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$ (20 JANUARY 2016): Earnings Watch

U.S. Home Builders Index Treads Water

The Composite Housing Market Index from the National Association of Home Builders-Wells Fargo held steady during January at 60 after falling 7.7% during the prior two months.

The index of single-family home sales increased 3.1% (8.1% y/y) to 67 and recovered December’s decline. Offsetting this rise, however, was a decline in the index of expected sales during the next six months. It fell 4.5% to 63, but still was 5.0% higher than one year ago.

Home builders reported that their traffic index fell 4.3% to 44. That repeated the prior month’s decline and left it at the lowest level in six months.

China Highlights Pivot to Service Sector Stressing the positive in its flagging economy, China’s government says a transition from industry toward services is advancing, but the latest snapshot of economic performance suggests that shift will be arduous.

(…) In reporting that economic growth dropped to 6.9% last year, the government’s statistics bureau said Tuesday that for the first time services accounted for more than half of the economy, climbing to 50.5% from 48.1% the year before. Meanwhile, manufacturing’s share shed more than two percentage points, falling to 40.5%. (…)

Rather than rapid growth in services and consumption, some analysts said the restructuring is more a reflection of the downturn in China’s traditional industrial growth drivers. Growth in the industrial sector slowed sharply to 6.0% in 2015 from 7.3% in 2014 while services expanded to 8.3% last year from 7.8% a year earlier. (…)

Consumption amounted to about two-thirds of economic growth last year, up 15 percentage points from 2014, the statistics bureau said Tuesday. While disposable income outperformed the economy, increasing 7.4% last year, many analysts said overall consumption figures generally include government spending, unlike statistics provided by most other nations.

Beijing hasn’t released detailed statistics yet. But of the 51.4% of the economy made up by consumption in 2014, only 37.9% was household spending, according to official figures. (…)

President Xi Jinping has said a growth target of 6.5% is necessary to meet a goal aimed at doubling its citizens’ income between 2010 and 2020. (…) According to Minsheng Securities Co., China’s infrastructure spending would need to grow by at least 18.7% this year for the country to reach the 6.5% target. (…)

Capital flight from China worse than thought Emerging markets saw an estimated $735bn in net capital outflows last year

(…) Emerging markets saw an estimated $735bn in net capital outflows last year with all but $59bn of that coming from China. In October, the global finance industry group had predicted 2015 would see net outflows from emerging markets of $540bn, the first since 1988. (…)

The discrepancy revealed on Wednesday, the IIF said, came in large part because of accelerating capital flight from China in the final three months of last year via channels used to circumvent capital controls. Over-invoicing for exports, cash transactions and other such flows recorded as “errors and omissions” accounted for $216bn of the $676bn in China’s net outflows in 2015, according to the IIF. (…)

Chart: China and emerging markets net capital flows

Pegs under pressure

Two currency pegs have come under increasing pressure in recent days. Authorities  in Saudi Arabia moved this morning to stem the tide of traders betting against the riyal’s peg to the U.S. dollar by banning local riyal forward options. Those forwards had jumped to their highest in at least two decades. In Hong Kong, local dollar forwardssunk to the weakest since 1999, forcing interbank lending rates to their highest in seven years. Hong Kong Monetary Authority Chief Executive Norman Chan reiterated on Monday his commitment to keeping the linked exchange-rate system. (Bloomberg)

Eurozone House Prices Record Fastest Rise Since Financial Crisis

The European Union’s statistics agency Wednesday said house prices in the eurozone were 1% higher in the third quarter than in the three months through June and 2.3% higher than in the same period of 2014. That was the largest annual gain since the first quarter of 2008, six months before the financial crisis was triggered by the collapse of the Lehman Brothers investment bank.

During the third quarter, house prices rose most rapidly in Austria, where they were up 9.3% on the year. Prices also rose rapidly in Germany, where they were up 5.6% on the year as unemployment rates fell to their lowest levels since reunification and wages began to pick up.

By contrast, house prices fell in both France and Italy, while there were continuing recoveries in Ireland and Spain. (…)

IMF Again Cuts Global Outlook The International Monetary Fund once again cut its outlook for the world economy, warning that economic turmoil in China and financial contagion throughout emerging markets threaten to curb global growth.

