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MORE UNCERTAINTIES:

• Clinton Health Another Landmine for Suddenly Vulnerable Markets

(…) While investors and analysts were reluctant to speculate on Clinton’s health, they said expectations she will prevail in November have been a factor in the calm and predicted the scrutiny will intensify. (…)

“It’s already priced into the market that Hillary Clinton is going to be president so right now anything that changes that narrative is going to give the market a pause to consider what that would mean.” (…)

• Clinton and Trump: Healthy Enough to Serve?

U.S. Wholesale Sales Slip While Inventories Are Unchanged in July

Wholesale sector sales slipped 0.5% m/m (-1.0% y/y) in July following an outsize 1.7% m/m (revised from 1.9% m/m) jump in June. The Action Economics Survey had looked for a 0.2% m/m increase. Nondurable goods sales, which had led the June jump, also led the July slide. They fell 1.0% m/m (-2.6% y/y) after a downwardly revised 2.2% m/m surge in June. Sales of petroleum and petroleum products slumped 3.5% m/m in July, nearly offsetting a 3.9% m/m jump in June. Sales fell generally across the major nondurable goods product groups. Durable goods purchases edged up 0.2% m/m (0.7% y/y) in July despite modest monthly declines in sales of motor vehicles and machinery. Furniture and lumber sales rebounded smartly in July after declines in June.

Inventories at the wholesale level were essentially unchanged in July (+0.5% y/y) from a slightly upwardly revised June level (though the 0.3% m/m increase initially reported for June was not revised). July inventories were also revised up slightly from the advance report released on August 26. (…)

With sales slipping and inventories essentially unchanged, the inventory-to-sales ratio in the wholesale sector edged up to 1.34 in July from 1.33 in July. It had either declined or remained unchanged for five consecutive months. The expansion high was 1.37 reached in January 2016.

  

S&P warns over UK recovery ‘mirage’

Said Sophie Tahiri, economist at S&P Global Ratings:

While the news is encouraging, we believe it has no bearing on the cloudy longer-term outlook for the U.K. economy… The uncertainty surrounding the U.K’s future outside of the E.U. and the associated economic risks, which we think are pronounced and predominantly skewed to the downside, will gradually take its toll, particularly on investment, as businesses start dealing with the new Brexit reality.

Woes at Italy’s Biggest Bank Reverberate in Europe Troubles at UniCredit, Italy’s biggest bank by assets, could threaten not only Italy’s ailing economy but also the continent’s already fragile financial stability.

UniCredit, Italy’s largest lender by assets, emerged as one of the weakest big banks in Europe in July’s stress tests, showcasing the failure of its attempts to respond to rock-bottom interest rates and a huge pile of bad loans.

Now, as Jean-Pierre Mustier, the bank’s new chief executive, readies a big-bang plan to revive UniCredit’s fortunes, he faces a series of unpalatable choices: Aggressive action to cut the bank’s €80 billion ($89.9 billion) in bad loans—the largest of any European bank—would force the Milanese bank to raise billions in fresh capital, while an asset sale could help bolster its capital position but would hurt already thin profit.

Meanwhile, the travails of Italy’s No. 3 lender, Banca Monte dei Paschi di Siena SpA, promise to only complicate Mr. Mustier’s job. On Thursday, Monte dei Paschi said its CEO, Fabrizio Viola, had agreed with the bank’s board to resign, in a surprise move that came as that bank works on a plan to shed €28 billion in bad loans. (…)

A major move to unload bad loans, perhaps as much as €20 billion, “will be key for a rerating of the stock,” said Vicenzo Longo, a Milan-based strategist at IG Markets.

However, Monte dei Paschi presented a plan in July to sell €28 billion of bad loans at 27% of face value. That has effectively set a new benchmark for the pricing of Italian bad loans. Since UniCredit attributes a higher value to its bad loans, a sale of €20 billion of loans would force it to take €2 billion in write-downs—thus increasing the size of a capital increase. (…)

Finally, Mr. Mustier cannot present his plan until after a national referendum in Italy—likely in late November—that threatens to topple Italian Prime Minister Matteo Renzi’s government and is already unnerving investors.

