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

NEW$ & VIEW$ (7 JUNE 2016)

Yellen: No Rate Rise Until Economic Outlook Clears Janet Yellen affirmed the Federal Reserve won’t be raising interest rates until new uncertainties about the economic outlook are resolved, echoing conclusions investors drew Friday after weak jobs data.

(…) Her comments represented a shift from less than two weeks ago, when she confidently said a strengthening economy meant the Fed likely would move rates up again in the “coming months.” She dropped that time frame reference Monday. (…)

Ms. Yellen also said a number of “considerable and unavoidable” uncertainties could affect the economic outlook and the path of interest rates, including sluggish global growth, weak business investment, low U.S. productivity growth and uncertainty about the outlook for inflation.

“The uncertainties are sizable, and progress toward our goals and, by implication, the appropriate stance of monetary policy will depend on how these uncertainties evolve,” she said. (…)

On an upbeat note, Ms. Yellen said she expects the economic expansion to continue, noting that overall the labor market’s progress has “been quite positive,” household incomes have been rising, the housing sector is strong and fiscal policy is now providing a boost to the economy, rather than a drag. (…)

“Speaking for myself, although the economy recently has been affected by a mix of countervailing forces, I see good reasons to expect that the positive forces supporting employment growth and higher inflation will continue to outweigh the negative ones,” she said.

(…) and then went on to list a number of reasons she thinks that is so, including the low level of weekly jobless claims and the recent step up in consumer spending.

What she didn’t do, however, is give even a hazy indication of when the Fed might again raise interest rates. This was in contrast to last month when she said it would be probably be appropriate to raise rates “in the coming months.” And it was in contrast to the minutes of the Fed’s April meeting, which repeatedly mentioned the possibility of raising rates at next week’s meeting. (…)

FYI, in her speech yesterday, Mrs Yellen used the word “uncertain” 15 times and “uncertainties” 5 times. Is this really dovish?

Pointing up The WSJ’s James Mackintosh writes an interesting piece today: You Know Almost Nothing About the Economy; Get Used to It

(…) The payrolls figures have a huge margin of error, are subject to big revisions, and offer little in the way of guidance to the future. The Bureau of Labor Statistics is 90% sure that its conclusion of 38,000 jobs created is right to within 115,000 jobs, and so lies somewhere in the range of a loss of 77,000 to the creation of 153,000 jobs.

(…) payrolls are subject to big revisions, averaging 43,000 in either direction since 2003 and occasionally, as in November of 2012 and 2014, adding more than 100,000 jobs to the initial report. It is possible the bad May figures could be revised away. (…)

The hardest thing to do is to accept the uncertainty. With error margins, revisions and the shifting structure of the economy, it isn’t only jobs figures that might mislead. Paul Donovan, global economist at UBS Investment Bank, points out that many survey measures have become less reliable as fewer consumers fill them in, although this doesn’t apply to the corporate payrolls survey. The rise of self-employment means even company data, though, are less representative than before. (…)

Not only don’t we know where the economy is going. We don’t even know where it is, and after revisions we frequently find we were wrong about where the economy was, too. (…)

Investors who give up their pretensions to know where the economy is going can find ways to construct sensible portfolios. The first is to focus on the one thing you do know: how much you paid. Buy low, and there’s more chance of being able to sell high. The second is scenario planning. While you can’t reliably forecast the economy, you can look at possible extreme outcomes and invest accordingly. The final one is diversification. It may not help much in a crisis, when everything moves together, but in the absence of any other information, a spread of assets and countries is the best alternative to perfect foresight.

This is not a paid advertisement for Bearnobull, although it is what I advocate:

  • Accept that we don’t know the future.
  • Understand where we are on valuations to be able to calculate potential upside vs downside (reward vs risk) based on fundamentals.
  • Monitor trends in economic data and investor sentiment.
  • Assess scenarios from the above.
  • Set investments on probabilities, emphasizing valuations over trends. It is not as bad to be wrong on trends when valuations are low then when they are high. Buying low brings time on your side.
  • Be disciplined and patient.

