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 APRIL 2016): “Global” risks feared globally.

Split Fed sees ‘appreciable’ global risks Minutes show policymakers divided over timing of next rate rise

Many Federal Reserve policymakers were warning of “appreciable” risks to the US economy from global developments at their latest meeting as a deeply divided body of officials debated how soon to further increase short-term interest rates. (…)

The minutes suggested those advocating caution outnumbered those seeking action this month, supporting market perceptions that the Fed will not move until its June meeting at the earliest. (…)

Public statements have pointed to disagreements among officials, however, with a number of regional Fed presidents putting forward a bullish view of America’s prospects. (…)

The minutes shed further light on these disagreements, with policymakers differing for example over whether the US is nearly at full employment and how much weight to put on a recent pickup in inflation and subdued inflation expectations. (…)

“Several participants expressed the view that the underlying factors abroad that led to a sharp, though temporary, deterioration in global financial conditions earlier this year had not been fully resolved and thus posed downside risks,” the minutes said.

It was noted, for instance, that weak growth overseas could lead to a further appreciation in the dollar, something that would drag on exports and inflation.

The fact that the Fed has limited room to cut rates if the US economy slows was also a major consideration for a number of policymakers. (…)

ECB says willing to act as Draghi warns on global uncertainty
Pointing up Draghi’s Big Bazooka Is Misfiring

(…) Despite central banks doing just about everything bar throwing money from helicopters, companies still won’t deploy cash. Global capex fell about 10 percent in 2015, according to Standard & Poor’s, and could shrink another 4 percent this year. That’s driven by the ailing commodities sector. But if energy and materials are excluded, capex still shrank 2 percent last year.

What’s gone wrong? In a world marred by low growth and industrial overcapacity it’s hard for companies to generate a return exceeding their WACC and this is clearly slowing investment. (…)

Good BB piece with charts. This also not helping:

Sad smile German economic growth remains sluggish amid near stagnation of manufacturing

Germany’s composite Output Index (produced by Markit from its manufacturing and service sector surveys) fell to an eight-month low of 54.0 in March, pointing to a slowdown in economic activity at the end of the first quarter. The survey data are nevertheless still signalling modest, albeit unspectacular, GDP growth of approximately 0.4% in the opening quarter of 2016.

Modest GDP growth signalled

Worryingly, the forward-looking indicators suggest that growth could slow even further in coming months. The amount of new work received by businesses rose at the weakest rate since last August, which in turn resulted in a more cautious approach with regards to hiring. Although employment continued to rise during the month, the rate of job creation equalled February’s near one-year low, with goods-producers cutting payroll numbers for a second consecutive month. Moreover, levels of work outstanding rose only marginally, which could lead to a further slowdown of jobs growth in coming months.

Germany’s mighty service sector continued to grow at a steady pace throughout the first quarter, leading the economy’s expansion, although failed to gain traction from prior months. There have been reports recently from survey participants that the large inflow of refugees led to increased activity, especially with regards to building new shelters. This development was also reflected in recently strong construction PMI numbers, with the index reaching its highest level since the first quarter of 2011 in February, before slowing in March.

Meanwhile, the manufacturing sector grew at a snail’s pace during the past two months, thereby highlighting how the sector is struggling in an uncertain global economic environment. Despite ticking higher from February’s 15-month low, at 50.7, the PMI signalled a near-stalling of manufacturing.

Steady services growth contrasts with weak manufacturing

(…) The strong euro clearly has some negative side effects. First, it makes imports from overseas cheaper, which will add additional downward pressure on inflation and lead to ‘import substitution’. Second, exports will be more expensive. This is particularly bad news for Germany’s more export-oriented manufacturers, who are already struggling in the current global economic environment. Markit’s PMI New Export Orders Index fell to an eight-month low in March, signalling a near-stagnation of foreign sales. With the exception of the marginal decline in July 2015, it was the lowest reading in over a year. (…)

More global risks:

IMF Warns of Possible Crises for Emerging Markets Hit by Outflows An exodus of cash from emerging markets in recent years is closely tied to developing economies’ slower growth rates and could end with financial crises in the countries involved, the International Monetary Fund says.