Prepare for a power shift after Germany’s general election

The Brexit vote was the ultimate electoral upset this year. The US elections and the Italian constitutional referendum may be next, followed by the Dutch and French elections next year. What about Germany, where elections are due in the autumn of 2017? Is an electoral upset there possible as well?

Yes and no. The interesting question is not who will win. The answer is: very likely Chancellor Angela Merkel if she decides to run. It is quite possible that the same “grand coalition” government will emerge, less grand perhaps, but with mostly the same ministers. What makes this election so interesting and important for the rest of Europe is a likely power shift within the Bundestag.

We caught a whiff of the pending power shift at last week’s elections in Ms Merkel’s home state of Mecklenburg-Vorpommern, north-east Germany. The chancellor’s Christian Democrats suffered one of their worst results in the party’s history, ending up with less than 20 per cent of the vote. It came third behind the Alternative for Germany (AfD), which started life as an anti-euro party and has now morphed into a nationalist anti-immigrant party.

The AfD is not represented in the Bundestag. Nor are the liberal Free Democrats. Right now, the grand coalition parties — the CDU, its Bavarian sister party, CSU, and the Social Democrats — hold 80 per cent of the seats. The Greens and the Left party hold the rest.

All this will change next year. The latest opinion poll by Insa puts the AfD at 15 per cent of the vote nationwide. The FDP has recovered from its defeat in 2013 and is on course to clear the 5 per cent threshold required for entry to the Bundestag. That alone will ensure that the majority of the grand coalition parties will shrink as Germany adjusts to a seven-party parliament. In addition, both the CDU/CSU and the SPD have lost support since the last election. The CDU is down by 10 percentage points. The polls put the two coalition partners at barely over 50 per cent.

One of the reasons any change in the composition of parliament matters is the internal division between the CDU and the CSU on Europe and immigration. Ms Merkel has no problem organising majorities at present. But if the polls are borne out at the ballot box next year, the Bundestag will be able to constrain her on matters ranging from Brexit to the debate on the future of the EU and the eurozone. Today the executive is strong and the legislature is weak. This is going to reverse. (…)

Hanjin to Pay to Unload Stranded U.S.-Bound Ships

Hanjin Shipping Co. has both the funding and the legal permission necessary to unload four ships bound for U.S. ports., one of its lawyers said in federal court on Friday.

“We’re making a lot of progress,” the lawyer, Ilana Volkov, told Judge John Sherwood at a hearing in U.S. Bankruptcy Court in Newark, N.J. “We have the money to fully service those four ships.”

Ms. Volkov said a South Korean court authorized Hanjin to use $10 million in a U.S. bank account to pay workers to unload four container-laden ships bound for the U.S.

Hanjin also has asked the court for another $3.5 million to have goods that have already been unloaded and are sitting at U.S. ports delivered to their owners. Ms. Volkov said the financing could be approved and the supply chain for those containers could be jump-started as soon as Wednesday.

Court papers show a total of 13 ships either owned or leased by Hanjin whose next port of call is in the U.S. (…)

• Hanjin Shipping Unloads Cargo at U.S. Port A Hanjin Shipping vessel was set to finish unloading freight in California, clearing the way for more of its ships to dock, as the ailing South Korean company works with ports to get a frozen supply chain moving.

HIGH YIELD SPREADS AND THE ISM

Business activity worsened in August. The ISM indices of US business activity for August warn of continued lackluster business sales that threaten to crimp private-sector hiring activity, increase default risk, and widen corporate bond spreads.

The ISM index of US manufacturing activity fell from July 2016’s 52.6 and August 2015’s 51.0 to August 2016’s 49.4, its most contractive score since the 48.2 of January 2016. Moreover, the ISM index of US service-sector activity tumbled from July 2016’s 55.5 and August 2015’s 58.3 to August 2016’s 51.4, where the latter was its worst showing since the 50.8 of February 2010.