(…) Deeper downturns in many of the world’s largest developing countries and a weaker-than-expected expansion in the U.S. prompted the IMF to downgrade its forecast for global growth this year by 0.2 percentage point to 3.4%. That is a meager improvement from last year’s 3.1% growth rate. (…)

The IMF slashed its forecasts for Brazil, where a government corruption scandal is compounding its growth problems. The fund now expects the economy will contract by 3.5% this year, 2.5 percentage points lower than its last forecast. Russia’s economy will shrink by 1% this year, 0.4 percentage point deeper than the IMF’s previous outlook.

Meanwhile, a strong dollar is weighing on U.S. exports, subduing acceleration of the world’s biggest economic engine. The IMF said the American economy should grow by 2.6% this year, up a hair from last year’s 2.5%, but 0.2 percentage point down from its prior forecast.

The eurozone and Japan are adding little to global growth, expanding by 1.7% and 1%, respectively, as they struggle to revive growth amid high debt loads and anemic demand.

The IMF left its forecast for China’s economic growth to cool to 6.3% this year and 6% next year, down from 6.9% in 2015. (…)

3 FORECASTERS
Pointing up More from Howard Marks: What Does the Market Know?
SENTIMENT WATCH

(…) “This correction has overly punished other sectors and now we’re ready to take advantage of it,” Bianco wrote in a note to clients Tuesday. “We are not panicked by this correction because we understand it. It’s driven by a profit recession centered at certain industries caused by factors that we’ve long flagged as risks.”

Bianco expects “zero profits” from energy with oil at $35 a barrel and cut his earnings estimates for the materials, industrial capital goods and retailing industries. At the same time, he raised estimates on airlines, autos and consumer staples and said technology and health-care stocks are trading at some of the cheapest valuations in three decades. (…)

Bianco’s prediction for a near-term rally came in a note in which he lowered his estimate for the S&P 500 by 2.2 percent to 2,200 from his Jan. 7 prediction of 2,250. The level implies a 17 percent gain from Friday’s close and is 3.2 percent above the May high.

The move was Bianco’s second cut to his 2016 year-end forecast, following his 25-point reduction earlier this month. Citigroup Inc.’s Tobias Levkovich trimmed his 2016 target last week by 2.3 percent to 2,150, citing the persistent rout in oil.

EARNINGS WATCH
  • 42 companies (13.5% of the S&P 500’s market cap) have reported. Earnings are beating by 4.8% while revenues have surprised by 0.2%.
  • The beat rate is 76%.
  • Expectations are for a decline in revenue, earnings, and EPS of -3.3%, -5.1%, and -3.5%. EPS growth is on pace for +0.6%, assuming the current 4.8% beat rate for the remainder of the season. This would be 6.4% excluding Energy. (RBC Capital)

Thomson Reuters’ EPS forecast is –4.7% for Q4’15. For Q1’16, it sees +0.5%, down from +2.3% on Jan. 1.

Good chart from Bespoke Investment
Driver’s Licenses Lose Allure for Young America’s youth aren’t rushing out to get their drivers licenses as they once did, a trend that signals the auto industry’s new interest in car-sharing services and autonomous vehicles might be the right tack.

A study published this week by the University of Michigan reports a sharp decline over the past two decades among people under 25 years of age getting their driver’s licenses.

The drop signals high-schoolers and college-age Americans are less interested in driving than previous generations. And the change is spreading to their parents and grandparents, moves that have auto makers scrambling to ramp up investments in alternative mobility services such car-hailing services.

