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

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…

NEW$ & VIEW$ (6 JUNE 2016): Slow & Slower; Trump Slump.

Weak Hiring Pushes Back Fed’s Plans U.S. companies slowed their hiring drastically in May and unemployment fell as people dropped out of the labor force, a bleak picture for Federal Reserve officials as they prepare to debate increasing short-term interest rates at a policy meeting this month.

Employers added 38,000 jobs in May, the weakest performance since September 2010, the Labor Department said Friday. The unemployment rate, obtained from a separate survey of households, fell to 4.7% from 5% in April largely due to a steep decline in labor-force participation.

Revisions to previous payroll data showed employers added a combined 59,000 fewer jobs in April and March than previously reported. That brought average monthly job growth in the past three months to 116,000, a sharp slowdown from the average growth of 219,000 over the prior 12 months. (…)

After the report’s release, Fed governor Lael Brainard said in a speech in Washington that “tentative signs of slowing in the labor market” and ongoing risks such as sluggish global growth mean “we cannot take the resilience of our recovery for granted.”

(…) the May payrolls tally was depressed by a strike at Verizon Communications Inc. that temporarily idled 35,100 people during the Labor Department’s survey period. Those workers returned to work Wednesday and should lead to a rebound in the June jobs report. (…)

Nearly half a million people dropped out of the workforce last month, dragging down the share of Americans participating in the labor force by 0.2 percentage point to 62.6%. The labor-force participation rate has declined by 0.4 percentage point over the past two months, offsetting gains in the first quarter. (…)

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. (…)

Clock More on this later today…(HOLD OR FOLD?)

U.S. Trade Gap Widened 5.8% in April The trade deficit widened in April as overall import and export levels remained muted, a reflection of slow global economic growth.

Exports of goods and services rose 1.5% while imports climbed 2.1%. (…)  For the January to April period, U.S. exports and imports are both down just over 5% from the same time a year earlier. (…)

From Haver Analytics:

The highlight of the April report was the benchmark revisions that extended back to January 2013. Every monthly revision to the goods and services trade balance was positive, that is, a smaller deficit than previously reported. (…) The source of the revisions was mainly exports. Again, every monthly revision to exports was positive, averaging a $2.5 billion increase per month across both goods and services. Revisions to imports were significantly smaller and were both positive and negative, averaging only $0.3 billion per month. These revisions should reduce the drag from trade that has been evident in the GDP figures.

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Global economic growth falters in May

The JPMorgan Global PMI, compiled by Markit from its worldwide business surveys, fell from 51.6 in April to 51.1 in May, its second-lowest reading since the end of 2012 (a low of 50.8 having been seen in February).

The data point to global GDP (at market prices) rising at an annual rate of just 1.5% in the second quarter, assuming no material change is seen in June, below the long run average of 2.3%. That’s almost unchanged on the rate of growth signalled in the first quarter.

Emerging markets once again led the slowdown, with the PMI signalling a return to slight contraction after two months of marginal growth. Developed world growth also remained firmly in the doldrums in May, having slowed to the second-lowest in just over three years.

Pointing up A deeper dive into the data highlights the absence of any noteworthy growth driver in the global economy. (…)

The weak PMI reading of 49.7 in May, down from 50.2 in April, is historically consistent with GDP across the emerging markets rising at an annual rate of just 4%; well below the double-digit rates seen prior to the financial crisis.

Among the emerging market economies, a further slowing to near-stagnation signalled by the Caixin PMIs for China acted as an ongoing dampener on demand across the rest of emerging Asia. Manufacturing in Asia excluding China and Japan, for example, stagnated in May. Growth across manufacturing and services in India meanwhile slowed to one of the weakest rates seen over the past two years, according to the Nikkei PMIs. Russia likewise only managed to eke out modest growth, though the sluggish expansion represents a surprising sign of stability after the downturn seen at the start of the year.

Heavy-Duty Truck Orders Tumbled 31% in May

The industry ordered 14,300 Class 8 trucks, the type used on long-haul routes, extending a deep slowdown this year. The figure was down 31% from the same month in 2015, though up more than 4% from April, according to ACT Research.

The trucking industry went on a vehicle buying binge in 2014 and 2015, and many companies are now struggling to find enough freight to fill their expanded fleets. Most large trucking companies have said they will sharply reduce purchases of new trucks until the market shows signs of improvement. Orders typically see a lull in May, but were still well below the 18,000 to 19,000 new vehicles per month needed just to replace aging and damaged trucks, analysts said. (…)

In late May, Volvo AB said it would lay off workers at its Dublin, Va. plant in late May, on top of job losses at the same facility announced in December. Even so, dealers have struggled to move large inventories of unsold trucks, another factor depressing new orders.