Regarding economic uncertainty, one way to live with volatile and unreliable data is to focus on trends rather than on specific data points. Another way is to focus on the more solid data sets. Markit’s PMI surveys are the best sources. The data come from corporate purchasing managers whose job it is to monitor and understand what’s going on upstream and downstream, i.e. at the client level (demand) and at the production level (supply). These guys specialize in trend analysis, their data is accurate (within the limits of a survey), timely and never revised. Markit does the same surveys on manufacturing and services across the world simultaneously every month, even providing flash estimates three-quarters of the way. This is why I post them dutifully.

What air freight volumes tell us about global trade

Shipping volume is often used to track global trade, but air freight levels are even more closely tied to global production levels, an International Air Transport Association analysis shows. A softening in world trade demand in early 2016 is echoed in air freight volumes during that period, IATA says.

Trains too as this Raymond James chart shows:

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And trucks (RJ):

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China warned on hostile business climate US officials and EU executives feel increasingly unwelcome

Foreign multinationals feel increasingly unwelcome in China, American officials and European business executives said on Tuesday, at the start of a second day of high-level Sino-US talks.

“Concerns about the business climate have grown in recent years, with foreign businesses confronting a more complex regulatory environment and questioning whether they are welcome in China,” Jack Lew, US Treasury secretary, said ahead of a meeting with senior US and Chinese business executives. (…)

Only 47 per cent of European businesses plan to expand their China operations, according to the chamber’s annual business confidence survey, down from 56 per cent last year and 86 per cent in 2013. (…)

It said 41 per cent of its members planned to cut costs in China, led by the car industry.

European executives from the car, chemicals, transport and logistics, and IT and telecoms sectors reported the highest level of overcapacity among the companies surveyed, as well as the largest decreases in revenue in 2015 compared with the year before. (…)

China is not about to seriously attack is excess capacity problem:

China’s Real Unemployment Rate Is Three Times Higher Than The Official Number

(…) based on a new report by Fathom Consulting, it appears that China is also dramatically misreporting what may be the one most critical for social stability metric, its unemployment rate, which when stripped away of the political propaganda, is more than three times greater than the officially reported rate.

According to Fathom, China’s underemployment Indicator has tripled to 12.9% since 2012 even while the official jobless rate has hovered near 4% for five years. (…)

BTW, Markit’s China PMI surveys have been documenting the negative employment trends in China for quite a while, first in manufacturing, lately also in services.

HOLD OR FOLD?

Fed officials will be closely watching the next jobs report, due in a month, to determine whether May’s performance was an aberration—potentially allowing them to proceed with a rate increase at their July or September meetings—or the beginning of a deeper slowdown across the economy.

Even with the latest pullback, the three-month average for jobs growth remains in line with the pace senior Fed officials see as appropriate for this stage of the economic expansion. (WSJ)

Is May’s terrible employment number a “one number aberration”?

  • Facts: February +233k, March +186k, April +123k, May +73k (ex-Verizon). Looks like a clear trend to me. Yet, voting Fed Governor Loretta Mester said Friday afternoon:

(…) “you can’t read too much into one number” as seasonal factors loomed large and the Verizon Communications Inc. strike affected the number negatively, Mester said. “The weak employment number has not changed fundamentally my economic outlook” as “the economy is definitely moving in the right direction,” she said.

  • 116k new jobs is the weakest 3-month average in 5 years.
  • image_thumb3The breadth of job gains was bad: 51.3% of industries expanded payrolls in May, down from 53.8% in April and 56.3% in March (the recent peak was 71% in November 2014)
  • Service providers, who have been propelling job growth, added just 61,000 to their ranks, less than half of the April increase.
  • The last time a work stoppage had a meaningful impact on monthly jobs data—at Verizon in 2011, incidentally—an increase in temp workers helped counter the strike effect. But temp workers dropped by 21,000 last month. A pretty good leading indicator, temp workers are down by about 64,000 so far this year.
  • Full time jobs dropped 312k in the last 2 months while part time jobs rose 118k.
  • U.S. employers shed 96,000 information-technology jobs in May, knocking total IT employment down by 2.1% to 4.452 million, according to an analysis of Friday’s Bureau of Labor Statistics data by IT industry trade group CompTIA. The slide follows similar declines in April in one of the more robust sector of the economy.
  • Average hourly earnings of private-sector workers rose 5 cents to $25.59 last month (+2.5% YoY). The average workweek held steady at 34.4 hours last month for the 3rd consecutive month.