(…) “Much of the decline in inflows can be explained by the narrowing differential in growth prospects between emerging market and advanced economies,” the IMF said in a study included in its World Economic Outlook publication. “Both weaker inflows and stronger outflows have contributed to the slowdown.”

Flows to 45 key emerging markets have fallen off by more than $1 trillion since 2010, withhalf of the drop coming from China, the world’s second-biggest economy, and Russia, which has faced international sanctions and a precipitous drop in energy prices, the IMF said. (…)

Collectively, the reversal in capital flows is equivalent to an outflow of 1.2% of gross domestic product in the most recent four quarters, compared with an inflow of 3.7% of their GDP in 2010. The slowdown occurred in three-quarters of the economies the IMF studied.

It is the third major pullback in three decades for the emerging markets, and it comes at a time when the extra growth offered by emerging markets contracted by 0.75 percentage point, the IMF said. (…)

SENTIMENT WATCH
U.S. Braces for Worst Earnings Season Since 2009 Crisis: Chart

U.S. corporate profits are expected to drop the most in 6 1/2 years in the first quarter, led by a wipeout in the embattled energy sector. Earnings for companies in the Standard & Poor’s 500 Index will fall 9.8 percent year-over-year, which would be the sharpest decline since the third quarter of 2009 and a fourth consecutive quarter of contraction, according to Bloomberg data. Results will be insufficient to justify current stock valuations, says Alex Bellefleur, head of global macro strategy and research at Pavilion Global Markets.

Wait, wait! There is a potential silver lining:

Weak U.S. earnings expectations set stage for stock gains

When Wall Street’s quarterly earnings season kicks in to high gear next week, hundreds of companies will vie for the bragging rights that come from “beating the Street” – showing revenues and profits that are higher than analysts expected.

That hurdle may be unusually easy to clear this quarter, as analysts, who saw oil prices and stocks collapse at the start of the year, went really negative on the first quarter of 2016.

While the majority of companies typically beat forecasts, the bar for positive surprises may be even lower this time around, with analysts expecting profits of S&P 500 companies to be down 7.4 percent from a year ago, according to Thomson Reuters data.

With a handful of early reports coming in well above expectations and some evidence of stability in two company-hurting trends – falling oil prices and a rising dollar – some strategists are predicting enough positive news in an otherwise negative earnings season to boost stocks at least in the short term. In order words: First quarter earnings will be bad, but maybe not that bad.

(…) roughly 80 percent of S&P companies that have already declared first-quarter results are beating expectations. That is higher than usual, and includes strong performance from a diverse group of companies, including Lennar Corp (LEN.N), FedEx Corp (FDX.N) and Adobe Systems Inc (ADBE.O). (…)

It was “an absolute collapse in expectations,” said Jonathan Golub, chief equity strategist at RBC Capital Markets in New York.

The drop in analysts’ views between Jan. 1 and now was almost triple the typical 3.5 percent preseason decline, he said, and “about as bad as we’ve ever seen, with the exception of the period going into the ’08-09 crisis.” (…)

Could be overdone. But a problem remains: unless earnings beat by 8-9%, highly unlikely, EPS will still be down YoY in Q1, dragging trailing earnings lower. Unless inflation diminishes markedly, the Rule of 20 fair index value will keep falling. The yellow line of the chart below peaked in March 2015 at 2174, falling 4.4% to its current 2079. If Q1’16 EPS drop 5%, trailing EPS will decline 1.2% to about $116.00, bringing “fair value” to 2053. Given current high valuations, investors would need a lot of faith in the economic environment to drive equities much higher. Central bankers are certainly not helping on that matter!

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Another reason to be careful on building too high beat expectations is that smaller companies seem to be struggling. Here’s a great chart from the NFIB via Zerohedge charting the current margin squeeze. This helps explain why small and mid-cap stocks keep underperforming larger caps.