Since the financial crisis of 2008, the proportion of Americans under 70 years of age holding a driver’s license has declined even as annual U.S. light-vehicle sales have slowly climbed back to levels seen early last decade, University of Michigan researchers Michael Sivak and Brandon Schoettle found. (…)

The population, however, has grown 14% during that period and the age of the nation’s existing vehicle fleet has risen—two factors that suggest today’s underlying demand may not be as strong as it was 15 years ago. Rising sales incentives and used-car inventories, analysts say, point to demand plateauing, and heightening the need for car executives to explore alternative revenue streams. (…)

Among the survey’s notable statistics: 77% of people between the ages of 20 and 24 were licensed to operate a vehicle in 2014, down from about 80% in 2011 and 92% in 1983. Less than a quarter of 16-year-olds today have their licenses, down from 46% in 1983; and 60% of 18-year-olds have one, down from 80% in 1983. (…)

Iranians Squeeze Moderate Leaders Days after Iran secured relief from economic sanctions under a contentious nuclear deal, the country’s powerful hard-liners are moving to sideline more moderate leaders who stand to gain from a historic opening with the West.

(…) Reformists have been largely sidelined since the opposition Green Movement was violently suppressed in 2009, and currently have only a smattering of the 290 seats in parliament. But they were hoping to capitalize on momentum from the opening represented by the nuclear deal to build support—a prospect U.S. officials have backed.

Mr. Khamenei urged close monitoring of American obligations under the nuclear deal on Tuesday, warning against U.S. deception. He has described the U.S. as Iran’s enemy. (…)

Thousands Apply to U.S. to Forgive Their Student Loans Americans are flooding the government with appeals to have their student loans forgiven on the grounds that schools deceived them with false promises of a well-paying career.

NEW$ & VIEW$ (19 JANUARY 2016): China; Oil.

Did you miss yesterday’s New$ & View$?

Bank of Canada to cut key rate to zero in 2016, Barclays says
JPMorgan: Canada Really Needs a Weaker Loonie
2015 GDP Shows China Wrestling With Slowdown

The growth rate, released by the government on Tuesday, moderated to 6.8% for the fourth quarter and 6.9% for 2015.

(…) President Xi Jinping also urged the officials “to stabilize short-term growth.” Premier Li Keqiang talked of “increasing downward pressure” on the economy, complicated by slack global demand. (…)

Other data released Tuesday traced the deepening slowdown. Value-added industrial output rose a less-than-expected 5.9% in December compared with a year earlier, slowing from 6.2% growth in November. Fixed asset investment in non rural areas climbed 10.0% last year, compared with an increase of 10.2% for the first 11 months of the year. Retail sales, a bright spot in the economy, grew 11.1% in December from a year earlier, a tick down from November’s 11.2% increase. (…)

With the gloomier outlook, Chinese officials have said the government is looking to increase deficit spending this year to generate growth, even if that tactic has limits. Higher spending on infrastructure last year showed signs of kicking in as investment levels grew faster after lending in November and December increased, and the government is expected to spend more heavily on infrastructure this year, but the upturn may be short lived given that investment figures showed weakening in December. (…)

Households and companies now spend the equivalent of 20% of GDP on interest payments, more than the U.S., Japan or the U.K. and equal to Korea, said research firm Gavekal Dragonomics, citing figures from the Bank for International Settlements. (…)

Louis Kuijs, Oxford Economics: “With nominal GDP growth in services exceeding that in the secondary sector by an unprecedented margin, the share of the tertiary sector in overall GDP rose a whopping 2.4 percentage points to 50.5% in 2015. While this suggests substantial rebalancing, it is in part due to severe downward pressure on output prices as many firms in overcapacity sectors are not responding sufficiently to price signals, underscoring the need for bolder reform. In any case, the robust growth in the consumption and services nexus is key for policymakers – they need it to avoid labor market stress.”

Julian Evans-Pritchard, Capital Economics: “The upshot is that while the official GDP figures shouldn’t be taken at face value, growth does appear to have been broadly stable last quarter and the December data, although mixed, don’t suggest that China is now entering a deeper economic crisis. On the contrary, with the tailwinds from recent policy stimulus still gathering we actually expect the data to gradually turn more upbeat over the next few months.”