A regression model that attempts to explain the high-yield bond spread’s month-long average with the ISM indices of manufacturing and non-manufacturing activity generates a meaningful adjusted-R square statistic of 0.68. According to the model, the ISM’s August 2016 data predict a 736 bp midpoint for the high-yield bond spread — far wider than the recent 519 bp. August 2016’s predicted midpoint was the broadest since August 2009’s 753 bp, or when the ISM factory index equaled 53.5 and the non-manufacturing index was at 49.1.

Only if the ISM indices continue to predict a high-yield spread that is far above its recent value might high-yield bond prices sink. A month’s worth of mediocre readings from the ISM falls considerably short of constituting a meaningful trend. Nevertheless, both the credit and equity markets have priced-in a rejuvenation of sales and operating income that may not materialize. (Moody’s)

Rate-Rise Fears Trip Up Markets The Dow industrials fell almost 400 points, as doubts over central banks’ willingness or ability to stimulate economic growth sent stocks and bonds tumbling.

The yield on Germany’s 10-year bund, which had been negative almost without exception since Britain voted to leave the European Union on June 23, popped into positive territory Friday.

The European Central Bank damped market sentiment on Thursday by deciding to leave its bond-buying and interest-rate policies unchanged, rather than expanding them as some investors had hoped.

An official with the Federal Reserve deepened concerns by suggesting Friday that the Fed still might raise interest rates even after a week of relatively weak U.S. economic data.

“A reasonable case can be made for continuing to pursue a gradual normalization of monetary policy,” Federal Reserve Bank of Boston President Eric Rosengren said in a speech. (…)

Yields on 10-year Treasury notes jumped to 1.671%, their highest level since June 23. (…)

“We have the ability to be patient,” Robert Kaplan, president of the Federal Reserve Bank of Dallas, said in an interview with The Wall Street Journal Friday. (…)

“We have an opportunity to continue to get employment gains in this country,” Fed governor Daniel Tarullo said in an interview with CNBC Friday. He said he expected a “robust discussion” at the September meeting about whether to raise rates. (…)

Federal-funds futures, which are used by traders to place bets on central-bank policy, on Friday showed a 24% chance of a U.S. interest-rate rise in September, compared with an 18% chance as of Thursday, according to CME Group Inc. The expectation for a rate rise by December rose to 55%, from 51% on Thursday. (…)

Investors, however, are concerned the ECB and Bank of Japan are getting closer to the limits on bonds they can buy under their programs. (…)

Investors in some countries have been paying more for government bonds, and even some corporate bonds, than they will get back when the debt matures.

That makes little sense unless they believe buying by central banks will keep pushing the price of debt higher and yields lower. Otherwise, the math on longer-dated debt means rising yields can lead to big losses. (…)

EARNINGS WATCH

This Market Watch piece scared many last Friday:

Wave of profit and sales warnings puts spotlight on new risks companies face At least 10 companies this week alone have lowered outlooks for the second half of the year

Ford Motor Co. F, -2.75% Barnes & Noble Inc. BKS, -2.87% Tractor Supply Co.TSCO, -1.38% Supervalu SVU, -4.44% Sprout’s Farmers Market Inc. SFM, +0.93% Pier 1 Imports Inc. PIR, -5.88% General Mills Inc. GIS, -3.59% HD Supply Holdings Inc.HDS, -3.93% EnQuest PLC ENQ, +2.68% Dave & Buster’s Entertainment Inc.PLAY, -2.24% and Kroger Co. KR, +0.64% are among the companies tempering expectations for their second half during this holiday-shortened week. (…)

But total pre-announcements so far this quarter are not really “a wave” as MW itself acknlowledges:

So far, 78 of the 113 S&P 500 companies that have provided an outlook for the quarter have issued negative earnings-per-share guidance, according to FactSet senior analyst John Butters. That’s a 69% rate — below the five-year average of 74%. Looking at the S&P 600, 63 out of 89 companies, or 71%, have issued negative EPS guidance, said Butters.