Meanwhile, this support may also be fading:

Mega deals morph into mega problems for Wall Street

(…) Some of the mega transactions that had champagne corks popping in boardrooms are running into antitrust problems and, in the case of pharmaceutical firm Pfizer Inc’s (PFE.N) $160 billion takeover of rival Allergan PLC (AGN.N), political opposition to a deal that envisaged the biggest drug company in the United States moving to Ireland to lower its taxes. (…)

The political uncertainty and antitrust concerns mean that firms will think twice about future tie-ups that consolidate industries and move tax dollars offshore. (…)

But the consequence of greater consolidation is increased scrutiny by antitrust officials. That was exemplified on Wednesday by the U.S. government filing a lawsuit to stop Halliburton from buying Baker Hughes, arguing the combination of the No. 2 and No. 3 oil services companies would lead to higher prices in the sector.

The Justice Department and Federal Trade Commission (FTC), which enforce antitrust law, have filed lawsuits to stop an unusually high number of deals in the past 18 months. FTC officials are in court this week to block a merger between Staples Inc (SPLS.O) and Office Depot Inc (ODP.O).

“It isn’t just the number of proposed deals that makes this a unique moment in antitrust enforcement; it’s their size and their complexity,” U.S. Attorney General Loretta Lynch said in a speech on Wednesday.

“This represents a remarkable shift toward consolidation and it presents unique challenges to federal enforcers in our work to maintain markets that serve not just top executives and majority shareholders, but every American.”

In Europe, meanwhile, talks between Orange SA (ORAN.PA) and Bouygues SA (BOUY.PA) to create a dominant French telecoms operator collapsed last week, amid competition concerns and a stand-off between Martin Bouygues and French Economy Minister Emmanuel Macron about the clout the billionaire would have gained in the former state monopoly, according to people familiar with the matter.

For bankers, scuttled deals cost money.

NEW$ & VIEW$ (6 APRIL 2016)

Americans’ Hiring Rose in February to the Highest Since Before the Recession More Americans were hired to start a new job in February than in any month since before the recession that began in 2007—about 5.4 million people.

Tuesday’s report also showed an increase in the number of people who voluntarily quit a job in February, which rose to about three million from 2.9 million. Labor economists generally regard the overall rate of quitting as a sign of the labor market’s health. When the economy is thriving, more people have the opportunity or the confidence to search for a better job. (…)

The number of job openings was unchanged in February.

Note the flattening in the number of job openings since the middle of 2015 while hires kept climbing, (Chart from Doug Short)

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BTW, yesterday’s ISM Non-Manufacturing Index rose but its Employment index, which sank below 50.0 in February, barely moved, seemingly more in sync with Markit’s Services PMI…(Chart from CalculatedRisk)

Russia sees oil price of $45-$50 per barrel ‘acceptable’ as it prepares for freeze deal – sources

(…) “The level of $45-50 (per barrel) is acceptable from the point of view of market balance: if prices go higher shale oil production could start to recover.”

A Russian Energy Ministry spokeswoman confirmed that the information provided by the sources was correct. (…)

The sources who discussed Moscow’s position said they believed Iran would struggle to quickly reach levels it has announced. They said Iranian growth is now coming mostly from selling oil from storage and putting easy-to-launch fields on stream.

“A freeze without Iran is being discussed. At the moment we don’t see tough conditions (from others) for Iran to join,” one of the sources said. (…)

The Russian sources said that the deal to freeze oil output is expected to speed up rebalancing of oil supply and demand by around half a year. (…)

SENTIMENT WATCH
Thumbs up Equities firm as risk appetite recovers Better China data and rising oil prices ease growth fears
Thumbs down Global bond yields plunge to record-low 1.3 percent.
  • German Yields Join March to Zero A surge in government-bond prices has taken 10-year yields in Europe’s strongest economy to the brink of once-unthinkable territory: negative interest rates.

The German bund’s yield hit 0.08% Tuesday, the lowest in a year and just a hair short of the all-time low for a closing yield of 0.073%, according to Tradeweb.