“Dealer inventories of Class 8 trucks remains bloated, so the only truck orders now are mainly for replacement purposes,” said Don Ake, vice president of commercial vehicles at FTR Research, which published a similar estimate of big rig orders. He said he expected more production shutdowns over the summer.

German Factory Orders Declined in April on Weak Export Demand

Orders, adjusted for seasonal swings and inflation, fell 2 percent from the prior month, when they rose a revised 2.6 percent, data from the Economy Ministry in Berlin showed on Monday. The reading, which is typically volatile, compares with economists’ forecast for a drop of 0.5 percent. Orders slid 0.5 percent from a year earlier. (…)

Export orders fell 4.3 percent, led by a 13.3 percent slump in investment-goods demand from the outside the euro area that followed an 11 percent surge the previous month, the ministry report showed. Euro-zone orders gained 2.5 percent and domestic orders rose 1.3 percent, marking the third consecutive monthly increase.

Gavyn Davies: Global activity steady, but the US slows again

(…) The overall picture is therefore one of steady but disappointing growth, with little indication of a major cyclical acceleration at present. In particular, growth in the US remains subdued, and seems to be running at or below the 2 per cent threshold apparently required by the Federal Reserve to justify a June/July increase in interest rates. (…)

The latest results suggest that US GDP growth in the period ahead may well come in below the latest consensus forecasts.

The full set of the latest global nowcasts is available here.

(…) The latest reading for global growth stands at 3.1 per cent, which is still 0.5 per cent below the trend rate.

The improvement compared to the low points seen in February has been observed in both the advanced economies and the emerging markets. In the AEs, the latest nowcast shows growth running at 1.4 per cent, while in the EMs the growth rate is 4.7 per cent. China seems fine this month, with growth hovering around 7 per cent.

Although recession risks have diminished sharply in most large economies, the improvement in growth seems to have stalled in the past few weeks, with hopes of a strong cyclical rebound once again proving unfounded so far. (…)

Taken together with the weak jobs figures for May, these nowcasts suggest that the recent lurch towards hawkishness by FOMC members was, at the very least, premature. (…)

The latest set of forecasts, shown below, indicates that US GDP growth may track at lower rates than expected by the consensus for several quarters ahead. The Federal Reserve’s long-standing tendency to overstate the likely strength of the US recovery could therefore be happening again. However, the nowcast models suggest that future growth in China may be slightly higher than shown in recent consensus projections.

Lawrence Summers: Trump win would endanger economy

(…) If he is elected, I would expect a protracted recession to begin within 18 months. The damage would be felt far beyond the United States.

First, there is a substantial risk of highly erratic policy. Mr Trump has raised the possibility of more than $10tn in tax cuts, which would threaten US fiscal stability. He has also raised the possibility of the US restructuring its debt in the manner of a failed real estate developer. Perhaps this is just campaign rhetoric. But historical research suggests that presidents tend to carry out their major campaign promises. (…)

Second, in a world economy defined by global integration, Mr Trump’s economic nationalism is highly dangerous.(…) Withdrawal from trade agreements does not currently require congressional approval. If Mr Trump did even half of what he has promised, he would surely set off the worst trade war since the Great Depression.

Third, prosperity depends on a secure geopolitical environment. Requiring Japan and Korea to defend themselves and scaling back Nato is a prescription for emboldening China and Russia and promoting nuclear proliferation. A perception that the US is at war with Islam rather than with radical elements within Islam is an invitation to terrorism. In such an environment, investment and trade are unlikely to flourish.

Fourth, Mr Trump’s authoritarian style and cult of personality surely would take a toll on business confidence. (…)

Finally, there is the question of uncertainty and confidence. Improving business confidence is the cheapest form of stimulus. Creating an environment where every tenet of the rule of law, internationalism and consistency in policy is up for grabs would be the best way to damage a still fragile US economy. In no election in my lifetime has a major party candidate for president been so dangerous for the economy.

Markets are discounting the possibility of a Trump presidency. Let us all pray they are right.

