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 MARCH 2014)

THE “NEW AND IMPROVED” FORWARD GUIDANCE

With the new vague guidelines for forward guidance including just about everything except the kitchen sink, the Fed can do just about anything with rates, including raising them sooner than most investors and FOMC members anticipate. (BMO Capital Markets)

In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends—a conclusion that could come this fall. She offered that projection with many caveats, but some investors took it as a sign that the Fed could start raising interest rates sooner than expected. (…)

The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December.

The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start. It said instead that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008.

(…) the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends. (…)

Ms. Yellen acknowledged that officials might have been too optimistic about the economic outlook early in the year. But she and other officials largely stuck to their projections for how growth and inflation will unfold in the coming years.

Fed officials see inflation slowly returning from nearly 1% recently to 2% in the years ahead and the economy reaching a growth rate around 3% or a little less. They reduced their estimates for the unemployment rate, which they see falling to between 6.1% and 6.3% by year-end, from 6.7% in February. They attributed recent sluggishness in growth in part to “adverse weather conditions.” (…)

(…) “It’s hard to define but, you know, it probably means something on the order of around six months or that type of thing,” she said. “What the statement is saying is it depends what conditions are like.”

For the financial markets, it did not matter what it depended on. They had heard six months. Add six months on to this October, when the Fed is likely to end its asset purchases, and – depending on the timing of Fed meetings – you get to March or April 2015. That is some months earlier than the Fed had been expected to raise rates.

In a matter of seconds, the S&P 500 shed about 1 per cent and yields on Treasury securities soared. If Ms Yellen did not already realise the awesome power of her every word as Fed chair, she does now. (…)

It was an unfortunate slip, however, because it was the one solid moment in a muddy set of Fed communications. (…)

The vagueness of the statement meant that markets naturally looked towards the FOMC’s interest rate forecasts for a better idea of where the Fed is going. Those were hawkish, showing that the median Fed official expects an interest rate of 1 per cent by the end of 2015, up from 0.75 per cent before.

But Ms Yellen said to disregard the forecasts. (…)

From this morass, it is still possible to work out roughly what Ms Yellen meant. (…)

(…) Yields on two-year Treasury notes climbed as much as 10 basis points yesterday, the most since June 2011.

“With the shift to qualitative guidance, the only quantitative metric we have is the fed funds projections from the Fed,” said Dean Maki, chief U.S. economist for Barclays Plc in New York and formerly an economist at the central bank. “So while the statement and Chair Yellen in the press conference said little had changed, the Fed’s projections suggested that there was a notable change in the Fed’s outlook.”

Summarizing Yellen’s First (Disastrous) Press Conference

“Miss me yet?”

To me, here’s the most important from yesterday’s FOMC statement:

the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends.

Bearish stuff!

BANKING ON BANKERS?

A less-dovish than expected Janet Yellen on Wednesday and a more-dovish than expected Stephen Poloz on Tuesday have a) thrashed the C$ to below 89 cents, and b) pulled Canadian 5-year bond yields in line with their U.S. counterparts for the first time in years. With Canadian overnight rates well above the fed funds rate since 2010, most short-term Canadian bond yields have been stuck above U.S. levels. However, with the market now looking for Fed rate hikes in 2015, possibly early in the year, and some pushing further out BOC rate hikes, 5-year yields have met in the middle. That’s a big development.

With Chair Yellen not ruling out a possible rate increase “around six months” after the end of QE (putting it in Q2 2015), and Governor Poloz not ruling out a possible rate cut, the loonie is flying straight into some pretty stiff headwinds. (BMO)

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Add the China slowdown, weakening commodity prices…and if oil prices turn south, the loonie will drown.

Goldman Cuts Its Outlook For China

The bank lowered its 2014 forecast to 7.3 percent from 7.6 percent late Wednesday. It also cut its 2015 outlook to 7.6 percent from 7.8 percent.

“Both trade and consumption – factors that we had expected to provide positive support to growth this year – disappointed in the first two months of 2014, relating to the anti-corruption efforts, which affected consumption, and the soft DM (developed market) recovery,” economists led by Li Cui, managing director, China Macro Research at the bank wrote in a note.

While Goldman forecasts 7.3 percent growth in the first quarter, it doesn’t expect the economy to slow much further beyond this level for the remainder of the year. It sees growth at 7.5 percent, 7.3 percent and 7.2 percent for the second, third and fourth quarters, respectively.