For now, S&P 500 companies are expected to show a decline in EPS of 2.12%, according to FactSet; that would be a sixth straight quarter of decline. As recently as the end of March, analysts were expecting EPS growth of 3.2% for the quarter. Sales are expected to show growth of 2.2%, which, if it materializes, would break a six-quarter streak of declines. (…)

Here’s what Factset actually said:

In terms of estimate revisions for companies in the S&P 500, analysts have made smaller cuts than average to earnings estimates for Q3 2016. On a per-share basis, estimated earnings for the third quarter fell by 2.5% over the first two months of the quarter. This percentage decline is smaller than the trailing 5-year average (-3.4%) and trailing 10-year average (-3.8%) for the first two months of a quarter.

In addition, a smaller percentage of S&P 500 companies have lowered the bar for earnings for Q3 2016 relative to recent averages. Of the 113 companies that have issued EPS guidance for the quarter, 78 have issued negative EPS guidance and 35 have issued positive EPS guidance. The percentage of companies issuing

As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings decline for Q3 2016 is -2.0% today. On June 30, the expected earnings growth rate was 0.4%. If the Energy sector is excluded, the estimated earnings growth rate for the S&P 500 would improve to 1.2% from -2.0%.

As a result of upward revisions to sales estimates, the estimated sales growth rate for Q3 2016 is 2.6%, which is slightly above the estimate of 2.5% at the start of the quarter. If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would improve to 4.0% from 2.6%.

Thomson Reuters has Q3 EPS down 0.5%, also 2.5% lower than on June 30th, and Q4 up 8.3%, essentially unchanged from recent weeks. TR’s tally of pre-announcements also reveals the inexistence of “a wave”. TR’s negative pre-announcements are below last year and last quarter at the same time. In fact, positive pre-anns are actually up.

With the important final 3 weeks of September ahead, things may change but, in reality, so far, so good as far as Q3 earnings go.

That said, one of the problems is that positive economic surprises did not last very long as this Yardeni chart shows:

Given that Fed funds futures indicate that 1 of 4 investors expects the Fed will raise rate next week, there is nervousness about a policy mistake should the Fed actually go. Draghi’s feet dragging last week added to the confusion.

Let’s do the numbers:

• Last week’s 2.2% setback to 2133 brought the trailing P/E to 18.5 and the Rule of 20 P/E to 20.7.
• Based on this morning’s pre-opening of 2100, the trailing P/E is 18.2 and the Rule of 20 P/E 20.4.
• The S&P 500 Index 200-day moving average is at 2058, right on the current “fair value” level of 2050 (20.0 on the Rule of 20).
• Many corrections since 2013 stopped at the 19.2 level which is 1965, another 7.6% drop on the S&P 500 Index.
• The Jan. 2016 correction stopped at 18.3 which would be 1850, a much more serious 13.3% debacle.

Small cap stocks have substantially outperformed YTD up 32% between their 2016 low and high. They dropped 3.3% last Friday but they may have much more downside given their Q3 earnings trends (green line on chart from Ed Yardeni)…

…and high leverage (The Daily Shot):

But high leverage is just about everywhere:

Speaking of leverage, this next chart shows US corporate debt as a percentage of the GDP. Deutsche Bank points out that the level is consistent with recession. (The Daily Shot)

The impact of high leverage on corporate profitability has, so far, been masked by low interest rates. But the rot is there…

SENTIMENT WATCH

• Global Selloff Threatens to Spiral as Central Banks Angst Builds

A selloff in fixed income is starting to snowball into a global market rout.