As to whether May was a head fake or a one-month aberration, the recent downward trend is in sync with Markit’s PMI Employment Index unlike in 2011, 2014 and 2015:

  • Goods producing employment has declined for 4 consecutive months losing 77k jobs, down 1.2% YoY. The trend is certainly not suggestive of an “economy definitely moving in the right direction”, is it?

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  • Involuntary part-time work jumped a huge 468,000. We were barely back at the previous tops in one of Yellen’s favorite indicator. It has stalled this year.
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This close-up shows the upturn. The hope is that we will experience a repeat of 2012-13.

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AN EMBARASSED FED…

All these speeches by FOMC members in recent weeks telling us that this data-dependent Fed was confident that the conditions to raise rates were being satisfied. The culmination was on May 27th when Mrs. Yellen said that “growth looks to be picking up from the various data that we monitor”. Given all the data that I monitor, by myself in my tiny office, little of this data lately being of a “growth-picking-up” type, I sarcastically began to “watch the monitoring”, curious to see what the huge staff at the FOMC was seeing that I was not.

Throughout the month of May, I signalled multiple signs of weakness in the economy. It began in early May when the reliable PMI surveys showed no signs of a Q2 bounce and continued weak new order trends. On May 5, I wrote about the poor productivity data coupled with weak corporate revenues and new orders meaning that “something had to give” and that that something was employment. On May 18, reacting to San Francisco Fed President John Williams saying that “the data to my mind are lining up to make a good case for rate increases in the next few meetings, not just June”, I listed the news and data I had monitored since April 29 to show that there was not much of a line-up for a good case.

On May 23rd, I headlined Temp-Worker Freeze Bodes Ill for Economy from the WSJ because it is one of the labor market’s early warning data. Then we got Markit’s flash PMIs  on May 24th. Both the Manufacturing and the Services PMIs pointed to no Q2 bounce on weak orders, an accelerating decline in backlogs and more cautious hiring. On May 31st, I wrote

Markit’s Services PMI declined -1.6 in May to 51.2%, bringing the composite PMI down to just 50.8%, which Markit claims is consistent with less than +1% real GDP growth. The composite PMI for employment declined -0.9 to just 51.7%, which Markit claims is consistent with payroll employment of just +128k.

And also quoted the prescient NBF:

net job gains in the help-supply agencies industry has turned negative for the first time in the current expansion on a six-month annualized basis. In the past, such a development has always preceded a sharp deceleration in the pace of overall job creation. Consequently, we see non-farm payrolls growing only 90,000 in May, the weakest showing since March of last year.

The Philly Fed updates this chart after every major economic release. Is anybody at the Washington Fed, 140 miles south, monitoring this stuff?

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Beyond monitoring, there is analysis. I do no modeling nor other econometric stuff but I can think a little. The train of thought goes like this:

  • Employment growth has decelerated from the +2.2% YoY range in early 2015 to +2.0% during Q4’15 and Q1’16 and to +1.7% in May. The employment backwind is slowing.
  • There is nothing so far that suggests a change in trends. In both manufacturing and services, new orders remain weak, backlogs are declining and profit margins are being squeezed by rising wages and declining productivity.
  • Inventory levels are high throughout the economy.
  • Housing is the only sector showing a positive momentum. Businesses, exports and governments are not contributing.
  • Consumer income is growing but spending patterns are not solid. April retail sales numbers were good but suspect. Redbook’s data for May were up only 0.7% YoY. Thomson Reuters’ Same Store Sales Index, which covers 80 retailers, was down 1.1% YoY in May. Even the discount group was weaker with flat sales.
  • Car sales seem to have peaked cyclically last fall. They have been in a downtrend since and were –1.4% YoY in May.
  • Gas prices have turned back up.
  • In all, my sense is that the consumer is also getting squeezed: slower employment growth and rising inflation more than offsetting wage gains.
  • And the consumer could be scared by a “vocal” Fed desperate to raise interest rates, prompting tighter debt management, and by a presidential race which can only make Americans uncertain, prompting higher savings.
  • And now by a weakening economy and…
A SCARY FED