The plunge in German bond yields has resulted from the latest bout of aversion to risk on the part of investors, as well as an increase in the European Central Bank’s bond-buying program and the ECB’s embrace of negative rates. The programs increase demand for debt and drive down yields, which fall when prices rise.

Tumbling European bond yields could add to pressure on U.S. interest rates, even at a time when Federal Reserve officials are going out of their way to warn the markets that they may be underestimating the likelihood of further Fed rate increases this year. (…)

Around one-quarter of global government bonds have been trading at yields below zero, including German bonds that mature in less than 10 years. Japan’s 10-year government bond dropped below zero for the first time earlier this year, after the Bank of Japan adopted a negative-rate policy. Even yields on some European firms’ bonds have dipped below zero recently.

On Tuesday, the U.S. 10-year yield slipped to 1.727%, down sharply from 2.273% at the end of last year. (…)

The Fed’s holdings of Treasury debt account for close to 20% of U.S. government bonds outstanding, according to data from the Fed. The Bank of England’s holdings account for 26% of U.K. government debt outstanding at the end of March, and the Bank of Japan has gobbled up 30% of Japanese government debt outstanding, according to data from HSBC Holdings PLC.

In the eurozone, holdings of German government debt by the European Central Bank and the euro area’s national central banks accounted for 10% of German sovereign debt outstanding, according to HSBC. (…)

Ghost Default Tsunami Brewing

Investors worried by a potential second wave of defaults in the U.S. should be even more concerned about emerging markets.

Moody’s Investors Service says default rates currently stand at about 4 percent and could soar to as high as 14.9 percent by the end of the year under the most pessimistic scenario, Bloomberg News reports today. Its best-case projection is a 5.05 percent rate.

Edward Altman, New York University professor and creator of the widely used Z-Score method for predicting bankruptcies, has also forecast rising U.S. defaults this year, saying in January that recession could follow even with a rate of less than 10 percent, given the increase in debt since the financial crisis.

(…) According to Standard & Poor’s, emerging markets recorded their highest number of defaults for 11 years in 2015, a tally of 26. The Bank of America Merrill Lynch High Yield Emerging Markets Corporate Plus index currently comprises 696 bonds, a number that’s risen from 346 eight years ago. Based on those numbers, the delinquency rate stands at only 3.7 percent (though the S&P figures don’t capture the entire universe of defaults). (…)

A further cause for concern: Fitch Ratings said in January that 24 percent of companies in seven of the biggest emerging markets have raised money offshore. That increases their vulnerability to weakening currencies, an issue that’s dogging Chinese issuers. Fitch also said that the share of banks and sovereign ratings on negative outlook is at the highest since 2009.

The rating company’s analysis of Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey shows that private-sector debt rose to an estimated 77 percent of GDP at the end of 2014, up from 46 percent in 2005.

Corporate defaults increased to a record in Brazil last year. China has also seen delinquencies climb exponentially, with at least 12 companies missing payments on bonds in the past two years.

If history is any guide, there’s a lot more to come. Another wave of defaults in the U.S. will trigger a tsunami in emerging markets.

Pfizer Terminates $160 Billion Allergan Merger
U.S. Prepares Suit to Block Halliburton-Baker Hughes Deal
Ninja What are the Panama papers and why do they matter?

(…) Companies such as Mossack specialise in helping foreigners hide wealth. Clients may want to keep money away from soon-to-be ex-wives, dodge sanctions, launder money or evade taxes. The main tools for doing so are anonymous shell companies (which exist only on paper) and offshore accounts in tax havens (which often come with perks such as banking secrecy and low to no taxes). These structures obscure the identity of the true owner of money parked in or routed through jurisdictions such as Panama.

(…) Over 11m documents have been leaked from Mossack’s secretive offices. The International Consortium of Investigative Journalists (ICIJ) this weekend went public with its findings that the firm had, wittingly or unwittingly, helped clients evade or avoid tax, launder money or mask its origins. More astonishing than their methods, which are well known, was the scale of activity and the people involved. The 2.6 terabytes of data are thought to contain information about 214,500 companies in 21 offshore jurisdictions and name over 14,000 middlemen (such as banks and law firms) with whom the law firm has allegedly worked.