U.S. Work Hours Should Defrost Soon

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The recent sag in U.S. weekly work hours has raised a few eyebrows, as the index is unchanged in the past six months, the weakest showing since the early days of the recovery. Blame Mother Nature. Average weekly hours worked plunged 1.7% annualized from September to February, led by construction (-5.5%) and retail (-3.1%), two areas greatly affected by the nasty weather. Meantime, despite recent softness, private-sector payrolls still rose a decent 1.9% (or more than 2 million at an annual rate). Look for hours worked to accelerate in the spring, supporting income and spending.

Let’s hope BMO Capital’s economists prove right. Weather or not, construction and retail were also greatly affected by rising interest rates and housing prices and very slow growth in real disposable income.

The latest confidence survey of the heads of Corporate America, as measured by Business Roundtable, was encouraging. The Economic Outlook Survey rose for the second consecutive quarter in Q1, climbing to a 2-year high of 92.1. Although sales expectations for the next six months slipped a bit, anticipated capital spending jumped again, this time up 9 pts in the quarter, while expected hiring also increased but at a more moderate pace. (BMO)

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Yuan Falls Farther, but Ride May Be Nearly Over China’s yuan hit its lowest point in more than a year, but analysts say Beijing—having slowed hot-money inflows—is unlikely to allow much more depreciation in the near term.

(…) It has fallen every day since China widened the currency’s daily trading range over the weekend, losing 1.3% of its value against the dollar—increasing the loss for 2014 to 2.8%, nearly wiping off the entire 2013 gain of 2.9%. In Shanghai trading Thursday morning, the yuan fell to an intraday low of 6.2334 to the dollar—its lowest level since late February 2013. (…)

Beef And Hog Prices Surge

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The current outbreak of PEDV (porcine epidemic diarrhea virus) in North America is having a huge impact on hog prices. The disease, which poses no risk to food safety but is lethal to piglets, is estimated to have caused the loss of up to 5 million animals over the past year, or around 4-5% of annual slaughter. Even without PEDV, hog markets were set to tighten significantly this year as lower feed prices spur herd expansion and limit the supply of animals available for slaughter. As a result, inflation-adjusted hog prices have soared to their highest level since the early 1990s (and to record highs in nominal terms). However, markets appear to be anticipating a relatively short-lived disruption—the futures curve peaks in June at 133¢/lb and falls back to 87¢ in December. (BMO)

The Problem With Forward P/E’s

(…) Beginning in the late 90’s, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue.  However, the problem with forward operating earning estimates is that they are historically wrong by an average of 33%.  The chart below, courtesy of Ed Yardeni, shows this clearly.

Yardeni-Forward-EstimatesLet’s take this exercise one step further and consider the historical overstatement average of 33%.  However, let’s be generous and assume that estimates are only overstated by just 15%.  Currently, S&P is estimating that earnings for the broad market index will be, as stated above, $120.34 per share in 2014 but will rise by 14% in 2015 to $137.36 per share.  If we reduce both of these numbers by just 15% to account for overly optimistic assumptions, then the undervaluation story becomes much less evident.  Assuming that the price of the market remains constant the current P/FE ratios rise to 18.08x for 2014 and 15.84x for 2015.  (…)

Lastly, with corporate profits at record levels relative to economic growth, it is likely that the current robust expectations for continued double digit margin expansions will likely turn out to be somewhat disappointing. (…)

Profit-Growth-GNP-ForwardGrowth-030314

Slumping Fertility Rates in Developing Countries Spark Labor Worries Thailand is one of the pockets of the developing world to see sharp declines in fertility rates, bringing concerns about shrinking labor pools and aging populations.

Birthrates have fallen in Thailand in recent years, making it one of the poorest countries facing the prospect of shrinking labor pools and an aging population. Such problems, while familiar in Europe and Japan, used to be unheard of in the up-and-coming economies of Southeast Asia.

Thailand’s fertility rate has fallen to an average of just 1.6 children per woman, from seven in the 1970s, disrupting centuries of tradition in which children care for their parents. That is forcing political leaders to look for new sources of economic growth and community leaders to search for ways to make the elderly more self-sufficient. (…)

Other pockets of the developing world also have seen sharp declines in fertility rates, including Brazil, Mexico and parts of India and Southeast Asia. Rising prosperity appears to be one catalyst. If the trend continues, the United Nations projects—in its “low-growth” forecast—that the global population will hit 8.3 billion in 2050 before declining to less than the current level of 7.2 billion by 2100. (Its “mid-growth” forecast projects 10.85 billion by century’s end.) (…)

Demographers such as Michael Teitelbaum at Harvard Law School and Jay Winter, a history professor at Yale University, note that already more than half the world’s population lives in aging countries where the fertility rate is less than 2.1 children per woman—the rate required to replace both parents, once infant mortality is taken into account.