The worries about China’s slowing growth

(…) no one much believes the numbers. China has long been suspected of massaging data to smooth its growth trend, under-reporting GDP when overheated and over-reporting it during lulls. Judging by the eerie stability of key indicators recently, China’s statisticians appear to have been doing just that. In year-on-year terms, growth over the past six quarters has been 7.2%, 7.2%, 7%, 7%, 6.9% and 6.8%. Such a tight clustering is improbable. Private surveys suggest that growth was much lumpier last year, with the economy initially soft, then picking up in the final months thanks to stimulus policies. Using a composite of alternative data from electricity usage to car sales, many analysts reckon last year’s growth rate was really 5-6%—not bad, though certainly not as buoyant as the government says.

Headline growth is, however, only the first of the concerns. Look under the hood at the composition of Chinese growth, and the picture that emerges is of extreme weakness in certain parts of the economy. Heavy industry is in bad shape, blighted by overcapacity and falling demand. Service sectors from finance to health care are much more robust. But services, by their nature, are mainly delivered locally; China is able to provide more of what it needs by itself, not through imports. That is cold comfort for other countries, especially commodity producers, which had come to count on ever-stronger Chinese demand. Official data are admirably clear on this bifurcation of the economy: services output grew by 11.6% year-on-year in nominal terms in the first nine months of 2015, whereas manufacturing grew by just 1.2%.

The biggest fear about Chinese growth is that much worse is still to come. Total debt has gone from about 150% of GDP before the global financial crisis in 2008 to nearly 250% today. Increases in indebtedness of that magnitude have been a forerunner of financial woes in other countries. Cracks are beginning to appear in China: capital outflows have surged, bankruptcies are occurring more frequently and bad loans in the banking sector are rising. It is all but certain that more pain lies ahead, though quite how much and how it will play out are matters for debate. If there is one thing all can agree on about China’s economy, it is that the gap between official data and market perceptions has widened to a chasm.

China devaluation – a necessary evil?

(…) The key question is whether China can restore confidence in its exchange rate policy, not least among its own citizens. For as long as a renminbi devaluation of unknown size continues to overhang the markets, an abatement in capital outflows, and a return to stability, seems difficult.

It is even possible that the event that markets most fear – a controlled depreciation of 10 per cent or so – might be the only way of restoring calm, if accompanied by other reforms. Until the renminbi is deemed by the global financial system to be at a sustainable level, fear of disruptive change will dominate sentiment.

The PBOC does not seem to agree. Last week, it finally intervened in the foreign exchange markets with enough conviction to halt the recent depreciation, temporarily at least. The new exchange rate regime has now been spelled out in some detail. The central bank has decided to maintain a “relatively stable” renminbi against a basket of foreign currencies, while allowing much greater flexibility than before against the dollar.

But it has also said that, in the longer term, the exchange rate against the basket may be allowed to move, in line with changing economic fundamentals. The central bank clearly wants the exchange rate to become gradually more market determined, as it shifts to a monetary system where domestic money market rates are used as the main instrument of monetary policy.

This makes good sense, except that the present level of the exchange rate does not command market confidence. In part, this is because there is so much suspicion that the State Council, not the PBOC, is ultimately in charge of exchange rate policy. There is continued speculation in the markets, whether true or not, that President Xi Jinping’s economic staff believes a devaluation will be needed to restore stability. This, and the expectation of an imminent tightening in controls over outward capital movements by Chinese households, is leading to a rush for the exits.

The Economist has calculated that if only 5 percent of China’s population decides to take advantage of the $50,000 annual limit on foreign investment, the outflow in 2016 would be equivalent to the whole of China’s $3.3tn in foreign exchange reserves. The reserves have already fallen by almost $700bn since the peak, and the rate of decline is showing no sign of abating.

So is it now clear that the renminbi is fundamentally overvalued and needs to fall? The PBOC denies this, pointing out that the current account of the balance of payments remains in comfortable surplus, and that long term capital flows are also still in the black. Indeed, it describes the possibility of devaluation as “ridiculous and impossible”, concluding that

There is not a basis for the RMB to devalue continuously. It will remain strong among the reserve currencies.

The authorities clearly have no desire to be accused of “competitive devaluation” by the US, especially in an American election year. Nor do they want to increase the cost of foreign currency debt, measured in renminbi. Latest estimates suggest that foreign debt stands at about $1.5tn, so a 10 per cent devaluation could increase its domestic value by about 1.5 per cent of GDP, according to Goldman Sachs. Finally, there little sign of a generalised hard landing in the economy at present, which would make a devaluation unavoidable.