Shares in Europe and Asia dropped the most since the aftermath of the U.K. Brexit vote in June, and U.S. stock-index futures fell as concern spread that central banks are preparing to wean markets off unprecedented stimulus. (…)

• Friday Was Just The Start: Here Are Goldman’s 5 Reasons Why The Selling Will Continue

• First, our Sentiment Indicator shows an extreme bullish reading of 95, which suggests the S&P 500 index will fall by 2% during the next month. (…)
• Second, we anticipate a rise in political uncertainty, which will translate into a lower P/E multiple.
• Third, recent US economic data has been disappointing. The labor report, retail sales, and both the ISM manufacturing and non-manufacturing surveys were below consensus expectations. The US MAP score  of economic surprises is now negative for the first time in two months. The Goldman Sachs Current Activity Indicator (CAI), a real-time measure of the pace of domestic economic growth, is now just 0.9%.
• Fourth, the weak macro data means downside risk to EPS forecasts. Consensus bottom-up adjusted EPS estimates for 2016 equal $118 but have been unchanged for three consecutive years – the epitome of “fat and flat.”  Negative EPS revisions have equaled 0.5% during the past three months (-0.2% excluding Energy). Looking forward, the bottom-up consensus expectation of 7% year/year S&P 500 EPS growth in 4Q seems aggressive given it assumes Financials EPS surges by 14%. A patient Fed with rates on hold represents a headwind for the sector where ROE is now below 10%.
  Fifth, equity valuation remains extended. The S&P 500 index trades at the 84th percentile of historical valuation while the median stock is at the 98th.

• This Market Selloff May Be Different (Mohamed A. El-Erian)

(…) 1. It is unlikely that fundamentals will improve significantly any time soon.

2. Politics and geopolitics aren’t helping.

3. The usual antidotes to such market episodes are no longer as much of a certainty.

(…) The main reason is not that stock valuations have been ultra-cheap. They have not. It is that downward trends have been more than offset by liquidity injections, particularly those from share repurchases by corporations, including those with large amounts of cash on their balance sheets, and unconventional central bank policies that have involved sizable asset-purchase programs. (…)

Those, like me, who worry about an excessive decoupling of stock prices from fundamentals also feel that the dominating impact of liquidity may be changing and potentially waning. This is particularly the case for central banks, whose market intervention is evolving because of a change in what former Fed Chairman Ben Bernanke described as a “benefit, cost and risk” equation.

The shift is not just a matter of the declining benefits of protracted unconventional monetary measures — characterized by less central bank policy economic effectiveness overall, as well as the Bank of Japan’s experiment with negative rates, which has been not just ineffective but also possibly counter-productive. This evolution is also the result of (justified) mounting concerns about collateral damage and unintended consequences, especially when it comes to the detrimental effects of ultra-low and negative nominal interest rates, distortions to the healthy functioning of markets, mounting threats of future financial instability and central bank vulnerability to political interference.

Such considerations have underpinned signals from central bank that they are becoming more reluctant to do more absent a notable deterioration in economic activity. This became more evident last week when the European Central Bank refrained from specifying additional policy actions. It may also have influenced the remarks by Boston Fed President Eric Rosengren on Friday that highlighted the markets’ excessive discounting of the possibility of rate hikes.

4. The private antidote may also be less notable from now on.

Stocks have benefited from enormous corporate cash injections, including $1.7 trillion in U.S. stock repurchases from 2012 through 2015, according to Goldman Sachs data cited in a recent Financial Times article. The windfall for investors has been amplified by consistently higher dividend payments.

Now, however, there are partial indications that slowing growth in both buybacks and dividends may become less of a potent force.

According to Bloomberg data, average corporate cash cushions have shrunk to their lowest in three years as earning growth slows. The appetite of companies for financial engineering, including issuing bond to fund buybacks, may also be restrained by rising yields and uncertainty about future prospects.

All of this means that markets will again try to force central banks into a round of supportive liquidity injections and an even more protracted period of ultra-low interest rates. And there is no definitive reason to expect that they won’t succeed. But the longer-term prospects of such a strategy are becoming weaker by the day; and the more companies realize this, the lower the prospects for higher corporate buybacks and dividend payouts.

Without a significant improvement in fundamentals, investors would be well-advised to remember that there is an impending limit to how much liquidity injections can protect markets from the underlying economic reality.

THE MOST HATED BULL MARKET EVER? THINK AGAIN.

Equity allocations are very high after a more than tripling in values. Not much dry powder is available. (Chart from Lance Roberts)