This is both an opportunity and a threat. On one hand, it could help preserve natural resources in nations that have been taxed by rapid population growth. But some economists blame a slowdown in population growth for contributing to such disparate events as the Great Depression and Japan’s sluggish growth rates in recent decades. (…)

China saw its working-age population decline by 3.45 million in 2012 and 2.45 million last year—a cumulative decline of 0.63% since 2011 and a sign that expansion has ended. (…)

Fertility rates rise and fall. The improving economy in the U.S. helped stabilize fertility rates in 2012 at 1.9 after four years of declines, according to the National Center for Health Statistics. When immigration is taken into account, the U.S. population still is growing. (…)

NEW$ & VIEW$ (19 MARCH 2014)

CEOs See No Quick Increase in Hiring

(…) Nearly half of CEOs surveyed by the Washington trade group said they expect to boost U.S. capital spending in the next six months, compared with only 39% eyeing higher spending three months ago. But while 72% of CEOs see an increase in sales in the next six months, only 37% expect to boost U.S. employment, according to the survey released Tuesday. Forty-four percent see their U.S. payrolls unchanged. (…)

Business investment and economic growth would likely rise noticeably if Congress were to rewrite the tax system in ways that cut corporate rates and narrowed loopholes, Mr. Stephenson said. “We don’t believe there’s anything that will drive economic growth like tax reform would,” he said. (…)

Events in Russia and Ukraine also appear to be influencing sentiment. The group conducted the survey between Feb. 21 and March 7, as events unfolded in the Eastern European nation. (…)

“We’re all watching this like a hawk,” Mr. Stephenson said. “We have a lot of business at stake in Europe.”

Mortgage Applications Decrease in Latest MBA Weekly Survey

imageMortgage applications decreased 1.2 percent from one week earlier, according to data from the Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey for the week ending March 14, 2014. …
The Refinance Index decreased 1 percent from the previous week. The seasonally adjusted Purchase Index also decreased 1 percent from one week earlier.…

The 4-week average of the purchase index is now down about 18% from a year ago.

INFLATION WATCH

According to the Federal Reserve Bank of Cleveland, the median Consumer Price Index rose 0.2% (2.2% annualized rate) in February. The 16% trimmed-mean Consumer Price Index also increased 0.2% (1.9% annualized rate) during the month. The median CPI and 16% trimmed-mean CPI are measures of core inflation calculated by the Federal Reserve Bank of Cleveland based on data released in the Bureau of Labor Statistics’ (BLS) monthly CPI report.

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Median CPI is continuing to rise by 0.2% per month, double the rate of the weighted CPI and core CPI. Total CPI is currently +1.1% YoY compared with +2.0% for Median CPI. This -0.9% spread is slightly more than the 0.83 standard deviation since 1990. Over the last 25 years, Total CPI and Median CPI have been identical, on average, with median CPI being much less volatile and a more stable indicator of inflation. The probabilities are thus that Total CPI will soon rise towards the 2.0% YoY level. If you missed my March 17 piece on producer prices, it is here.image

CHINA RETAIL SALES SLOW DOWN

Total retail sales of consumer goods increased only 11.8% Y/Y in January and February, significantly lower than government targets in 2014. In 2013, both retail and restaurant sales Y/Y deceased significantly due to the anti-corruption campaign. Restaurant sales suffered the most but stabilized after an adjustment in 2013; however, retail sales are still decreasing. The anti-corruption campaign continues to impact sales while personal income Y/Y remains low. Therefore, retail Y/Y is likely to fall short of the government target in 2014. (CEBM Research) (Chart from Ed Yardeni)

China Slowdown Adds to U.S. Firms’ Challenges China’s broad economic slowdown is adding another worry for U.S. companies already dealing with rising wages, formidable competition for workers and selective regulation.