However, there is a severe problem in the shape of the rebalancing of the economy away from old manufacturing sectors towards the new economy. Western economists have tended to see this as a silver lining in the recent economic history of China, arguing that the economy is successfully shifting resources towards the sectors that will dominate its future. But a careful look at the data suggest that this is far from the whole story:

The optimists point to the rise in the share of services in nominal GDP, and the corresponding decline in industrial sectors, as shown in the above left graph. Measured in current prices, the rebalancing appears to be well underway, with the share of industrial sectors falling from 47 per cent in 2011 to 40 per cent now.

However, almost the whole of this rebalancing in nominal terms has occurred because of a large drop in the relative price of industrial products compared to services. In real, inflation adjusted terms (above right graph), there has been no rebalancing whatsoever in the past decade taken as a whole (though there has been a percent or two in 2014-15). The needed shift in real resources – labour and capital – out of the moribund sectors has therefore barely started.

This conundrum is explained by the collapse in industrial goods prices that has occurred as excess industrial capacity has built up in the Chinese economy. Although this has happened in most manufacturing sectors, it has been at its most severe at the low-value added end – ie in heavy goods industries that are probably now making significant losses but are still being propped up by the state.

Most other economies, both developed and emerging, are experiencing negative producer price inflation as commodity prices have collapsed, but the size of the industrial sector in China makes it a particular problem there, and it has been exacerbated by the rising renminbi in 2013-15.

In the Central Economic Work Conference in December, President Xi firmly established “supply side reform” as the new buzz word for policy in 2016. That means that excess capacity will be tackled by plant closures and job losses, offset by easier fiscal and monetary policy.

In a western economy, it would be taken for granted that such a programme would be accompanied by a drop in the real exchange rate as overall monetary conditions are loosened. Flexible, market determined exchange rates can go down as well as up. Perhaps that is also becoming a necessary evil in China.

Europe’s Corporate Bonds Trading at Recession Levels A wave of selling has taken Europe’s corporate-bond market to levels typically seen during recessions, another indication that the turmoil in global markets could spread into the wider economy.

The gap in yields, or spread, between Eurozone high-grade corporate debt and safer government bonds has ballooned to its widest level in nearly three years, according to Barclays bond indexes. Three years ago, the European economy was in recession following the sovereign-debt crisis that had engulfed the continent. (…)

Oil Market Could ‘Drown in Oversupply’ Oil prices could fall further this year as the market faces an “enormous strain” on its ability to absorb new supplies from producers such as Iran, the International Energy Agency said.

(…) The oil markets could be left with a surplus of 1.5 million barrels a day in the first half of 2016, and “unless something changes, the oil market could drown in oversupply,” it said. (…)

The IEA said Iran could add around 300,000 barrels a day of additional crude by the end of the first quarter, and that the return of Iranian crude to the global market will inevitably and largely offset the 600,000 barrels a day drop that is expected in supplies from producers outside OPEC.

Global inventories, which rose by a notional 1 billion barrels in 2014–2015, will see a further build of 285 million barrels in 2016, which will put storage infrastructure under pressure despite significant capacity expansions .

The IEA, which advises developed countries on energy policy, maintained its expectation for global oil demand growth this year at 1.2 million barrels a day, down from 1.8 million barrels a day in 2015 it anticipated in December.

The unseasonably mild winter saw global oil demand growth fall to a one-year low of 1 million barrels a day in the fourth quarter of last year, down from a near five-year high of 2.1 million barrels in the third quarter.

Supplies from OPEC fell by 90,000 barrels a day in December to 32.28 million barrels a day due to lower production from Iraq and Saudi Arabia, the report said, adding that OPEC has effectively been pumping at will since 2014.

Output from OPEC countries is now 1.06 million barrels a day higher than the same period of last year, a major factor in oil prices falling below $30 a barrel

Iranian output rose in December by 40,000 barrels to its highest level since June 2012, the report said.