Pound Tumbles After Polls Show Brexit Gaining Momentum
China’s Debt Load Is (Much) Higher Than Previously Thought, Goldman Says

(…) Of particular issue is the rise in opaque loans given noises surrounding China’scircular financing schemes, which involve banks lending to non-bank financial institutions (NBFIs) as opposed to directly to companies. While this “round-tripping,” as Goldman dubs it, does help boost bank profits, it also means more investments on bank balance sheets and more money meandering through the financial system as opposed to moving into the real economy through an increase in M2 money supply.

Faced with an increasingly tangled system of financing and a money supply measure that doesn’t fully encapsulate new credit creation, the Goldman analysts opt to take a slightly different approach to gauge the strength of China’s recent credit boom. They look at the (adjusted) flow of money emanating from households and companies and going into various financial investments.  

On that basis, China’s credit creation came in at 24.6 trillion yuan ($3.7 trillion) last year — far outstripping the 16 trillion yuan increase in money supply and the 19 trillion yuan of TSF. (…)

“Such a scale of deterioration [in China’s leverage] certainly increases our concerns about China’s underlying credit problems and sustainability risk,” the Goldman analysts conclude. “The possibility that there is such a large amount of shadow lending going on in the system that is not captured in official statistics also points to [a] regulatory gap, and underscores the lack of visibility on where potential financial stress points may lie and how a possible contagion may play out.”

Punch Deutsche Bank raised the same point last month (see Certain Uncertainties)

Saudi Arabia Cuts Oil Prices in Europe Saudi Arabia on Sunday cut its oil prices to Europe, signaling mounting competition after OPEC failed to cap its output amid Iran’s exports ramp up.

In an email sent to customers, state oil company Saudi Aramco said it had cut its light crude prices by 35 cents a barrel to northwest Europe and by 10 cents a barrel to the Mediterranean for July deliveries.

The price reduction is surprising, as demand typically grows in the second half of the year as refineries return from maintenance. In addition, markets have recently been buoyed by outages in countries like Nigeria.

(…) The absence of output limits effectively gives a blank check for the group’s two most influential members and rivals, Saudi Arabia and Iran, to pump at will. (…)

Shipments from Iran to the EU have now reached 400,000 barrels a day. They are set to increase to 700,000 barrels a day in the coming months after Iran clinched deals with Greek, French and Italian refiners, according to Iranian officials.

By contrast, Saudi Arabia exported 800,000 barrels a day on average to Europe last year, according to the International Energy Agency. (…)

Competition for market share has been less intense in Asia, where Iran was always allowed to sell. On Sunday, Saudi Arabia increased its light-crude prices to the Far East by 35 cents a barrel.

It also raised prices by 10 cents a barrel in the U.S., where Iran is still banned from selling.

SENTIMENT WATCH

Dominic Rossi, Global Chief Investment Officer for equities, Fidelity International

(…) We have seen a modest rise in manufacturing surveys in both the US and China. European industrial production has been surprisingly resilient and has recently accelerated.

But not all areas are seeing a pick-up. Japanese industrial production remains weak and a similar story can be seen in most emerging economies as well. Nevertheless, as we progress through 2016, the annualised comparisons will become progressively easier and a nascent recovery in global manufacturing will become far more visible and widespread.

At the same time, domestic consumption patterns in the developed world have held up pretty well. The US consumer is in a healthy state. Increases in the minimum wage across a number of states will give further support to consumption. The personal savings rate is still elevated as much of the boon from the lower oil prices has been saved thus far. In Europe, too, unemployment is steadily falling and retail sales excluding car purchases are accelerating. (…)

While the worst may be over, there is ample supply in most markets with few industries or companies showing any signs of pricing power. (…)

With this background, the Federal Reserve can adopt a reasonably dovish approach to monetary policy, with a possible one or two rate rises this year, which I still suspect will start this summer.

Such a gradualist approach should arrest any weakness in the dollar, without triggering a sharp leg higher, which would be highly damaging. (…)

S&P 500 earnings have been basically flat for the last two years, as it had to contend with the dual headwinds of a strong dollar and weak commodities. Both headwinds have now abated, potentially fostering a much more favourable outlook for earnings growth in 2017.

Fidelity International estimates that the impact of weak commodities and a strong dollar will continue to depress 2016 earnings, which it estimates will fall 1 per cent.

As 2017 approaches, the annualised comparisons will become easier and thus Fidelity estimates earnings growth of 12.4 per cent in 2017, with a return on equity of 17 per cent. These forecasts could support a level for the S&P 500 of 2,250 over the next 12 months. The big risk is the political cycle rather than the economic one.