A survey of U.S. companies operating in China released Wednesday shows that 50% cite the falloff in growth—to 7.7% last year from a peak of 14% in 2007—as among the biggest risks they face. That is a tick higher than the 47% the American Chamber of Commerce survey received last year. (…)

The 365 companies that responded to the AmCham survey listed rising labor costs and the difficulties of finding and keeping skilled employees as among their biggest challenges. Then there is a regulatory system that often seems to come down harder on foreign companies than Chinese ones. (…)

Two out of five of the companies polled in the survey said foreign businesses are less welcome in China than in the past, while only one in 10 said they felt more welcome. Seventy percent are profitable, though.

Among the other problems of doing business in China, U.S. companies cited Internet censorship, the struggle to protect patents and copyright, and a new, lengthier system for visas. (…)

Troubles recruiting and retaining skilled employees seems incongruous with universities producing 7 million graduates a year. But companies and experts said that those students aren’t entering the labor market with the right qualifications.

“The problem is the education system hasn’t quite caught up,” said Andrew Polk, an economist at the Conference Board, a U.S. business research outfit. “You’ve got more people in the so-called skilled labor pool who aren’t quite as skilled as companies need them to be.” (…)

On the other hand, China’s well-publicized, health-threatening air pollution problem is making it harder to attract senior executives from abroad. This is now a problem for half of the companies that responded to the survey, up from a third last year, according to the AmCham report.

Yuan Falls Against U.S. Dollar China’s yuan has erased most of the gains made in the past year, as it fell sharply for the third consecutive day against the U.S. dollar after the central bank doubled the currency’s trading band over the weekend.

At 6.2009, the yuan weakened 1.1% from the 6.1351 central parity, the level set by the People’s Bank of China each day around which the currency can fluctuate.

Punch George Magnus: China’s financial distress turns all too visible

(…) The incidence of financial distress is rising and becoming more visible. The recent drop in the renminbi, and the sharp fall in copper and iron ore prices are the latest high-profile manifestations of China’s changing outlook. These are not random developments or bad luck, but connected parts of a complex economic transformation with deflationary consequences for the world economy and skittish financial markets. (…)

Slowing economic growth, chronic overcapacity and rising debt service problems in key industries are becoming more common, raising the risk of chain defaults involving suppliers and purchasers. Overcapacity recently prompted a senior executive in the Chinese Iron and Steel Association, Li Xinchuang, to say the problem was so severe it was “probably beyond anyone’s imagination”.

In an industry survey by the State Council, 71 per cent of respondents said overcapacity in iron and steel, aluminium, cement, coal, solar panels and shipbuilding was “relatively or very” serious.

Last week’s market scare, however, was focused on copper, which has fallen nearly 15 per cent this year, and by more than a third from its 2011 peak. Falling prices have embraced a swath of both ferrous and non-ferrous metals, sending ripples from Perth to Peru. (…)

Large swings in market prices are happening also for murkier – and largely speculative – reasons that hinge on the use of copper and ore as collateral for loans, and as a means of raising finance abroad and bringing it onshore to spend or lend. As the authorities clamp down on credit creation and shadow financing, falling prices, including that of collateral, will expose participants to losses, and markets to the risk of distress selling.

Pointing up The transmission effects of lower prices into emerging markets and the global economy are most likely to prove disruptive, even if the positive real income effects for consumers eventually win out.

China’s economic transformation is happening regardless. Its leaders have choices only about how to manage it, and when to accommodate what is likely to be a painful adjustment. Sage advice would be to grin and bear it now, so as to avoid harsher outcomes later. But the political willingness and capacity to do so is unpredictable.

It is still possible that China will blink, raise infrastructure and housing spending and new credit creation, and lower bank reserve requirements and the renminbi. This would introduce a sharp twist to the underlying plot, but lead to a more dramatic conclusion. (Chart from Ed Yardeni)

‘Technical’ Recession in Russia Likely in 2Q-3Q on Shock to Investment, Demand

image(…) The investment plans of private companies, especially foreign-owned, are likely to be scaled down until there is more geopolitical visibility. This grants an
adjustment to our expectations of private sector capital expenditure growth from moderation to outright contraction. This, together with a less optimistic outlook for
residential investment — on the back of tighter monetary conditions — implies a downward revision to our expectation of overall investment this year from 2 percent
growth to a 3 percent contraction.

Capex cutbacks are likely also to affect consumers via hiring and wage intentions. The household savings ratio is likely to grind higher this year, which might shave
an additional 0.5 percentage points off consumption growth. We have lowered our consumer spending outlook to 1.6 percent. Domestic demand is likely to be brought to an almost complete halt this year, following 2.5 percent growth last year and a 6.8 percent gain in 2012. A persistent slowdown in domestic demand and continuous downward revisions to company sales expectations are in turn likely to keep the pace of destocking elevated through most of the year.