Although by no means all of these are criminal or even shady, the first public examples make for telling reading. On the naughty list are people such as Ukraine’s president, Petro Poroshenko, who promised to sell his business interests on taking office. He seems to have merely transferred assets to an offshore shell. Other heads of government, such as Russia’s Vladimir Putin and Iceland’s Sigmundur David Gunnlaugsson are suspected of hiding ownership of offshore assets by putting them in the names of friends or relatives. Mossack denies any wrongdoing, as does Mr Gunnlaugsson. A spokesman for Mr Putin has denounced the allegations as a case of “Putinophobia”.

After the initial naming and shaming, it will become clearer in the coming weeks who was using these structures for dodgy reasons. While examples of the offshore industry enabling dictators, terrorists and drug cartels will (rightly) capture much of the attention, it would be a shame if other miscreants escape. The global industry of service providers, which sell financial secrecy to those who can afford it, have in some cases done more than just feast on poorly designed tax policies. The Panama documents suggest that some actively looked the other way when faced with a less-than-clean client. An estimated 8% of the world’s wealth ($7.6 trillion according to Gabriel Zucman, an economist) is stuffed away in offshore accounts, most of it done perfectly legally, as a raft of public relations people hasten to say as their clients’ names are flung around in the press. But legal or not, the newspapers taking aim at Mossack and the like will strike a chord. They are in tune with contemporary sentiment: the fundamental disconnect between global elites and the rest, for whom taxes are as certain as death.

From a WSJ editorial:

(…) The scale is eye-popping. Longtime friends and associates of Russian President Vladimir Putin channelled $2 billion through Panama over the years, ICIJ says in its report on the documents. A Kremlin spokesman described the report as “Putinphobia.” A family member of Chinese President Xi Jinping allegedly has a Panama connection, as do the Saudi king and the son of Malaysian Prime Minister Najib Razak. Mr. Xi’s brother-in-law and the Saudi government declined to comment to ICIJ, while Mr. Najib’s son told the group he had used a Panamanian company “for international business.”

Some Western leaders also are mentioned in the leaks, including Iceland’s Prime Minister Sigmundur David Gunnlaugsson, and several former British members of Parliament as well as the deceased father of Prime Minister David Cameron. ICIJ says it has found evidence that some 140 leaders and politicians, and potentially hundreds of other individuals, established companies in Panama over the nearly 40 years for which it has obtained records.

The fact that an individual created such a company, or opened bank accounts in Panama, is not proof of any wrongdoing, and some individuals in the documents have said they had legitimate business dealings that warranted a Panamanian presence. The Mossack Fonseca law firm responded that it “does not foster or promote illegal acts.” It will take significantly more parsing, beyond the year ICIJ and its partners already have devoted, to determine any criminal liability.

That’s not stopping the media from jumping to conclusions, and many are oddly focusing on tax avoidance. The claim is that these leaks show how easily wealthy individuals have been able to use Panamanian bank-secrecy laws—long a target of global tax campaigners—to “conceal” their wealth. (…)

Governments have to enforce their tax laws. But it’s hard to see how the big question in this story is whether everyone with a company in Panama paid the correct amount of tax. The far more important question is how so many public officials in so many governments managed to accumulate so much money.

It’s no surprise that the world’s undemocratic and nontransparent regimes figure prominently in the Panama Papers. The leak offers new insights into how the powerful few enriched by such regimes deploy their cash.

Western governments should be particularly alert to the ICIJ’s suggestion that some of the transactions it identified were intended to circumvent Western sanctions on regimes or individuals. Russian and Chinese citizens in particular deserve to know more about their leaders’ finances, and the good news of the Internet era is that they’ll find out despite their government’s efforts to suppress the news.

All of these angles warrant further exploration, in the press and among voters and perhaps also in courtrooms around the world. The mistake now would be to narrow the focus prematurely, zeroing in on tax avoidance that is a hobbyhorse of the political class but in this case is a distraction. The real news here are the incomes and far-flung bank accounts of the political class.