The IEA cut its forecast for 2016 OPEC crude oil demand by 300,000 barrels a day to 31.7 million barrels per day due to slightly weaker demand growth.

Supplies from outside OPEC, which proved “resilient” for most of last year, shrank on an annual basis in December for the first time since September 2012.

In total, global oil supply grew by 2.6 million barrels a day in 2015 following similar large gains of 2.4 million barrels a day in 2014.

(…) “After seven straight years of phenomenal non-OPEC supply growth, often greater than 2 million barrels a day, 2016 is set to see output decline as the effects of deep capex cuts start to feed through,” the producer group said in its closely watched monthly report.

Though OPEC acknowledges more than 2 million barrels a day of new projects are still planned to go ahead this year, the organization still expects non-OPEC output to fall by almost 700,000 barrels a day in 2016 as the effects of lower capital spending are felt.

The U.S. is expected to see the biggest decline in production, with output forecast to fall by nearly 400,000 barrels a day, but OPEC said places such as Canada, the North Sea, Latin America and parts of Asia are also particularly vulnerable.

OPEC’s oil production, on the other hand, remains elevated, despite declining by 200,000 barrels a day last month, according to secondary sources. The group’s output—including newly reinstated member Indonesia—fell to 32.2 million barrels a day in December led by lower production in Nigeria, Saudi Arabia and Iraq. The group’s output still remains above the anticipated demand for its oil though, which OPEC sees rising by 1.7 million barrels a day to 31.6 million barrels a day this year.

Saudi Arabia’s decision to reduce energy subsidies will lead to higher fuel prices and limit growth in the country’s consumption of oil in 2016, according to the International Energy Agency. Similar cuts by other Gulf Arab states will further squeeze demand growth in the Persian Gulf region. (…)

Saudi oil demand is forecast to rise by just 45,000 barrels a day to 3.3 million barrels a day in 2016, sharply lower than the 125,000 barrel-a-day expansion in 2015, the IEA said. Subsidy cuts by Bahrain, Oman and the United Arab Emirates will add to the impact on Middle Eastern oil demand, which will gain by only 100,000 barrels a day to 8.3 million barrels a day, it said.

As of Jan. 11, gasoline prices in Saudi Arabia rose to 0.75 riyals (20 cents) per liter from 0.45 riyals per liter for 91-octane fuel, and 0.9 riyals per liter from 0.6 riyals per liter for 95-octane grade, said the IEA, a watchdog agency for the world’s most industrialized countries. (…)

(…) The Beijing-based explorer will produce 470 million to 485 million barrels of oil equivalent this year, slipping from 495 million in 2015, it said in a statement to the Hong Kong stock exchange Tuesday. That would be the first decline since at least 1999. The company said it will spend a maximum 60 billion yuan ($9.1 billion), down from last year’s 67.2 billion yuan.

Total spending last year missed the company’s original target, highlighting how producers have struggled with oil’s plunge to a 12-year low. The price collapse hasdelayed $380 billion worth of investments on 68 major upstream projects, according to industry consultant Wood Mackenzie Ltd., and has forced suppliers from BHP Billiton Ltd. to BP Plc to write down the value of assets and fire workers. (…)

Cnooc’s production won’t reach 2015 levels for at least two more years. It’s targeting output of 484 million barrels of oil equivalent in 2017 and 502 million in 2018. The company plans to start four new projects this year while drilling 115 exploration wells, it said. The lower-end of the company’s production target sets output this year at about 1.29 million barrels a day, a drop of more than 68,000 barrels a day. (…)

SENTIMENT WATCH:

David Rosenberg:

(…) The notion that Energy defaults (this is not the same as residential real estate circa 2008, not by a long shot) or the Emerging Market space can tip this $18 trillion beast otherwise known as U.S. GDP into a sustained downturn is hyperbole to an extreme. (…)

The capitulation is in. (…)

Few, however, are willing to call this a buying opportunity. (…)

But lost in the bearish narrative are the cash flow benefits to consumers – whether they spend the cash flow or not is a separate matter, but the real income effect is undeniable.

Regionally, countries like Japan, India, China and much of Continental Europe are huge winners.