Altogether, we cut our GDP growth out-look for this year to zero percent from the 1.3 percent we previously expected, which essentially implies a technical recession over the second and third quarters. (…) (Vladimir Kolychev and Daria Isakova are economists at VTB Capital in Moscow. Via BloombergBriefs)

The U.S. only exports some $40B worth of goods to Russia. Europe, some $400B.

Chile economy shrinks, German prices, Italy exports drop
  • Chile: Gross domestic product in the fourth quarter missed forecasts, with the economy shrinking 0.1 per cent, compared with consensus forecasts for a 0.3 per cent rise. Year on year, the economy expanded 2.7 per cent compared with forecasts for a 2.8 per cent increase. For the whole of 2013, the economy expanded 4.1 per cent.
  • Germany: The wholesale price index dropped at the fastest rate in four months in February, recording a 1.8 per cent decline, a faster drop than both January and December. The Zew economic sentiment indicator decreased again in March, falling by 9.1 points in March to 46.6. However, it remains much higher than the historical average of 24.6 points.

      • “In this month’s survey the Crimea crisis is weighing on experts’ economic expectations for Germany. Nevertheless, the indicator’s level suggests that the economic upswing is currently not at risk,” said Zew president Clemens Fuest.

  • Italy: The trade balance showed that exports dropped 1.5 per cent overall in January seasonally adjusted from December, while imports dropped 1.6 per cent. To the EU, exports dropped 1.7 per cent, while imports rose 1.4 per cent, and to non-EU countries, exports dropped 1.2 per cent and imports dropped 5.3 per cent. However, the November-January three-month period paints a slightly better picture, seasonally adjusted from August-October, with exports overall rising 1.1 per cent and imports falling 2.1 per cent.
U.S SHALE RESOURCES

Remember when shale gas took off, naysayers were all over predicting that costs would be too high and/or the decline rates would be too swift? BloombergBriefs updates us, offering another example of what happens when the American entrepreneur spirit is let loose:

imageSince the North American shale-a-thon began, the producing industry has steadily improved drilling, production and well completion practices, dramatically lowering costs and expanding the economically recoverable resource. In the early days of the Barnett, for example, it took 25 to 30 days to drill and complete a horizontal gas well. Now, it takes 10 days. The trend is similar across more recent oil and gas shale plays in the Lower 48.

Besides drilling rigs now being three times faster, peak production rates on new shale wells keep improving, alongside average monthly U.S. production additions (Figure 4). These trends reflect both enhanced completion techniques and the fact that drilling targets are high-graded as the industry’s understanding of specific plays ripens over time.

MORE ON U.S. SMALL CAPS

Scotiabank Equity Research adds to yesterday’s piece on small caps:

U.S. small caps are expensive on all metrics we track (P/E, P/B, P/S, P/CF). On a forward P/E basis, the S&P 600 is trading at 19.9x forward earnings, which is
close to one standard deviation above average. U.S. small caps also appear pricey relative to other small cap benchmarks and relative to large caps.

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Our Combined Valuation Score (CVS) stands at the high-end of its historical range (blue bar in Exhibit 8). Our CVS is an aggregate of four valuation metrics and it highlights how these metrics deviate from their historical averages. We also overlay the S&P 600 performance 12-month out (red line). When the CVS hits elevated levels, the S&P 600 tends to have a more muted performance 12-M later. image

U.S. small caps are also the most expensive in the world in absolute terms.image

SENTIMENT WATCH

Thumbs down Of course, not all is rosy, as sentiment indicators are again reaching concerning levels of optimism, with the Ned Davis Research Crowd Sentiment Poll moving into extremely optimistic territory, which is typically a contrarian/bearish indication. And as we’ve noted, the last 13 midterm election years have experienced a substantial (typically first-half) pullback, with the average decline for the S&P 500 being 18.7% (thanks to Strategas Research Partners).

Thumbs up The good news is that equally consistent has been the rallies that have followed those corrections; averaging 32% for the 12 months after the correction’s finale. Our belief is that 2014 could also bring another decent-sized pullback, perhaps in the second quarter if history holds, but that we’ll end the year higher than we are now as economic growth accelerates in the United States and stabilizes globally. (Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.)

Gift with a bow A real treat (tks David): Watch as 1000 years of European borders change