Seriously, can anybody qualify all this Fed up-Fed down thing as serious? Amid all these front page seeking Fed talking heads, we thought that Mrs Yellen was the deeper thinker and truly the boss. That faith has been lost in translation in recent months. Cynics may say this is organized propaganda. Sadly, I prefer to think that this is a clueless group pushing on a string, too focused on trying to keep markets calm, losing all credibility in the making.

THE RISKS

Is an economic recession coming? Or will the economic slowdown coupled with rising wages result in a deeper and lasting profit recession?

Our clueless Fed is also “toolless”. The ECB has remained credible so far but its toolbox is not much better equipped. Abe’s arrows are all pointing down and China is experiencing the difficulty in transitioning such a huge economy which, in any event, is clearly slowing and struggling with excessive debt and capacity. In any event, its opacity makes it a less reliable source of comfort.

In addition, the U.S. is stuck with a lame-duck President busy issuing new regulations, a Congress absent until next spring and a Presidential race, uninspiring to say the least.

Meanwhile, Verizon gives its 40,000 workers

an 11% raise over four years, including 3% upon ratification, and 2.5% on each anniversary of the contract. In addition, they will receive a $1,250 signing bonus, and a minimum of $700 in corporate profit sharing payments in each of the next four years.

This is equivalent to a 4.3% annual wage cost increase, in a highly competitive, slow growth industry. VZ’s sales per share have grown 0.8% in the last year.

Fingers crossed HOLD?

  • Employment is still rising and we never know with revisions. May could prove to be an aberration as many are suggesting…
  • The consumer has spending power and could decide to use it…
  • Corporate earnings pre-announcements are not worsening. In fact, they are pretty good considering the apparent state of the economy. This is as of June 3rd.:

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Thumbs down FOLD?

  • Most recent key economic data point down, even with low interest rates, still rising employment, improving wages and ok equity markets…
  • Central banks are clueless, headless and toolless.
  • Fiscal stimulation in the U.S. is not around the corner.
  • Even without a recession, profits are under pressure from low revenue growth rates and rising labor costs. Estimates for Q2’16 earnings are –3.6% YoY, down from –2.2% on April 1st, –3.2% on May 5 and –3.4% on May 16. We all know the game but the trend is uninspiring.
  • Things are not rosier in Europe where Q2 earnings are expected down 5.7% vs –1.0% expected on April 1st. BTW, Q1 EPS were down 10.8%.

The S&P 500 Index is again bouncing off the 20 line on the dependable Rule of 20 valuation scale. The actual P/E on trailing EPS stands at 17.9 and it is especially not advisable to use forward earnings at this time given the high expectations for Q4 (+9.8%). Earnings are not about to provide any lift judging from current trends. Can we get enough investor enthusiasm to propel valuations higher into the more risky area? Not from the Fed, not from Congress, not from the current or future President as far as I can judge.

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This is a game of probabilities:

  • Valuations are right at the high end of the “Lower Risk” band of 15-20 and neither higher earnings nor much lower inflation are likely to provide the key to enter the “Rising Risk” area over the shorter term at least. Upside thus appears limited.
  • Central bank liquidity has been excessive for a long time now and equities remain stuck at 2100.
  • Potency and credibility of the only institutions that have provided leadership and actual support in recent years has diminished considerably.
  • The SPX has been unable to definitely cross beyond 2100 for 18 months and its bouts of volatility have all been to the downside.
  • The tilt to economic news is clearly on the negative side.
  • Brexit on June 23rd.
  • China?
  • The U.S. elections?

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I downgraded equities to 2 stars on March 28 at 2032 on the S&P 500 Index. There are no fundamentally solid reasons to upgrade. Highly risk averse investors should fold. Personally, I will keep pruning my exposure but I am not ready to downgrade to 1 star which would mean a recession/bear market ahead. But I will keenly be watching the monitoring…