled back. They now target those with criminal records and other suspects. And with cooler heads in Congress, U.S. immigration policy may end up mirroring Canada’s with a point system aimed at admitting those with the skills this country needs.

Trump’s planned deregulation and lower corporate tax rates may spur capital spending, but the correlation between the growth in capital expenditures and productivity gains is low, sometimes negative. More machines alone don’t spur efficiency. More important, productivity-enhancing new technologies grow explosively, but since they start from essentially zero, it takes decades before they move the productivity needle significantly. Aside from those yet to be developed, today’s well-known technologies such as robotics, additive manufacturing, biotech and self-driving vehicles are no doubt still in their infancy.

The argument that protectionism inhibits economic growth is also suspect. Sure, eras of rapid global economic growth are also periods of strong foreign trade advances, but do trade gains stimulate economic activity or the reverse? You can’t prove causality with statistics. If you beat a drum every time there is a total eclipse of the sun, it will go away. No causality, but 100 percent correlation.

Also questionable is the robots-will-eliminate-workers theory. A recent McKinsey study found only 5 percent of 800 occupations and 2,000 job tasks are likely to be entirely automated. Instead, half of current jobs will be changed significantly, forcing employees to adjust. At the same time, automation may hike global productivity by 0.8 percent to 1.4 percent per year during the next half century.

The catalyst for the return to rapid economic growth will, no doubt, be a huge fiscal stimulus program. Voters who are mad as hell after a decade or more of no growth in real incomes elected Trump and the Republican Congress, and politicians will respond. It will take two or three years to come to fruition, but look for huge infrastructure outlays and large increases in military spending. Stocks don’t normally discount that far ahead, but maybe that’s what leaping equities are anticipating, despite all the uncertainty in Washington, the nation and, indeed, the world.

Here’s what Shilling wrote in his always excellent Insight of Feb. 2017:

We continue to look for massive fiscal stimuli and rapid economic growth in reaction to voters mad as hell over a decade of no purchasing power growth, but that’s only after the two or three years it takes for Congress to act; increased defense spending to occur and infrastructure outlays to work their way through the states that actually spend the money. We also wrote that the Fed, zealous for fiscal stimuli since monetary policy is impotent, would buy the resulting surge in new Treasury debt to keep leaping bond yields from offsetting the effects of increased government spending—helicopter money.

We also noted that Congress stands between Trump and fiscal spending, but the President is relatively free to pursue the principal goal that got him elected, protectionism. So it would be international actions first and fiscal stimuli later, we argued. So far, that’s the way it’s unfolding.

Fiscal action is on hold while Trump escalates the ongoing trade war with China, plans a Mexican wall and tightens immigration policy. So the Trump trades are being reconsidered with stabilized Treasury bond prices, flat oil prices and stocks moving sideways after the Dow Jones Industrial Average’s much-ballyhooed breakthrough to 20,000 failed to hold.

These recent actions make us more confident over the long-run investment themes we laid out last month, although we continue to urge caution and large cash holdings in portfolios. (…)

Uncertain equity prices. They are expensive in relation to corporate earnings, and those earnings are not based solidly on revenue gains but on cost-cutting, which appears to have run its course. As noted earlier, investors jumped the gun on the revival of rapid economic growth. Markets anticipate, but it’s probably too early to discount fiscal stimuli that will take two or three years to materialize. Nevertheless, equity bull markets don’t die of old age, and the current one may continue until terminated by a financial shock or by central bank restraint.

Gavyn Davies: Whatever happened to secular stagnation?